Reaching The Fed’s 2% Target Will Cost America Big, New Research Shows

There’s inflation, and then there’s big, elevated, inflation, humongous out-of-control inflation.

And depending on which type you are fighting the impact on the economy will be different, new research shows. In America, the cost could be brutal.

“The U.S. will not experience a quick, low-cost transition from moderate inflation to the Fed’s two-percent target,” according to an National Bureau of Economic Research paper titled Disinflation and the Stock Market: Third World Lessons for First World Monetary Policy. It was written by Anusha Chari at the department of economics, at UNC Chapel Hill and Peter Blair Henry at the Hoover Institution.

The issue is that while American inflation is irksome, it is still relatively moderate, and squeezing down to the long-standing 2% target will dramatically hurt the U.S. economy, the paper suggests.

It highlights the matter in a couple of bullet points.

• “(1) the net present value of reducing high inflation is positive;”

What that means in non-economics speak is that if you live in a high inflation country like Venezuela which had an official inflation rate of 1200% last November, then reducing the level of inflation adds value to the economy.

According to the researchers, crushing inflation in a high inflation environment would result in 12-month stock returns on average of an additional 48% versus normal as investors anticipate more moderate inflation.

The second bullet gives markedly different results.

• “(2) the net present value of reducing moderate inflation is negative;”

That means that at country such as America with mid single digit inflation and not four-digit price rises like Venezuela had, the the cost benefit payoff is bad. How bad? Well on average stock returns were minus 18% (versus normal) when a central bank tried to reduce modest inflation to 2%. Put another way, investors see little but pain ahead when the central bankers push hard for an ultra-low inflation target.

Despite these findings the Fed seems determined to hit its 2% target regardless of the economic pain that’s likely to manifest.

The authors conclude by emphasizing the problem: “There is no historical precedent for a painless return from moderate to low inflation,” the paper states and adds that a fast return to lower interest rates is unlikely. “Policymakers—and financial markets—ignore this lesson at their own peril.”