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Why the Federal Reserve wants to see more inflation

Annie Baxter Dec 12, 2014

If you’re one of those people out there worried about inflation, the Bureau of Labor Statistics has a message for you: Don’t sweat it.

The bureau’s gauge of prices at the wholesale or producer level showed a gain of just 1.4 percent over the year ending in November. That’s the smallest annual increase in months.

Prices aren’t growing much faster for consumers, either.

Though the Federal Reserve has set an inflation target of 2 percent, we’re just not there.

But why do we need inflation at 2 percent, anyway?

“A little bit of inflation seems to be the sweet spot,” says Robert Dye, chief economist at Comerica Bank.

Dye says if prices get too high, consumers lose confidence and wealth — they have to spend too much on goods and services. But if prices plunge too low, businesses lose money and may go bankrupt.

Still, why is 2 percent the sweet spot?

“Nobody really knows what the right number is,” says Alan Blinder, an economics professor at Princeton University and former vice chairman of the board of governors of the Federal Reserve System.

Blinder says even if the 2 percent target seems random, there’s a lot of consensus around it; other central banks use it, too. Blinder says part of the reason for picking that number  and sticking with it  is just to create clear expectations about how fast prices will rise. You don’t want to keep changing the target, which he says, would confuse people, “as if the length of the yardstick was changing every year.”

But some economists say you also want to avoid falling consistently short of that target, which has been happening in the U.S.

Blinder argues that’s a sign the Fed should keep stimulating the economy  to try to nudge the inflation rate up a bit.

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