NEW YORK (TheStreet) -- Inflation is one of the most important factors considered when the Federal Reserve decides whether or not to change interest rates. Understanding the importance of inflation helps one understand why the Fed does what it does and why it keeps a keen watch on a very low or a very high inflation rate.
Moderate inflation is good for a healthy economy but target inflation rates differ across different economies. The Federal Reserve has held its interest rate close to zero for a long time but the inflation still remains below target levels. While the Fed remains sure about reaching its target inflation rate of 2% in the long run, it remains cautious of its next move. Janet L. Yellen said in a recent speech at the University of Massachusetts at Amherst that as the labor markets improve, inflation is expected to follow. However, if the Fed's expectations for growth remain disappointing again, it may postpone an interest rate hike.
Here are five basic things you should know about inflation-- and below are five more:
1. How does a "Zero Interest Rate Policy" affect inflation?
When rates are kept too low or close to zero, there should be a legitimate fear of high inflation in the economy. Theoretically, the easier and cheaper it is to borrow money, the less money is worth, driving up the real cost of goods and services. Over a period of time, a high inflation rate can reduce the nation's capacity to make economically correct decisions in the long run.
Holding zero interest rate policy for long is not a good thing, but many factors can influence the decision of raising interest rates. If interest rates have been kept low for too long, it could overheat the economy, leading to high inflation.
After two decades of slow growth, the Bank of Japan resorted to a zero interest rate policy so as to combat deflation and encourage economic recovery. The central banks of United States and United Kingdom also implemented similar policy after the Great Recession.
2. Is there any "ideal" inflation rate -- and how much is too much?
An ideal inflation rate is one that helps in maximizing the economic well-being of the public. This varies over time and between economies.
Deviations of inflation between what is actual and what was expected can be confusing. Yellen, in her speech at UMASS, the Fed chief pointed this problem out. She mentioned, "Economists' understanding of the dynamics of inflation is far from perfect." However, changes in monetary policies can somewhat help in controlling a very high or a very low inflation.
High inflation rate can be catastrophic for the economy. Persistent high inflation can affect household budgets and discourage business by increasing the after-tax cost of capital. Prices are adjusted more frequently in businesses that can in turn affect inflation expectations.
3. Why is low inflation bad for the economy?
A very low inflation is likely to postpone purchases, leading to slow consumer spending and investment. When prices of goods and services do no rise as expected, then sales and wages will remain low as the companies will not be earning increasing profits. Companies, households and even governments have a harder time paying off debts. A prolonged low inflation can also lead to deflation that if prolonged can restrain consumer spending further leading to a recession. In other words, an excessively low inflation can be as damaging for an economy as high inflation. According to The Fed chief, "The most important cost is that very low inflation constrains a central bank's ability to combat recessions."
4. Why is the current inflation so low?
The current inflation has run well below the target rate and the reasons are "falling prices for energy and non-energy imports, that have helped in keeping consumer goods and imports cheap, Yellen said in her 40-page speech. However, she further mentioned that as factors holding down inflation gradually disappear, a rebound should be expected as these temporary conditions diminish.
In her speech she states, "as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored."
5. What is the current situation of Fed interest rates?
The Fed does not respond to market turbulence, but it's decisions are affected by certain concerns like a strong dollar, falling oil prices and a bleak global economic outlook that together significantly affect the U.S. economy. Even though, the interest rates governed by the Fed have been kept close to zero for a while, inflation still remains below the Fed's target rate of 2%, owed to the "temporary effects of falling prices for energy and non-energy imports".
According to Nobel Laureate, Joseph E. Stiglitz, "The usual argument for raising interest rates is to dampen an overheating economy in which inflationary pressures have become too high. That is obviously not the case now."
However, Yellen remains optimistic about inflation getting back to its target over the next few years. The Fed chief mentioned that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year but "if the economy surprises us, our judgments about appropriate monetary policy will change".
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.