The long-anticipated hike in US Fed base interest is likely to slow the pace of expansion in the broader economy, and while the robust increase in Q2 GDP of 3.7% allows for such amove, the ongoing appreciation of the greenback, whilst causing additional deflationary pressure, might turn out to be a heavier blow to economic activity.
The most recent inflation figures for July have shown the weakest annualized increase in prices since March 2011, at 1.2%, while monthly price gain has been nearly flat for four consecutive months, at 0.1%.
The Fed outlook is painting a brighter picture, as outlined by Vice Chairman Stanley Fischer on Saturday, with inflation allegedly gaining momentum due to the fading negative impact of the dollar's appreciation, however, that is hardly the case.
International markets are still anticipating a hike in US borrowing costs and investors are buying into the dollar, allowing the US currency to strengthen further and impairing US inflation. Until the Fed makes a move, this pattern is unlikely to change.
However, in order to change that, US monetary authorities could tweak their inflation target, moving it higher, from the current 2% up to 3-4%.
Recently, President of Boston Fed Eric Rosengren, along with his Minneapolis colleague Narayana Kocherlakota put forth the idea of lifting he US Fed inflation target to 4%, a move, they argue, allowing more room for rate cuts in case of future crises.
It is true that implications in US monetary and fiscal policy (with near-zero base interest and a heavy debt burden at 75% GDP) render the nation exposed before a possible global economic turmoil. This is the reason the US Fed is so eager to hike base interest this year.
However, would a higher inflation target help real economic expansion, if combined with several consecutive hikes in borrowing costs? It is hardly so.
That said, lifting inflation targets could help inflation sometime in the nearest future, but its immediate effect for real economic expansion in case of a simultaneous rate hike would affect no more than 0.1% of GDP dynamics.
Current US inflation is weak, and anything more that a symbolic hike in borrowing costs might cause moderate deflation, effectively eating away at economic growth.
An immediate rise in inflation targetsmight have contributed to the acceleration in real inflation to just above 2% by late 2015, allowing for a harmless December hike. Unless the Fed acts in such a manner, a potential mid-September or October hike will severely maim a Q3 economic expansion.