Allison Schrager

Returning to 2% inflation may be harder than many think, and rates will likely range between 3% and 4%

Inflation in the United States has fallen to 3.5%, but it remains far above the Federal Reserve's target

Persistent inflation squeezes household purchasing power, especially when wages fail to keep pace with rising prices

Structural factors such as diminishing effects of globalization and technology, and an aging population, may make high inflation more persistent

The Bottom Line

Inflation may settle at levels above the Fed's target, squeezing household purchasing power and increasing volatility in interest rates and markets, while a return to 2% looks increasingly difficult.

The U.S. Bureau of Labor Statistics reported Tuesday that the consumer price index fell 0.4% in June, bringing the 12-month inflation rate down to 3.5%.

That's good news, but still not enough. Inflation remains too high. Even with the June decline, which is largely due to falling gasoline prices, the average inflation rate over the past three months was 3.8%, roughly double the Federal Reserve's 2% target.

Minneapolis Federal Reserve President Neel Kashkari recently stated what everyone knows: people hate inflation, which they have been enduring for more than five years, and every time they go to the grocery store, 'they feel they are falling further and further behind in keeping up with rising prices.'

No doubt. When wages don't keep up with inflation, people are hurt because their purchasing power effectively declines. Worse is the unpredictability, as consumers don't know how much goods will cost when they shop.

In finance, the value of an asset declines as the volatility of its returns increases. Unexpected inflation does the same to wages. Average real hourly wages, after accounting for inflation, fell by 0.33% in April, May, and June, compared with the average gain over the past 20 years, according to data compiled by Bloomberg. But while everyone agrees that inflation is too high and highly uncertain, no one wants to admit that this might be the new normal.

How long will we live with high inflation?

It may be forgotten that not long ago, policymakers desired inflation between 3% and 4%. For much of the 20th century, that level would have been considered a policy success. Then, throughout most of the 2010s, inflation remained below target, near zero, and seemed too low. That left central banks almost powerless to influence the economy. At that time, many policymakers and economists thought 4% inflation was better than 2%, as it gave monetary policy more room to be effective.

Companies also didn't mind, because high inflation allows for indirect wage cuts. When inflation is high during a recession, companies can reduce labor costs simply by withholding raises. That may seem bad, but it's still better than laying off employees.

Fed Chair: No leniency with high inflation.

The world is now receiving a harsh reminder of how much people hate inflation. It not only makes them poorer but also affects everyone simultaneously, unlike unemployment. Every healthy economy experiences some inflation because it's a sign of growth, but it's best kept at an ideal level: moderate, predictable, and bearable.

Why does 3% or 4% inflation seem high today?

What exactly is meant by moderate and bearable? An inflation rate of 4% or even 3% seems high because it is far above 2%. After about 20 years of low inflation, expectations have changed, and people expect inflation to be so low that they don't need to think about it. These expectations are reflected in wage increases, so even when the economy is booming, 4% inflation raises the bar for needed raises to keep wages in line with rising prices.

While indirect wage cuts can be useful when the labor market is in very bad shape, they are harmful at other times. Moreover, higher inflation leaves more room for volatility, and the accompanying uncertainty is as destructive as the inflation level itself. Finally, higher inflation also means higher and more volatile interest rates, adding more risk to financial markets and raising the cost of capital.

If economists have learned anything in the past few years, it may be that inflation above 2.5% is much worse than we thought. That's unfortunate, because the Federal Reserve may be unable to bring inflation back to that level. The central bank has insisted for years that inflation rates would return to target, but that hasn't happened.

True, the economy has faced policy shocks such as the pandemic, wars, and tariffs, but such shocks are part of economic reality. Perhaps the low inflation of the 2000s and 2010s was the result of deflationary pressures from technology and globalization, factors that may not repeat. Indeed, an aging population may actually lead to higher inflation. Once inflation expectations become entrenched, whether toward lower inflation as in the 2000s and 2010s or toward higher inflation as now, they are difficult to change.

What are the economic challenges of inflation?

A world where inflation ranges between 3% and 4% poses many challenges. First, the Federal Reserve still promises to bring inflation back to 2%. If it fails, its credibility will suffer, as will its ability to manage monetary policy in the future. Moreover, rising prices are a real burden on households, especially if wages do not keep up.

Finally, high inflation not only complicates the task of central banks but also of other policymakers in managing various risks. Some expect price pressures to ease if oil prices stabilize, or if artificial intelligence boosts economic productivity. That may indeed happen, but that bet is starting to look more like wishful thinking.

Not long ago, many economists believed that overshooting the Federal Reserve's 2% target might be better than undershooting it, or that the target itself should be 3% or 4%. Perhaps we should all realize how much better things were back then.

Columnist for Bloomberg Opinion. She is a senior fellow at the Manhattan Institute

Distributed by Asharq Bloomberg