Maybe markets should forget about 'transitory'
Stubbornly higher inflation doesn't mean the Fed's wrong ... yet.
The Fed considers 2% inflation to be optimal because it balances its dual mandate of price stability and maximum employment. The problem is that, before the Fed adopted FAIT in August 2020, if inflation started to rise toward this 2% level, the Fed typically would begin raising rates to slow inflation to prevent it from overshooting the 2% target. In practice, this strategy kept inflation from reaching 2% throughout the post-global crisis recovery and expansion, hampering economic and employment growth, particularly in low- and moderate-income communities that are now higher on the Fed’s policy radar. So, policymakers adopted FAIT as way to play catch-up, largely on worries a sub-2% inflation world could lock the economy into a self-reinforcing disinflationary spiral, undermining its growth potential and making it more difficult for policymakers to use tools that can help it attain—and maintain—its desired 2% inflation target.
Prices for most everything are up—gas, housing, cars, appliances, oil, natural gas, food (have you priced a good steak lately?), toys (if you can find them). Wages are climbing fast, too—average hourly earnings rose at a 6% annualized pace the past six months. Virtually every broad measure of inflation is running at multidecade highs. But while the Federal Reserve (Fed) may have gotten more than it wished for—inflation above 2%—it’s too early to call “policy mistake.’’ Earlier this year the Fed said it expected inflation to run hot as the economy pulled out of the pandemic recession, but was vague about for how long, saying only pricing pressures likely would prove “transitory.”
The question is, how long can inflation run hot? Possibly a lot longer than some investors think. Remember, when the Fed a year ago laid out its new flexible average inflation targeting (FAIT) regime, it did so because it wanted inflation to run a little hot. It was—and is—seeking to lift average long-term PCE inflation to 2%, a level until this year that it had failed to meet for more than a decade. What it didn’t say is how far it was looking back to compute this long-term average. 10 years? 5 years? Less? This matters because the longer the Fed looks back, the longer it could let inflation run above 2% without feeling compelled to start reining it in. Since the depths of the global financial crisis, average PCE inflation ran well below 2% before this year. That’s a lot of ground to make up to lift the long-term average to 2%, if indeed the average goes back that far.
The recent spike in inflation should be viewed in this context. While there are reasons to wonder if inflation will moderate anytime soon—froth is coming off some transitory reopening components but the shelter-inflation upswing has begun and supply chains remain clogged—it’s too early to say whether some of these pressures will prove more structural than temporal. That is, the Fed’s FAIT strategy is being tested, and the test isn’t over yet. While FAIT doesn’t explicitly define the time frame over which inflation is averaged, September’s policy meeting and minutes provided clues. Policymakers projected PCE to average 4.2% this year before tailing off to 2.2% next year and in 2023 and 2.1% in 2024. Their dot plot also indicated the first rate hike could come before the end of next year. Consumer inflation expectations suggest a longer period of rising prices, with the latest New York Fed survey putting medium-term inflation expectations—those for three years out—at 4.2%, the highest since the series started in 2013. Short-term expectations are at 5.3%, also a new high. So, there are reasons to believe inflation risks are to the upside and will continue to challenge central bankers’ ill-defined “transitory” view. One way or the other, time will tell.