May 12, 2023
“From the perspective of monetary policy, our focus remains squarely on our dual mandate to promote maximum employment and stable prices for the American people. My colleagues and I understand the hardship that high inflation is causing, and we remain strongly committed to bringing inflation back down to our 2 percent goal.
That’s a quote from the official statement Fed Chair Jay Powell reads after every FOMC meeting. It’s boilerplate copy (or at least has been for the past year and a half). And he pretty much leads every statement with it (with the exception of last May’s when he opened by telling everyone the banking system was sound).
If you read the financial news at all, I’m sure you’ve heard of the Fed’s “2% inflation mandate.” From the way they talk about it, you’d think it was carved into a stone tablet. Or at least backed by some NASA-level math that says 2% inflation is optimal for economic growth.
When asked at a press conference last December about the possibility of changing their 2% target, Reuters quoted the chairman as saying:
“We’re not considering that. We’re not going to consider that. Under any circumstances,” Powell said. “We’re going to keep our inflation target at 2%. We’re going to use our tools to get inflation back to 2%.”
So 2% it is. But what’s the magic of 2%? And how does it really affect the Fed’s actions?
Let’s take a look…
The History of the Magic Number
So where did the magic 2% number come from?
The idea of an inflation goal goes back to a 1978 amendment of the Employment Act of 1946 that became known as the Humphrey-Hawkins Act. The act stipulated that the nation should work toward four specific goals: full employment, growth in production, price stability, and balance of trade and budget.
Originally the president was given discretion to set those goals. Congress and the Fed were brought in later.
Over the years, the idea of price stability, i.e. consistent inflation, went from 4% in 1983 to 0% in 1988.
On January 25, 2012, the Fed officially pronounced:
The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.
But understand that 2% isn’t strictly 2%. The Fed doesn’t consider it a hard target or a ceiling of any kind. Instead, as they further explained in a 2016 addendum to their 2012 2% pronouncement, it’s a “longer-term” projection:
The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates…
So it’s not exactly 2%. It’s whether inflation is “running persistently above or below this objective.” So what is “persistently?” Six months? Twelve months? No one knows.
In July of 2021, they came back and announced a new “monetary framework:”
The Federal Reserve now intends to implement a strategy called flexible average inflation targeting (FAIT). Under this new strategy, the Federal Reserve will seek inflation that averages 2% over a time frame that is not formally defined. This means that after long periods of low inflation, the Federal Reserve will not enact tighter monetary policy to prevent rates higher than 2%.
It’s just a little ironic that just as inflation was getting off to the races, they were enacting a new policy that would let it exceed their 2% target for an indeterminate time frame.
In any case… 2% isn’t really the “target” they make it out to be.
And Why 2% Anyway?
There are a number of countries around the world that also maintain a 2% inflation target. Which would seem to give the number the appearance of being a widely accepted notion. (If everybody’s using it, it must be important.)
The closest anyone has ever come to explaining the basis for it is by saying it is as close to zero inflation as they can reasonably get without risking a deflationary turn. (Negative inflation is what’s known as deflation and that usually accompanies deep economic recessions or depressions.)
But the truth is… There’s no actual reason for it.
Economist William Spriggs — the former chair of the Howard University Department of Economics and Assistant Secretary for Labor Policy in the Obama administration — has come right out and said so…
“There’s nothing written in stone that says inflation is supposed to be limited to 2%. That target was not the result of an economic model that says 2% inflation is the ideal inflation.”
Bank of America economist Ethan Harris backed this idea up saying there’s little to suggest that 2% is any kind of optimal target. In fact he argued:
“The evidence is that steady 4% inflation imposes very small additional costs compared to steady 2% inflation. Either way the economy adapts.”
That’s not exactly politically persuasive talk, but he’s not necessarily wrong. I’ll come back to this in a second. For now let’s take a look at the more practical implications of inflation targets and interest rates…
Inflation, Interest Rates and You
Take a look at the chart below. You can clearly see how interest rates across the yield curve tend to move in tandem with inflation (represented by the CPI).
Something else you can clearly see is that for most of this time, interest rates have traded above the rate of inflation. This is what you would expect in a reasonably healthy economy. I’ve talked about this before as well, but when inflation exceeds nominal interest rates (or wages or whatever) the real value of those returns goes negative. In other words you’re losing money.
Two times in this 50 year span we’ve seen inflation get out of control. Back during the “great inflation of the 1970s and 80s and today. Let’s zoom in for a closer look…
Between 1972 and 1974 you can see inflation (the purple line) start rising, eclipsing 10-year rates. Fed funds were finally pushed above inflation causing it to fall back below market yields (with the help of a recession). But inflation reignited in 1977 and again outpaced all other interest rates on the upside. It wasn’t until then-Fed Chair Paul Volcker let fed funds off the leash (and pushed the economy into not one but two recessions between 1980 and 1983) that it was finally brought under control.
During that time you can see what happened to bond investors’ returns. Here’s the 10-year versus inflation (the green line the net of the two rates or… real returns).
Here’s the two-year versus inflation
Even overnight rates…
What’s worse, you can see that real rates have been near zero or negative pretty much since the “Great Financial Crisis” back in 2007.
So what’s the takeaway?
Wealth has been stolen from the investing public for the past 15 years. And it’s likely this bout of secular inflation doesn’t come fully under control until the Fed can normalize REAL interest rates. (Free money can’t support an economy indefinitely.)
Another Problem Rearing Its Head
Forgetting the banking crisis for a second and focusing on inflation, the Fed would appear to be making progress on that front.
The latest 25 basis point hike to a 5-5.25% target range, puts funds just above last month’s headline PCE (the Fed’s preferred and notoriously flexible inflation measure as previously explained here) print of 4.2% (for March). Headline CPI for April was 4.9%, essentially flat. So while they’re not “crushing” it, they have finally managed to get the funds rate back just above inflation.
But that’s all. Longer term rates haven’t followed. The 10-year yield is trading near 3.5% while the 2-year is just under 4% — still well into negative territory where real rates go.
Overall the Fed is by no means out of the woods. In fact, looking at the chart from the 70s-80s, they appear to be closer to the first peak than the second that finally did inflation in. (Incidentally, over the 10 year period when inflation was flying in the late 70s, inflation averaged 9% a year.)
And the clock is ticking on their efforts because another development may be threatening any potential success.
A couple sections back, I wrote that economist Ethan Harris noted that there was little difference between a 2% and 4% inflation target. He said either way the economy adapts.
That observation is starting to show in the market. The Wall Street Journal just reported…
The article explained that America’s previous obsession with inflation has begun to fade. It cited a recent Gallup poll in which only 9% of responses named inflation as the most important problem the country is facing.
Its slide down the scale of importance, now ranking somewhere between government leadership and immigration and gun issues, suggests that people may actually be waving the white flag and surrendering to the idea of permanently higher inflation.
In addition to the polls, this shift in expectations has also shown up on the supply side. Goods and service providers are finding that they can hike prices with minimal downside:
In earnings reports, companies complain a lot less about input costs or labor shortages; they do report effortlessly raising prices. The new buzzword among chief financial officers is “elasticity”: how sensitive sales volume is to price increases. The less sensitive, the better for companies. “Our elasticities remain favorable on an aggregate basis,” Procter & Gamble Chief Financial Officer Andre Schulten said last month, describing a quarter in which the company’s sales volume dropped 3% from a year earlier while it raised prices about 10%.
The central bank’s inability to anchor inflation expectations at the magic 2% does significant damage to their credibility. Right now, according to the New York Fed, inflation expectations one year out are still at 4.4%. This is a problem for them.
(The truth is the damage is done. I’ve said before, even if the Fed does get the rate of inflation back to 2%, you’re still paying prices 20-plus percent higher than you were just a couple years ago.)
Nevertheless… The Fed is going to have a rough decision to make.
They can kill their sacred 2% cow and find a way to justify a higher inflation target for a longer period of time. This is a definite possibility. In the Reuters article I cited above, Powell…
…allowed “there may be a longer-run project” that could take a fresh look at the central bank’s inflation goal.
But moving the inflation goalposts doesn’t really get the job done.
On the other hand, they can keep pushing rates higher (above the rate of inflation) until a recession does.
Not a great set of choices.
Make the trend your friend,
Bob Byrne
Editor, Streetlight Confidential