The new image of inflation

BERKELEY – At the beginning of February 2022, the equilibrium rate of inflation for the five-year Consumer Price Index (CPI) in the United States bond futures market was around 2% per year, an index that corresponds to a forecast chain-weighted personal consumption expenditure (PCE) inflation rate of 1.6% per year over the next five to 10 years. Given that inflation of 1.6% is well below the 2% target of the US Federal Reserve, in that month I felt very good about being on the “Transitional Team”, or at least on the “The Fed Will Team”. has” or the “Team Inflation expectations remain solidly anchored”.

But then, late that month, Russian President Vladimir Putin, the would-be Grand Prince of Muscovy, ordered a hit-and-run invasion of Ukraine. Things did not go as he had planned. The Ukrainians fended off the initial attack and both sides prepared for a longer war of attrition. The prices of energy, grains and fertilizers skyrocketed. The world began to worry that come winter, Europe would freeze over and many other countries, from Egypt to Nigeria, would starve.

Due to these fears, the five-year forward CPI inflation rate soared from 2% per annum to its peak of 2.67% on April 21, 2022, while annual PCE inflation expectations within from five to 10 years they reached 2.27 percent. That PCE projection suggested that bond traders had not lost confidence in the Fed’s commitment to its inflation target.

But assuming the Fed’s target range spread to be 0.6 percentage points means that the bond market expects the central bank to stay on target if five-year CPI inflation, five years ahead, rises. maintains between 2% and 2.6 percent. That April 2022 peak projection raised concerns. For those whose hair was already on fire, there was every reason to fear that we were just one more big supply shock away from losing the inflation expectations anchor that has kept prices relatively stable for decades.

Maybe we were, but since we didn’t get that extra big adverse supply impact, it doesn’t matter now. The PCE chain inflation rate for November was just 0.16%, which is less than 2% per year when multiplied by 12. Surely one swallow doesn’t make a summer and one data point doesn’t make a trend. Even the fall of 0.62% in June (7% annual) is not necessarily bankable. After all, we also saw some declines between December 2021 and April 2022, and between August 2021 and December 2021.

As I said before, this pandemic business cycle has been one of those rare periods where I haven’t been envious of the members of the Federal Open Market Committee (FOMC). What they do over the next six months won’t really affect the real economy of demand, employment, and output for a year, and it won’t significantly affect the inflation news for a year and a half. There will be a lot of new developments in the next 18 months, some good and some bad.

Whatever the Fed decides to do, it will almost certainly regret it later. Will it continue to exaggerate interest rate hikes? If so, the economy will, two years from now, be mired in secular stagnation again, with interest rates at their zero lower bound and no visible path to a rapid return to full employment. Will the economy achieve a “soft landing” through immaculate disinflation, or will further political pressures and supply shocks lead us into stagflation and a painful and prolonged recession?

Nobody knows. But if I were at the FOMC right now, I would have two considerations in mind. First, the Fed doesn’t have to move slowly. The last six months have shown that there are very few downsides to quick monetary policy changes. Up until this month, the Federal Reserve was raising interest rates by 75 basis points at a time, and even that rate isn’t a rate limit. The FOMC should take advantage of this apparent optionality. When the situation is unclear, you can pause, confident in knowing that you can move very quickly when the situation clears up.

Second, in hindsight, former Fed Chairman Alan Greenspan’s 1996 decision to set the inflation target at 2% per year was wildly ill-advised. Yes, there can be substantial benefits to maintaining and strengthening the credibility of the Federal Reserve by getting the economy back to the 2% annual target, even if that target is raised in the medium term. But is that really the kind of credibility the Fed wants to have? Is it a good thing for markets to think they will stick with policies that no longer fit the new circumstances, just because they said they would? Once again, I do not envy the members of the FOMC this winter.

*The author is a Professor of Economics at the University of California, Berkeley, a Research Associate at the National Bureau of Economic Research, and the author of Slouching Towards Utopia: An Economic History of the Twentieth Century. He was US Deputy Assistant Secretary of the Treasury during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in engineering Mexico’s bailout during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies and cemented his stature as a leading voice in economic policy debates. .