Are you worried about inflation? Don’t be

Last summer, the Fed switched to “average inflation targeting.” The Fed’s main goal is to ensure that the PCE inflation will average around 2% over the long term and that future overshoots will compensate for any short-term discrepancies.

Although a starting point is not specified, we can assume that January 2020 is the beginning. Therefore, according to the Fed’s target, inflation should average 2% in the 2020s.
Let’s look at TIPS, a rough representative of bond market inflation forecasts:

These rates roughly represent the expected PCE inflation, as TIPS holders are compensated according to the CPI, and the CPI inflation rate tends to be about 25 basis points above PCE inflation.

There are two reasons why the TIPS spread is consistent with Fed credibility. First, what I said regarding the CPI PCE inconsistency is backward. Markets may expect the difference to be slightly lower going forward.
Secondly, there is a possibility that traditional bonds are slightly more liquid than TIPS and therefore can be sold with a slightly lower expected return, making real market inflation expectations underestimated somewhat.

The Fed predicts 2.4% PCE inflation for 2021. TIPS markets show that investors expect 2% PCE inflation in 30 years and slightly higher inflation in the next five years. All of this is consistent with the Fed’s AIT framework as some compensation is required to exceed 2% inflation in 2020. Due to AIT, the economic recovery will likely be much faster than during 2009-19.

This is a success. Of course, I prefer NGDP targeting more and if they need to target inflation, I would prefer PCE targeting, but even the successful implementation of AIT would be pretty good compared to the 60s, 70s, 80s, and 2010s.

So what will the Fed do in the 2020s? Will inflation be on average 2% or more? Currently, the markets expect a modest increase in the next 5 years to compensate for the low inflation in previous periods. And then roughly 2% inflation. Isn’t that what the Fed says it wants?

If the markets think that this outcome will require higher interest rates than the Fed currently sets, I don’t think it is correct to interpret this as a lack of policy credibility and I prefer to describe it as a difference of opinion. If markets did not expect inflation to average 2% in the 2020s, we could speak of a lack of policy credibility. However, these rates show that confidence in the Fed has increased. Moreover, maybe it would be much better to act a little more “irresponsible.” The Fed was too “responsible” for a long time.

Some fear that all this could get out of hand at some point and result in higher inflation than it should have been. There is a way to see this:

If we experience high NGDP growth during the 2020s (i.e. More than 4%), we will have high inflation. If there is 4% growth, there will be moderate inflation. If we have less than 4%, the Fed would be below its target. It’s all about monetary policy. When it comes to inflation, fiscal policy doesn’t matter. Fiscal stimulus does not matter. And markets are optimistic.

Will the Fed give us 2% inflation in the long run, or are they a bunch of liars? I’m trusting them right now, but we’ll see.

P.S: David Beckworth and Ramesh Ponnuru has an excellent piece about this issue:

The evidence that high inflation is on the way is weak. It’s too weak, actually: An economy on the verge of a robust recovery would be showing more signs of rising inflation. Right now, inflation appears more likely to stay below its optimal level than above.

Read the whole thing.

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