We think that the Federal Reserve’s current cycle of rate hikes has peaked at a range between 5.25% and 5.5%.
While inflation stands well above the Fed’s official 2% target, we think that because of the economic and political shocks since the pandemic, the Fed will raise its inflation target in the coming years to a range between 2.5% and 3%.
We expect the Fed to hold its policy rate steady at 5.25% to 5.5% at its meeting next week.
We expect the Fed to hold its policy rate steady at 5.25% to 5.5% at its meeting next week and would advise the Fed to begin shaping expectations about a likely cyclical peak at that range.
Policymakers and investors should expect the Fed’s interest rate outlook, or dot plot, to reflect a modest shift toward that likely peak.
In addition, we anticipate that the Fed will raise its forecast on growth this year and lower its expectations of unemployment and inflation in its Summary of Economic Projections, to be released at the meeting.
Although we do not expect any change to the long-run rate forecast, it is highly probable that one of the Fed’s major narratives for the rest of the year is how long it will stick to the 2% inflation target given the major economic changes occurring domestically and globally.
The Fed’s inflation target
We contend that a changing geopolitical landscape, shifting trade patterns and structural changes in the economy require a rethinking of inflation targeting, at least in the short term.
The rigidness of the 2% target that held for so long is no longer applicable in an era of profound change in the labor market, the global supply chain and constrained supplies of energy, food and housing.
For this reason, we suggest that a more flexible target of 2.5% to 3.0% is a better fit. We show this to be a reasonable objective, given current trends in price stability and the need to incentivize investment and economic growth.
Is 2% realistic?
But after nearly two decades of an implied and then official 2% inflation target, how do we get there?
The argument against modifying the target centers on the Fed maintaining its credibility after so many years of defining price stability as the 2% inflation rate. The consistency of Fed guidance is a crucial element for financial and economic stability, so considering this change does not come lightly.
We suggest an incremental approach as the Fed quietly raises the tolerance level for inflation to a 2.5% to 3.0% range while keeping its policy rate at 5.5%.
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That pause would be followed by a series of reassessments in recognition of the now-frequent shocks that have affected global price stability and the global supply chain.
For example, an increase in the inflation target might better reflect the constraints on food that we expect until the war in Ukraine ends. It would also better reflect the higher cost of energy while Russia and the Middle East control the supply of fossil fuels, which affects prices of all other goods. Finally, a range of 2.5% to 3.0% might better reflect the short supply of affordable housing.
While none of these issues are intractable, neither the Fed nor the administration has control over Russia’s interference in the food supply chain.
While consumers can adjust their demand for gasoline in the long run, there is little choice in the short run, particularly for low- and moderate-income households. In addition, it will take more than a few months for the supply of housing to catch up to demand.
Finally, recognition that the 2% inflation target might no longer be realistic would help to moderate the volatility and distortions in the bond market, and increase the willingness to borrow and lend.
There is much to be said about the benefit of a 2% inflation target. It was prescient when it was formally adopted in 2012, correctly anticipating the development of Asia’s productive capacity and the crash of energy and commodity prices in 2014-15.
In fact, the disinflation and threat of deflation that characterized the decade-long recovery from the financial crisis made the 2% target a lofty goal for getting the economy back on its feet.
The Fed’s preferred measure of inflation—the personal consumption expenditures index—moved above its 2% target in only 11% of the months between 2012 and last year.
Those were different times: Anemic economic growth, falling real wages and the availability of cheap goods from Asia all resulted in a low-inflation regime.
Moving beyond 2%
We see the multiple shocks since the pandemic as being unique, having created the potential for an economic shift in structure. We expect to see the effects of a new generation of technological advances, the continued evolution of work preferences, and the expansion of production initiatives all coming at a time of drastic geopolitical changes.
For example, while the shale revolution has not proved to be the antidote to OPEC’s dominance in oil, technological advances are providing a realistic option for energy supplies. Roughly a quarter of electricity in Texas (the nation’s top producer of oil and gas) is now generated by renewable sources, with more to come.
While the outsourcing of manufacturing to Asia turned into a logistic nightmare during and after the pandemic, American industrial policy and infrastructure investment are laying the groundwork for higher-wage employment and a reduction in income inequality.
These advances are already becoming evident. We can now associate price stability and full economic potential with minimal levels of unemployment.
Because of recent shifts in labor mobility, higher wages and changing employment preferences, the headline unemployment rate has averaged 3.6% over the last 12 months, with the estimate of the natural rate of unemployment dropping from the 5% rule of thumb to 4.4%.
Before the inflation surge last year, there were even hints that the Fed would allow the inflation rate to move above 2% to counteract the previous decade of disinflation.
But with oil prices having reached $120 a barrel last year and once again rising, the Fed seems determined to push inflation down to 2%.
By any measure, the Fed’s track record of adhering to a 2% target for so many years is remarkable. Even after the recent spike in prices, inflation expectations hover around 2.3% over the next 10 years.
We are calling for the Fed not to eliminate the target altogether but instead take more time in getting there. Moving to a target of 2.5% to 3% is more like an acknowledgment of the elephant in the room, and of the immediate need to nullify the influence of Russia and OPEC on food and energy prices.
Inflation in the post-pandemic era
Inflation is determined by the supply and demand for goods and services. For most consumers, that becomes apparent in the relationship between inflation and gasoline prices and the price of food.
It is unlikely that prices of food, energy or shelter would have reached their current levels without the pandemic or the war.
Higher prices in the post-pandemic era were a result of the recovery of demand for energy in late 2020 as vaccines became available, and then in late 2021 when it became apparent that Russia would invade Ukraine.
The same goes for the cutoff of food supplies from Ukraine during the war. We should also note the increased costs of specific goods during the period of supply chain disruptions, with shortages of computer chips affecting the cost of used cars being a prime example.
While consumers can shift to lower-priced food, energy is a different story. The high cost of substitution allows a limited number of efficient producers of crude oil in Russia and the Middle East to restrict supply and raise prices.
Finally, rents of shelter are the largest component of consumer expenditures, and those costs have soared as the pandemic changed work-life requirements.
It is unlikely that prices of food, energy or shelter would have reached their current levels without the pandemic or the war.
While few are advocating a full-out 1980s recession to crimp demand, the alternative of publicly pushing for higher prices to change consumption choices would be equally distasteful and disastrous politically. The alternative is to quietly hold the federal funds rate at 5.5% for the time being.
Determining the sweet spot for inflation
Inflation can be thought of as a regressive tax that affects low-income households the most. Families at the bottom of the income ladder are less likely to hold assets whose value will increase along with inflation. (Real estate is the most common asset.)
Instead, low-income households hold cash, the buying power of which deteriorates as inflation increases.
Inflation can be thought of as a regressive tax that affects low-income households the most.
But that is not to say we should strive for zero inflation. There are other ways to reduce inequality.
As the economist Thomas Piketty says, zero inflation does no one much good. He points to the paucity of pre-industrial rates of growth when inflation was more or less nonexistent. Still, Piketty stresses, inflation is inegalitarian, inflicting the most damage on those who can least afford it.
This best explains why Federal Reserve Chairman Jerome Powell frequently talks about protecting the balance sheets of low-income households by squashing inflation.
The same logic applies to the necessity of a non-zero equilibrium unemployment rate. In the best of times, there will always be a segment of the labor force that is out of work.
As the former Federal Reserve Chairman Ben Bernanke said in a speech in 2010, “Because a healthy economy must allow for the destruction and creation of jobs, as well as for movements of workers between jobs and in and out of the labor force, the longer-run sustainable rate of unemployment is greater than zero.”
Closing the argument for the Fed’s dual mandate for full employment and price stability, Bernanke added that “the inflation rate that best promotes our dual objectives in the long run is not necessarily zero” and that Fed policy “participants have generally judged that a modestly positive inflation rate over the longer run is most consistent with the dual mandate.”
For policymakers, the advantage of nonzero rates of inflation and higher nominal interest rates is the greater ability to react to higher inflation or unemployment.
If the policy rate and nominal interest rates were stuck at near-zero, there is little the Fed could do to clamp down on an overheating economy.
Likewise, with interest rates near zero, there is little room for a policy response should demand plunge and the economy grind to a halt.
With respect to the relationship between economic growth and inflation, since the 1980s both the economy and inflation have settled into a 2% groove, notwithstanding bursts of activity from time to time.
The Fed’s mandate, after all, is price stability, not zero inflation. Excluding the periods of shortages during the pandemic shutdown and the dramatic drop in demand, a modest rate of inflation normally implies increased demand for new products and changes in personal choice that become the catalyst for growth.
Imagine if society allowed only flip phones because their prices had dropped to $20. Yes, that would have kept inflation even lower than what it was. But we would much prefer our more capable iPhones.
Inflation and the return on capital
The difficulty in generalizing the effects of inflation on the return on capital is that investment preferences change according to circumstances.
For instance, in the 21st century, Piketty reports 4% to 5% rates of return on real estate, the same as the pre-industrial return, but with a far greater expectation of profit when selling the property. Piketty also mentions that higher average returns are required for business investments because of increased risk.
During the decade of near-zero interest rates, the 2.25% average yield on a risk-free 10-year Treasury bond was less than the 2.5% average annual increase in the consumer price index, which leads to the importance of inflation and inflation expectations in the investment-decision process.
Positive rates of inflation imply that debt will be repaid in deflated values of the dollar. In broad terms, if the interest rate on a 10-year loan is 4.25% and if the expected rate of inflation is 2.25% over the 10 years of repayment, that implies a real, or inflation-adjusted, interest rate of 2%.
The yield on Treasury Inflation-Protected Securities is currently about 2%. The trend in TIPS yields exemplifies the extremely low and negative inflation-adjusted interest rates during the decadelong recovery from the financial crisis and then again during the trade war and pandemic starting in 2019.
During this extended period of low growth, low inflation and artificially low interest rates meant to promote growth, estimates of the natural (real) rate of interest dropped to less than 1%.
With inflation so low, and with low rates of return on investment, the choice was between holding onto cash or taking more risk.
For instance, while inflation has been centered on 2.5% per year from 2010 to today, a buy and hold equity-market strategy has grown at an average annual rate of 11%. That implies a real return of 8.5% per year.
The point here is that while the returns on speculative investments are great for some, those investments were not necessarily promoting economic growth.
That takes us full circle to the need for fiscal policy when private investment is not likely. Those circumstances defined the era from 2010 to 2020, when austerity dominated the politics, resulting in CPI deflation and PCE disinflation within a low-growth economy.
Looking for a fiscal partner
The inflation of the past two years also suggests a new set of circumstances that require an examination of monetary and fiscal policy objectives.
Monetary policy was never meant to be the sole steward of the economy and price stability. There is a role for the fiscal authorities.
For example, when the economy is overheating and the demand for goods and services outstrips supplies, prices will increase. This calls for the Fed to increase the cost of credit, but it also calls for progressive increases in taxes by the fiscal authorities.
A tax increase would not only reduce demand, but also limit the supply of cash sloshing around the globe, reducing the risk of financial market bubbles that feed into the inflation rate.
The policy partnership is not what happened over the past four decades, with the fiscal authorities unwilling to react to shocks that seem to accompany each decade.
Instead, the Federal Reserve shouldered the burden to fulfill its dual mandate for price stability within an economy operating at full potential.
The takeaway
We advocate a quiet increase in the Fed’s 2% inflation target to 2.5% to 3% in the near term until the central bank is ready to engage in a reassessment of its policy.
This target is realistic given the constraints on food and energy supplies, and a housing shortage that is raising the cost of shelter and, in turn, inflation.
We also advocate a joint monetary and fiscal response to inflationary pressures, with higher interest rates augmented by progressive taxation to dampen demand.
Finally, we recognize the improbability of zero inflation and instead see modest inflation as a sign of an expanding economy able to meet changing personal preferences.
