The new image of inflation - Sectors

As of early February 2022, the breakeven rate of five-year consumer price index (CPI) inflation five years from now in the US bond market was around 2% per year, a figure which corresponds to a chain-weighted personal consumption expenditure (PCE) inflation forecast of 1.6% per year within 5 to 10 years. With inflation of 1.6% falling well below the US Federal Reserve’s 2% target, I entered that month feeling pretty good about being on the «Transitional Team,» or at least the «Team the Fed understood things” or in the “Team inflation expectations remain solidly anchored”.

But then, later that month, Russian President Vladimir Putin, the would-be Grand Prince of Muscovy, surely made a lightning invasion of the 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, cereals 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 CPI inflation rate, five years from now, shot up from 2% per year to its peak of 2.67% on April 21, 2022, while the annual PCE inflation expectations within 5 to 10 years they reached 2.27%. That PCE projection suggested that bond traders had not lost confidence in the Fed’s commitment with its inflation target.

But assuming the Fed’s target zone width is 0.6 percentage points, which means that the bond market expects the central bank to stay within the target, if five-year CPI inflation, five years from now, remains between 2% and 2.6%.

(See: Interest rate hikes, will consumption dynamics change?).

The peak of April 2022 worries. For those whose hair was already on fire, There were plenty of reasons to fear that we were just one more big supply shock away from losing the expectation anchor. of inflation that has kept prices relatively stable for decades.

Maybe we were. But since we didn’t get that extra large 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 does not make a summer and one data point does not make a trend.

What they do over the next six months will not affect the real economy of demand, employment and production for another year

Even the fall of 0.62% in June (7% annual) is not bankable. After all, we also saw some declines between December 2021 and April 2022, and between August 2021 and December 2021.

As I said earlier, this pandemic business cycle has been one of those rare periods where you didn’t envy the members of the Federal Open Market Committee (FOMC). What they do in 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.

(More: US central bank raises rates 25 basis points, points to more hikes.)

Whatever the Fed decides to do, it will almost certainly regret it later. Will it continue to exaggerate interest rate hikes? Yes that’s how it is, the economy, within two years, will once again be mired in secular stagnation, 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 additional supply shocks and political pressures lead to 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.

(You may be interested: Usury rate reaches the highest peak of this century, 45.27%).

The FOMC should take advantage of this apparent optionality. When the situation is unclear, you can pause, confident in the knowledge that you can move very fast.

Second, in retrospect, former Fed Chairman Alan Greenspan’s 1996 decision to target inflation at 2% per year was wildly ill-advised. Yes, there can be substantial benefits to maintaining and strengthen the credibility of the Federal Reserve by bringing the economy back to the 2% annual targeteven if that goal 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 that they will persist with policies that will no longer adjust to new circumstances, just because they said they would? Once again, I do not envy the members of the FOMC this winter.

(Also: Dollar in Colombia: what is the reason for its downward trend?).