Federal Reserve policymakers are openly voicing their willingness to accept above-target inflation even as price pressures are beginning to build.
“Let me be clear: A small and transitory overshoot of 2 per cent inflation would not be a problem,” William Dudley, president of the Federal Reserve Bank of New York, said in a January 11 speech. “Were it to occur, it would demonstrate that our inflation target is symmetric, and it would help keep inflation expectations well-anchored around our longer-run objective.”
Such talk suggests that the central bank won’t respond willy-nilly to mounting price pressures with significantly stepped-up interest rate increases. “The Fed has been a best friend for investors for many years, and that is not about to change,” Robert Perli, a partner at Cornerstone Macro LLC in Washington, wrote in a January 16 note to clients.
After what Fed Chair Janet Yellen has described as a mysterious fall last year, inflation is showing signs of inching back up, with the core measure the central bank favours rising to 1.5 per cent in November from 1.3 per cent in August. Inflation expectations in the Treasury bond market are also on the rise.
Dudley, who is vice-chairman of the policy-making Federal Open Market Committee, is not the only Fed official to have evinced a tolerance for above-target inflation in recent days.
“It would actually be helpful if we were able to get inflation not just at 2 per cent, but above it for a while,” Philadelphia Fed President Patrick Harker told reporters on January 5.
St. Louis Fed President James Bullard even went so far as to suggest on January 10 that policymakers should consider shooting for inflation above 2 per cent for an extended period to make up for its below-target performance over the past five years.
Tepid price pressures have enabled the US central bank to raise rates at a gradual pace, allowing Wall Street stock prices to continue pressing ahead to record highs without upsetting the bond market. After hiking rates three times last year, monetary policymakers have pencilled in three more moves for 2018, according to the median projection of forecasts released in December.
Harker thinks two rate increases this year are likely to be more appropriate than three. While he does see inflation rising a bit above target in 2019, he said he’s not that confident that will occur.
“If soft inflation persists, it may pose a significant problem” by depressing price expectations and turning into a self-fulfilling prophecy, he said.
Bullard, for his part, doesn’t foresee the Fed raising rates at all this year.
Dudley, in contrast, thinks that three interest rate increases this year is not “an unreasonable sort of starting point” for thinking about Fed action in 2018. He also worries about the risk of the economy overheating over the next few years and the Fed eventually having “to press harder on the brakes” to slow it down.
The chatter about inflation breaching its target is taking place against the backdrop of a brewing debate among policymakers about the continued usefulness of the 2 per cent objective. One idea that’s been mooted: Adopting a price level target instead.
Under such an approach, the central bank would commit to making sure that prices rise by an average 2 per cent per year for an extended period. So if inflation runs below target for a while, policymakers would seek to make up for that by engineering commensurate price increases above 2 per cent. And vice versa.
That differs from the current framework, where bygones are bygones and the past performance of inflation has no direct implications for policy going forward.
While it will take the Fed quite a while to make such a change, the ongoing discussion “is going to percolate in day-to-day decision-making” before that, making the central bank more willing to accept higher inflation in the interim, Perli, a former Fed official, said.
Bullard seemed to agree.
“Even if formal adoption of price level targeting is not realistic in the near term, the ideas behind it could nevertheless influence near-term policy,” he said in a January 10 presentation to the CFA Society of St. Louis.
“This would suggest leaning toward inflation somewhat in excess of the stated inflation target to make up for past misses on the low side,” he added.
Former Fed Governor Laurence Meyer reckons that officials might tolerate inflation rising to around 2.5 per cent.
Dudley’s stated willingness to accept an overshoot “has a lot of force” given his senior position in the Fed hierarchy, according to Meyer, head of Monetary Policy Analytics, an independent research advisory service based in Washington.
“I call it a poor man’s price level targeting,” he said.