Inflation Is Not Just Inevitable, It’s Part of the Fed’s Plan

(Bloomberg Opinion) -- As inflation measures reach their highest readings in more than a decade, the Federal Reserve faces a crucial test. Officials have so far emphasized that this is a temporary surge, driven by pandemic-related shortages and supply-chain disruptions, and so there is no need to raise rates in response to it. They need to make clear that interest rates won’t increase even if the rise in inflation lasts longer than expected.

The view that inflation is transitory is a reasonable thesis given the challenges associated with bringing the entire U.S. economy back online after an unprecedented shutdown. Yet precisely because this situation is unprecedented — both in the scale of the economic downturn and the size of the government response — it’s impossible to tell how large the spike in inflation will be, or how long it ought to take the economy to get through it.

A number of economists and commentators fear that businesses and consumers may interpret the Fed’s complacency as sign that it’s no longer committed to controlling inflation over the long run. If that happens, they say, then a self-fulfilling cycle will set in: Firms will raise prices in anticipation of higher inflation, thereby helping to bring about the very inflation they fear. At that point, the argument goes, the Fed would have to raise rates so high that the economy would enter a recession.

Then there is the argument that it’s market participants who, after a decade of near-zero rates, have become too complacent. Under this view, sharply rising interest rates are inevitable, and the fact that Wall Street hasn’t yet priced them in means the financial sector is setting itself up for a rude awakening.

Between these two extremes — waiting too long to begin tightening monetary policy or tightening faster and harder than anyone expects — lies the middle ground that Fed Chair Jerome Powell has been striving for the last three years.

The labor market never fully healed under Janet Yellen’s tenure as Fed chair, despite rock-bottom interest rates and trillions in quantitative easing. That’s largely because financial markets were worried that she might suddenly reverse course, raising rates to head off any incipient surge in inflation before it rose above the Fed’s 2% target. As a result, market participants were reluctant to lend to businesses except in fast-growing sectors like technology or to consumers unless they had stellar credit.

Private-sector investment was thus persistently slower, the job market weaker, and inflation lower than they otherwise would have been. Ironically, so many quarters of subdued inflation justified the Fed’s low interest rates — yet didn’t dispel the fear that tightening might be just around the corner.

Under Powell the Fed has adopted a policy known as average inflation targeting. That means the Fed will make up for quarters in which inflation is below its 2% target by allowing inflation to run above target for a while, so that over time inflation averages roughly 2%.

The coming bump in inflation gives the Fed the opportunity to demonstrate its commitment to this new framework. The Fed’s preferred measure of inflation, core PCE, rose 0.9% from March and is likely to rise well above 2% in the second half of this year. That’s fine — because core PCE came in at only 1.4% for all of 2020.

Moreover, it has averaged 2% or less every year since 2007. That’s a lot of ground to make up. The Fed doesn’t specify exactly how long of a period factors into its average. Nonetheless, even if inflation ran closer to 3% for the rest of this year and all of the next, by almost any interpretation the longer-run average would be near or below 2%.

The U.S. hasn’t seen 3% annual inflation since 1992. So it’s understandable that some observers and the financial markets would be rattled. If the Fed simply makes it clear that average really means average, however, its credibility will be strengthened, not weakened.

Keeping this message consistent will be a difficult task, especially as the chorus of naysayers gets louder. But Powell has demonstrated an ability to cut through the noise before. If he does it again, the Fed’s new framework could last for years to come.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a Bloomberg Opinion columnist. He was formerly vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. He is also co-founder of the economics blog Modeled Behavior.

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