Jerome Powell, chairman of the U.S. Federal Reserve, is reflected in a table while signing an appointment affidavit after taking the oath of office as chairman of the Board of Governors of the Federal Reserve in Washington. (Photographer: Andrew Harrer/Bloomberg)

Fed: Despite Inflation, Plan for 3 Rate Hikes Is Still on Track

(Bloomberg View) -- Predictions of four Federal Reserve interest-rate hikes this year are on the rise. But the central bank has two questions to answer before it decides to act more aggressively than planned: How much preemptive tightening is already in the pipeline, and how symmetric is the 2 percent inflation target?

It doesn’t take much imagination to tell a story of a more hawkish Fed. The economy finished 2017 with considerable momentum that seems to be carrying forward into 2018. Add to that an already low unemployment rate and a surprise inflation boost in January, and it’s easy to see why central bankers might panic and think they are falling behind the curve.

But are they really falling behind the curve? Remember these circumstances were long anticipated by central bankers. In the fall of 2015, Fed Chair Janet Yellen presented a long speech explaining the inflation model and justifying the beginning of a rate-hike cycle, even though turmoil in financial markets during the previous summer eventually short-circuited the Fed’s plan after just one hike, in December 2015. The Fed was not able to return to rate increases until a year later.

Nonetheless, it did return, and central bankers continued tightening in 2017 despite inflation that was well below forecast. Why move forward with tightening in a low-inflation environment? Because policy makers believed their medium-term inflation forecast and did not want to be put in a position of accelerating the pace of rate hikes when that inflation emerged.

In effect, the Fed put five rate hikes into the pipeline in anticipation this day would arrive. Now that it may have arrived, what should they do? Cleveland Federal Reserve President Loretta Mester provided her thoughts last week:

Since the lows seen last summer, inflation has moved up. We will likely see higher inflation numbers once the price declines of last March drop out of the year-over-year measures. But just as we didn’t overreact to last summer’s weaker inflation readings, we shouldn’t overreact to these increases either. Instead, I remain focused on the medium-run outlook for inflation, and I anticipate that with the economy growing above trend and the demand for labor resources continuing to strengthen, inflation will gradually move up to 2 percent on a sustainable basis over the next one to two years.

Mester’s point is that the Fed remains focused on the medium-term forecast. That projection told central bank officials to not overreact to surprising low inflation in 2017 by slowing the pace of rate hikes. It also tells them to not overreact to the expected higher inflation of 2018 by accelerating the pace of rate hikes. Also note that these words of caution come from a policy maker believed to lean to the hawkish side of the Fed.

What about faster-than-expected inflation? This is where the symmetry of the Fed’s inflation target comes into play. Critics argue that the bank’s actions since the crisis -- raising rates despite low inflation -- proves 2 percent is an inflation ceiling, not a target. Policy makers say that’s not true. Words are cheap, however, relative to action. If policy makers are truly committed to a symmetric inflation target, they should be willing to tolerate above-target inflation of the same magnitude as the below-target inflation they tolerated. Arguably, this would be a protracted period of inflation as high as 2.5 percent as long as conditions allowed them to maintain their medium-term forecast.

The trick, then, is to keep an eye on the medium-term forecast. As long as the Fed remains confident the projected path of rates will yield the results they expect -- 2 percent inflation -- it will stay the course. What would change that forecast? Most likely is a combination of continued solid growth plus evidence that the January inflation number is not just a flash in the pan, but the beginning of a trend that threatens to set inflation expectations adrift if not addressed more aggressively. Also, to me, the outlook speaks more to continued hikes in 2019 than an acceleration of hikes in 2018.

So when considering the likely policy path, don’t forget that the Fed acted preemptively in anticipation of this day. The new Fed chair, Jerome Powell, will hesitate to abandon the gradual policy path in the absence of clear and convincing evidence the bank is falling behind the curve. I don’t think we are there yet.

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

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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