The idea of an inflation target was established in January 2012, in the aftermath of the 2008-09 financial and economic crisis. The Fed said then that an explicit goal would help promote the central bank’s dual mandate: low unemployment consistent with stable prices. And in those tough postcrisis years, the extraordinary easy monetary policy succored an economy flat on its back.
Despite the Fed’s assiduous ministrations, however, inflation has stubbornly resisted the 2% target for most of the past five years. The 12-month change in the consumer-price index was a tame 1.7% in July, down from a more than 2% run rate earlier in the year.
There are two downsides to the Fed’s unrelenting—if as yet unsuccessful—pursuit of a specific inflation target. First, the central bank’s credibility is at risk, notes economist A. Gary Schilling. “If you say you have the monetary tools to effect that target, and you don’t, then one has to question their tools,” he says.
Schilling, who advocates eliminating the target, wonders “why the Fed is in the inflation-forecasting game at all,” given its poor record at forecasting, whether it’s gross domestic product or inflation. “[Dropping] it would be a jolt, but the Fed would end up with more credibility.”
In June, the Fed indicated there would probably be another 25-basis-point hike in the federal-funds rate, now 1%, to 1.25% in December, and three more similar increases in 2018. (A basis point is a hundredth of a percentage point.) Few believe that, particularly with the terrible hurricane damage in Houston, with potentially more to come in the Southeast.
The fed-futures market indicates just one more hike by about September 2018, according to Bloomberg. As Barron’s has pointed out more than once, fed futures have been more successful than the Fed itself at predicting interest-rate changes. (The fed-funds rate is used by banks that lend funds maintained at the Fed to other banks.)
It’s the direction of inflation data that matters most to the Fed, even more than the level of inflation, says Morgan Stanley economist Ellen Zentner. With a specific goal, however, it’s difficult to convince markets of that, she says. In other words, investors believe the central bank should do nothing because the 2% level hasn’t sustainably been met.
The other problem with targeting rather than maintaining a flexible response, which was the case before 2012, is the risk that the Fed “keeps policy too easy for too long,” says Mike O’Rourke, chief market strategist at JonesTrading.
The country has had price stability for five years, but to gain a few basis points more of inflation, the Fed has pursued an easy policy for an extended period of time, potentially inflating a bubble in financial assets, he says.
Consumer prices are under control, but stocks and bonds are near all-time highs, and real estate is frothy. Private-equity deals are being done at higher and higher multiples, too. Sub-2% inflation before 2008—before the public target—wouldn’t have justified extraordinarily accommodative monetary policy, O’Rourke adds. “Why is the Fed micromanaging the economy for want of a few basis points of inflation, when it’s close to the target and not volatile?” he asks.
The fed-funds rate should have been at 2% already, he says. And, he asserts, you wouldn’t have the financial-asset bubble that exists now had the Fed moved earlier. Nearly a decade of accommodative policy has delayed the business cycle, but, he adds, the cycle hasn’t been eliminated.
With a target, the Fed has painted itself into a corner. It won’t raise rates as fast as it should for fear of pricking the asset bubble that overly easy money has helped create. Down the line, when rates do rise, the risk is of a bigger drop in asset prices then otherwise might have been.
ZERO INTEREST RATES pulled the economy out of the crisis, but is the medicine now worse than the cure? What good is an inflation target that effectively holds down mortgage rates if that policy also drives house prices beyond the reach of the middle class? And for stocks, low rates have been the gift that keeps on giving.
Instead of waiting for 1.7% inflation to reach 2%, perhaps the Fed should declare an inflation-target victory and get on with normalizing rates before the bubbles get too much bigger.
The Fed faces an increasingly difficult trade-off, says Morgan Stanley’s Zentner. The risk, she adds, is that if the Fed does nothing in the current environment of low unemployment and easing financial conditions, it runs the risk of having to raise rates quickly later on and at a speed that markets won’t like at all.
Layered on this is one big unknown: Four of seven Fed governorships will soon be open, and it’s a good bet that Donald Trump–appointed players will want to keep rates low. Fed Chair Janet Yellen, who helped introduce the explicit inflation target, might not be reappointed after her term ends on Feb. 3, 2018, though she could stay on as a governor until 2024.
Perhaps it’s time for the Fed to stop being a helicopter parent to the U.S. economy. Micromanaging inflation could lead to troubles down the road. The next Fed meeting is Sept 19-20. Stay tuned.
Vito J. Racanelli, Barron’s, September 9, 2017.