Fed Watch: Inflation Hysteria Redux

I am in general agreement with Calculated Risk on this point:

I also think the economy is picking up, and I agree that as slack diminishes, we will probably see real wage growth and an uptick in inflation.

Moreover, note that this is largely consistent with the Federal Reserve’s outlook as well.  Recall St. Louis Federal Reserve President John Williams from April, via Bloomberg:

Williams, who forecast the Fed will start raising interest rates in the second half of next year, said inflation has “bottomed out” and will gradually accelerate to the central bank’s 2 percent target. He said prices have been held down by temporary forces such as a slowdown in health care costs.

The Federal Reserve has consistently predicted higher inflation, and consistently been surprised that that inflation has not yet arrived despite rapidly falling unemployment rates.  It would appear, however, that their forecasts are finally coming true.  Hence, I also agree with Calculated Risk when he says:

On inflation: I’m sympathetic to people like Joe Weisenthal at Business Insider who is looking for signs of inflation increasing; I’m starting to look for signs of real wage increases and inflation too. I just think inflation isn’t a concern right now (Weisenthal was correct on inflation over the last several years  in contrast to the people who were consistently wrong on inflation).

It is enough to simply say that inflation is coming.  That in and of itself is insufficient.  Any inflation call needs to be placed in the context of magnitude and expected monetary policy response.  Regarding both, follow Calculated Risk’s warning:

Monetary policy can’t halt the violence in Iraq or make it rain in California – and this is why it is important to track various core measures of inflation.

The Fed doesn’t target core inflation.  They target headline inflation.  But they also believe that headline inflation will revert to core, and as such tend to be more concerned with core inflation in excess of 2%.  Consider the history of core inflation since 1985:


I included a 25pb “forecast error” band around the Federal Reserve stated 2% target for PCE inflation; no one believes they can consistently hit 2% in the short-term, hence it is a medium term target.  The most obvious feature is that for the last twenty years, core measures of inflation have more often than not been at or below the the upper range of the Fed’s error band, especially for core-PCE inflation.  Average core-PCE inflation:  1.7%.  Average core-CPI inflation: 2.2%.  Indeed, if core-PCE were the target, it is fairly clear that the Fed would have been on average undershooting its objective for the past two decades.

It is simply difficult for me to become too worried about inflation given the history of the past twenty years – twenty years in which the US economy was at times substantially outperforming the current environment no less.  Underlying inflation simply has not be a problem.

It was not a problem because the Federal Reserve tightened policy multiple times to preempt inflation. Expect the same during this cycle as well – the Fed will begin to gradually raise interest rates sometime next year, and they will maintain a gradual pace of tightening as long as they believe core-PCE will consistently average 2.25% or less.  Currently, I anticipate the first rate hike will occur in the second quarter of 2015.  If the unemployment rate falls to 5.5% by the end of this year, I would expect the first hike to be in the first quarter of 2015.

What about headline inflation?  Headline inflation is at the mercy of the Middle East and the weather, leaving it more volatile than core:


Average PCE inflation since 1994:  1.9%.  Average CPI inflation since 1994: 2.4%.  Arguably a pretty good track record.  It is really no wonder that it is so difficult to motivate the inflation lectures in Principles of Macroeconomics.  All the students are twenty or less years old.  They simply have no experience with inflation as a troubling 1970s-style phenomenon.

How will headline inflation influence monetary policy?  If you combine headline inflation well in excess of 2.25% (I suspect something more like 3%) with tight labor markets and rapid wage/unit labor cost growth, I think the Fed will accelerate the pace of tightening (indeed, the second two conditions alone would probably do the trick).  If we experience high headline inflation in the context of weak wage growth, expect the gradual pace of tightening to continue.  Under those circumstances, the Fed will believe that headline inflation will depress demand and lessen inflationary pressures endogenously.

Bottom Line: If you are making a short-term bet on higher headline inflation, primarily you are making a bet on energy and food.  That bet is about the Middle East and weather, not monetary policy.  I don’t have an opinion on that bet.  If you are betting on inflation over the medium-term, primarily you are making a bet on higher core inflation. More to the point, you are betting against the Fed.  You are essentially betting that the Fed will not do what it has done since Federal Reserve Chair Paul Volker – tighten policy in the face of credible inflationary pressures. I would think twice, maybe three times before making that bet.

This piece is cross-posted from Tim Duy’s Fed Watch with permission.