The Federal Reserve’s dual mandate – its mission – is the achievement of price stability (low inflation) and maximum employment. There are, however, points in the economic cycle at which reaching these goals requires the Federal Reserve to walk an especially narrow tightrope.
Right now is one of those times. Inflation is still running very close to its 40-year highs. And even though the Fed has raised interest rates 75 basis points a pop at each of its last three Open Market Committee meetings, those moves have had little – if any – beneficial impact on inflation. Actually, there are signs that inflation is getting worse. The core consumer price index (CPI) – which purposely excludes extra-volatile food and energy prices – accelerated 0.6% from August to September. On a year-over-year basis, core CPI was up 6.6% in September, which is the fastest 12-month increase for that measure in just over four decades.
One of the reasons rate hikes haven’t served to lower inflation up to this point is because they apparently have done nothing materially to lower demand – which is why the Fed raises rates in the first place. As a matter of fact, the headline unemployment rate is not only not moving up…it’s dropping. From August to September, U-3 unemployment drifted down from 3.7% to 3.5%, equal to its 50-year low.
So, there’s no real evidence in any part of the economy that rate hikes have done anything thus far to bring down inflation. And that reality is moving the Fed toward the position of having to decide on which side of the tightrope to fall: live with significantly higher prices, or raise interest rates to such a degree that the result is a drastically negative impact to the economy, including a soaring unemployment rate.
But as it happens, there may be a third option. That would be to split the difference; to hike rates up to the point where inflation finds its way back to the neighborhood of 2% – but no closer. In other words, to apply enough pressure throughout the economy that inflation gets down to a more palatable 3% or 4%…but not so much pressure that the economy is left in shambles in the effort to get inflation all the way back to 2%.
What I’m effectively referring to is a decision by the Fed – made with its eyes wide open – to revise the inflation target to a level higher than 2%.
To be clear, this revision wouldn’t necessarily come in the form of an officially-declared adjustment to the existing target. The 2% target was officially set by the Bernanke-led Fed back in 2012 as a part of its “longer-run goals and policy strategy” statement. The move was considered historic because it was the first time the central bank actually declared an inflation target.
I don’t necessarily see the Fed making any sort of official policy-based revision to its 2% target. What I do think is that – in the interest of preserving a measure of economic harmony – the central bank could decide to back away from the inflation fight once CPI decreases to 4%. It’s a move that would be tantamount to an official revision of the target.
And I am not at all alone in considering that possibility.
In point of fact, chatter that the Fed might raise its inflation target has been growing steadily since the consumer price index (CPI) crossed above the 8% threshold earlier this year.
Back in April, economist Mohamed El-Erian laid out his plainspoken, relatively straightforward case for the Fed changing their inflation target:
What will force the Fed to change their target is the recognition that by being so late they can’t get [back] to that target. They would also worry that by hitting the brakes too hard they may push this economy not just into a short-term recession but into a longer-term recession. And they will be very tempted – and lots of people will push them – to raise their target from 2% to 3% as a way out.
While noting the Fed surely would receive plenty of blowback by accepting higher inflation, El-Erian – with a bit of a scolding tone – added, “That’s what you get when you waited too long to recognize what inflation is and to take action. We should have started QT (quantitative tightening) last year. We didn’t, and we’re now paying the consequences of the Fed being so late.”
As I said suggested earlier, there’s no shortage of economists and analysts who think the Fed eventually might make its peace with a higher inflation target, given the potential gravity of the consequences associated with staying on the path to 2% inflation.
In May, Barron’s shared the thoughts of well-known economist Ed Yardeni in an article about the prospect of the Fed deferring to a higher inflation number. Yardeni said rent inflation, specifically, is what likely will hamstring the central bank in its efforts to get back to 2%. According to the economist, the nature of rent inflation means the Fed effectively can’t do anything about it short of initiating a “severe recession,” and he thinks the central bank ultimately will conclude the “price might be too high.”
Since Yardeni shared these thoughts, rent inflation – which represents about 40% of core CPI – has proved relentless. In September, rents rose 7.2% on a year-over-year basis – the fastest increase in 40 years.
Yardeni reiterated his outlook recently, suggesting the Fed will hike one more time in November and then call it quits “because the financial stability issue will pop up as a primary concern.”
Some observers think the onset of higher structural inflation – which I wrote about last week – will serve as the culprit that forces the Fed to settle for a bigger inflation number. Tim McDonald of Pennant Investors told Barron’s that secular changes to the inflation outlook such as reduced globalization and the transition to green energy will ultimately remove a return to 2% from the Fed’s menu of options.
Economist Joe Brusuelas of RSM, an economic consulting firm, says his analysis reveals that an acceptance by the Fed of a higher target will result in the economy enduring decidedly less damage, overall.
According to Brusuelas, getting inflation back down to 2% will demand a loss of 5.3 million jobs and an unemployment rate of 6.7%. However, in his estimation, acceptance of a higher 3% inflation rate would translate to a loss of “only” 1.7 million jobs and an unemployment rate of 4.6%. Brusuelas sees that as the kind of path the Fed is more likely to take.
And it’s worth noting that Brusuelas’s projection of the unemployment rate required to get inflation back down to 2% – as ominous as it is – isn’t as great as those of other economists. Some – including former Treasury Secretary Larry Summers – think it will take six million lost jobs and unemployment at 7.5% to return inflation to 2%.
Nobel Laureate Economist: We’re Better Off at a Stable 3%-4% Inflation Rate
Also, Paul Romer, former chief economist at the World Bank and co-recipient of the 2018 Nobel Prize in economics, has suggested on more than one occasion that the Fed should be considering a revised target of up to 4% so as not to unduly damage economic growth.
“I think we’d be much better off at a stable 3%…maybe a stable 4%,” Romer said during a May appearance on Bloomberg Surveillance. Romer noted that “the argument you hear against that is ‘Well, if it’s 3 or 4%, it’ll also be 6, or 7, or 8, or 9,’ and that doesn’t make any sense to me. We could target a stable 4% inflation rate if we wanted to.”
Publicly, the Federal Reserve does not appear open to settling for a higher target. In June, responding to questioning by Rep. Andy Barr (R-KY) about whether the Fed would reestablish the inflation target at a higher level, Jerome Powell said flatly, “That’s not something we would do.”
Indeed, St. Louis Federal Reserve President James Bullard recently went as far as describing the idea of raising the target inflation level above 2% as a “dangerous concept,” saying that “to have a major central bank deviate from the international standard, I think would set up chaos around the world on inflation.”
Jim Bullard’s dismissal of a higher inflation target seems appropriate in a do-whatever-it-takes-to-defeat-inflation sort of way. But the question remains: Just how much pain are Americans willing – or even capable – of withstanding in order to see inflation return to the 0% to 2% range we knew for so long?
In fact, I think it’s worth pondering if we, as a nation, possess the same tolerance for economic hardship that we once did.
There’s reason to believe we may not. In last week’s article, I discussed why it’s likely we could see direct economic stimulus payments – such as those issued during the pandemic – deployed more readily in future crises. Among the reasons is that the pandemic payments were overwhelmingly popular with Americans, and, relatedly, there’s been a big upswing over the last decade in the number of people who think government should do more to make life easier for citizens.
And if we do not have the same tolerance for economic hardship, it’s hard to imagine that message won’t get across loud and clear to Powell and the rest of the Fed leadership.
As I see it, this is the bottom line for consumers and retirement savers: There’s a variety of excellent reasons to question if we will see a return to inflation in the 0% to 2% range anytime remotely soon. And – despite Fed insistence to the contrary – one of those reasons could be unwillingness on the central bank’s part to inflict the tremendous damage on the economy that analysts say is required to stuff inflation back in the bottle labeled “2%.”
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