The Fed’s New, Squishy Inflation Target

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In reading over the monetary policy changes the Federal Reserve announced yesterday (as detailed here) and noting how they intend to tie interest rate decisions (and perhaps other policy changes) to both the jobless rate and the inflation rate, it occurred to me that their inflation target has lots of wiggle room in it.

BernankeFor better or worse, it’s pretty clear what unemployment rate they’ll use as the Labor Department publishes this every month and, though it has its share of quirks (e.g., the official jobless rate went down last month as the number of employed people fell), when the Fed says they’ll keep monetary policy super-easy until the unemployment rate falls below 6.5 percent, at least everyone knows what that means.

But, their new inflation target is a different, squishy thing that, per the policy statement, has two components – their own future projections for consumer prices and the meaning of the phrase “well anchored”. It’s highlighted below, right from the policy statement:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Admittedly, no one is really concerned about inflation these days, so, for a little while a least, I don’t think anyone’s going to be asking too many questions about this, but, clearly, people are already confused and, someday, it really might matter.

It’s pretty common to find statements like this that in no way reflect what the Fed said yesterday:

They’ve said that interest rates will remain low until unemployment falls below 6.5 percent or the inflation rate exceeds 2.5 percent…

Here’s another example:

…the Fed said that it plans to continue to keep interest rates low until unemployment drops to 6.5 percent, or until inflation hits 2.5 percent.

Their new inflation target is not nearly as simple as what many people seem to think and breaking it down into its constituent parts might shed some light on exactly how squishy it really is.

The first component – inflation projections – are apparently the Fed’s own forecasts. They didn’t say so, presumably, because it would have been much less convincing to say “inflation, based on our own projections, of no more than 2.5 percent…” rather than the more circuitous route taken in the policy statement above.

Nonetheless, for those who have scrutinized the statement closely, that appears to be the consensus and it just so happens that they released a new forecast just yesterday:

economic projections fed reserve 2012 and beyond

Naturally, Federal Reserve economists forecast inflation of just under two percent.

That’s their target, so, why would any Fed economist think the result might be any different when looking out over the next year or two. Despite their recent failings, they remain a confident bunch and to predict inflation of, say, 3 percent or 4 percent that far out would be tantamount to saying, “We’re going to fail at our job”.

If more people were concerned about inflation today, then there would surely be more discussion about this particular “target”, but they’re not, so there isn’t.

I just don’t see how, even if current inflation is running at 5 or 10 percent, the Fed will do anything other than predict inflation at two percent two years hence – maybe 2.5 percent – so, this really isn’t a target at all.

As for the second component of the new inflation target, that is, that “longer-term inflation expectations continue to be well anchored”, this too is pretty squishy.

Of course there are the yield spreads between Treasuries and inflation protected Treasuries, but, for the foreseeable future, the Fed will be one of (if not the) biggest buyer of U.S. debt and this tends to keep Treasury prices high and yields low. Whatever value there used to be in yield spreads as they relate to inflation, it’s not what it used to be since the Fed has a rather large presence in this particular market.

Consumer confidence surveys are also used as gauges of inflation expectations and it’s worth noting that last week’s consumer sentiment survey from the University of Michigan had the five-year inflation outlook up one-tenth to 2.9 percent.

The latest consumer confidence survey from the Conference Board had inflation expectations edging lower, down from 5.8 percent to 5.6 percent, so, it’s a pretty safe bet that they won’t be using either one of these to determine if inflation expectations are “well anchored”.

All in all, the Fed’s new inflation target is much less than meets the eye and this could have important implications for investors someday.

There will be lots of “wiggle room” for the Fed if and when the time comes that consumer prices do begin a sustained rise and this would favor the natural resource sector in general, monetary metals in particular. With the Fed now promising to print $1 trillion in new money each year until such time that the economy improves, the odds of inflation someday mattering again have gone up substantially, albeit from very low levels.

Source: Iacono Research

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About Tim Iacono