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The Fed’s Average Inflation Target (AIT) will soon tell the Fed to aim for DEFLATION

Summary:
Back in April I warned that given the massive expansion of the US broad money supply we could very well be heading from double-digit inflation in the US later in 2021 or 2022. At that time inflation was at 1.6% (March). Today we got inflation for June – and now inflation is at 5.4% and core inflation is at the highest level in 30 years. So far my inflation simulation seems to be pretty much on track. But that is not the topic for this blog post – at least not the main topic. Rather I want to discuss what the latest inflation numbers imply for Fed policy going forward. Back In August 2020 at the online Jackson Hole conference Fed chairman Jerome Powell announced a revision to the Fed’s long-run monetary policy framework by re-framing this goal as an average inflation

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Back in April I warned that given the massive expansion of the US broad money supply we could very well be heading from double-digit inflation in the US later in 2021 or 2022.

At that time inflation was at 1.6% (March). Today we got inflation for June – and now inflation is at 5.4% and core inflation is at the highest level in 30 years.

So far my inflation simulation seems to be pretty much on track.

But that is not the topic for this blog post – at least not the main topic. Rather I want to discuss what the latest inflation numbers imply for Fed policy going forward.

Back In August 2020 at the online Jackson Hole conference Fed chairman Jerome Powell announced a revision to the Fed’s long-run monetary policy framework by re-framing this goal as an average inflation target (AIT) of 2% over the long-run.

This means that the Fed will tolerate inflation running above (below) 2% for a period if it in periods years has undershot (overshot) it’s target.

This was by many – including myself – interpreted as the Fed for some time could tolerant inflation above 2% as inflation since the outbreak of the Great Recession in 2008-9 far mostly have been below 2%.

The Fed, however, was not very clearly in telling us anything about the the timeframe – is it an average over 2 years, 5 years or even 10 years? We simply don’t know even though it by some Fed officials have been hinted that it probably was 4-5 years.

Where are we now?

The timeframe of course is relevant if we want to judge whether the Fed should ease or tighten monetary conditions going forward.

But lets say we want to give the Fed a lot of room to ease monetary policy and allow inflation to overshoot on the upside.

We can do that by saying that we will take the entire period after 2008 where inflation has been below a 2% trend path.

If we look at the US price level measured by CPI less food and energy then we can compare the actual development in the price level with a 2% trend path.

The starting point is the time, which gives the Fed the most room to overshoot inflation going forward. We get that by starting the 2% “target” path in the Autumn of 2010.

The graph below shows that.

The Fed’s Average Inflation Target (AIT) will soon tell the Fed to aim for DEFLATION

We see that for a long time – particularly from 2013 to 2019 the Fed was undershooting the 2% inflation target. However, just before the Covid-19 pandemic (and the lockdowns!) hit in 2020 the price level was actually back at the 2% target path.

But when the shock hit in 2020 we saw the price level drop below the 2% path, which obviously justified monetary easing.

HOWEVER, we now see that the price level is well-ABOVE the 2% target path.

Consequently, if the Fed is serious about the AIT then US consumer prices should be growing SLOWER than 2% annualized until the price level (CPI core) gets back to the 2% target path.

Presently (June) the US prices level (CPI core) is around 1.5% above the target path and if the trend in inflation over the past year continues in the coming three months then the price level will be 2% above the target level in the Autumn. If my simulation (from) April continue to be correct then it will be an even larger ‘gap’.

This effectively means that in a few month the AIT will actually imply that the Fed should target DEFLATION going forward.

I very much doubt that the Fed will do that and therefore within a few months the Fed will have to revise it’s AIT framework.

One can only wonder what effect that will have on the Fed’s overall credibility.

Lars Christensen
International economist, Money Doctor, Founder of Markets & Money Advisory, Research Associate Stellenbosch University [email protected] +45 52 50 25 06

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