Fed’s subdued inflation forecast needs explaining

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For Federal Reserve officials keen to get inflation under control, the outlook has certainly improved in recent weeks.

First, inflation has peaked. In particular, goods price inflation declines as supply chain disruptions ease and demand shifts toward services and away from goods. And even though the labor market remains exceptionally tight, wage inflation has stabilized rather than continuing to climb.

Second, inflation expectations remain remarkably well anchored. While households’ short-term inflation expectations are high, longer-term expectations have fallen. Similarly, market-based measures based on the spread between nominal 10-year Treasuries and inflation-protected 10-year Treasuries also declined.

Third, the Fed’s efforts to steer market expectations about the future path of monetary policy have been, for the most part, effective. Market participants expect monetary policymakers to move “quickly” to neutrality, with interest rate hikes of 50 basis points expected at each of the next two meetings of the Federal Open Market Committee and with the fed funds rate peaking around 3% next spring, from the current range of 0.75% to 1%. As part of this, Chairman Jerome Powell has become more forceful in clarifying that raising rates to “a more normal level” is “not a stopping point. It is not a point of view. The Fed will continue until there is “really clear and compelling evidence that inflation is coming down,” he added.

Fourth, financial conditions have tightened significantly. U.S. stock prices have fallen about 15% from their peak in the first week of January, 10-year Treasury yields have risen about 1 percentage point in the past three months, credit spreads widened and the dollar appreciated. Since tighter financial conditions are the means by which higher short-term rates slow economic growth, Fed officials should be pleased that market participants are taking the monetary policy tightening campaign more seriously. from the Fed.

Nevertheless, the Fed’s job is far from done. First, the FOMC needs to be more realistic in its own forecast of what will be needed. In the latest FOMC summary of economic projections in March, the inflation rate expected for the end of 2024 magically fell back close to the Fed’s 2% target even as monetary policy was not tightened enough to raise the unemployment rate to a level that Fed officials consider consistent with stable inflation over time. The forecast posed an open question: if the unemployment rate does not rise materially, how does inflation fall back to the Fed’s 2% target?

It will be noted when the SEP projections are updated at the next FOMC meeting in two weeks to see if participants expect to make monetary policy tight enough, which would mean a median federal funds rate above 3% in order to push the unemployment rate above the 4% level deemed compatible with keeping inflation stable at the Fed’s 2% target.

Second, Fed officials and market participants continue to underestimate the level of short-term rates that will be needed to tighten financial conditions enough to bring inflation down to 2% from the last year-over-year reading. by 6.3%. If, in the long term, a short-term neutral rate is 2.4% (median estimate of the FOMC) when inflation is 2%, then the neutral rate should be higher to compensate for the fact that inflation is higher. Furthermore, given that the Fed’s expanded $8.9 trillion balance sheet continues to drive activity – the balance sheet will not go “neutral” until it reaches the desired level in about three years – the short-term neutral rate must be higher during this time.

Third, the risks of a hard landing continue to be underestimated. According to Fed officials, tightening monetary policy can slow the economy and eliminate the imbalance between current labor supply and demand without precipitating an economic slowdown. This assertion runs counter to economic history. Every time the unemployment rate has increased by half a percentage point or more, the result has been a widespread recession and a much larger increase in unemployment. With the labor market tighter than ever, the need to raise the unemployment rate is greater, making the odds of a hard landing higher, not lower. .

Finally, while short-term uncertainty about the stance of US monetary policy has diminished significantly in recent weeks, financial conditions have eased somewhat, with stock prices rebounding and bond yields falling. If this easing of financial conditions were to continue, Fed officials would have to react by pushing short-term rates higher than currently expected.

More other writers at Bloomberg Opinion:

Is a recession coming? Watch out for this indicator: Kathryn EdwardsHas US consumer spending peaked? : Robert BurgessReady to buy a house? Wait a few weeks: Conor Sen

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Bill Dudley is a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics. A senior fellow at Princeton University, he was president of the Federal Reserve Bank of New York and chairman of the Federal Open Market Committee.

More stories like this are available at bloomberg.com/opinion


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