Inflation is worse than it looks
The government recently announced that the 12-month rise in the CPI slowed from 8.5% in March to 8.3% in April. But this is not good news, as inflation is actually getting worse.
People have become used to thinking of inflation in a “let bygones be bygones” fashion. Don’t cry over spilled milk; let’s focus on the inflation rate going forward. That might be appropriate under the Fed’s old inflation targeting regime, but is not appropriate under average inflation targeting. Consider the following graph of 5-year TIPS spreads:
With the recent decline, 5-year TIPS spreads are about the same as 6 months ago, albeit still higher than a year ago. But the situation is much worse than it looks. To see why, consider the following example:
Suppose that in 2021, 5-Year TIPS spreads were 3%, and they remained 3% in 2022. Also assume that inflation was 8% during 2021-22. Then investors in 2021 would have been forecasting a total of roughly 15% inflation over 2021-26. In 2022, investors would be forecasting a total of roughly 20% inflation over 2021-26 (8% + 4*3%). In that case, the forecast inflation rate for 2021-26 would have risen from 3% to 4% [(8% + 4*3%)/5] between 2021 and 2022. That’s not a big problem under inflation targeting, but it is a big problem under average inflation targeting where past inflation rates matter. This is why the inflation problem is getting steadily worse, even as inflation forecasts stay around 3%.
Today’s report showed a 0.6% jump in the core CPI, perhaps the single most discouraging data point in the past year, so it’s not just food and oil. The Fed remains behind the curve. This reminds me a lot of the 1970s; where during the early stages of the Great Inflation there was lots of excuse making, lots of people denying the reality of excess demand. There was also a (false) perception that Fed policy had tightened because interest rates had increased, even though interest rates do not measure the stance of monetary policy.
Christopher Waller recently suggested that it wasn’t just the Fed that failed to predict the surge in inflation. That’s true. But the problem with Fed policy is not that they failed to anticipate the rise in inflation, it’s that they’ve (de facto) abandoned FAIT. Under a credible FAIT regime, the market will do the forecasting. Even if the Fed is behind the curve, the markets will tighten policy by pushing up rates in anticipation of the future Fed tightening required to produce an average inflation rate of 2%. Without that commitment, the markets will not engage in stabilizing speculation and the Fed’s job will become much harder. Without FAIT, the Fed actually does have to become a sort of Nostradamus. It does have to accurately predict inflation and know exactly when to raise rates.
PS. Yes, FAIT is not the same as simple average inflation targeting of 2%. But using any reasonable interpretation of FAIT the Fed has abandoned its new policy regime. For instance, James Bullard once suggested that FAIT was sort of like NGDP level targeting, but NGDP growth is also far too high relative to trend. And given the recent decline in the labor force, one could argue that NGDP should be below trend.