Lars Svensson has argued that monetary policymakers should “target the forecast”, which means they should set their policy at a position expected to lead to on-target inflation.
Early in 2024, a few high inflation readings led to concern that we might not be on track for a soft landing. Inflation eased later in the year, and in September the Fed began cutting interest rates. In recent weeks, however, 5-year inflation breakevens have been creeping upward, and yesterday they spiked up to 2.46%. To be clear, this interest rate spread is based on the CPI, which runs a bit hotter than the PCE index targeted by the Fed. Nonetheless, it suggests that inflation is still expected to run above of the Fed’s 2% target. And while the Fed has a dual mandate, the labor market is also currently strong, and thus provides no justification for intentionally running inflation above target.
Today, the Fed meets to discuss monetary policy. It will be interesting to see how they decide to react to the recent surge in TIPS spreads. If they adhered to Lars Svensson’s target the forecast maxim, you’d expect them to tighten monetary policy.
It’s also worth considering how a NGDP futures targeting regime would handle this problem. Under current market conditions, I’d expect most investors to take a long position on NGDP futures, forcing the Fed to take a rather extreme short position and exposing the Fed to severe losses if NGDP growth overshoot the target. But I also believe that the Fed would be unwilling to accept that risk, and would tighten policy enough to restore credibility in the financial markets.
PS. Many pundits believe that the election outcome was heavily influenced by public anger over inflation. If so, the bond market reaction to the election was certainly something to think about. If inflation is truly the issue that the public cares about most, then how should the media have described the market reaction to the election? How did the media describe the market reaction to the election? (To be clear, inflation is not the economic issue that I care about most.)
In other words, never reason from an inflation rate change.
PPS. Speaking of market forecasts, Alex Tabarrok has a great new post, with implications that go far beyond election prediction markets.
READER COMMENTS
King Banaian
Nov 7 2024 at 4:04pm
Having just listened to Powell’s press conference, I wish I had read this first. He seemed to dismiss this gap, saying (this is from memory, I was driving) that the readings are consistent with 2% core PCE target. I know the Atlanta Fed does some short-run measures to determine average deviations from 2. Do we know what those are for the 5- and 10-year TIPS (and the 5/5 forward)? If not, R is getting a workout tonight!
Effem
Nov 7 2024 at 4:17pm
Unless I missed it, the only mention of market inflation expectations is that they are “well anchored.” Clearly the Fed does not put much weight on this measure.
Scott Sumner
Nov 7 2024 at 4:35pm
Unfortunately, I believe that you are correct.
Kevin Erdmann
Nov 7 2024 at 8:25pm
The quarter point cut may have been considered hawkish. 5 year breakevens were down 6 bp.
Scott Sumner
Nov 8 2024 at 1:19am
I think it was anticipated, already priced in.
Jeff
Nov 8 2024 at 9:12am
Both Trump elections were a repudiation not of “inflation” but of stabilization policy more generally. In an age of ubiquitous data and ever-better forecasting, outside of a very limited community, nobody really buys the idea that “the economy” needs perpetual “help” in the form of forever inflation or fiscal and monetary “support”. If “jobs” truly is the goal, then bar the doors to imports (Trump) or bring back the CCC/WPA (Bernie). For the past 16 years “jobs” has been an excuse to rationalize trillion dollar checks to speculators. No one is fooled.
Scott Sumner
Nov 8 2024 at 12:48pm
This comment is wrong on so many levels I don’t even know where to begin. Start with the fact that voters know nothing about “stabilization policy” so that could not possibly have been a deciding factor. Second, Trump is a huge supporter of stabilization policy, favoring aggressive monetary stimulus and the most massive fiscal stimulus in history.
I have no idea what you are even talking about. Please think a bit more before posting a comment here.
Jeff
Nov 8 2024 at 11:45pm
Whether someone can name a policy doesn’t mean they can’t understand the essence. All social animals have highly tuned mechanisms for detection and deterrence of freeloading. And both candidates were in favor of stimulus, though Trump seems likely to pursue it in a way that is overall more destabilizing. The difference is that with regard to almost any policy (FAIT, TARP, anything…) Trump will say “Yes, it’s rigged. It’s been rigged for people like me for a long time, and if you’re nice to me I might rig some little thing for you too (No tax on tips!)”. While a Democrat will say “Ha ha, no, it’s definitely not rigged, it’s just too ‘wonkish’ for dummies like you to understand.” Democrats of course lose those arguments.
Scott Sumner
Nov 9 2024 at 2:50pm
You’ve just contradicted your first comment. Please think a bit more before commenting in the future.
Todd Ramsey
Nov 8 2024 at 9:50am
“Many pundits believe that the election outcome was heavily influenced by public anger over inflation.”
I don’t understand what point you are making here. Is it that the election outcome was not about anger over inflation; or that pundits are mischaracterizing anger over declining real wages as anger over inflation; or something else? Thanks.
Scott Sumner
Nov 8 2024 at 12:53pm
I do think the election was partly about inflation. Markets reacted to the result as if inflation will get worse. In that case, the market reaction to the Trump election was negative. But the media stories I saw suggested a positive market reaction.
I suppose you could defend that view by pointing to the stock market, which may be anticipating economic growth. But during the Biden administration we were all being told that booming GDP and a strong stock market didn’t matter, all the public cared about was inflation.
I’m confused.
Philo
Nov 8 2024 at 12:48pm
“Lars Svensson has argued that monetary policymakers should ‘target the forecast’ . . . .” It is incredible that such an obvious point should have been considered a novel proposal, and should not already have been fundamental to every regulator’s thinking.
Scott Sumner
Nov 8 2024 at 12:49pm
And it’s still highly controversial!
Spencer Hall
Nov 8 2024 at 12:50pm
The 2-year roc in means-of-payment money, the volume and velocity of money, bottomed in August. It will accelerate next year, i.e., inflation will be higher in 2025.
David S
Nov 9 2024 at 4:45pm
2025 to 2026 could be a pretty interesting year for monetary policy. People don’t like high inflation, but there’s a pretty good chance that we’re conditioned to PCE of 2.5 to 2.8% for sustained periods. If that’s combined with good GDP growth then everything might seem fine for a while—sort of like the early 90’s. There could be some mild admonishments from the Fed about the sustained overshoot of PCE, but if everybody is happy, no meaningful tightening will happen.
Or, as Scott has suggested, the fiscal bill is coming due and we’ll have sustained high borrowing costs and an NGDP growth environment that is depressed with those slightly higher PCE rates—A mini-stagflation of sorts.
Or, things could go really sideways for reasons that no Fed board can control.
Craig
Nov 10 2024 at 9:38am
Markets may be a bit whipsawed on inflation. Prior to 2022 I’d say it looked like they had absolutely no fear of inflation right up through peak reading in June 2022, but now, having been given an inflation haircut [multi trillion dollar inflation haircut], they might be a bit inflation shy at this point with breakevens a bit higher than they should be right now.
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