Tag Archives: Price Stability

Almost Looks Like the Fed Has a 3% Inflation Target

16 Sunday Nov 2025

Posted by in Inflation, Monetary Policy

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Inflation leveled off below 3% in 2024 and has drifted around the 3% level in 2025. The rate of increase in the core PCE (Personal Consumption Deflator) is the inflation measure of most interest to the Federal Reserve as a policy reference, but advances in the core CPI (Consumer Price Index) have settled at about the same level. The core inflation rates exclude food and energy prices due to the volatility of those components, but even with food and energy, inflation in the PCE and the CPI have been running near 3%.

It’s a 2% Target… Or Is It?

The Fed continues to maintain that its “official” inflation target is 2% for the core PCE. However, the central bank is now easing policy despite inflation running a full percentage point faster than the target. The rationale turns on the Fed’s dual mandate to maintain both “price stability” and full employment, goals that are not always compatible.

Currently, the labor market is showing signs of weakness, so the Fed has elected to ease policy by guiding the federal funds rate downward, and by putting a stop to run-off in its balance sheet holdings of securities. The latter ends a brief period of so-called quantitative tightening.

Just a couple of months ago, the central bank announced a new emphasis on targeting 2% inflation in the long run, with notable differences from the “flexible average inflation targeting” (FAIT) that it claimed to have adopted in 2020. In some respects, the Fed appeared to be giving more primacy to the “2%” definition of price stability than to the full employment mandate. Yet the “new approach” still allows plenty of wiggle room and might not differ much from the approach followed prior to FAIT.

No FAITful Error

Here’s how David Beckworth characterizes the way FAIT ultimately played out. He says that in practice the Fed took:

“… an asymmetric approach to the dual mandate: It would implement makeup policy on misses below the inflation target, and it would respond to shortfalls from maximum employment. These asymmetries, while well- intended, created an inflationary bias that caused FAIT to fail the ‘stress test’ of the 2021–22 inflation surge. This failure caused the Fed to effectively abandon FAIT in early 2022 and become a single-mandate central bank focused on price stability.“

Scott Sumner says the Fed never really really practiced FAIT to begin with. It should have been a symmetric policy, but it wasn’t. During 2021-22, the Fed did not attempt to correct for rising inflation. Instead, it focused on the recessionary effects of Covid and the impingements of Covid-era restrictions on employment.

Clearly, Covid was a shock that monetary policy was ill-suited to address without reinforcing inflation. Furthermore, the pandemic inflation was thought by the Fed to be transitory, but easing policy was a critical error. Stimulating demand via monetary accommodation gave inflation more permanence than the Fed apparently expected.

Lost In the Tea Leaves Again

While a strong commitment to price stability is welcome, it’s not clear that is what’s guiding the Fed’s decisions at the moment. Again, the Fed’s preferred inflation gauge has flattened out at around 3%. However, with uncertainty about tariffs and tariff pass throughs in 2026, the weak dollar, and unrelenting Treasury borrowing, easier monetary conditions could well set the stage for persistent inflation above 3%, despite the official 2% target. That might help explain the failure of longer-term interest rates to decline in the wake of the Fed’s latest quarter-point cut in the federal funds target in October.

Suspicious Minds

Speculation that the Fed is allowing its true inflation target to creep upward is hardly new. Back in June, former New York Fed economist Robert Brusca noted the following:

“A Cleveland Fed survey already has the business community thinking that the REAL target for inflation is 2.5%.”

More recently, Mark Sobel of the Official Monetary and Fiscal Institutions Forum stated that the real target, for now, is probably 3%:

“But could the Fed stealthily and unintentionally end up near 3%? Even apart from above-target inflation in recent years, short- and longer-term structural forces are at play that could usher in slightly higher inflation, notwithstanding Fed speeches on the sanctity of the 2% inflation target.“

Chewing On Data

It’s pretty clear that the Fed has become a skittish about the pace of the real economy, lending more weight to the full employment part of its dual mandate. Employment growth slowed over the past year, partly due to government employee buy-outs and separations of illegal immigrants from their employers. The last official employment report was in early September, however, so the nonfarm payroll data is two months out-of-date:

Private payroll growth from ADP over the past two months has not looked especially encouraging:

Tariffs and weakened profit margins have likely had a contractionary effect, and the six-week government shutdown just ended will shave 0.5% or more off fourth quarter GDP growth. Furthermore, while money (M2) growth has accelerated over the past year, it remains fairly restrained.

And the monetary base has been pretty flat for most of 2025:

We’ll see where these aggregates go from here. The extended “restraint” might now be of some concern to the Fed, given recent doubts about employment and economic growth. Still, in October, Fed Chairman Jerome Powell said that another quarter-point cut in the federal funds rate target in December was not a foregone conclusion. That statement seems to have worried equity investors while offering little solace to bond investors.

Aborted Landing

If (and as long as) the Fed gives primacy or greater weight in its policy deliberations to employment than inflation, it might as well have adopted an inflation target of 3% or more. The additional erosion in purchasing power wrought by that leniency is bad enough, but the effect of monetary policy on the real side of the economy is more poorly understood than its effect on nominal variables. The Fed’s shift in priorities is both unreliable on the real side and dangerous in terms of price stability. These concerns are even more salient given the upcoming appointment (in May) of a new Fed Chairman by President Trump, who seems eager for easy money.

The Perils of Powell: Inflation, Illiquid Banks, Lonnng Lags

01 Saturday Apr 2023

Posted by in Inflation, Monetary Policy

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To the great chagrin of some market watchers, the Federal Reserve Open Market Committee (FOMC) increased its target for the federal funds rate in March by 0.25 points, to range of 4.75 – 5%. This was pretty much in line with plans the FOMC made plain in the fall. The “surprise” was that this increase took place against a backdrop of liquidity shortfalls in the banking system, which also had taken many by surprise. Perhaps a further surprise was that after a few days of reflection, the market didn’t seem to mind the rate hike all that much.

Switchman Sleeping

There’s plenty of blame to go around for bank liquidity problems. Certain banks and their regulators (including the Fed) somehow failed to anticipate that carrying large, unhedged positions in low-rate, long-term bonds might at some point alarm large depositors as interest rates rose. Those banks found themselves way short of funds needed to satisfy justifiably skittish account holders. A couple of banks were closed, but the FDIC agreed to insure all of their depositors. As the lender of last resort, the Fed provided banks with “credit facilities” to ease the liquidity crunch. In a matter of days, the fresh credit expanded the Fed’s balance sheet, offsetting months of “quantitative tightening” that had taken place since last June.

Of course, the Fed is no stranger to dozing at the switch. Historically, the central bank has failed to anticipate changes wrought by its own policy actions. Today’s inflation is a prime example. That kind of difficulty is to be expected given the “long and variable lags” in the effects of monetary policy on the economy. It makes activist policy all the more hazardous, leading to the kinds of “boom and bust” cycles described in Austrian business cycle theory.

Persistent Inflation

When the Fed went forward with the 25 basis point hike in the funds rate target in March, it was greeted with dismay by those still hopeful for a “soft landing”. In the Fed’s defense, one could say the continued effort to tighten policy is an attempt to make up for past sins, namely the Fed’s monetary profligacy during the pandemic.

The Fed’s rationale for this latest rate hike was that inflation remains persistent. Here are four CPI measures from the Cleveland Fed, which show some recent tapering of price pressures. Perhaps “flattening” would be a better description, at least for the median CPI:

Those are 12-month changes, and just in case you’ve heard that month-to-month changes have tapered more sharply, that really wasn’t the case in January and February:

Jason Furman noted in a series of tweets that the prices of services are driving recent inflation, while goods prices have been flat:

A compelling argument is that the shelter component of the CPI is overstating services inflation, and it’s weighted at more than one-third of the overall index. CPI shelter costs are known as “owner’s equivalent rent” (OER), which is based on a survey question of homeowners as to the rents they think they could command, and it is subject to a fairly long lag. Actual rent inflation has slowed sharply since last summer, so the shelter component is likely to relieve pressure on CPI inflation (and the Fed) in coming months. Nevertheless, Furman points out that CPI inflation over the past 3 -4 months was up even when housing is excluded. Substituting a private “new rent” measure of housing costs for OER would bring measured inflation in services closer the Fed’s comfort zone, however.

The Fed’s preferred measure of inflation, the deflator for personal consumption expenditures (PCE), uses a much lower weight on housing costs, though it might also overstate inflation within that component. Here’s another chart from the Cleveland Fed:

Inflation in the Core PCE deflator, which excludes food and energy prices, looks as if it’s “flattened” as well. This persistence is worrisome because inflation is difficult to stop once it becomes embedded in expectations. That’s exactly what the Fed says it’s trying to prevent.

Rate Targets and Money Growth

Targeting the federal funds rate (FFR) is the Fed’s primary operational method of conducting monetary policy. The FFR is the rate at which banks borrow from one another overnight to meet short-term needs for reserves. In order to achieve price stability, the Fed would do better to focus directly on controlling the money supply. Nevertheless, it has successfully engineered a decline in the money supply beginning last April, and recently the money supply posted year-over-year negative growth.

That doesn’t mean money growth has been “optimized” in any sense, but a slowdown in money growth was way overdue after the pandemic money creation binge. You might not like the way the Fed executed the reversal or its operating policy in general, and neither do I, but it did restrain money growth. In that sense, I applaud the Fed for exercising its independence, standing up to the Treasury rather than continuing to monetize yawning federal deficits. That’s encouraging, but at some point the Fed will reverse course and ease policy. We’ll probably hope in vain that the Fed can avoid sending us once again along the path of boom and bust cycles.

In effect, the FFR target is a price control with a dynamic element: the master fiddles with the target whenever economic conditions are deemed to suggest a change. This “controlled” rate has a strong influence on other short-term interest rates. The farther out one goes on the maturity spectrum, however, the weaker is the association between changes in the funds rate and other interest rates. The Fed doesn’t truly “control” those rates of most importance to consumers, corporate borrowers, government borrowers, and investors. It definitely influences those rates, but credit risk, business opportunities, and long-term expectations are often dominant.

The FOMC’s latest rate increase suggests its members don’t expect an immediate downturn in economic activity or a definitive near-term drop in inflation. The Committee may, however, be willing to pause for a period of several meeting cycles (every six weeks) to see whether the “long and variable lags” in the transmission of tighter monetary policy might begin to kick-in. As always, the FOMC’s next step will be “data dependent”, as Chairman Powell likes to say. In the meantime, the economic response to earlier tightening moves is likely to strengthen. Lenders are responding to the earlier rate hikes and reduced lending margins by curtailing credit and attempting to rebuild their own liquidity.

Is It Supply Or Demand?

There’s an ongoing debate about whether monetary policy is appropriate for fighting this episode of inflation. It’s true that monetary policy is ill-suited to addressing supply disruptions, though it can help to stem expectations that might cause supply-side price pressures to feed upon themselves (and prevent them from becoming demand-side pressures). However, profligate fiscal and monetary policy did much to create the current inflation, which is pressure on the demand-side. On that point, David Beckworth leaves little doubt as to where he stands:

“The real world is nominal. And nominal PCE was about $1.6 trillion above trend thru February. Unless one believes in immaculate above-trend spending, this huge surge could 𝙣𝙤𝙩 have happened without support from fiscal and monetary policy.”

In reality, this inflationary episode was borne of a mix of demand and supply-side pressures, and policy either caused or accommodated all of it. Nevertheless, it’s interesting to consider efforts to decompose these forces. This NBER paper attributed about 2/3 of inflation from December 2019 – June 2022 to the demand-side. Given the ongoing tenor of fiscal policy and the typical policy lags, it’s likely that the effects of fiscal and monetary stimulus have persisted well beyond that point. Here is a page from the San Francisco Fed’s site that gives an edge to supply-side factors, as reflected in this breakdown of the Fed’s favorite inflation gauge:

Of course, all of these decompositions are based on assumptions and are, at best, model-based. Nevertheless, to the extent that we still face supply constraints, they would impose limits to the Fed’s ability to manage inflation downward without a “hard landing”.

There’s also no doubt that supply side policies would reduce the kinds of price pressures we’re now experiencing. Regulation and restrictive energy policies under the Biden Administration have eroded productive capacity. These policies could be reversed if political leaders were serious about improving the nation’s economic health.

The Dark Runway Ahead

Will we have a recession? And when? There are no definite signs of an approaching downturn in the real economy just yet. Inventories of goods did account for more than half of the fourth quarter gain in GDP, which may now be discouraging production. There are layoffs in some critical industries such as tech, but we’ll have to see whether there is new evidence of overall weakness in next Friday’s employment report. Real wages have been a little down to flat over the past year, while consumer debt is climbing and real retail sales have trended slightly downward since last spring. Many firms will experience higher debt servicing costs going forward. So it’s not clear that the onset of recession is close at hand, but the odds are good that we’ll see a downturn as the year wears on, especially with credit increasingly scarce in the wake of the liquidity pinch at banks. But no one knows for sure, including the Fed.

Price Stability: Are We There Yet?

22 Thursday Dec 2022

Posted by in Inflation, Liberty, Monetary Policy

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The answer to that question, kids, is a resounding no! The Federal Reserve created far too much liquidity during and after the pandemic and waited too long to reverse that policy. That’s a common view among the “monetarazzi”, but far too many analysts, in the next breath, assert that the Fed is going too far in tightening policy. Sorry, but you can’t have it both ways! Thus far, the reductions we’ve seen in the monetary aggregates (M1, M2, M3) represent barely a trickle out of the ocean of liquidity released during the previous two years. The recent slight moderation in the rate of inflation is unlikely to gain momentum without persistence by the Fed.

This Could Be Easier

I humbly concede, however, that a different approach by the Fed might have been less disruptive. A better alternative would have involved more aggressive reductions in the gigantic portfolio of securities it acquired via “quantitative easing” (QE) during the pandemic while avoiding direct intervention to raise short-term interest rates. In fact, allowing interest rates to be determined by the market, rather than via central bank intervention, is more sensible in terms of pricing debt of any duration. It also suggests a more direct and sensible approach to managing the growth of the money supply. Of course, had the Fed unwound QE more aggressively, short-term rates would surely have risen anyway, but to levels appropriate to rationing liquidity more efficiently. Furthermore, those rates could have served as a useful indicator of the market’s ability to digest a particular volume of sales from the Fed’s portfolio.

Getting Tight

The chart below shows the level of the monetary base (bank reserves plus currency) over the past five years from the Trading Economics site. The monetary base is the narrow monetary aggregate supporting growth of the money stock and is under fairly direct control of the Fed.

The base has declined substantially during 2022 largely as a consequence of the Fed’s restrictive policies. However, it has retraced only about a third of the massive expansion engineered by the Fed over the two prior years. Here is the corresponding plot of the M1 money stock (currency plus checking deposits):

So the reductions in the base have yet to translate into much of a reduction in the money stock, though growth in all of the aggregates has certainly declined. No one thinks this will be a walk in the park. Withdrawing liquid capital from markets accustomed to swilling in excesses will have consequences, particularly for investors who’ve grown undisciplined in their approach to evaluating prospective assets. Investors and society at large inevitably pay the price for the malinvestment encouraged by unbridled money growth (not to mention misdirected industrial policies … that’s a different can of worms).

But the squeamish resist! I got a kick out of this tweet by Noah Smith in which he pokes fun at those who insist that the surge in inflation was a mere transitory phenomenon:

“Team Transitory: OMG inflation is just going to go away, you don’t need to raise interest rates.

Fed: *raises interest rates*

Inflation: *goes down a bit*

Team Transitory: SEE, I told you inflation was going away and that you didn’t need to raise interest rates!!”

Well, in fairness, “Team Transitory” has been fixated on supply disruptions that very well should resolve with private efforts over time. Some have resolved already. And again, we’ve yet to feel much impact from the Fed’s tighter policy, but I’m amused by the tweet nevertheless.

In fact, the surge in inflation has been driven by both supply and demand factors, and it’s true the Fed can do very little about the former. But stalling the effort to purge excess liquidity and demand-side inflation risks allowing expectations of inflation to edge higher, creating an environment in which price pressures are more resistant to policy actions.

Inflation And Its Proximate Sources

It is indeed good news that inflation has tapered slightly over the past few months, or at least the “headline” inflation numbers have tapered. Weaker energy prices helped a great deal, though releases from the Strategic Petroleum Reserve aren’t sustainable. Measures of “core” inflation that exclude food and energy prices, and more central measures of inflation within the spectrum of goods and services, have moved sideways or perhaps shown signs of a slight moderation.

Here’s a plot of several measures of CPI inflation taken from the Cleveland Fed’s web site. Note that the median component of the CPI has finally hit a plateau, and a “trimmed” measure that excludes CPI components with extreme changes has dipped slightly. The Core CPI has fluctuated in a range just above 6% for most of the year.

The deflator for personal consumption expenditures (PCE) gets more emphasis from the Fed in its policy deliberations. The latest release at the start of December showed patterns similar to the CPI:

With respect to the PCE deflator, the slight dampening of price pressure we’ve seen recently came primarily from the supply side, with some progress on the demand side as well. Energy was one factor on the supply side, but even the core PCE deflator shows less supply pressure. Adam Shapiro has a decomposition of the PCE deflator into supply-driven and demand-driven components (but the chart only goes through October):

First, without endorsing Shapiro’s construction of this dichotomy, I note that the impact of monetary policy is primarily through the demand side of the economy. Of course, monetary instability isn’t good for producers, and excessive money growth and inflation create uncertainty that inhibits supply. But what we’ve seen recently has more to do with the curing of supply chain bottlenecks that cropped up during the pandemic (or in its wake), and Shapiro attempts to capture that kind of phenomenon here.

Still, many would argue that the November CPI showed sufficient progress for the Fed to pause its tightening campaign. The reductions in the monthly price increases were fairly widespread, as shown by this table from the CPI report:

The next chart from Joe Wiesenthal (via Bloomberg) displays trends in broad CPI categories, but it shows vividly that the reductions were concentrated in energy components and goods prices, while services and food inflation did not really abate. (The legend is so hard to read that I took the liberty of blowing it up a bit below the chart itself):

Playing Catch-Up

While the Fed’s effort to restrain inflation began in earnest in the spring of this year, it lifted the federal funds rate target rapidly. Here’s another chart from Adam Shapiro, via the Wall Street Journal: the Fed’s current tightening cycle is the fastest in 40 years in terms of those rate hikes:

Fast, yes, but they got a late start in the face of a rapid acceleration of inflation, and for what it’s worth, the Fed’s rate target remains below the rate of inflation. Yes, I’m forced to acknowledge here that the Fed’s preference for rate intervention and targeting is just what they do, for now. In any case, top-line inflation and strictly demand-side inflation are still above the Fed’s 2% target.

Fabian Fiscal Expansionists

One “fix” recommended in some circles suggests that the Fed’s inflation target is too low, as if price stability had nothing to do with its mandate! The idea that low-grade inflation is a healthy thing has never been convincingly demonstrated. In fact, the monetary literature leans strongly in the direction of price stability and an optimal rate of inflation of zero! That the Fed should aim for higher inflation seems like a cop-out intended to appease those who still subscribe to the discredited notion that there exists a reliable long-run tradeoff between inflation and unemployment.

In fact, proposals to increase the central bank’s inflation target would enable more deficit spending financed with the “printing press”, which is at the root of the demand-side inflation problem we now face. A major justifications for ballooning levels of federal spending has been so-called Modern Monetary Theory (MMM), which has gained adherents among statists in the years since the Great Recession. MMM holds that “important” initiatives can simply be paid for with new money creation, rather than interest bearing debt, or God forbid, taxes! “Partisan” is probably a better description than “theorist” for any fan of MMM, and they have convinced themselves that money financed deficits are without inflationary consequences. Of course, this represents a complete suspension of the law of resource scarcity, not to mention years of monetary history. Raising the Fed’s inflation target plays well with the same free-lunch advocates who rally behind MMM.

The Fed’s Unfaithful Fiscal Partner

Federal budget control is likely to take another hit this week with passage of the $1.7 omnibus spending bill. It includes spending increases with no immediate offsets as required under the pay-as-you-go budget law. It delays those offsets to 2025 and increases deficits in the interim by hundreds of billions of dollars. It also sets a new, higher baseline for discretionary appropriations in future years. The federal deficit has already risen dramatically compared to a year ago under the fiscal profligacy of Congress and the Administration. Another contributing factor, however, is that the interest cost of servicing the national debt has spiked as interest rates have risen. Needless to say, none this makes the Fed’s job any easier, especially as it seeks to reverse QE.

Say Uncle!?

When will the Fed begin to take its foot off the brake? It “only” raised the Fed funds target by 50 basis points at its meeting last week (after four 75 bps moves in a row. It is expected to raise the target another 50 bps in early February and perhaps another 25 in March. Strong signals of imminent recession would be needed for the Fed to call it off any sooner, and we’re definitely seeing more hints of a weakening economy in the data (and see here, here, here, and here). More definitive declines in inflation would obviously help settle things. Otherwise, the Fed may pause after March in order to gauge progress toward its goal of 2% inflation.