News & Insights

The Fed Claims There is An Inflation (as in, a lack of) Problem—Not Really!

The Federal Reserve (Fed) made a shift last week in its policy toward inflation—the relationship between the level of unemployment and future inflation trends and its monetary policy framework in relation to inflation expectations for the United States. It announced its plan to view its 2 percent inflation target as an average level target and not a maximum cap rate. What does this mean? The Fed is confirming that its estimate of inflation over the past few years has been running below 2 percent, and thus it is comfortable with, and even wants to allow, future inflation levels to rise over 2 percent to get to a long-term average of 2 percent.

To accomplish this goal, the Fed expects to keep its accommodative monetary policy in place for an extended period. And as of the writing of this piece, the markets are currently projecting money market rates for the U.S. will remain close to zero through 2023. To justify this change, the Fed is pointing out that all anyone has to do is look at the U.S. economy since the end of the Great Recession a decade ago and see that, while unemployment levels dropped to record lows, there was no surge of inflation. The Fed is saying, in effect, that the long held economic relationship between employment and inflation no longer holds. In other words, the Phillips curve is dead.

I would suggest, however, that there is no deflation problem as the Fed would have us to believe. Just in looking at the Bloomberg chart below, which is a combination of common nominal measures of inflation in addition to several market-based inflation expectation indexes, we can readily see the recent decline in these readings in correlation with COVID-19.  However, we can also see that overall inflation over the past five years has only been ever so marginally lower than the previous decade-and-a-half. And, while globalization and world trade have certainly pushed some measures of inflation marginally lower, the fact remains that, when evaluating core service inflation readings (i.e., attempting to remove, to the best degree possible, the effects of world trade) we can see that core inflation tracks generally with national wages. Before the outbreak of COVID-19, U.S. national wages were consistently running more than 2 percent on an annualized basis, and since 2018, have increased at a rate closer to 3 percent. This data leads me to argue that the Philips curve is not as dead as the Fed would like us all to believe.

What is really going on here? I suspect that the Fed has the obvious and well justified need to maintain high levels of current monetary policy accommodation, but it also feels the need to justify this requirement for reasons other than the obvious one–COVID-19. As a result, it must either cite an incorrect conclusion regarding deflation trends or acknowledge it is just using inflation as an excuse to justify the desire to maintain a lower for longer rate view. Regardless of which reason we believe, it seems clear there is no real problem with disinflation in the United States. The Fed certainly needs to maintain highly accommodative monetary policies as the global economy continues to battle the effects of the pandemic. My preference is that the Fed says that without feeling obligated to justify it with some alternative and incorrect explanation of long-run deflation trends that doesn’t appear to be supported by the facts.