In June, the Federal Open Market Committee (FOMC) raised its target federal funds rate by 75 basis points, moving the target range 1.5 percent to 1.75 percent. This was largest one-time gain in the target federal funds rate since 1994. Why did the Fed change its position so quickly? And how are investors reacting to this financial tightening?
As noted in the Federal Reserve’s Statement of Long-Term Objectives and Monetary Policy Strategy, the FOMC “seeks to achieve inflation that averages 2 percent over time,” as measured by the Personal Consumption Expenditure Price Index (PCEPI ). PCEPI inflation is measured using a price level that weights prices against consumer spending. The Fed also controls PCEPI core inflation that does not include food and energy, as this measure tends to be better at predicting PCEPI over longer time periods.
Some complain when Fed officials or economists refer to Core PCEPI on the grounds that food and energy prices matter a lot to American consumers. But such complaints are wrong. The Federal Reserve does not deny the importance of food and energy prices, which are included in the targeted PCEPI program. The focus on core PCEPI (and other variables) is simply meant to reduce the likelihood that the Fed is overreacting to short-term fluctuations in food and energy prices that cause PCEPI inflation to hover around core PCEPI inflation.
Over the past few months, core PCE inflation has been on a downward trend year-on-year. It peaked at 5.3 percent in February. In May, it was only 4.7 percent.
In contrast, PCEPI inflation has risen. Higher energy prices, largely due to Russia’s invasion of Ukraine and related economic sanctions, have propelled gas prices to new highs. In many states, the price of gasoline exceeds $5 per gallon, and the price of diesel often exceeds $6 per gallon. This played a role in the rise of PCEPI and CPI inflation.
A more important effect of higher energy prices is that they limit economic growth. For now, the FOMC wants to prevent a significant rise in PCEPI inflation. Aggressive policies will slow down inflationary pressures in general and likely lead to rate cuts.
The Future of Inflation
What do markets say about expected inflation? One way to distinguish between short-term and long-term inflation expectations is to compare breakeven inflation rates over 5 and 10 years. The break-even inflation rate compares the rate of return on inflation-adjusted bonds with the rates on uncompensated U.S. Treasury bills of the same maturity. They subtract the inflation-adjusted security rate from unadjusted securities. Because these inflation-protected securities are adjusted for inflation as measured by the CPI, the break-even inflation rate refers to expected changes in the CPI.
We can compare the spread of 5-year bonds and 10-year bonds to get a clearer picture of inflation expectations over time. The wider spread between 5- and 10-year break-even rates means that there is a discrepancy between short-term and long-term inflation expectations.
On the chart, I plot the difference between the two by subtracting the 10-year break-even rate from the 5-year break-even rate. When the 5-year break-even rate is higher than the 10-year break-even rate, this means that investors expect inflation to be higher on average in the near future than in the more distant future. The larger the spread between rates, the greater the discrepancy between short-term and long-term inflation expectations.
In the first quarter of 2021, short-term inflation expectations exceeded long-term inflation expectations. In April, investors expressed serious concern as the gap between 5- and 10-year break-even inflation reached 0.65 percent. Since then, Fed Chairman Jerome Powell and other FOMC members have voiced their concerns about controlling inflation and inflation expectations. The return of the gap to 0.28 percent indicates that investors are convinced that the Fed is serious about tightening and will be effective. With the change in position, investors expect inflation to not only be lower on average over the next 5-10 years, but there will be less discrepancy between inflation in the short and long term.
Inflationary expectations and rates of interest rate increase
Jerome Powell slams on the brakes. But how long and how much should we expect Powell’s Fed to tighten? It’s hard to predict policy direction exactly, but it seems clear that Powell intends to keep raising the federal funds rate target until inflationary expectations cool off. Inflation expectations have followed a downward trend in recent months, along with core PCEPI inflation. The cooling of inflation expectations is encouraging news as these expectations refer to a more volatile and higher CPI. But PCEPI inflation continues to rise.
The Powell Fed has made it clear that its 2 percent inflation target is not a symmetrical target, meaning it does not offset long periods of inflation above 2 percent. This means that this is the average inflation upshift target. However, current inflation expectations are above 2 percent. If Powell and the FOMC want the target to be effective, they must convince investors that the Fed will take the steps necessary to keep PCEPI at 2 percent. And they must do it quickly. The longer inflation stays above 2 percent, the less credible will be the Fed’s commitment to maintain the 2 percent target. And since the target is not a true average target, the best the Fed can do to keep inflation expectations stable is to quickly push PCEPI inflation to 2 percent.
This is one reason to think that the FOMC may be overstretched. Prioritizing a soft landing over maintaining the 2 percent target would result in a discrepancy between inflation expectations and the inflation target. The slower the FOMC moves to lower inflation when it is significantly higher (it currently exceeds the target by more than 2 percentage points), the more markets will perceive the 2 percent target as an ineffective cap. The result will be relatively higher inflation expectations and interest rates over the long term, as well as a persistent mismatch between the stated inflation target and inflation expectations. To avoid this, the Federal Reserve may prioritize reducing inflation in the short term.
The quiet transition from a symmetric to an asymmetric 2% target undermines confidence in the Fed. He says he intends to keep inflation at an average of 2 percent, but his asymmetric approach means that inflation will average above 2 percent. If the FOMC believes that inflation should average above 2 percent, it should set a higher inflation target, say 3 percent, and offset periods of excess inflation by also keeping inflation below the average target for extended periods. This will stabilize inflation expectations and increase the likelihood of a soft landing without requiring a quick tightening meant to signal the severity of the Fed.