The government recently announced a 12-month rise in CPI from 8.5% in March to 8.3% in April. But that’s not good news, because inflation is actually getting worse.
People have become accustomed to thinking about inflation in the “let the days go by” fashion. Don’t cry for spilled milk; Let’s focus on inflation going forward. This may be appropriate under the Fed’s old inflation target regime, but it is not. Average Inflation targets. Consider the following graph of 5 year tips spread:
With the recent fall, the 5-year TIPS spread is almost the same as 6 months ago, though still higher than a year ago. But the situation is much worse than it seems. To see why, consider the following example:
Suppose that in 2021, the 5-year TIPS spread was 3%, and in 2022 they remain at 3%. Also assume that inflation between 2021-22 was 8%. Then in 2021, investors would have predicted a total inflation of about 15% compared to 2021-26. In 2022, investors will forecast a total inflation of 20% from 2021-26 (8% + 4 * 3%). In that case, the inflation rate forecast for 2021-26 will increase from 3% to 4%. [(8% + 4*3%)/5] Between 2021 and 2022. This is not a big problem under the inflation target, but it is a big problem under the average inflation target where the past inflation rate is important. This is why the inflation problem continues to worsen, even though the inflation forecast is close to 3%.
Today’s report shows a 0.6% jump in core CPI, probably last year’s single most discouraging data point, so it’s not just food and oil. The Fed is behind the curve. It reminds me a lot of the 1970s; Where a lot of excuses were made in the early stages of great inflation, a lot of people denied the reality of excess demand. There was also a (false) notion that the Fed has tightened policy because interest rates have risen, although interest rates do not measure monetary policy position.
Christopher Waller recently suggested that it is not just the Fed that has failed to forecast inflation. That’s true. But the problem with Fed policy is not that they have failed to forecast inflation, they have (de facto) abandoned FAIT. Under a credible FAIT regime, the market will forecast. Even if the Fed is behind the curve, markets will tighten policy by pushing up rates in anticipation of future Fed tightening to create an average inflation rate of 2%. Without that promise, markets will not be able to stabilize speculation and the Fed’s job will become more difficult. Without FAIT, the Fed would have to be like Nostradamus. It needs to accurately predict inflation and know exactly when to raise rates.
PS Yes, FAIT general average inflation is not like the 2% target. But using any reasonable explanation of the FAIT, the Fed abandoned its new policy regime. For example, James Bullard once suggested that the FAIT is similar to the NGDP level target, but much higher than the NGDP growth trend. And given the recent decline in the labor force, one could argue that the NGDP should be below trend.