As expected, the Federal Open Market Committee (FOMC) announced no changes to its administered rates following its April meeting, and Federal Reserve Chair Jerome Powell did not provide new information about the Fed’s bond-buying programs. The FOMC reaffirmed it wants to observe substantial progress toward its dual mandate on employment and price stability, including assurances that the worst of the pandemic is behind us, before scaling back accommodation.
While this wasn’t a new message from Powell, it’s nonetheless notable that the Fed is so focused on backward-looking data instead of forward-looking projections, since the outlook has improved so substantially and monetary policy works with long and variable lags. However, we think this new focus is a necessary condition for the Fed’s ultimate success, primarily due to the importance of anchoring long-term inflation expectations.
The end of ‘copacetic coincidence’
Since the formal introduction of the Fed’s 2% inflation target in 2012, median FOMC estimates of the neutral real interest rate (r*) have declined substantially from 2.25% in January 2012 to 0.5% today. The implications of this decline are profound: The FOMC now has less room to accommodate adverse economic shocks by cutting its benchmark interest rate. And this, in turn, increases the likelihood that the Fed will be constrained by the zero lower bound in the future, and elevates the risk that the U.S. economy will face more frequent periods of disinflation or outright deflation that over time depress inflation expectations. These risks are especially acute under a strictly forward-looking inflation-targeting strategy – the Fed’s previous approach – since 2% acts more like a ceiling than a long-term average. In this case, the resulting drift lower in inflation expectations further tightens the constraints on the central bank.
Fed Vice Chair Richard Clarida discussed this in an April 14 speech, when he declared the end of “copacetic coincidence.” In a paper he wrote in 2003, Clarida found that absent a zero-lower-bound constraint, a monetary policy that targets actual inflation should deliver long-run inflation expectations well-anchored at the target “for free.” However, Clarida noted, in a low r* world, this copacetic coincidence no longer holds.
This explains the importance to the Fed’s broader monetary policy strategy of longer-term inflation expectations. It also explains why the Fed shifted last year to a flexible average inflation-targeting approach, which aims for above-target inflation after periods when inflation runs persistently low. However, important questions related to inflation expectations remain: How anchored are long-term inflation expectations? And what are they currently implying for realized inflation, and the Fed’s ability to achieve its target? In response to these questions, we would make a few points:
- Inflation expectations appear to adapt slowly to trends in realized inflation.
- As a result of the period of persistently below-target U.S. inflation following the global financial crisis, inflation expectations appear to have re-anchored under the Fed’s longer-run 2% target.
- If the Fed wants to sustainably reach its target, it must raise inflation expectations.
- Raising inflation expectations likely will require a period of above-target inflation.
- Additional fiscal stimulus may be exactly what it takes to jump start the period of above-target inflation.
Recently Vice Chair Clarida stated that, in his view, once normalization begins, the pace of Fed rate hikes will depend critically on the extent to which inflation expectations are rising. While some have interpreted this to mean that the Fed will view any rise in inflation expectations as a worrisome indicator of broader inflation risks, our analysis suggests it’s a necessary condition for the Fed to achieve its inflation target. Indeed, the Fed would likely prefer to see inflation expectations that slowly move back toward the 2% target.