Jay Powell, like his predecessor, has emphasized that the two percent inflation target is symmetric. That is, in the Fed’s ideal world the inflation rate would float around two percent per year, peaking just above roughly as a much as it dips a bit below. The recent trend, for inflation to float between 1.5 and two percent, is due to merely transitory phenomena, he explained. These should be expected to fade away in the coming months to a year.
Yet, some of my fellow economists and I have questioned that explanation. Inflation has been lower than two percent, we argue, because the market believes that the Fed wants inflation below two percent. Consequently, any sign that inflation might be approaching two percent is interpreted with panic among investors. They assume and fear that interest rate hikes will soon follow.
In expectation of higher future interest rates from the Fed, they demand higher returns on long-term loans. Higher interest rates on long-term loans reduce the number of projects which can be profitably invested in. That reduction in investment reduces demand in the economy now and productivity growth later, pushing down prices and wages respectively.
Lower price and wage growth mean less inflation. In this way, expectations become self-fulfilling. The belief that the Fed will punish the markets for high inflation leads to a cautiousness that produces low inflation. It’s critical then that Fed manage those expectations. If the Fed wants inflation to float symmetrically around two percent, markets have to believe that they won’t be punished for the occasional transgression above 2 percent.
An op-ed from market analyst and former Fed economist Michael Ivanovitch suggests that market participants are less than sure about that.
Let me make that clear: The policy settings that we see now are reflecting the Fed’s forecasts that economic growth over the next year and a half will keep price inflation contained within the 0-2 percent target range.
The question is: What happens if that forecast is wrong, and price increases begin to accelerate in the months ahead? …
The answer is that bond prices would sink, and that the Fed would step up rate hikes until it sees that the economy is slowing down. But by the time the Fed sees signs of an activity downturn and subsiding inflation, the economy could be into an irretrievable tailspin as a result of a lagged recessionary impact of interest rate increases that went beyond the necessary policy restraint.
Not only does Ivanovitch fear that markets will be punished for above two percent inflation, he thinks it is natural and perhaps even inevitable that the punishment will involve a new recession. With those fears hanging on each inflation report, it is no wonder that we’ve seen such a volatile response to even the hint of accelerating wage growth. And, as long as the market has these fears, it’s going to be tough – not impossible, but tough, for us to break through to a higher growth path.