Read for 5 minutes (Reuters) – LONDON (Reuters) – As the US economy reopens after the epidemic, rapidly rising consumer prices have erased years of below-target inflation, raising questions about when the central bank will begin to reduce monetary stimulus. Customers shop for fruits at Reading Terminal Market in Philadelphia, Pennsylvania, United States, on February 6, 2021, during the coronavirus illness (COVID-19) pandemic. Hannah Beier/Hannah Beier/Hannah Beier/Hannah Beier/Hannah According to data from the Bureau of Labor Statistics, consumer prices in the United States increased at a compound annual rate of 3.00 percent each year for the two years ending in June 2021, the largest two-year increase since October 2008. Core consumer prices, excluding volatile food and energy products, grew at a compound annual rate of 2.82 percent, the quickest pace in over a quarter-century. Comparisons with 2019 help to prevent distortions produced by the first wave of the pandemic and substantial business closures in 2020, and they highlight that increased inflation is not only due to baseline effects. As part of its examination of longer-run goals and monetary policy, the Federal Reserve committed to achieving an average inflation rate of 2% over time in August 2020. Senior policymakers at the time remarked that inflation had been “consistently” below target in recent years, and that it should be permitted to run modestly beyond target for a while in order to return the average to 2%. They didn’t say when they think the undershoot started, how much of a price-level deficit they want to fix, or how long inflation will be averaged over to determine compliance with the target. All of the undershooting in core consumer price inflation since April 2009 has now been reversed thanks to the recent spike in core consumer prices following the reopening of the economy (tmsnrt.rs/3xHaOI7). VERSUS PCE In fact, the Fed has given itself a more expansionary aim by defining its objective using the personal consumption expenditures (PCE) price index rather than the consumer price index (CPI). For technical reasons, such as calculating method and extent of coverage, the PCE index rises more slowly than the CPI (“Focus on prices and spending”, Bureau of Labor Statistics, May 2011). Since the turn of the century, core PCE inflation has averaged 1.73 percent each year, compared to 2.01 percent for core CPI. Since the turn of the century, core PCE inflation has been below the 2% target 74 percent of the time, compared to only 46 percent for core CPI. This is one of the reasons why the Fed sees inflation differently from consumers. However, even using the Fed’s chosen metric, the recent price increase has erased all of the inflation undershooting dating back to April 2015. BASELINE OPTION Core PCE prices are still around 3.6 percent lower than they were in June 2008, with a forecast annual growth rate of 2% until June 2021. If the Fed decides to offset inflation undershooting all the way back to the financial crisis, more than a decade of price hikes, it will open up a lot more room for inflation to overshoot in the short term. The Fed might allow inflation to run well above goal on its preferred PCE measure throughout 2022 and into 2023, as some top officials appear to intend. Targeting average inflation for more than a decade would provide the Fed almost limitless leeway to continue buying bonds and keeping interest rates near zero. However, whether the price level in 2008, which was set on the brink of the financial crisis, when global oil prices were at a record high, is an adequate baseline remains an open topic. There is no theoretical reason to choose 2008 as the baseline year and a 13-year averaging period over any other year or averaging period. FED DISCRETIONIt’s possible that policymakers have opted to pursue an expansionary monetary policy and are selecting baselines and averaging periods to allow them to look past above-target inflation rates. This reveals a fundamental flaw in the average inflation targeting policy framework: without a better definition of the averaging period, the objective becomes totally arbitrary. The Fed could shift its focus to maximizing employment levels if it took a more discretionary approach to inflation. However, the cost of doing so would very certainly be greater price increases over time, potentially exceeding the 2% target in the long run. After allowing inflation to remain at 2.5 percent or higher for several years, the central bank is unlikely to create a significant economic cycle slowdown to bring it back to 2 percent or lower. If inflation rises over the Fed’s long-run target, the central bank may simply change the baseline and averaging period to avoid a painful monetary contraction and ensure that inflation stays above 2% in the long term. Without a defined baseline or averaging period, an average inflation aim risks becoming meaningless. Columns that are related: – Increased wage growth in the United States will assist to keep inflation at bay (Reuters, June 15) – If the recovery continues, U.S. inflation will rise (Reuters, June 11); – An empty supply chain will keep the global economy thriving (Reuters, June 3); – The Fed’s concentration on jobs implies major inflation overshoot (Reuters, June 3); – (Reuters, May 18) Elaine Hardcastle did the editing./n
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