Is The Federal Reserve Preparing To Increase Their Inflation Target?

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To investors,

There has been significant scrutiny of the US monetary and fiscal policy decisions over the last decade. The proponents believe that the various activities have helped mitigate severe short-term pain during the Global Financial Crisis and COVID-19 pandemic. The critics believe that market intervention has continued to kick the can down the road and created a larger problem that will only lead to more pain in the future.

Maybe one side of the debate is right, but more likely, each argument has an element of truth to them. It is possible for people in positions of leadership to mitigate short-term pain at the expense of long-term crisis. In fact, I would argue this is the most accurate analysis of the past decade or so.

A key driver of these monetary and fiscal policy drivers is inflation targeting. Sarwat Jahan writes for the IMF:

“In recent years, many central banks, the makers of monetary policy, have adopted a technique called inflation targeting to control the general rise in the price level. In this framework, a central bank estimates and makes public a projected, or “target,” inflation rate and then attempts to steer actual inflation toward that target, using such tools as interest rate changes. Because interest rates and inflation rates tend to move in opposite directions, the likely actions a central bank will take to raise or lower interest rates become more transparent under an inflation targeting policy. Advocates of inflation targeting think this leads to increased economic stability.”

When describing why inflation targeting is so effective, Jahan writes:

“In general, a monetary policy framework provides a nominal anchor to the economy. A nominal anchor is a variable policymakers can use to tie down the price level.”

To better understand how inflation targeting works, Sarwat Jahan highlighted:

“Inflation targeting is straightforward, at least in theory. The central bank forecasts the future path of inflation and compares it with the target inflation rate (the rate the government believes is appropriate for the economy). The difference between the forecast and the target determines how much monetary policy has to be adjusted. Some countries have chosen inflation targets with symmetrical ranges around a midpoint, while others have identified only a target rate or an upper limit to inflation. Most countries have set their inflation targets in the low single digits. A major advantage of inflation targeting is that it combines elements of both “rules” and “discretion” in monetary policy. This “constrained discretion” framework combines two distinct elements: a precise numerical target for inflation in the medium term and a response to economic shocks in the short term.”

Lastly, Jahan explains what is required for inflation targeting to be effective:

“Inflation targeting requires two things. The first is a central bank able to conduct monetary policy with some degree of independence. No central bank can be entirely independent of government influence, but it must be free in choosing the instruments to achieve the rate of inflation that the government deems appropriate. Fiscal policy considerations cannot dictate monetary policy. The second requirement is the willingness and ability of the monetary authorities not to target other indicators, such as wages, the level of employment, or the exchange rate.”

Alright, so now that we understand how inflation targeting works, why it is important, and what is required, you are probably wondering why I am spending so much time on a nuanced aspect of the financial market.

The answer is that I have an intuition that the Federal Reserve is preparing to significantly increase the target inflation rate.

This decision will not be taken lightly by the central bank and their leadership, but it ultimately signals that inflation has escaped their control and rather than pull it back in with aggressive monetary policy decisions, the next best option is to simply manipulate the benchmark to make the situation appear less bad.

This isn’t a random conspiracy theory, nor is it an uniquely original idea. Yesterday CNBC had a conversation with Mohamed El-Erian, the Chief Economic Adviser of Allianz and former CEO of PIMCO, where they discussed this very topic of inflation target increases.

The idea of increasing the inflation target by 50% is fairly extreme, but humans like round numbers and this would be a full-on capitulation by the Federal Reserve. They may not have many other options. Before the inflation target is increased though, it will be important to pay attention to the mainstream media conversation.

My expectation is that there will be a flurry of expert guests who start to float this idea, which will then normalize it in the eyes of the market. Once the market has begun to digest the change and potential impact, the Federal Reserve will have the ability to make the change without as much pushback or negative impact.

There is no guarantee that the inflation target is going to be increased. This is just a hunch at the moment. After I watched El-Erian discuss the prospects of a change so openly though, it became more obvious to me that this is a very real option on the table now. I’ll do my best to unpack the ramifications of a decision like this in a future letter. For now, it is important to keep your eyes open and your head on a swivel.

50% increases in the inflation target by the world’s most established economy, and most trusted central bank, don’t exactly happen all the time. The impact will be interesting to watch. Hope you all have a great day. I’ll talk to everyone tomorrow.

-Pomp

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