As the Federal Reserve embarks on a review of its long-run monetary framework, questions about its inflation target are resurfacing. We believe now is the time for change.
A clear challenge to central bankers globally in the past decade (or three, in the case of Japan) has been engineering sufficient inflation in a low-interest-rate environment to ensure inflation expectations are well-anchored. Despite central banks' massive balance sheet expansions, forward guidance, and yield curve control, inflation has fallen short of their targets: Japanese inflation is still near zero, European core inflation seems stuck around 1%, and U.S. core inflation has averaged 1.5% since 2008.
Fed proposals: what to do, and when?
To combat this issue, various current and former Federal Open Market Committee members have floated the idea of modifying the existing 2% inflation target (as measured by personal consumption expenditures or PCE). However, we believe subtle differences between the proposals could have big implications for their efficacy. Former Fed Chairman Ben Bernanke, for instance, has put forth a price-level-targeting strategy, whereby central bankers aim to overshoot their 2% inflation target when the policy rate is up against the effective lower bound. Other proposals to alter the inflation objective would aim to engineer an overshoot now.
We note that the Fed is being forward-looking in preparing ahead of the next recession for challenges that may arise when the cycle turns. But a key question is when is the right time for the Fed to communicate comfort with overshooting its 2% medium-term target - and when can it succeed at re-anchoring inflation expectations around this level?
In his 30 November speech, New York Federal Reserve President John Williams mentioned "average-inflation" targeting, the idea being that inflation should average 2% over a cycle. Inflation would overshoot 2% in good economic times to compensate for any undershoot in bad times. According to market-based measures, U.S. inflation expectations are closer to 1.6%, which happens to be in line with realized core PCE over the past decade. So, if the clock was reset in 2008, the Fed inflation target for the next decade would be 2.4% to balance out the low inflation years - and this would help re-anchor long-term inflation expectations to 2%.
The time is now
Ensuring inflation expectations are re-anchored higher is fundamental, in our view. In a low-rate environment, higher inflation expectations are the antidote to a vicious circle in which low inflation expectations keep rates low, which keeps inflation expectations low (as central bankers run out of tools), and so on.
With unemployment low and the U.S. economy enjoying a fiscal "sugar rush," the odds of successfully engineering an inflation overshoot look pretty good - and that is pretty rare. We've learned from the crisis that the gravitational pull of low rates and deleveraging can keep inflation stubbornly low, even well past the first half of the recovery. Engineering inflation is not an easy task; central bankers may communicate their willingness to do what it takes to push inflation higher, yet fail to convince the market and economic actors that they have the tools to do so. Words only go so far, and engineering inflation after hitting the zero lower bound is nearly impossible.
We believe the time to re-anchor inflation expectations is now when the Fed has decent odds of successfully engineering an overshoot.
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