MNI SOURCES: Fed To Refine Inflation Overshoot Parameters

Federal Reserve officials are coming under pressure to define their tolerance for higher inflation much sooner than expected, as fears build of a possible short-term surge in price expectations which could test the credibility of the FOMC's newly-installed inflation make-up strategy, Fed sources told MNI.

With vaccine breakthroughs, excess savings and another trillion or more in potential fiscal relief expected to stoke demand and price pressures, the much-feared deflation threat from the Covid-19 economic crisis has receded, sources said.

That indicates a stronger likelihood of inflation returning to the Fed's 2% target more quickly than policymakers expected -- and sets up a test of the Fed's commitment to its new flexible average inflation targeting regime at a time when the FOMC is still hashing out the specific parameters of a desired overshoot, sources said.

Opinions differ among FOMC members on a ceiling for inflation, a suitable averaging period, or when to allow exceptions to the rule should the trajectory of prices prove too swift. Reaching consensus may be a challenge, Fed sources said. But policymakers broadly agree that being more explicit about the parameters of the new framework will help clarify uncertainty related to the inflation outlook.

WARY FED

Fed officials are understood to be wary of a scenario in which a short-run pop in prices sparks a fire under inflation expectations, seen as closely tied to actual inflation, compelling the Fed to either move to a more neutral stance sooner than expected or more forcefully defend its inflation make-up strategy.

The FOMC is keen to avoid tightening too preemptively as it has done in the past, and it would take a significant escalation of inflation risk to divert it from its current policy path, sources said. But, while policymakers see that outcome as unlikely, they are also less confident in their ability to judge where inflation is headed in a post-pandemic economy.

Inflation expectations have headed steadily upward since late last year. Firms' price growth expectations for the year ahead have climbed to 2.2% on average from a low of 1.4% in April, according to the Atlanta Fed's survey of businesses in its district. A weekly survey of consumers conducted by the Cleveland Fed also finds inflation expectations rising since late fall to a range of 5% to 10% from 3% to 5% earlier in the year.

TIPS breakevens have hit multiyear highs, although once liquidity effects and risk premia are accounted for, market-based measures of inflation expectations look stable relative to the pre-crisis period.

The data reassure policymakers that a Covid demand-shock-led deflationary spiral won't materialize -- but also beg the question of when inflation will be deemed unacceptably high, sources said.

Fed Chair Jay Powell has signaled the central bank will wait to dial back monetary support until the economy has reached a broad and inclusive full employment goal and 2% inflation on a sustained basis.

SHORT-TERM LOOK THROUGH

Policymakers are prepared to look through above-2% inflation for a few months this spring, as base effects distort calculations, sources said. A surge in demand for services as vaccinated consumers start spending cash cushions could see businesses charging higher prices, but that is also viewed as temporary.

Officials are looking to generational trends like deglobalization, reshoring and deficit spending for indications that conditions are developing that would sustain higher inflation over the long run.

More immediately, a boost in prices would be welcome for an economy still suffering from not enough inflation, especially in the service sectors.

The Dallas Fed Trimmed Mean PCE inflation rate, a favored internal Fed indicator of underlying price pressures, has decelerated to 1.7% from 2.1% a year earlier. It is behaving as Phillips curve models would expect given the roughly 2 pp increase in the number of permanent unemployed over the same period.

A San Francisco Fed analysis shows contributions from supply-sensitive categories of core PCE inflation are still small while the drag from demand-sensitive categories is dissipating. Categories that don't fall neatly into either category also show gradual disinflation, albeit the trend is decelerating.