MNI: Fed Able To Tolerate Above-2% Inflation, To Keep Target

The Federal Reserve would be likely to tolerate inflation rates above 2% for longer than it would prefer in order to prevent unemployment from rising too quickly, former senior Fed officials told MNI, though they stressed that going further to enshrine a 3% target as some experts have favored won't happen anytime soon.

Inflation is expected to decline rapidly this year, helped by lower energy prices, increased goods supply and falling shelter inflation, but there's uncertainty over how much unemployment must rise to bring down wage growth and more stubborn core-services-excluding-housing price categories. Forced into a tradeoff between still-high inflation and rising joblessness, the FOMC could accept slower progress on both.

"My view is it’s implausible to contemplate that the committee will raise the inflation objective any time soon or outside of a formal framework review. (Fed Chair Jerome) Powell was unequivocal that it’s not going to happen in the near term," said former Fed Board research director David Wilcox, who has argued for a switch to a 3% target in order to deliver a long-term boost to employment while allowing more room to cut rates in downturns.

But faced with excessive inflation and rising unemployment, "they might indeed slow down as they get close and then wait for a propitious moment, either to go to 2%, or to announce a discussion about 3% or so," former IMF chief economist Olivier Blanchard told MNI.

ANCHORED EXPECTATIONS

After its January meeting Wednesday, the Fed will reaffirm its commitment to 2% as "most consistent over the longer run" with its mandate to promote stable prices and maximum employment.

In 2020 the central bank added after a year-long framework review that it will accept inflation "moderately above 2% for some time" following periods when it has run persistently below 2%, to avoid extended periods of near-zero interest rates. But that was before inflation got out of hand.

Despite elevated headline data, key measures of inflation expectations have remained relatively well anchored near 2%, a testament to market faith that the Fed will fulfill its mandate. Changing the target now would plant seeds of doubt as to how officials would respond the next time they have an inflation problem, said Marc Giannoni, former Dallas Fed research director, now at Barclays.

"The FOMC remains concerned that the longer inflation remains above target, the more likely inflation expectations will move up," he said. "The longer they leave inflation at 3% or above, the more costly for the economy it will likely be to bring inflation back to target."

Most officials have pushed back strongly against the idea of altering the inflation target. But one policymaker recently appeared to open the door to a more flexible approach.

"I haven't heard anything or seen anything that would make me think that 2% is the wrong target. But whenever we next talk about policy I'd certainly be open to talking about a range as a concept," Richmond Fed President Thomas Barkin told reporters after a speech.

2025 FRAMEWORK REVIEW

Even if the Fed implicitly allows inflation to run hotter while it waits for labor slack to translate into weaker demand, it cannot appear to countenance any major deviation from 2%.

"They would have to demonstrate they’re taking both legs of the mandate seriously and that they’re not having a casual disregard for the higher target of inflation," said Wilcox, now an economist with the Peterson Institute for International Economics and Bloomberg Economics.

Should the Fed return inflation to 2% in a reasonably timely manner and keep it there, there may be an opening by the 2025 framework review to say the world has shifted and a higher target is warranted.

"The big question is what unemployment rate is needed to get the employment cost index down to 3%. Nobody knows," said former Fed Board economist Joseph Gagnon, an advocate for a higher inflation target. "If ECI stabilizes at 3.5% or 4%, will the Fed really start tightening again? I hope not. I think the Fed should raise the target to 3% and allow ECI up to 4% if the economy is growing sustainably and inflation settles down between 2 and 3%."