What is the FED’s inflation target?

The Fed’s definition of its inflation target, as altered under the August 2020 monetary policy review, is as follows: “The FOMC seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

The FED says nothing about what should happen if inflation runs significantly over target for a period of time, as it has done in recent years. For instance, there’s no commitment to aim for a period of sub-2% inflation if actual inflation has overshot for a number of years. The FED left this blank, but it seems clear from the speeches of FED members, led by Chair Powell, that their aim in this event is to get inflation back to 2%, not below.

FED members have not clearly expressed a desire to bring inflation below 2% for a period of time so that average inflation remains in the vicinity of the 2% target. It is possible that they are thinking in these terms but do not want to let us know, perhaps for fear that it could create an expectations-led plunge in inflation that puts the Fed back in the awkward situation it found itself in before Covid, when inflation was stuck below 2%.

However, it seems much more likely that FED Chairman Powell et al want to get inflation back to 2%, not below. If this is the case, it is clear that the inflation target is asymmetric, with the FED willing to tolerate some inflationary overshoot but unwilling to tolerate inflationary undershoots. Such a bias in the target might have been appropriate in the ‘lowflation’ days before Covid-19 but seems more questionable today.

But does this really make any difference? The general public still hears the 2% number and probably won’t have time for any of these idiosyncrasies encapsulated in the move to inflation averaging. Hence, it seems unlikely that the FED’s asymmetric bias towards the 2% target will lift inflation expectations amongst the general public, and survey data seems to bear this out. But what about inflation expectations in the financial markets, such as breakeven rates or forward-starting inflation swaps?

Even here, it does not appear that there has been a significant uplift in inflation expectations. Now clearly, this is not easy to determine, as the surge and subsequent plunge in actual inflation in recent years have introduced significant volatility into this inflation pricing. We also have to bear in mind other factors, like the issuance of inflation-protected bonds relative to conventional treasuries. But trying to bear all this in mind, we would still argue that market-based inflation expectations have not risen materially since these changes from the FED.

Can we conclude from this that the market disbelieves this story of an asymmetric bias within the FED? Steve Barrow, Head of Standard Bank G10 Strategy, is not so sure. For a start, he can’t just assume that the Fed will achieve its inflation aim. The FED spent considerable time trying to lift inflation without much success ahead of the COVID-19 pandemic. Looking ahead, the market might perceive that the FED’s policy bias is, indeed, asymmetrically geared to inflation that’s above 2% but believes that cyclical and/or structural factors will counterbalance this bias and hold inflation below the Fed’s target (whatever it happens to be).

“We can’t know what’s in the mind of the market in pricing inflation this way, but the danger, as we see it, is that longer-term inflation expectations are too low and that a part of this is down to the Fed’s ‘higher’ inflation bias,” said Steve Barrow.