Consumer price inflation came in higher than expected in June. Headline prices rose 0.6% (expected 0.5%) on the back of a sharp 12.3% rise in gasoline prices but also a 0.6% gain in food costs. Still, even after excluding food and energy, core prices rose 0.2% (expected 0.1%). That said, one month does not make a trend. It is a challenge to expect strong inflationary pressures to emerge given the weak economic environment. The Fed should be free to maintain a very accommodative policy stance. Federal Reserve Governor Lael Brainard indicated the Fed is heading toward even easier policy and gave a strong signal that yield curve control was coming.
Core CPI snapped back to a 2.6% annualized pace in June as activity across the nation picked up:
As I wrote yesterday, one upside inflation surprise isn’t very interesting. Given the general economic weakness and high levels of unemployment, the outlook screams “disinflation.” That’s the baseline expectation. Still, it is always worth thinking about a counter-intuitive position. To get to an inflationary outlook, I think you have to expect considerably longer support for incomes such as that in the first half of the year coupled with the negative supply shock delivered by the virus. Basically, a story in which we have finally delivered enough fiscal stimulus to generate some upward pressure on prices given that a nontrivial fraction of what we would normally be spending on has been shuttered or we are avoiding for safety concerns. Again, not my baseline, but I am always on the lookout for changing dynamics when we all finally agree to some conclusion. When and if inflation ever does become interesting again, I am confident that we will first spend 5 years denying that it is interesting.
Federal Reserve Governor Lael Brainard presented a rather sobering outlook for the U.S. economy anticipating that conditions will be sufficiently weak to generate years of below-target inflation. What does that mean for policy? She provides a roadmap:
Looking ahead, it will be important for monetary policy to pivot from stabilization to accommodation by supporting a full recovery in employment and returning inflation to its 2 percent objective on a sustained basis. As we move to the next phase of monetary policy, we will be guided not only by the exigencies of the COVID crisis, but also by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support.
In other words, the Fed learned from the last expansion that they shouldn’t rush to tighten policy. Notably, the Fed need to avoid a deterioration of inflation expectations:
Because the long-run neutral rate of interest is quite low by historical standards, there is less room to cut the policy rate in order to cushion the economy from COVID and other shocks. The likelihood that the policy rate is at the lower bound more frequently risks eroding expected and actual inflation, which could further compress the room to cut nominal interest rates in a downward spiral.
Remember when we used to worry about inflation expectations becoming unanchored to the upside? Good times. Brainard argues that the Fed should ignore past estimates of the Phillips curve and make the pre-pandemic labor market the Fed’s policy objective:
With underlying inflation running below 2 percent for many years and COVID contributing to a further decline, it is important that monetary policy support inflation expectations that are consistent with inflation centered on 2 percent over time. And with inflation exhibiting low sensitivity to labor market tightness, policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence. Instead, policy should seek to achieve employment outcomes with the kind of breadth and depth that were only achieved late in the previous recovery.
What tools does the Fed have to work with? Brainard goes first to the obvious two:
With the policy rate constrained by the effective lower bound, forward guidance constitutes a vital way to provide the necessary accommodation. For instance, research suggests that refraining from liftoff until inflation reaches 2 percent could lead to some modest temporary overshooting, which would help offset the previous underperformance. Balance sheet policies can help extend accommodation by more directly influencing the interest rates that are relevant for household and business borrowing and investment.
Note how she presents the inflation goal. The goals is to fall behind the curve and not act until actual inflation reaches two percent on a sustainable basis. That is very different than the Fed’s strategy of the last recovery. Then the Fed tightened on the basis of the inflation forecast. Now Brainard is looking to set policy on inflation outcomes. By doing that, policy lags will ensure the Fed creates above target inflation. She then gives a nod toward average inflation targeting by calling for a make-up strategy that offsets past inflation shortfalls.
Then she opens the door further for yield curve control:
Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree of familiarity with their use. Given the downside risks to the outlook, there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve.
The logic is essentially how I outlined the situation last week. The Fed will feel pressure to do more without expanding the balance sheet further. That leaves yield curve control as the next likely path forward. They have to talk it out first:
Bottom Line: Don’t fret about the inflation number. It’s not yet a trend and telling a story of how it becomes a trend feels a bit forced even if interesting to think about. The Fed will soon be turning its attention on what more it can do. Eventually it will get to yield curve control.
Correction: In yesterday’s post, I incorrectly stated market expectations for today’s CPI report and instead used last month’s actual. Sorry for any confusion.