By: Phil Kernen

Over the last several decades, globalization took root, delivering the affordable goods we demanded when and where we wanted. COVID-19 turned that efficient system upside down, breaking supply chains and raising the costs of doing business. A shift away from globalization was already underway, and COVID accelerated it. Where do we go next? 

In January 2012, after debating the topic for almost two decades, inflation targeting became a central goal of the Federal Reserve. The hope was that by defining their purpose explicitly, the investing public would reflect greater confidence in the ability and commitment of the Federal Reserve to maintain stable prices. They set the target at 2%. Since 2012, annual price changes measured by the Consumer Price Index (CPI) have only met or exceeded 2% four times. 

Why 2%? Many other developed-country central banks have chosen a similar target, though Australia has a higher objective at 2 – 3%, and Israel manages a broader range of 1 – 3%. Inflation targets for developing countries can often be higher. These are theoretical levels, and the Fed believes that 2% over the long run is most consistent with its mandate for maximum employment and price stability.  

In August 2020, the Fed changed its inflation approach from managing a 2% ceiling to a 2% average. In the past, it would tighten monetary policy in advance of increasing prices. In the future, since price increases have been consistently below 2%, they would keep monetary policy loose until inflation arrives, letting it run hot, or higher than 2%.

From the Federal Reserve to explain their logic: 

For many years, inflation in the United States has run below the Federal Reserve’s 2 percent goal. But inflation that is too low can weaken the economy. When inflation runs well below its desired level, households and businesses will expect this over time, pushing expectations for inflation in the future below the Federal Reserve’s longer-run inflation goal. This can pull actual inflation even lower, resulting in a cycle of ever-lower inflation and inflation expectations.

If inflation expectations fall, interest rates will decline too. There would be less room to cut interest rates to boost employment during an economic downturn. Following periods of inflation persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation modestly above 2 percent. By seeking inflation that averages 2 percent over time, the FOMC will help to ensure longer-run inflation expectations remain well-anchored at 2 percent.

Inflation expectations are now unanchored and rates are rising. As a result, the Fed will be watching for the point at which average inflation since January 2012 equals, then exceeds, 2%. That crossover point using CPI came and went last September. Current prices are 2.6% higher than they would be if inflation had only grown 2% annually.

Recording successive annual price increases well above a random 2% target is one thing. Recognizing that average inflation is quickly moving past its 2% target is another thing entirely. Maybe the fact that it is running hot is why the Fed is finally starting to take inflation seriously.