A disappointing Fed inflation forecast

Forecasts are generally judged on the basis of their accuracy. But when it comes to Fed forecasts of inflation, another criterion is appropriate; is the forecast consistent with the Fed’s announced policy goal?

The Fed’s new long run forecasts for PCE inflation have been raised significantly since the previous set of forecasts, three months earlier. That’s not how a sound central bank operates. You don’t raise the inflation forecast, you adjust policy so that the average inflation rate over the 2020s remains at 2%. Here’s the data (and change from previous forecast):

2020: 1.3%

2021: 5.3% (+1.1%)

2022: 2.6% (+0.4%)

2023 2.2% (+0.1%)

2024: 2.1% (unch.)

2025-29: 2.0% (unch.)

So the Fed has raised its average inflation forecast for the 2020 from 2.2% to 2.36%. Why?

Yes, the Fed has a dual mandate, and thus a bit of leeway to adjust inflation. But nothing in the labor market has changed over the past three months that would justify a higher average inflation rate for the 2020s. Even worse, I suspect that inflation will end up being even higher than the Fed is currently forecasting. This is a very disappointing forecast.

Even if inflation comes in right at 2.36% for the 2020s, that outcome will not be consistent with the Fed’s announced 2% FAIT regime. If you are going to set a target, then why not try to hit the target? Why forecast failure?

PS. A few months ago the Fed thought 2.2% met the dual mandate. In that case, I wish that today the Fed had adopted a policy predicted to lead to PCE inflation of:

2020: 1.3%

2021: 5.3% (+1.1%)

2022: 2.4% (+0.2%)

2023 2.0% (-0.1%)

2024: 1.9% (-0.2%)

2025-29: 1.8% (-0.2%)

That would have left their inflation forecast for the 2020s unchanged at 2.2%, despite the recent surge in prices.

Yes, 2.36% is not a disaster; we’ve seen worse (the 1960s, 1970s, 1980s, 2010s, etc.) But why settle for anything short of optimal?

PS. Yes, inflation is a bad indicator. But NGDP growth in 2022 is also likely to be excessive.



18 Responses to “A disappointing Fed inflation forecast”

  1. Gravatar of Seth Seth
    15. December 2021 at 15:50

    Your point about failing to hit the target is on target (no pun intended). But there are two questions:

    1. What grade does the Fed deserve for not hitting their target and/or not choosing a MP that will help achieve their target. Your post is correct on this point – a low grade.

    That brings us to the second question:

    2. Is 2% the appropriate long-run inflation target? With r* in the 1% range, a 2% target means we are likely to enter recessions at 3% nominal rates (at best), and are this brings a high risk of hitting a ZLB in any (every?) recession. Wouldn’t a slightly higher target of 4% or so be far better in the long run?

  2. Gravatar of ssumner ssumner
    15. December 2021 at 17:35

    Seth, You might want a higher inflation target, although I’d prefer a NGDP level targeting approach. But as long as they’ve set the target at 2%, they need to try to achieve that target.

    Given the past history of really bad Fed mistakes, I’d give current policy a B.

  3. Gravatar of Alex S. Alex S.
    15. December 2021 at 18:43

    I see and get what you’re saying. One thought though: for the Fed to do what you suggest via then SEP would probably require it to take the FFR path above R* in 2024.

    My interpretation of the SEP is that the FOMC does not want to risk pulling the rug out from under the recovery by signaling a rate hike pace that is stronger than what futures are currently predicting. Note that fed funds futures and the SEP are now aligned at last (the SEP path had been consistently shallower this year).

    In a nutshell, the Fed is (inadvertently) saying that it’s going to allow the level of NGDP to make a “one-time” shift upward and take it back down to ~4% growth thereafter. I think what you recommend (in the absence of a formal NGPDLT) would risk a recession. Conversely, playing with fire in the other direction risks begetting a stagflation scenario.

  4. Gravatar of Rodrigo Rodrigo
    16. December 2021 at 04:40

    I get your point. They are going to overshoot their inflation target and it looks like the market was relieved to know the fed will not wait for full employment to try and tap down inflation. But Powell has a very good understanding of current inflation and is unwilling to use a blunt tool (monetary policy) to crack down inflation knowing it would be unwise to do so at this time because the source if inflation is still a shortage of supply. You have championed the idea the fed should have cut rates early and aggressively in 2008 but this would have caused them to overshoot their inflation target at the time, ECB should not have raised rates when they did but they would have probably overshot inflation as well. You will probably point out the framework was wrong at the time and AIT is probably not the correct target for this particular point in time. It feels like Powell realized hitting an explicit inflation target is less important than making sure the recovery continues. Should they change their target? Probably, but even ngdp target would have been inadequate. So instead of focusing on if they hit their target should the fed not be judged on the quality of the outcome? I feel Powell deserves a lot of credit for choosing not to to hit his target.

  5. Gravatar of Lizard Man Lizard Man
    16. December 2021 at 05:03

    What it looks like to me is that the Fed is moving to a regime shooting for at least 2% inflation. Given how much the public (and hence politicians) hate inflation, they can trust that political pressure will always keep them honest about inflation getting too high. But they need an institutional floor on inflation to keep it from getting too low.

  6. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    16. December 2021 at 07:44

    The conventional wisdom’s definition of inflation is wrong. The transactions concept of money velocity, Vt, has its roots in Irving Fisher’s truistic “equation of exchange”: P*T = M*Vt, where (1) M equals the volume of means-of-payment money; (2) Vt, the transactions’ rate of turnover of this money; (3) T, the volume of transactions units; and (4) P, the average price of all transactions units.

    The “econometric” people didn’t like the equation because it was impossible to calculate P and T. Presumably therefore the equation lacked validity. Actually, the equation is a truism – to sell 100 bushels of wheat “T”, at $4 a bushel “P” requires the exchange of $400 “M” once, or $200 “Vt” twice, etc.

    So, P doesn’t increase unless there is a decrease in T, or an increase in M or Vt.

    But there is no “Fool in the Shower”. Contrary to Powell and Greenspan et al., the distributed lag effect for M*Vt has been a mathematical constant for > 100 years.

    The problem as Dr. William Barnett of Divisia Aggregates says: “the Fed should establish a “Bureau of Financial Statistics”. I.e., M2 is mud pie.

  7. Gravatar of Capt. J Parker Capt. J Parker
    16. December 2021 at 07:46

    Dr. Sumner said “Yes, 2.36% is not a disaster; we’ve seen worse (the 1960s, 1970s, 1980s, 2010s, etc.) But why settle for anything short of optimal?”

    If in the 2020’s there is a significant supply shock that results in a temporary textbook increase in inflation and then a return to price level growth at 2%. What then is optimal policy?

    Let’s say the Fed was doing NGDPLT and a supply shock had the path of NGDP running below trend. Monetary policy is then used to bring NGDP back to trend. What would the path of prices look like in this situation? I submit that returning NGDP to trend doesn’t make up for the lost production during the supply shock and consequently NGDPLT policy doesn’t lead to you “make up” for the temporary period of higher inflation.

    I’m not not challenging NGDPLT as good policy. I’m simply saying that if the Fed were to say NGDP should grow at 4% and the price level should grow at 2% and they did an OK job at NGDPLT then if a supply shock results in inflation above target rate NGDPLT would not put prices back on the pre-shock path. NGPLT would put prices on a higher but parallel path. So 2.36% inflation for the 2020s may indeed be optimal where optimal takes into account the path of NGDP and employment.

  8. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    16. December 2021 at 08:10

    Admittedly the data for the variables used by the FED’s technical staff are flawed. So are nearly all economic statistics, but that does not preclude the staff from using them. An educated estimate is better than no estimate at all.

    We know the progression of money on inflation:
    03/1/2020 ,,,,, 0.21
    05/1/2020 ,,,,, 0.46
    07/1/2020 ,,,,, 0.53
    09/1/2020 ,,,,, 0.61
    11/1/2020 ,,,,, 0.79
    01/1/2021 ,,,,, 1.31
    03/1/2021 ,,,,, 1.51
    05/1/2021 ,,,,, 1.65
    09/1/2021 ,,,,, 1.88
    11/1/2021 ,,,,, 1.93
    01/1/2022 ,,,,, 2.21
    03/1/2022 ,,,,, 1.54

    But the effect of the FED’s operations on AD using interest rates is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given injection of additional reserves, nobody knows until long after the fact.

    The consequence is a delayed, remote, and approximate control over the lending and money-creating capacity of the payment’s system.

  9. Gravatar of rayward rayward
    16. December 2021 at 08:10

    Fed watching, and Fed listening, is just a part of the signaling school of economics that has taken hold in America. Fed signals, people react. Economic policy by psychology. Do economists have so little confidence in their theories and models they must defer to psychology for an effective economic policy? It’s reassuring that Sumner actually practices economics rather than psychology.

  10. Gravatar of ssumner ssumner
    16. December 2021 at 08:35

    Alex, I see the risk of recession as being much higher if they don’t do what I suggest. To me, the real danger is letting inflation get too high, and then having to create a recession to bring it back down. Better to be preemptive.

    Rodrigo, My views today are the same as in 2008—slow but steady NGDP growth—that’s what we need. Supply issues are not the problem, it’s excessively fast NGDP growth in 2022 that is likely to be the problem.

    Capt Parker, I wouldn’t be complaining if I thought the Fed was aiming for 4% NGDP growth. They are aiming higher.

  11. Gravatar of bill bill
    16. December 2021 at 10:53

    Your PS covered the comment I was going to write. It wouldn’t have been that hard for them to say 1.8% for whatever number of years got them to 2%. Ironically, looking at 10 year breakevens seems to imply that the Fed may even end up with less than 2% PCE inflation over the next 10 years.

  12. Gravatar of David S David S
    16. December 2021 at 12:28

    At the risk of a smackdown for using historical comparisons, we might be looking at situation comparable to 1989—where inflation and rgdp growth were a bit hot and the Fed instigated a mild recession. Similar thing happened in 1999.

    At the risk of even more smackdowns, I don’t think we’ll have a recession because I think the Fed is pivoting quite well right now.
    Biden is still doomed in 2024, but that won’t be the Fed’s fault.

  13. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    16. December 2021 at 14:41

    Checked CPI out; y-o-y change
    11/1/2020 ,,,,, 260.927 ,,,,, 0.011
    12/1/2020 ,,,,, 261.560 ,,,,, 0.013
    01/1/2021 ,,,,, 262.231 ,,,,, 0.014
    02/1/2021 ,,,,, 263.161 ,,,,, 0.017
    03/1/2021 ,,,,, 264.793 ,,,,, 0.026 *
    04/1/2021 ,,,,, 266.832 ,,,,, 0.042 *
    05/1/2021 ,,,,, 268.551 ,,,,, 0.049 *
    06/1/2021 ,,,,, 270.981 ,,,,, 0.053 *

    * will show deceleration y-o-y in 2022
    And that will coincide with long-term money flows

  14. Gravatar of steve steve
    17. December 2021 at 11:20

    and this post is the reason it’s called the dismal science…

  15. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    18. December 2021 at 05:59

    Inflation is likely to subside faster than anyone expects. The E-$ market is in contraction.

    Powell eliminated reserve requirements and Bair’s assessment fees on foreign deposits, changed the landscape of FBO regulations. It helped make E-$ borrowing less competitive and more expensive for U.S. banks.

  16. Gravatar of Gary G Gary G
    19. December 2021 at 09:50

    You have consistently argued that targeting price levels is wrong. We should target total spending, nGDP. To say that the 2.6% CPE prediction for 2022 should be replaced with 2% as proof they have a goal of intending to succeed means that you are saying they should target price levels. This is confused logic. They are trying to help us by showing the output of their CPE models. But they are likely predicting -6% rGDP growth due to unresolved supply chain disruptions. So this post criticizing the Fed cannot be valid.

  17. Gravatar of ssumner ssumner
    19. December 2021 at 15:26

    Gary, You said:

    “You have consistently argued that targeting price levels is wrong.”

    I’ve said that I’d prefer they target NGDP, but also said that if they announce they are targeting the price level, then they should hit the target.

    In any case, NGDP growth in 2022 is also likely to be too high.

  18. Gravatar of Gary G Gary G
    20. December 2021 at 04:00

    ************** ##########
    Thanks for your response to my post. Would you mind correcting two embarrassing typing mistakes? I missed the autocorrect error. CPE should be PCE. Also, 6% should be .6%

    Sorry to bother you.

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