Inflation Targeting: Has the Fed Lost Its Credibility?

Inflation targeting has been the monetary policy religion for many economists for generations. It was thought to be the key to keeping inflation stable and predictable. But, unfortunately, the track record of inflation targeting has not been great. This article will examine the disconnect between investors and Federal Reserve policymakers over inflation and assess whether the Fed’s inflation-targeting regime has lost its credibility.

The Disconnect Between Investors and the Fed

The US adopted an inflation target of 2% in 2012, yet inflation has remained below this level until the pandemic. Canada and the UK have not fared much better. Despite the central bank’s best efforts, inflation does not seem to return to 2% anytime soon, which could be the final death knell for the target’s reliability with markets. The Fed’s forecast of 2.8% this year, 2.5% next year, and 2% after that look increasingly optimistic, and consumers are more skeptical that inflation will return to 2%.

Four Possible Scenarios

There are four probable scenarios at this stage:

• The Fed increases rates a few more times, and markets (and the Fed) get the soft landing they are counting on, where inflation will fall and eventually stabilize around 2% without a big increase in unemployment or decline in growth.
• The Fed increases rates a few more times, and inflation falls, but not back to 2%. So the Fed lets this ride, and everyone learns to live with higher inflation.
• The rate increases thus far, plus another increase of half a percentage point, is enough to cause a recession as the overheated economy runs out of steam, taking inflation back to 2%. Monetary policy will get credit for lowering inflation but will share the blame for the recession with general post-pandemic economic weirdness.
• The bond market is wrong, and inflation goes up. As a result, the Fed is forced to increase rates more than expected, leading to a recession.

Related Facts

The 2-year bond yield is still less than 5%, and the 1-year is just above 5%, and the Fed funds rate will probably have to go to at least 6% to break inflation. The Fed has been serious about fighting inflation for more than a year and keeps predicting it will fall much faster than it does.

Key Takeaway

The disconnect between investors and Federal Reserve policymakers over inflation suggests that the Fed has lost its credibility. Moreover, the inflation-targeting track record has not been great, and it is increasingly unlikely that inflation will return to 2%. There are four probable scenarios at this stage, and the outcome will determine whether the Fed’s inflation-targeting regime has lost its credibility.

Conclusion

Inflation targeting has been the monetary policy religion for many economists for generations, but the track record of inflation targeting has not been great. Moreover, the disconnect between investors and Federal Reserve policymakers over inflation suggests that the Fed has lost its credibility. The outcome of the four probable scenarios will determine whether the Fed’s inflation-targeting regime has lost its credibility.