Lars Svensson has argued that monetary policymakers should focus on forecasting, which means aiming policy at a position that is expected to lead to within-target inflation.
Early in 2024, some high inflation numbers raised concerns that we may not be on track for a soft landing. Later in the year, inflation eased and in September the Fed began cutting interest rates. However, in recent weeks, five-year inflation breakevens have been creeping higher, peaking at 2.46% yesterday. To be clear, this interest rate differential is based on the CPI, which is slightly higher than the PCE index that the Fed targets. Nevertheless, this suggests that inflation is still expected to be above the Fed’s 2% target. And while the Fed has a dual mandate, the labor market is also strong right now, so it provides no justification for deliberately letting inflation rise above target.
Today the Fed meets to discuss monetary policy. It will be interesting to see how they decide to respond to the recent increase in TIPS spreads. If they were to stick to Lars Svensson’s forecast maxim, you would expect them to tighten monetary policy.
It is also worth considering how an NGDP futures regime would address this problem. Under current market conditions, I expect most investors to take a long position in NGDP futures, forcing the Fed to take a rather extreme short position and exposing the Fed to serious losses if NGDP growth exceeds target. But I also believe that the Fed will not accept that risk and will tighten policy enough to restore credibility in the financial markets.
P.S. Many experts believe that the election outcome was heavily influenced by public anger over inflation. If so, then the bond market’s reaction to the election was certainly something to think about. If inflation is really the issue the public cares about most, how should the media have described the market’s reaction to the election? How do the media describe the market’s reaction to the elections? (To be clear, inflation is not the economic issue I care most about.)
In other words: never reason based on a change in the inflation rate.
PPP. Speaking of market predictions, Alex Tabarrok has one great new postwith implications far beyond election prediction markets.