An inflation test for the new guy at the Fed

Ahead of congressional testimony tomorrow by new Federal Reserve Chairman Jerome Powell, Wall Street is buzzing with speculation that the Powell Fed will be willing let inflation run higher than its current target of 2%. Maybe as high as 2.5%. Some of this is clearly wishful thinking on the part of Wall Street economists. Letting inflation run hotter and holding back on interest rate increases as that happened would extend the life of the current nine-year-old economic expansion. At least for a while.

But a part of this thinking is a result of comments–private and public–by some Fed members that suggest that the central bank would be willing to let inflation run above 2% for a while. The phrase that’s being used is “a modest overshoot.”

For example,  on February 21 Minneapolis Fed President Neel Kashkari, one of the Fed’s most dovish members on inflation, suggested that the central bank should tolerate above-target price rises for a while. “We’ve been around 1.5 percent inflation for the last five or six years,” he told Bloomberg Television. “If we really are serious about a symmetric 2 percent target then we should be equally comfortable–or uncomfortable–with 2.5 percent inflation for the next five years. More recently St. Louis Fed President James Bullard called the rise in inflation expectations a “welcome development.”

The key for Powell and the Fed is keeping inflation expectations under control. History indicates that once expectations for higher inflation get embedded in the economy, it is really hard to rein them in and requires substantial interest rate pain.

Right now expectations in the bond market point to an average annual 2.1% increase in the Consumer Price Index over the next ten years. That’s up from the low in expectations of 1.67% in June of 2017.

The Fed doesn’t use the CPI as its inflation measure, however. It’s preferred index is the Personal Consumption Expenditure index. The CPI typically runs about 0.5 percentage points above the PCE so at 2.1% on the CPI, the bond market is looking for inflation well below the Fed’s 2% target.

Powell’s testimony in the House is scheduled for 10 a.m. tomorrow. His prepared remarks are scheduled for release at 8:30 a.m. He will then repeat his testimony in the Senate on March 1.