Recall back in September, when we wrote that "The "Scariest Paper Of 2022" Reveals The Terrifying Fate Of Biden's Economy: Millions Are About To Lose Their Job" we reminded readers of what we wrote last June, when we said that "at some point Fed will concede it has no control over supply. That's when we will start getting leaks of raising the inflation target"...
... and just a few months later that's precisely what happened because according to a growing number of economists, such as Obama's own top economic adviser from 2013-2017 and currently economic policy professor at Harvard, Jason Furman, "To bring price increases down to 2%, we may need to tolerate unemployment of 6.5% for two years" who added that to avoid a social crisis, "stabilizing at a 3% inflation rate is probably healthier for the economy than stabilizing at 2%—so while fighting inflation should be the central bank’s only focus today, at some point the Fed should reassess the meaning of victory in that struggle."
The point Furman - a lifelong democrat - was making was simple: if the Fed's inflation target does not rise from 2%, it would lead to (at least) a 6.5% unemployment rate in 2024 which would translate into no less than 10.8 million unemployed workers, an 80% increase from the 6 million today. Needless to say, this would be political suicide for any Democratic administration.
To be sure, there are huge implications to raising the inflation target, not least of which is - well - higher inflation, as well as sharply higher asset prices, and a catastrophic loss of credibility in the Fed. And yet, when the trade off is social unrest - which is inevitable if the Fed plans to keep rates at 5% or higher for several years - then the alternative is palatable. So palatable, in fact, that as we reported in November, Goldman and TS Lombard also got on board, with the former writing that "given that most would agree that a fast reduction in inflation to 2% is unlikely we can now have a debate whether raising the G10 inflation target to the 3-4% range is more optimal for reasons of maintaining employment levels or public debt sustainability than the 2% goal which would not be possible if inflation was sticky in the 6-10% range" while TS Lombard chief strategist Steven Blitz chimed in with the following:
In the end, a recession is pretty much baked in by what the Fed has done, signalled, and will do. The overall imbalance between the supply and demand for labor is too much of a driver of inflation, through wages and, in turn, services ex shelter, for the Fed to stop now and say they have done enough. Powell, in fact, was very clear there is much more to do. This does not negate the fact that the coming downcycle will greatly impact those that AIT [average inflation targeting] was seeking to protect and are only just getting closer to even in terms of employment. None of this changes the Fed’s coming actions, what this coming hit to employment does mean is that the political cycle for the Fed is about to get a lot hotter – from all sides. This is one reason why I have long believed, as have many others, that the Fed ultimately bails and raises the inflation target to 3%. Powell does not have the same license to keep unemployment high and real growth low for an extended period as did Volcker (more so in retrospect than at the time). My guess is, Powell knows that.
Then, last week, yet another financial icon joined the "raise the inflation target" bandwagon after Mohamed El-Erian told Bloomberg TV that the Fed won’t be able to get US inflation down to its 2% target without “crushing the economy,” even though he too conceded that the central bank is unlikely to officially change that goal post, instead the Fed will have to simply pretend it has a 2% inflation target even as it resets higher.
"You need a higher stable inflation rate. Call it 3 to 4%," El-Erian, the chairman of Gramercy Funds told Bloomberg Television. “I don’t think they can get CPI to 2% without crushing the economy, but that’s because 2% is not the right target.”
Calling the Fed “too data dependent,” El-Erian said supply-side developments, including an energy transition, the change in supply chains during the pandemic, a tight labor market and shifting geopolitical issues, necessitate the higher target inflation rate.
“It’s right to take data into account but you’ve got to have a view of where you’re going,” he said adding that the problem is that the Fed is stuck chasing an elusive 2% goal.
“You can’t change an inflation target when you’ve missed it in such a big way,” he said. He’s previously cautioned that changing the target would be a hit to the Fed’s credibility.
When asked on Friday if the Fed could “tolerate” higher inflation, El-Erian said that is “where I hope to go.”
El-Erian's appearance followed an op-ed he wrote for Project Syndicate last week in which he said that inflation has a 75% chance of rebounding, and the Fed could end up crushing the economy as it struggles to rein in soaring prices.
"Nearly two years into the current bout of inflation, the concept of 'transitory inflation' is making a comeback as the COVID-related supply shocks dissipate," Prices would then skyrocket to a 41-year-high, forcing Fed officials to walk back their words and aggressively hike interest rates in 2022 to cool off the economy.
He added the most likely scenario was inflation remaining sticky at 3%-4%, which El-Erian estimates has a 50% probability.
"This would force the Fed to choose between crushing the economy to get inflation down to its 2% target … or waiting to see whether the US can live with stable 3% to 4% inflation," he said, suggesting the Fed would need to keep interest rates high.
* * *
So fast forward to today, when all of the above puzzle pieces appear to have fallen into place, as none other than Jerome Powell's mouthpiece at the WSJ, Nick Timiraos flagged a report by Cleveland Fed researchers Randal Verbrugge and Saeed Zaman, whose model essentially rehashed what Jason Furman calculated last September, namely that the Fed's economic forecast is wrong, and either inflation will be too high, or unemployment. Specifically, the Fed projected that the FOMC's unemployment rate path brings core PCE inflation to 2.75% by 2025...
... and that alternatively, if the Fed is more focused on hitting its inflation mandate (i.e., pushing inflation down to the current target of 2%), "a deep recession would be necessary to achieve" the 2.1% inflation projection, hardly the stuff that gets Biden re-elected or keeps the Democrats in control of the Senate.
Recall, Furman said that if the Fed's inflation target does not rise from 2%, it would lead to (at least) a 6.5% unemployment rate in 2024 which would translate into no less than 10.8 million unemployed workers, an 80% increase from the 6 million today. The Cleveland Fed agrees, and in fact it's own calculation leads to an even higher unemployment rate:
We investigate the claim of former Treasury Secretary Lawrence Summers (reported in Aldrick, 2022) and the supporting assessment of Ball, Leigh, and Mishra (2022) that it will require two years of 7.5 percent unemployment from its current low level of 3.6 to 3.7 percent to bring inflation down to its 2 percent target. We find that one year of 7.4 percent unemployment would accomplish this task.
So how does this affect the Fed's inflation target? Well, as Fed mouthpiece Timiraos recaps their summary, the Cleveland Fed researchers conclude, "'if 2.8% inflation doesn't result in an un-anchoring of inflation expectations', the December FOMC projection (in which inflation stays somewhat above the 2% target for longer) would be the optimal policy."
Translation: while 2% may be the stated inflation target, the Fed - via its academic paper trial balloon channel - just admitted that it would be willing to accept a minimum inflation of 2.8% for at least the next 3 years. At that point, whether the Fed keeps the theoretical inflation target at 2% when the new and improved defacto target is 2.8%, will be up to whoever is the next Fed chair at the time, and a function of just how bad the next recession will be.
And now that the 2.8% (really it's 3% but fine, let's call it 2.8%) bogey is in the open, the next three years will be a convergence in narratives and academic speak to validate the Fed's gradual, implicit at first and then explicit, transition to a higher inflation target.
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