Our view is that the Fed will reset its 2% inflation target approximately one year from now if it wants to salvage the last vestiges of its credibility. While April’s CPI number may come down some due to the retreat in the price of oil, we could continue to see core inflation march higher for months to come. Regardless of the month-to-month movements in CPI, it will be difficult to get CPI back down to 2% from the current 8.5% for a number of reasons:
- Fed Funds Rate: The Fed can’t take the Fed Funds Rate anywhere close to CPI as there is simply too much public debt outstanding ($30 Trillion). Treasury simply could not afford to pay the interest expense on its debt if the Fed tried to replicate former Fed Chairman Paul Volcker’s approach to curbing inflation.
- Falling Asset Prices: The markets are the Fed’s master despite the Fed’s lip service about the economy and jobs being top priorities. As rates march higher, risk asset prices move lower. How much price action to the downside will the Fed be able to stomach? Not enough to get CPI back down to 2% in our view.
- Stop-and-Go Monetary Policy: This Fed is anything but hawkish. Monetary policy remains extremely accommodative as the Fed has only instituted one 25 basis point rate hike up from the zero bound and has yet to trim its balance sheet (quantitative tightening). Further, despite the Fed’s “independence”, it is all too quick to cave and subsidize fiscal deficits each year. This requires that the Fed print money and works against its inflation-fighting (if we can call it that with a straight face), effort. Therefore, given this Fed’s weak stomach, we imagine a scenario where the Fed tightens policy for a period and then stops before tightening again.
We expect inflation as measured by the CPI to be north of 5% exiting 2022 and north of 3-4% exiting 2023. Therefore, the Fed will be required to reset market expectations around its target CPI (2% is too low). 3% would be more like it, a full 50% higher than today’s 2% target.