Fed staff lose hope on inflation

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Hidden inside the minutes to the Fed’s 30 April meeting is an alarming paragraph that suggests Fed staff have grave concerns about inflation expectations.

The staff’s forecast for inflation was revised down slightly, reflecting some recent softer-than-expected readings on consumer price inflation that were not expected to persist along with the staff’s assessment that the level to which inflation would tend to move in the absence of resource slack or supply shocks was a bit lower in the medium term than previously assumed. As a result, core PCE price inflation was expected to move up in the near term but nevertheless to run just below 2 percent over the medium term. Total PCE price inflation was forecast to run a bit below core inflation in 2020 and 2021, reflecting projected declines in energy prices

Of necessity, this is written in a very wonkish way — but what it means is that inflation doesn’t get back to target by itself anymore. The period of low-flation has been so long that inflation expectations have fallen.

This is dangerous stuff. If this doesn’t change, risk management calls for easier policy very soon.

Why? because it means that if there’s any sort of shock the Fed is at risk of losing control of inflation expectations (to the downside). That will make it harder to get expected real rates down low enough to stimulate the economy — as if the ZLB problem wasn’t big enough already.

Of course, the market has already priced this in — ten years of missing the target is enough to educate more investors. Notwithstanding, it is notable that inflation expectations have fallen by ~40bps over the past six months.

The chart below shows the 5y5y forward breakeven rate from FRED (which is based on nominal and real cash bonds). This is a CPI measure, and CPI is ~50bps higher than PCE inflation (over the cycle), so 5y5y CPI breakevens at ~2% means the market expects PCE to be stuck ~1.5%.

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