Lars Svensson has argued that monetary policymakers should “target the forecast”, meaning that they should set their policy in an area that is expected to lead to the target inflation.
In early 2024, several high inflation figures led to concerns that we may not be on track to get there. Inflation eased over time, and in September the Fed began cutting interest rates. However, in recent weeks, the 5-year inflation break has been rising, and yesterday it increased to 2.46%. To be clear, this interest rate spread is based on the CPI, which is more volatile than the Fed’s target PCE index. However, it suggests that inflation is still expected to remain above the Fed’s 2% target. And while the Fed has a dual mandate, the labor market is also currently strong, and thus provides no reason to deliberately run inflation above the target.
Today, the Fed meets to discuss monetary policy. It will be interesting to see how they decide to react to the recent explosion of TIPS spreads. If they stick to Lars Svensson’s target in the forecast, you can expect them to tighten monetary policy.
It is also worth considering how the future NGDP government will handle this problem. Under current market conditions, I would expect many investors to take a long position on NGDP futures, forcing the Fed to take an extremely short position and exposing the Fed to significant losses if NGDP growth exceeds target. But I also believe that the Fed will not be willing to accept that risk, and will tighten policy enough to restore credibility to the financial markets.
PS. Many scholars believe that the outcome of the election was heavily influenced by public anger over inflation. If so, the bond market’s reaction to the election was certainly something to consider. If inflation is a public concern, how would the media have interpreted the market’s reaction to the election? How does the media explain the market’s reaction to the election? (To be clear, inflation is not an economic problem that I care much about.)
In other words, never think about changes in the inflation rate.
PPS. Speaking of market predictions, Alex Tabarrok has great new postand implications that go beyond election prediction markets.
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