A must read and some thoughts on inflation

Larry Summers: 5 reasons why the Fed may be making a mistake

Another great read on recommending an inflation target change. Too bad it didn’t take long before the lack of respect for radical uncertainty reared its head. Summers quickly points out that the Fed is preempting inflation without evidence from the data. Thus the Fed should wait to “shoot only when you see the whites of the eyes of inflation.” I can’t say I disagree, but as I mentioned in my longer write up on this topic, there is evidence inflation is coming and assuming inflation and the economy will behave identically to the past is flawed to begin with.

That said, I actually think this is a great read as it is more reserved than other “change the inflation target” arguments. Let’s quickly look at some of his arguments.

The first is the Fed has lost credibility. This is not debatable. The markets have (are) discounted (discounting) the number of rate hikes during this hiking cycle. This is mostly a self inflicted wound as the Fed has aggressively forecast more rate hikes than is logical. Also, as I briefly mentioned yesterday, inflation expectations are below 2% up to 20 years from now. This means that investors are expecting inflation to be less than 2% over the next 20 years.

I tend to agree with the argument that the inflation target should be something in the range of 2.3%-2.5% during expansions to offset lower levels during recessions. My issue is that making this range an explicit target is unnecessary. With a target of 2%, inflation will run over 2% as the Fed does not have perfect control over inflation. He uses the fact that the Fed has little control over inflation to argue that inflation is more likely to surprise to the downside as inflation has declined since January. The problem with this argument is it ignores the components of inflation and what is going on in the world. The main component of CPI is oil and oil prices have been the primary driver of weak inflation readings. If oil were to truly drop out of the equation (meaning any goods that have oil in the value chain are discounted to ignore the changes in the price of oil) then we would see much higher inflation readings.

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