MNI INTERVIEW: Fed At Neutral Risks Entrenched 3% Inflation

A series of supply shocks has given the Federal Reserve cover to delay confronting the deeper problem that trend inflation has been running well above target for at least two years and requires tighter policy to return to target, former Dallas Fed principal policy adviser Evan Koenig told MNI.

While headline inflation may fall in the coming months as tariff effects plateau and energy prices stabilize, Koenig warned that treating such a decline as a policy success would be a serious mistake when most core inflation measures are running just shy of 3%.

Nominal spending growth has been stuck at 5% for over two years -- a rate inconsistent with the Fed's 2% inflation target -- and Taylor rule prescriptions clearly point toward a more restrictive policy stance, he said in an interview. 

"I don't understand this satisfaction with being at neutral, and the satisfaction with the likelihood that headline inflation is going to fall. We're not likely to see a meaningful sustained reduction in inflation to 2% with a neutral policy stance," he said. 

"The FOMC eased up on the brakes by too much too soon. By doing that, it achieved the soft landing in the labor market -- for which it is to be congratulated -- but it's been at the cost of systematically too-high inflation." 

TRIMMED MEAN DISTORTION

New Fed Chair Kevin Warsh in April urged policymakers to pay more attention to trimmed-mean measures as better indicators of underlying price pressures. However, Koenig argues the Dallas Fed trimmed-mean rate, which registered just 2.3% in April, a full point below core PCE inflation, is very likely underestimating trend inflation. (See MNI INTERVIEW: Warsh Set To Dial Back Fed Guidance - Swanson)

He pointed to recent research from Dallas Fed economists showing the trimmed-mean's historically asymmetric trimming formula is producing a downward bias under current conditions, making the inflation picture look more benign than it is. 

Even setting that aside, Koenig notes that when headline inflation runs persistently above the trimmed mean, the trimmed mean itself has historically tended to drift higher over the following year. It happened in the Covid era and the same issue is surfacing now. 

"Given the size of that gap right now between headline and trimmed mean, it's likely to be a significant increase in the trimmed mean moving forward, so I don't see any reason to be too contented." 

NGDP TARGET

As a long-time proponent of a nominal GDP targeting framework, Koenig believes the central bank should be held directly accountable for the growth rate of nominal spending in the economy, treating adverse supply shocks simply as a shift in the mix of inflation and real activity. 

Supply shocks raise headline inflation temporarily but do not alter the underlying nominal spending trend, he said.

"A sound foundation for good monetary policy is steady growth in nominal spending at a rate consistent with 2% longer-run inflation," he said. "If you have an adverse shock, you'd see a temporary slowdown in growth and a temporary increase in headline inflation. If you stripped out those shocks, what you would have seen is more real growth than we had. But it wouldn't affect the average inflation rate over that period of time."

In contrast, the Fed's current flexible inflation targeting framework allows policymakers to look through transitory disturbances, on the grounds that tightening aggressively to offset price changes driven by energy, tariffs, or supply chain disruptions risks unnecessarily damaging employment and output. 

But the longer the Federal Reserve maintains a neutral stance while trend inflation is running near 3%, the more painful any eventual correction becomes, Koenig said. 

"If you have underlying inflation consistently running at 3%, sooner or later it's not going to be enough for the FOMC to say, we affirm our commitment to our 2% inflation target. People are going to start to wonder. And those longer-run inflation expectations that policymakers keep saying are anchored at 2% won't be anchored anymore." (See MNI POLICY: Warsh Could Reshape Fed On Rates, Communication)