- Sees ‘Transitory’ As ‘Less Useful’ Term To Describe Inflation Upsurge
- Calls For Clearer FOMC Communication on Inflation, Employment Goals
By Steven K. Beckner
(MaceNews) – Cleveland Federal Reserve Bank President Loretta Mester warned Friday that inflation could persist at higher levels next year and questioned the use of the term “transitory” to describe the current sharp overshooting of inflation.
Mester, who will be a voting member of the Fed’s policymaking Federal Open Market Committee in 2022, stressed the need for the Fed to reinforce inflation expectations to help it achieve the goal of average 2% inflation.
To that end, she suggested a number of “clarifications” the FOMC should make in its future policy statements in remarks during a webinar jointly sponsored by the Bank of Finland and the Centre for Economic Policy Research.
Although the FOMC has sought inflation “moderately above 2% for some time,” the price index for personal consumption expenditures (PCE) – the Fed’s preferred inflation gauge – rose 4.2% year-over-year in July and 3.6% excluding food and energy. Nevertheless, Chairman Jerome Powelll and other policymakers have repeatedly called the upsurge “largely transitory.”
Mester is not so sure.
“My own modal forecast is for inflation to remain high this year and then to begin to move back down next year,” she said. “However, I see upside risks to this forecast.”
“It is possible that the higher prices could cause longer-run inflation expectations to rise above the levels consistent with our 2% inflation goal, thereby putting upward pressure on inflation,” she warned, adding that the Fed would need to tighten monetary policy to avoid that.
“These levels could only be sustained if monetary policy was too accommodative, and the Fed would need to respond to bring inflation and inflation expectations in line with the 2% goal,” she said.
Mester said FOMC communications need to be improved to help control inflation expectations.
“These dynamics are difficult to communicate in a word or two, especially in an environment where both strong demand and supply factors are in play,” she conceded. “But a statement that offered more of an explanation of the FOMC’s views on the factors affecting current inflation readings, the outlook for inflation, and the risks around that outlook would give the public a better sense of the FOMC’s assessment than merely saying that elevated readings largely reflect transitory factors.”
For now, she suggested, continuing to describe surprisingly high inflation as “transitory” may not be appropriate, noting that “many businesses now tell us that the supply disruptions are lasting longer than they originally thought and many do not expect them to resolve until the middle of next year or later.”
“Many firms have been able to pass on the increased cost of inputs to their customers in the form of higher prices,” she continued. “ At the same time, labor shortages have led firms to raise wages.”
Mester said “these developments, along with continued elevated inflation readings, mean that the ‘transitory’ language has become a less useful description of the inflation situation.”
After adopting a new monetary policy framework last August, under which the FOMC departed from the previous strategy of tightening policy when unemployment falls to a theoretical “natural’ rate and aimed to overshoot its 2% inflation target to compensate for past undershooting, the FOMC adopted new “forward guidance” last December that provided for unabated bond buying until “substantial further progress” had been made toward its employment and inflation goals.
But Mester took the view that the FOMC’s forward guidance is less than satisfactory and cited some areas of potential improvement.
Her first proposed “area for clarification” was in how the FOMC describes its inflation objective and progress toward achieving it. She accepted that the FOMC should not specify a mathematical formula to determine whether average 2% inflation had been met, but should “maintain some flexibility.”
However, she added, “some clarity on how the FOMC will assess average inflation will help ensure that the new strategy lives up to its promise of anchoring inflation expectations at levels consistent with our longer-run 2% goal.”
For example, she elaborated, PCE inflation averaged 2% over the past five years as of the second quarter and is forecast to move above 2% for the next five years, leading to “a reasonable assessment … that we are at or close to meeting the average inflation goal. “
“But this is based on a 5-year window for averaging,” she went on. “Others may prefer a different time horizon. For example, PCE inflation has averaged 1.8% over the past 6 years and 1.6% over the past 7 years. Or they may prefer a fixed starting point rather than a moving average in order to assess progress on the inflation goal.”
“Depending on your benchmark, you would have different views on how much progress has been made toward the goal, and in order to promote achievement of the average inflation goal, the moderate overshoot you might be willing to tolerate could be different depending on the shortfall you perceive,” she added.
Mester said “a similar issue arises with the employment goal” as she moved to a second area of needed “clarification.”
“To interpret ‘substantial further progress’ one needs to know how much further there is to go, and this assessment depends on whether it is reasonable to expect labor market conditions to return to their strong pre-pandemic levels of February 2020,” she explained. “That is probably not a bad benchmark to use to assess progress for many indicators, but it is not necessarily the right one for other indicators.”
For example, she said measures of labor force participation include unusual numbers of retirees – 3 to 3-1/2 million since the pandemic began or “about twice as many as would have been expected based on population aging.”
Since “retirees typically don’t return to the labor market,” Mester said “we probably shouldn’t expect the overall labor force participation rate to approach its pre-pandemic level.” Therefore, “it is likely better to assess conditions using the prime-age participation rate to abstract from retirements.”
So Mester suggested the FOMC needs to do a better job of conveying how it is measuring progress toward “maximum inclusive employment” and how much progress it believes is being made:
“While it is important for the FOMC to look at a variety of indicators to assess progress on our employment goal, it is also important that we do so systematically,” she said. “As a committee, we should examine the same relevant set of indicators over time and communicate our assessment of progress based on that set of indicators.”
“This would be a way to align the public’s assessment with the FOMC’s so the public will understand when “substantial further progress” has been made,” she added.
Mester’s third area for clarification was inflation expectations, which the FOMC has said it wants to keep well anchored at 2%.
“To achieve this, it is important that we give the public a good sense of our policy reaction function under the new strategy and to demonstrate our commitment to it,” she said.
“ One helpful step would be if our post-meeting policy statement provided more of a narrative of our assessment of how changes in a consistent set of economic and financial data have or have not changed the medium-run outlook, the risks around that outlook, the appropriate policy path based on that outlook and risk assessment, and the considerations the FOMC will take into account when determining future changes in policy,” she said.
Mester acknowledged that “changing the policy statement like this would make it longer, but also more informative.”
She suggested that inadequate FOMC communication in that area have had adverse consequences. “Our experience this year with communications about inflation shows some of the challenges of not including enough narrative in our statement.”
“The sources of this year’s inflation increases have complicated communications and have made forecasting inflation considerably more difficult,” she elaborated. “Supply chain disruptions driven by the pandemic, coupled with pent-up demand let loose by the reopening of the economy, have led to a surge in measured inflation.”
The FOMC first pointed to the inflation upsurge in April, but described it as “largely due to transitory factors.”
“The statement did not elaborate further,” Mester recalled, adding that simply calling inflation “transitory” is “less useful” than it could be.
She was hopeful for improvement in FOMC communications, which she will help mold as a voter in 2022.
Contact this reporter: steve@dgulino
Content may appear first or exclusively on the Mace News premium service. For real-time delivery contact tony@macenews.com. Twitter headlines @macenewsmacro.