Investment Insights

Inflation: Is 2% the Right Target?

By Amit Chopra
7 July, 2020

Main Street and Wall Street have divergent opinions about the Fed's longstanding 2% inflation target.

Ever since the Federal Reserve broached the subject of average inflation targeting and price level targeting in early 2019, the market has been waiting for some guidance on what it all means for monetary policy. The recent "Fed Listens" summary gave us little insight into the Fed’s thoughts on inflation. If anything, it highlighted the dichotomy that exists between Wall Street and Main Street on this topic.

The "Fed Listens" summary brought to the forefront that Main Street in not as concerned about the inflation undershoot as is the Fed. This is no doubt because Main Street is not well served by rising prices. Unlike the Fed, those on Main Street do not feel a pressing need to push prices higher. Rather, they see little or no benefit from inflation. A large percentage of people live on a fixed income, and for others wages are not going up fast enough to keep up with prices of their major consumption bucket: food, healthcare and drugs to name a few. One panelist’s comment from the "Fed Listens" event in Chicago really drove this point home: “It’s expensive to be poor in America.”

So then why is the Fed hellbent to get inflation above 2%? Its reasons are many. The Fed wants low and steady inflation as that provides a foundation for stable economic growth. The Fed wants to have some cushion to stimulate economic activity in case of a slowdown. The Fed also wants to avoid the trap of debt deflation. This is where depressions occur, as the real value of debt rises due to deflation. This debt burden then leads to a cycle of defaults, drops in collateral values, and declines in lending activity and growth. The Fed also realizes that “an ounce of prevention is worth a pound of cure” and does not want to see the US come anywhere close to an entrenched period of deflation like Japan has experienced. Beyond these concerns around deflation, there is the issue of the debt overhang in developed markets that has built up over the ages. This debt burden needs to be addressed and many believe that in the absence of inflation, debt would become untenable.

Is the Fed’s fear of deflation overstating the risk? We are a long way from deflation and it is not evident that low inflation drives lower real growth. Does 1.5% versus 2% inflation really impact consumer behavior, business investing and lending activity? Consumers likely cannot tell this small difference in price levels and businesses are more driven by inherent growth opportunities as opposed to marginal price differences. The Fed likely fears our economy could be on a path similar to that of Japan. But, there is no real evidence of this as structural dynamics are different here in the US. Our corporate sector is healthier, our banks are solvent, our demographics are better, and our fiscal and monetary policies are more informed and coordinated. The asset bubble collapse in Japan was also of a larger scale. Besides, Japan’s real per-capita growth and income numbers remained healthy through their long episode of disinflation/deflation. What’s more, regarding debt deflation, debt dynamics in a world of QE and growing central bank balance sheets are less of a risk as would have been the case if the private sector balance sheet exploded.

Is 2% really the right inflation target? The Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), has averaged 1.6% since the Fed adopted a 2% inflation target in January 2012 and has been in a fairly stable range of 1.25%-2.0% on a 12-month rolling basis. An inflation target of 1.5% versus 2% would have meant we have been meeting our inflation objectives, which could have led to better sentiment and better inflationary expectations. Also, the underlying inflationary impulse in the US economy is hard to know in the given moment, and it varies over time. This is the case as the non-monetary drivers of inflation, such as productivity, demographics, technology and global trade are constantly changing. So why does the Fed have such a rigid target and should it adapt a range as its target?

Why are we printing so much money when there are no signs of sustained deflation, and is this making things worse? The Fed’s liberal policies have drawn the ire of many market participants due to potential unintended consequences and the impact of its policies on asset prices. Our sovereign debt burden is mounting, aided by the Fed’s balance sheet expansion. These excesses will have to be unwound sometime in the future. Are we just kicking the can down the road to future generations? Additionally, economies with low interest rates are sustaining structural damage through misallocations of capital and economic dynamism/falling productivity; meanwhile, inequalities are rising. Finally, there is the question of the seemingly insurmountable debt levels in developed markets. Is inflation the only way out from under of this debt burden? Ironically, central banks may be encouraging the growth of debt by keeping interest rates doggedly low, leading us further down the debt trap.

As focused as bond investors are on the Fed’s inflation targeting approach, it remains an elusive concept to Main Street. There are numerous open questions on this topic that the Fed needs to address as it enters a new inflation targeting regime. The Fed should clearly articulate its inflation goals to the financial world and perhaps more importantly to Main Street.


Definitions:

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Fed Listens is a series of events hosted by the Federal Reserve (Fed) during which a variety of stakeholders outside the Federal Reserve System  The sessions included overviews by academic experts of themes that are central to the review, including the FOMC’s monetary policy since the financial crisis, assessments of the maximum sustainable level of employment, alternative policy frameworks and strategies to achieve the dual mandate, policy tools, global considerations, financial stability considerations, and central bank communications. Other sessions featured panels of community leaders who shared their perspectives on the labor market and the effects of interest rates on their constituencies.

The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

 
 

  • Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

    Important Information 

    All investments involve risk, including possible loss of principal.

    The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

    International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

    Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Important Information:

    The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

    The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

    This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.

    This material is only for distribution in those countries and to those recipients listed.

    All investors and eligible counterparties in EU and EEA countries:

    In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Building Three, Number One, Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4. D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

    In the UK, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the UK Financial Conduct Authority.

    In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH.

    Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

    All Investors in Hong Kong and Singapore:

    This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

    This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

    All Investors in the People’s Republic of China (“PRC”):

    This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

    This material has not been reviewed by any regulatory authority in the PRC.

    Distributors and existing investors in Korea and Distributors in Taiwan:

    This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (109) Jin Guan Tou Gu Xin Zi Di 016; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

    This material has not been reviewed by any regulatory authority in Korea or Taiwan.

    All Investors in the Americas:

    This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

    All Investors in Australia and New Zealand:

    This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.