Can We Be Confident That Low Inflation Will Persist?

​The importance of inflation in determining the outlook for monetary policy appears to have risen in recent months as PCE price inflation has approached and exceeded 2%. The FOMC is emphasizing this higher inflation rate needs to be sustained and the 2% target is symmetric. A century ago, inflation was viewed in terms of the excess creation of money rather than as a measure of rising prices. QE has created more than $2 trillion of excess money. If the credit multiplier reconnects and money velocity rose, there would be a substantial potential inflation risk.  The last 70 years shows that inflation is hard to contain once it gains a momentum and that the low and stable inflation rate of the early 1960s gave no hint that a high and rising inflation decade was to follow. We view inflation as a monetary phenomenon but monetary policy may be accommodating other pressures. Demographics, fiscal expansion at full employment, and a protectionist trade policy are all potential forces for an inflation regime shift. Confidence that inflation will remain low seems too high given the history of inflation, the inability to forecast future inflation, and the poor state of inflation models. The FOMC pays too much lip service to core inflation and inflation expectations (survey and market-based), which are all poor indicators of future inflation. Since 2000, core inflation has had a zero correlation with future headline inflation.  We think the Fed is best served by sticking to a clear and simple 2% inflation target. We (and several FOMC participants) think this target has been met and could warrant faster rate moves than suggested by the median SEP path. Maintaining a 2% inflation rate at full employment with more than $2 trillion of excess liquidity cannot be taken for granted and requires continued policy action on both rates and the balance sheet.