There are certain things in this world that are immutable. No one disagrees with them. They are settled fact. Water is wet. We need oxygen to breathe. The Earth circles the sun.
But just because they’re immutable today, doesn’t mean they have always been. Take, for example, the belief that the Earth circles the sun. We have some solid evidence of this, including spaceships roaming around in the solar system which have collected data which makes this belief a no-brainer. It wasn’t always.
A Greek astronomer, Aristarchus of Samos, was the first to propose this idea. He came up with it in roughly 300 B.C. But he had no way to prove it. It wasn’t until Polish astronomer Nicolaus Copernicus wrote his “On the Revolutions of the Heavenly Spheres” in 1543 that any evidence of this truth was available. So, at best, this immutable fact has been so for 480 years. If you assume modern man has been around for 200,000 years, that means we’ve only held this belief for 0.24% of our existence. For the other 99.76% of our existence, the immutable fact that the sun circled the Earth was wrong!
So, what does ancient astronomy mean for the market? Not much – but it is an excellent reminder that things we assume to be true often aren’t. And that brings us to the Fed’s 2% inflation target.
We’re all familiar with the 2% threshold. It seems like it has always been the goal. But that got us thinking. Why is it the goal? Who made it the goal? Is it the right goal? It led us down an interesting rabbit hole that is worth exploring.
First, it’s important to understand that 2% (or below) is not exactly the norm. As you may recall us discussing in the past, Core PCE is the Fed’s preferred measure of inflation. We’ll use that as our measuring stick for this discussion.
The Core PCE statistic has been measured by the Bureau of Labor Statistics since January 1, 1960, and has been collected every month for the last 63 years. Its current level is 3.88%, down from a high in February 2022 of 5.57%.
Past performance is not indicative of future results.
Over the last 63 years, the average Core PCE has been 3.24%. Of the 764 measurements we’ve had of Core PCE, it has been at or below the 2 percent target 314 times (41% of the time). 241 (77%) of those times have happened in the last 27 years. In the first 36 years we only saw inflation below 2 percent 73 times (14% of the time). Simply put, 2% inflation is a pretty new thing.
But how did it become the target? Was it a well-researched academic article? Nope. It was a politician from New Zealand. In 1988, New Zealand was just coming off a pretty rough patch of inflation. It had reached as high as 15% and was now down to 10%. Their finance minister, Roger Douglas, was interviewed about the rate of inflation and was asked if he thought the 10% level was satisfactory.
His response? He wasn’t satisfied and wanted to see inflation between zero and 1 percent.
As you can imagine, the Reserve Bank of New Zealand (their Fed) was a bit caught off guard by his unplanned target for inflation. So, they got to work setting an official target and came up with 2%. They justified it with the belief that there was an “upward bias” to inflation (meaning the reporting comes in a little higher than the actual number) so a target of 2% matched with Douglas’ goal of 0 – 1%. They worked the math backwards to justify Douglas’ statement.
As you can see from the chart above, the timing of that plan coincided nicely with the coming fall in inflation. The end of the Soviet Union, growth of globalization, and the advent of the internet all lead to lower costs in goods and sustained lower inflation. Douglas’ timing was as impeccable as it was unplanned. Over the coming years, other central banks began to create their own 2% targets, the first time they had ever created targets before. 2% seemed an easy number to hit when inflation was trending toward that level anyway.
The U.S. Federal Reserve was struggling with this idea as well. In the mid-1990’s Alan Greenspan was leading the Fed and he believed we should set an informal target (i.e., one that wasn’t released to the public) of 0%. Another Fed Governor, Janet Yellen, argued that such a low target would be disastrous if a recession happened. She argued for 2%.
It wasn’t, however, for another 16 years that the investing public was given a public goal. It was Fed Chairman Ben Bernanke in 2012 who officially marked the U.S. down in the “2% target” camp, nearly a quarter of a century after Douglas’ offhanded remark. It wasn’t a hard cause to join when inflation had been at or around that level for nearly 15 years.
But that still leaves us with the big question – why 2%? More likely than not, it’s because it fit their models. Economists, much like investors, tend to extrapolate trends out to infinity. You and I both know that’s never actually how it works.
Which brings us to where we are today. Inflation has, unquestionably, fallen dramatically. While Core PCE does remain elevated, it is closer to the long-term average today – at 3.88% – than the 2% target is to the average. And the reversal of the trends of globalization makes it that much more unlikely we’re going to get back to the 2% goal.
The Fed seems to recognize this to some degree. Their latest projections don’t see a consensus 2% estimate until 2026 or later.
Past performance is not indicative of future results.
This leads us into the next few months and the role of the Fed. As we’ve mentioned before, it is possible that inflation rises a bit – or stalls at current levels – as we head into the end of the year. The chart below looks at Core CPI, but it remains true for Core PCE as well. If Core PCE settles in the mid-3% range for the first several months of 2024, how will the Fed respond?
There is a part of us that believes the Fed understands the 2% target is arbitrary. And that stable inflation – if even a bit higher than hoped for – is a good sign. Especially when the economy is showing this much strength.
But if that’s not the case, and the Fed is deeply committed to the 2% target? One can see a scenario of more hikes in 2024 and that’s a scenario that would not be good for the markets.
In the meantime, the economy is in a strong position. Several members of the Fed, including Chairman Powell, made it clear this week they don’t intend to hike again in November. That gives us until the December 13th meeting at the very earliest to make hay while the sun shines. The way they address the long-term 2% goal, and whether it is immutable, is going to be especially important to watch in the meantime.