Taps Coogan – May 12th, 2021

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Exactly why the Fed and other central banks have become so obsessed with inflation targeting is the subject of much debate as none have shown why exactly 2% PCE inflation at all times, in all developed economies would be optimal for growth, employment, or anything quantitative.

Personally, I subscribe to the explanation that central banks themselves tend to offer up. They believe that having inflation in the ballpark of 2% gives them the space to provide negative real rates without having negative nominal interest rates and outright wage deflation during recessions. That is not to say that ‘exactly-2%-at-all-times-for-all-conditions’ is optimal for the economy. It simply makes monetary policy more ‘pleasant.’ It minimizes negative signs on financial asset performance and avoids deflation, the kryptonite of big banks through whose lens the Fed views the world. Of course, to make achieving 2% inflation the objective of monetary policy because 2% inflation makes monetary policy easier creates a classically ‘post-modern’ self-referential loop void of deeper meaning.

As it were, non-central bankers understand that inflation driven by rising wages and a strong economy operating at full capacity is different than inflation produced by print-and-spend economic policies and incentivizing people not to work in an economy operating well below capacity. The former evokes thoughts of an economic boom. The latter evokes thoughts of the decline and fall of the Roman Empire. It’s not hard to spot the difference.

The chart below, via Oxford Economics’ Gregory Daco, sums up the difference between wage driven inflation and price inflation.

From late 2015 until Covid, the economy was able to generate the fastest inflation adjusted increase in median household income on record while simultaneously tolerating (barely at times) several interest rate hikes, a reduction in the Fed’s balance sheet, and a trade war with China. That was a period of wage-driven inflation.

Today’s inflation is the kind where companies are raising prices faster than wages. That, by definition, is going to give people that rely on their wages (as opposed to surging government transfer payments or investments) a sense that they are falling behind economically. They’ll feel that way because that’s exactly what’s happening to them.

We all now know how people react to years of inflation outpacing wages while central bankers and politicians tell them that the economy is doing great and financial markets surge endlessly, because that’s precisely what happened the last time we kept interest rates at zero for years and did QE program after QE program, swelled the deficit, told people inflation didn’t exist or didn’t matter, and masked the need for actual pro-growth economic reform.

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