The last time the Federal Reserve regularly hit its inflation target was 11 years ago, as financial markets in 2008 were entering the throes of a financial crisis and a recession.
In some ways, that represents a cautionary moment for Tom Porcelli, chief U.S. economist at RBC Capital Markets, who says if the Fed tries to achieve its 2% inflation target by keeping monetary policy loose for an extended duration, it could drive rampant credit growth and destabilizing financial excesses.
In a research note dated April 29, Porcelli warned investors and economists who say the U.S. central bank should keep monetary policy easier for longer to lift inflation, which he fears could lead to another “credit bubble.”
The RBC economist suggested a return to 2% inflation risked another painful market collapse.
“Since the late 1980s, the only time inflation volatility really jumped was in the wake of the housing bubble. Does anyone think that, for the sake of hitting the inflation target, the Fed should re-engineer another credit bubble? Because that is what it took to get us there last time,” said Porcelli.
Over the last 23 years, 86% of the times when core personal consumption expenditures, the Fed’s preferred inflation gauge, which excludes oil and food prices, stood above 2% on an annual basis were confined to the years between 2004 and 2008, according to RBC.
Yet to reach its 2% goal in that four-year period, the central bank unwittingly relied on cheap mortgages that helped lead to a rapid rise in housing and rental prices, bumping up broad-based inflation gauges.
To be sure, the years between 2004 to 2008 also saw the central bank raise the Fed's benchmark overnight lending rate 17 times, though the 10-year Treasury note yield TMUBMUSD10Y, +0.00% , the key benchmark for fixed-rate mortgages, experienced a more muted rise over that cycle.
“The reality is it has been incredibly difficult to engineer rates of core inflation of 2%, never mind anything north of that,” he said.
Since the mid-1990s, analysts have cited a litany of factors including globalization, an aging population and technological innovation for the persistence of inflation below 2%.
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Still, the Fed is under pressure to hold back on further monetary tightening after core PCE inflation fell to 1.6% in March, from hovering slightly above 2% in July. Market participants say the lack of inflation pressures will likely keep the Fed on hold, and potentially rate cuts down the road.
The White House has called for easier monetary policy, with President Donald Trump calling on the central bank to ease policy outright as recently as Tuesday. And chief economic adviser Larry Kudlow has pointed to the subdued core PCE inflation data as a sign that a rate cut was necessary.
To stimulate inflation increases, the Fed would strive to keep monetary policy accommodative, usually through lower interest rates, in the hopes that lower borrowing costs would boost the economy. Stronger hiring, in turn, would eventually lead to higher wage pressures. But even as unemployment rates have remained near multi-decade lows, inflation has struggled to hit the central bank’s 2% inflation target.
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That has added urgency to recent discussions at the Fed around potential tweaks to the central bank’s inflation framework that would see it become more comfortable with an inflation overshoot.
In recent months, Fed Vice Chairman Richard Clarida have raised the possibility of price-level targeting, the idea that the central bank would allow inflation to temporarily climb above 2% to make up for previous years when it fell short.
Yet Porcelli suggested such shortsighted policies could lead to further financial instability down the road.
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