The Fed Muddled Its Inflation Message

(Bloomberg Opinion) -- With a single word — “transitory” — Federal Reserve Chair Jerome Powell has sprung the “dove trap,” leaving market participants wondering if the central bank will ever commit to its 2 percent inflation target.

The two-day Federal Open Market Committee meeting that ended Wednesday produced a statement that closely matched expectations. The Fed held the target range for short-term interest rates steady, justifying their “patient” strategy with weaker domestic demand and slower inflation. This outcome seemed consistent with growing concerns among policy makers about low rates of inflation. Those concerns gave rise to growing expectations of a rate cut this year.

Powell, however, quickly upended that story. During the post-meeting press conference, Powell attempted to explain away slower inflation. Specifically, Powell said we “suspect that some transitory factors may be at work.” This means central bankers intend to look through the recent soft inflation numbers. In contrast, Powell just a few weeks ago described slower inflation as a “major challenge of our time.”

Powell was shifting gears and reporters took notice. Powell's message on inflation only grew more muddled as the press conference wore on. In response to one question, Powell noted that the Fed's policy goals statement says the central bank would be concerned only if inflation is running persistently below — or above — target. Given that this latest sub-par outcome is transitory, it doesn't rise to a level of concern. But what about the sub-par inflation outcomes since 2012? By extension, all those outcomes must be transitory, which is a clever way of defending persistently undershooting the target. Low inflation has simply been a persistently transitory outcome.

Powell also used alternative inflation measures to justify defending the inflation numbers as transitory, specifically referring to trimmed-mean measures. Oddly, though, he didn't take notice of the Federal Reserve Bank of New York's underlying inflation gauge, which has been ticking downward since last summer. It seems policy makers are looking around only for reasons to ignore low inflation.

Powell later said he thinks it important that “inflation run close to and sustainably around 2 percent” to hold inflation expectations steady. He specifically refers to the persistent downside misses to inflation as a threat to inflation expectations. If that's the case, why is the Fed so confident moving forward that the latest weakness is temporary? Shouldn't the Fed be concerned about the damage those past misses have had on inflation expectations?

What was really remarkable was that after defending slower inflation as transitory throughout the press conference, Powell says confidently that policy makers “don't see any evidence at all of overheating” and specifically mentions low rates of inflation as evidence that there is no overheating. How can it be that slower inflation is evidence against overheating while at the same time slower inflation is transitory? If the economy was overheating, we would expect inflation to be running persistently above 2 percent. If the economy was “just right,” we would expect equal misses on both sides of the inflation target.

But that's not the case. According to the Fed, all of the transitory shocks are on the low side of the target. How likely is that? Wouldn't you expect those shocks to be equally distributed around 2 percent? The simply reality is that if you are using inflation to explain that the economy is not overheating, you should conclude that inflation is running persistently below 2 percent and that the economy remains below full employment.

My take-away from this press conference is the Fed hasn't really changed its view on inflation — it's all talk, no action. Any outcome below 2 percent is by definition transitory. Any outcome at or above 2 percent is by definition persistent. This probably remains the case as long as the unemployment rate hovers at levels the Fed believes is consistent with above-full employment. It's exactly the dove trap that I began warning about in recent weeks. It just sprung sooner than I anticipated.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.