US Federal Reserve Chairman Jerome Powell said on Thursday that the Fed has adopted a policy of “average inflation targeting” — a meaningful shift in the approach to interest rate-setting that has guided the central bank over the past few decades. The change means that when inflation undershoots its 2% target, the Fed will attempt to overshoot the target in ensuing years — essentially accepting higher inflation. 

Speaking at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Economic Policy Symposium, Powell said that “following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” 

While the Fed’s move is aimed at supporting inflation expectations among households and businesses, could it lead to significantly higher CPI inflation? The answer is most likely “no”, or at least “not yet”, although that does not rule out the potential for asset price inflation. Even as the US has pumped massive monetary and fiscal stimulus in response to the COVID-19 pandemic, fundamental factors that generate inflation are not developing in a manner that suggests it is likely to move substantially higher in the coming quarters. 

Historically, extended periods of high inflation have been the exception, not the norm.

Sustained periods of high inflation are not that common in the US

 

There are five factors often cited as triggers for inflation: 

1. Easy monetary policy and excess money supply growth

Rising inflation did tend to follow accelerating money supply growth from the 1960s to the early 1980s. But since then, the correlation has deteriorated significantly. 

The link between money supply growth and inflation is not very strong

A rising money supply does not necessarily lead to higher prices if the velocity of money — the number of times a dollar is spent — falls. The rising money supply and falling velocity offset each other, limiting the impact on prices and real economic activity. As the economist Paul Samuelson put it in his 1948 economics textbook: “You can lead a horse to water, but you can’t make him drink. You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.” 

Velocity has declined as the private sector’s demand for money has increased. This has resulted from falling inflation expectations, lower interest rates that have reduced the opportunity cost of holding cash, uncertainty and until recently, deleveraging. With declining velocity, money supply growth does not generate faster economic activity. Thus, it does not lead to cause #2: excess demand, high resource utilization, and positive output gaps. Accelerating money supply and easy fiscal policy in the early 1960s caused US private final demand to sustain a very rapid 6.3% rate of growth over a five-year period. This ultimately pushed the US economy’s resource utilization rate — a combination of the capacity utilization rate and employment rate — over 90%, which is well above the roughly 80% that has, at least historically, signalled higher inflation. As a result, CPI inflation rose to 5.9% from 1.2% in the latter half of the 1960s.

 

1. Sources: Global Financial Data, Bureau of Labor Statistics. Annual data as of 2019.

2. Sources: Federal Reserve, Bureau of Labor Statistics. M2 growth data advanced 24 months to July 2022. CPI data as of July 2020. The M2 money supply includes cash, bank checking and savings deposits, and financial instruments such as money market securities that are easily convertible into cash.