Why the US Fed might be shooting for the front of the green, not the hole

Over the long run, the Federal Open Market Committee (FOMC) has an inflation target of 2%. It forms one of the three pillars of the Fed's mandate, the other two being maximum employment and moderate long-term interest rates. 

For those playing at home, US inflation is currently at 8.263% - way above 2%. So, as would be expected, it's hiking its tail off to depress demand in the hope that doing so will bring the parts of the economy that are supply-constrained back into equilibrium. 

But what if I was to tell you that the Fed might not be aiming for 2% at all? And that it might instead take its foot off the brakes when inflation drops to 3-4%. Indeed, at what point does the need for price stability gives way to the need to maintain employment and moderate long-term interest rates?

The concept of opportunistic disinflation may provide some answers. Citi's team of global economists, led by veteran Nathan Sheets, has just released a cracker of a research note discussing this, and I'll outline the key takeaways from it in this wire. 

 What is opportunistic disinflation?

When inflation is extremely high, as it is today, central banks go hard and hike, and maybe pair that with quantitative tightening - selling or letting expire the bonds on their balance sheets.

However, when inflation approaches the target, central banks become more dovish. They take their foot off the rate pedal and turn their attention instead to employment and output gaps. The idea, then, is that the final leg to the target is more or less taken care of by the market.

To use a golf analogy, it's like aiming for the front of the green in the hope that the momentum and green conditions will be enough to take the ball the rest of the way to the hole.  

Nothing new

When one thinks about central banks and inflation, the first banker they think of - after Jerome Powell - is former Federal Reserve Chair, Paul Volcker. 

In 1981, headline inflation peaked at 9.8%. Volcker brought it back under control by sending the cash rate to almost 20%. Volcker achieved two things - he got inflation under control, and he caused two recessions. 

However, while Volcker is the inflation poster boy, he didn't get CPI down to the 2% target. Oh no, that took another 15 years. Through the second half of the 80s, inflation sat at about 4%. 

"We find that inflation plateaued at roughly 4% through the second half of the 1980s, and then declined gradually through the 1990s, reaching 2% only toward the end of the period," Citi's analysts say. 

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