The Fed’s failure is neither that rates volatility has picked up nor that equity markets fell last week. Rather, it is that they cannot persuade the market that Fed policy will remain loose to generate inflation and improve income inequality. Indeed, just as inflation expectations picked up, bond yields have risen sharply, and the market is almost pricing the first Fed hike in 2022.
This was not meant to happen. The Fed introduced its average inflation target (i.e., allow inflation to overshoot) with much fanfare in August last year. Yet, the Fed’s own inflation forecasts as well as consensus are expecting no inflation overshoots (Chart 1). This means average inflation is likely to fall below the magical 2% level. It is ironic that the Fed has systematically failed to meet its inflation target ever since it got more explicit about doing so. And markets are calling the Fed’s bluff and pricing hikes to say that the Fed is not serious about creating inflation.
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