Summary
We examine the Federal' Reserve's mandate for price stability.
We look at the track record of US price stability since the mid 1990s
We discuss two measures of inflation: PCE (which the Fed targets) and CPI (which is more broadly discussed in the financial press)
We provide evidence that until recently the PCE rate was very stable and at or near the Fed's target
We observe the historic relationship between the US yield curve shape and the PCE rate
The Fed and rate targeting
On September 12th, 2018 James Bullard the President and CEO of the Federal Reserve Bank of St. Louis said;
"The FOMC named an explicit inflation target of 2 percent in January 2012, but I am arguing that the Committee behaved as if it had a 2 percent target well before that date."
We use some data from the past sixty years to examine this statement and provide some context for the Fed's rate rise on 15th June, 2022.
Responsibilities of the Federal Reserve.
The Fed is responsible for:
Conducting the United States' monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices.
Supervising and regulating U.S. banks and other important financial institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers.
Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
Providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation's payments systems.
In this article and in the light of recent upwards movements in inflation we are going to focus on the first of these responsibilities - monetary policy.
Figure 1: A comparison of the Fed Funds Rate (red) with the inflation benchmark 'PCE' (green)
As can be seen from the chart above Inflation (shown as the green line) is rising to its highest levels in 40 years. Inflation in the late 1970’s and early 1980’s is usually attributed to oil shocks, government overspend and higher wage demands. In January 1980, Inflation was 13.91%, and US Unemployment was 6.3%.
What does the data show about the willingness of the Fed to tackle inflation?
The Fed has been debating inflation targeting since the mid 1990s. While the Fed is not committed to a specific target at a particular rate, the policy is to achieve an inflation rate at or near 2% in the long run. James Bullard, President and CEO of the Federal Reserve Bank of St Louis stated in a presentation in September 2018 (link is in first paragraph above) that the first time a specific target was mentioned was January 2012, but the FOMC committee had “behaved as if it had a 2% target well before this date”
So how has the Fed done on that measure? In the chart below you can see two key measures of US Inflation from January 1978 to May 2022.
Figure 2: Two measures of US Inflation since 1978. The CPI (Consumer Price Index) - shown in red; also the PCE (Personal Consumption Expenditures) - shown in green.
These measures are the CPI (in red) and the PCE (in green). The CPI (Consumer Price Index) is most widely quoted in the press and is used as a basis for determining TIPS as well as US Inflation Swaps. PCE (Personal Consumption Expenditures) is less widely published, but this is the target measure used by the Fed for price stability. The chart would seem to strongly affirm James Bullard’s assertion that the Fed was behaving like it had a 2% target since 1995.
Context for the H1 2022 rate rises
Figure 2 shows a sharp rise in PCE in April and May of 2022. This takes PCE well outside of the range it has been occupying for the last 30 years. Given this sharp rise in the key rate watched by the Fed the response from the Fed seems justified. The Federal Reserve responded by raising rates by 75 basis points on Wed 15th June, following a 50bps rise in May on top of a 25bps March hike... Guidance is for a further 50-75bps rise in July.
US Rates and Inflation over the past six decades
If we look further back in time to capture economic cycles through inflationary and deflationary periods we can see the linkage between inflation and US rates. Let’s look at longer dated yields first. The chart below from January 1960 shows the movement of 10Yr US Govt yields along with the CPI. The two plots are correlated. There is a discernible lag in the rise in the 10Yr rate with respect to CPI throughout the ‘70s & ‘80s. The current rise in 2022 is comparable in magnitude to the ‘oil shocks’ of the 1970s
Figure 3: 10Yr US Govt Bond Market Yields (red) and US CPI (green) since 1960
If we then look at the short end of the yield curve and look at Fed Funds rates we see a similar correlation, but without as great a lag in the movement of interest rates with respect to inflation.
Figure 4: Fed Funds (red) and US CPI (green) since 1960
If we look at 10Yr Treasury Yields against PC the story is largely the same. The series are correlated with a slight lag evident in the Treasury plot relative to PCE in the late 1970s and early 1980s. Though from the mid 1990s onwards there is less correlation. Generally the PCE rate (until very recently!) has been stable around 2% and 10Yr market yields have been on a downward trend. Figure 5 below shows the 10 year market yield vs PCE since 1978.
Figure 5: 10Yr US Govt Bond Market Yields (red) and US PCE (green) since 1978
We can combine the data from figure 1 and figure 5 and look at the change in yield curve shape over time. In the chart below we animate monthly changes in a simple US yield curve. We take three short end rates: Fed Funds, 3m and 6m, a single mid-curve rate 5yr and a longer dated 10yr point. From this data we can see the changes to the steepness and the level of the yield curve. Each month we plot the PCE rate on the y-axis. From this we can clearly see that to combat high inflation we have high rates, often resulting in an inverted yield curve.
The most striking thing in this chart is how close PCE stays to 2% after the mid 1990s. It is certainly very volatile prior to that date. But you can see evidence of the flexing of the yield curve to keep the PCE rate close to 2% from about 1995 onwards. Hit the 'Play' button in the bottom left to see how close PCE stays to 2% after 1995.
Figure 6: US Yield Curve (red line) vs PCE (blue dot) for a range of date (yellow text on upper-right) since the mid 1980s. [Hit 'Play' to see the flexing of the US curve]
This chart also clearly shows the two secular rises in USD rates. The first in 2007/2008 associated with the Great Financial Crisis, and a smaller rise in 2020 associated with the outbreak of Covid-19.
We also see, for at least the past decade and a half, low and stable rates with a positively sloping yield curve. With inflation rising as sharply as it is many commentators are predicting that this moderation may not endure for much longer.
Figure 7: US Yield Curve (red line) vs CPI (blue dot) for a range of date (yellow text on upper-right) since the mid 1980s
While PCE is stated by the Federal Reserve as the relevant inflation benchmark, many commentators link Fed activity to CPI. For completeness sake we can look at the same plot in Figure 5, this time with the CPI rate shown on the y-axis for each animation frame. As before each frame represents a month. The month and year is shown in yellow in the upper right hand side of the chart. The lessons from both plots are broadly similar. While CPI exhibits a little more volatility than PCE and is generally higher, we see the same rising, steepening and inverting of the US curve in response to fluctuations in this inflation benchmark as we do with PCE.
Conclusion
The question posed was to what extent does the data support the implicit price stability mandate of the Fed?
James Bullard stated that the Fed had been behaving as though it has a 2% target since the mid 1990’s. Based on the data presented in this blog it is extremely hard to argue against his view. The PCE benchmark has been maintained at or around 2% since that time.
With the sharp recent rises in PCE the Fed has to date acted consistently with its mandate of price stability within the context of maximum employment.
This I hope puts into context the 0.75bps rise in June and adds further context for further anticipated rises this year; commencing with a 50bps to 75bps rise at the next meeting in July.