Many people are surprised by my claim that monetary policy is gradually getting more expansionary, even as interest rates start to rise and QE is being scaled back. But these instrument settings don’t tell us much about the stance of monetary policy. Instead, we need to look at the goal variables. The 5-year TIPS spread has been fairly stable over the past 10 months, at a relatively high level:

If the Fed were an inflation targeting central bank, then this would suggest little change in the stance of monetary policy over the past 10 months.  But the Fed is not an inflation targeting central bank; it’s an average inflation targeting central bank.  And the expected average inflation rate during the 2020s has been rising in recent months.

The actual PCE inflation rate over the past year is 5.8%, far above the Fed’s 2% target.  To make this high inflation “transitory”, inflation must average roughly 1.6% during the other 9 years of the decade.  Inflation was quite low in 2020 (1.3%), so we need about 1.7% per year for the rest of the decade.  This means that the gap between expected PCE inflation (about 2.6%, equivalent to 2.85% for the CPI) and the appropriate target (about 1.7% PCE inflation) has been widening over the past 10 months. Unfortunately, Fed chair Powell has recently seemed to waver on the Fed’s average inflation targeting commitment, suggesting that they have no intention of balancing years of above 2% inflation with periods of below 2% inflation.  This could lead to a dangerous loss of credibility in Fed policy.  

This is not to suggest that inflation averaging 2% for the rest of the decade would be a policy disaster; that would still be a better outcome than most previous decades.  But the longer the Fed waits to get inflation under control, the more painful will be the adjustment process.  Policy credibility is the Fed’s most powerful policy tool.  Without it things get much more difficult.