Yet look more closely, and it is clear officials are turning less sanguine—and that explains growing eagerness to start raising interest rates.
Last September, long before the supply bottlenecks emerged, the median forecast by Fed officials was for core inflation (which excludes food and energy) in 2022 of 1.8%. Every few months since then they have nudged that up, and in the forecasts released Wednesday they see core inflation next year at 2.3%.
While current-year forecasts get pushed around a lot by temporary factors such as a jump in oil prices, the next-year forecast reflects where inflation is expected to settle once temporary factors recede. The message from the Fed’s latest projections is that "transitory" is lasting an awfully long time. Indeed, next year’s projected 2.3% is the highest next-year core inflation forecast since projections were first published in 2007, according to Derek Tang of Monetary Policy Analytics.
This might explain why the Fed is accelerating plans to raise interest rates. The Fed is now buying $120 billion a month in bonds and wants that to fall to zero before it starts to raise rates. On Wednesday, the Fed signaled it would likely start tapering those bond purchases in November, which means the process would be over by mid-2022, clearing the way for a rate increase. Half of Fed officials think rates will start rising by late next year. Just last March, a majority of officials didn’t see that happening until 2024.
What changed? It isn’t because the economic outlook is stronger. In fact, officials now see slower growth and higher unemployment than they did in March. Chairman Jerome Powell explained that some officials simply wanted more confidence the expected recovery would materialize. But inflation risks clearly play a part.
A 2.3% inflation rate isn’t a big deal. Indeed, it would conform pretty closely to the Fed’s new goal of letting inflation run above 2% for a while to compensate for the many years it ran below 2%. Yet if officials are wrong, they are likely to have proved too low in their forecasts. With unemployment expected to fall to 3.8% by next year and 3.5% by 2023, the economy will be operating with little or no spare capacity, conditions that typically cause inflation to rise.
Fed officials think inflation risks are to the upside; a majority said so Wednesday. Six of 18 Federal Open Market Committee participants think core inflation will be 2.5% or higher next year.
If the Fed is more worried about inflation, investors aren’t. Long-term bond yields dropped a bit Wednesday, and bond-implied future inflation rates haven’t changed much since May. The market might have more faith in the Fed’s "transitory" story than the Fed itself.
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