Two main reasons why the Fed hasn’t been able to reach its 2% inflation target

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It has been almost a month since the Federal Reserve's new inflation framework was announced, as the new strategy involves average inflation targeting, which makes it more likely the central bank will allow inflation to run higher than the standard 2% target, before hiking interest rates.

The Fed has been chasing its 2% target in 2012, so why hasn’t it even come close to its goal?

“Technology and globalization have been significant driving forces over the past decades that have made it more difficult to figure out and project inflation growth,” according to Dominic Nolan, senior managing director at Pacific Asset Management. "These two factors have been powerful and underestimated forces that keep inflation subdued."

The Fed has failed to hit its 2% inflation target on any regular basis since it was set. "The Fed can’t create demand,” which is a big part of the reason why inflation remains low, Nolan said. “The world is full of supply, which is deflationary, and since the Fed can’t directly control demand, fiscal policy becomes more important,” he said. “Demand could increase with infrastructure projects, which puts money to work. Tax cuts have shown to be tools that increase liquidity and inflate assets, but doesn’t put money to work and hasn’t really created demand."

Dominic Nolan, senior managing director at Pacific Asset Management.

This year has been dominated by the coronavirus pandemic. In dealing with the crisis, Nolan believes Fed officials have "done their job," while politicians "have failed us."

Of course, the Fed’s actions have ballooned its already swollen balance sheet. "By the end of next year, the Fed's balance sheet could be as high as $9 trillion or $10 trillion,” he said. “For some perspective, the Fed balance sheet is around 30% of our aggregate investment grade market. The European balance sheet is close to 60% of their aggregate.”

He added that from an investor’s point of view, the support by the Fed has been a “very good thing” for asset prices.

“And from a consumer standpoint, the impact has not been as meaningful,” he said. “The problem is not the Fed. It is a lack of growth and demand, which is really beyond the central bank.”

After the financial crisis, the balance sheet went up, but the Fed never got to normalize it, and analysts say it is unlikely to revert to pre-financial crisis levels.

"I do not think the Fed would begin reducing the balance sheet until we see sustained and steady GDP growth," said Nolan. "That would mean real GDP growth to be at least 1.5% for more than a year without a negative quarter."

National activity index
The Federal Reserve Bank of Chicago's National Activity Index fell to 0.79 in August from 2.54 in July, the bank said on Monday.

Two of the four components were positive for the month, but all were lower than in July.

The index’s three-month moving average, CFNAI-MA3, dropped to 3.05 this month from 4.23 in the previous month.

The diffusion index fell to 0.62 in July from 0.73 in July.

Forty-five of the 85 components of the index made positive contributions in the month, and 40 were negative. Of the 29 that improved in the month, 11 were still negative. The 56 indicators in the month “deteriorated,” the fed said.

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Inflation Monetary policy Federal Reserve Federal Reserve Bank of Chicago