Starting around 2012-3, critics argued that the Federal Reserve was in danger of “getting behind the curve”. Being behind the curve means that rates are too low and that overall monetary policy is overly accommodative. After nearly a decade of historically low interest rates and three quantitative easing programs, inflation remains well – below the Fed’s 2% target. So far, the Fed is far from being behind curve as specified by the inflation vigilantes.

The Fed is behind a different curve in one important sense. The accompanying chart (Figure 1) shows the steady evolution in the Fed’s forecast of the longer term Fed Funds rate. In 2012, the FOMC expected the fund rate to be 4.25%; in 2013, the forecast dropped down to 4%; in 2014, there was a further downward adjustment to 3.5%; and most recently the Fed funds rate is expected to reach 3% over the longer term. In essence, the Fed has had to ratchet steadily downwards its implied funds rate, in large measure as inflation remained stubbornly well below the 2 % target. The Fed remains anchored on their belief that the economy will generate a sustained inflation rate of 2 % in “medium term” (a time frame frequently used by Janet Yellen).

Figure 1 Implied Fed Funds Rate

(Click on image to enlarge)

As Larry Summers put it bluntly, “the Fed is not credible with the markets at this point”. He goes onto argue that the Fed will not meet its 2 % target for long time as investor expectations are trending well below the 2% target (Figure 2).  

Figure 2 Market Inflation Expectations

(Click on image to enlarge)

Summers goes on to argue that:

“If the Fed were equally behind the curve with respect to rising inflation there would be hysteriaamong the commentariat…. Why shouldn’t there be concern about the disbelieved forecasts of action that if taken would push inflation further below the target than current forecasts?”

In other words, raising rates at a time when inflation is weakening only contributes to yet lower inflation in the future. Summers concludes that the recent rate hike of June 14^th was simply a policy mistake.