BlackRock Investment Institute

Macro insights

Looking through inflation noise

The Fed’s new policy framework is designed to counter stubbornly low inflation by flexibly targeting an average core PCE inflation rate of 2% over the long-run. Persistent misses over the past decade suggest the Fed will aim at inflation overshooting their target in coming years – and adopt a much more patient approach to policy normalization, in our view.

Playing catch-up

Chart showing where annual inflation would need to be, on average, over the subsequent five years to hit the Fed’s inflation target

Sources: BlackRock Investment Institute, with data from Refinitive Datastream and Haver Analytics, May 2021. Notes: The inflation makeup rate shows our estimate of how much inflation would need to be, on average, over the subsequent five years, to hit the Fed's target of an average inflation rate of 2% (dotted line) over the medium term under its current policy framework.

Inflation has run below target in the U.S. for most of the post-global financial crisis period, suggesting substantial periods of inflation overshoots will be needed to close the gap. This points to a ‘price level gap’ – the difference between the actual price level and what it would have been under the 2% target – of nearly 1.5% in the U.S, in our estimates. The chart shows where annual inflation would need to be, on average, over the subsequent five years to hit the Fed’s target. This makeup rate – currently at just under 2.3% – is a touch higher than the Fed’s own three-year inflation projection it set out in its March policy meeting, and in-line with current market pricing for inflation over the next five years.

The near-term spike in inflation – spurred in large part by supply constraints combined with surging demand as the economy reopens – has not made much of a dent in the cumulative inflation shortfall, in our view. This unusual supply-demand dynamic could lead to volatile inflation in the near-term. See our global weekly commentary for more.

We stand by our view on higher inflation on a longer-term horizon. We see U.S. CPI inflation averaging just under 3% between 2025-2030 – a risk markets are underappreciating in our view. The Fed’s new framework implies not only that inflation will likely be higher than expected, but also that monetary policy normalization will have to be much more patient than in the past.

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