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STRATEGIST: Targeting 2% inflation is like asking the 5-foot-4 kid to dunk

Nate Robinson dunking
REUTERS/Lucy Nicholson

Inflation is far from the Fed's target. 

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On Monday, the latest reading on "core" PCE showed prices in February rose 1.4% over the same period last year. "Core" PCE is the Federal Reserve's preferred measure of inflation, as it strips out the more volatile cost of food and gas. 

The Fed is targeting inflation running at 2%. 

In a note following the report, Peter Tchir at Brean Capital asks why the Fed is so set on targeting this level.

Here's Tchir:

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Asking the 5'4" Kid to Dunk 
In 20 years of data, there is only one window where PCE was above the 2% average, from late 2004 until the system crashed in 2008. Now is not the time to ask why we have selected a rate that was only sustainable once, and lead up to the biggest financial crash (although that is a question some might ponder). The bigger question, is why has the Fed picked a target of 2% on a metric that rarely reaches that? The PCE rarely gets to 2% in the first place, and rarely holds on to that level. Yes, prior to 1995 it was well above 2% for periods of time, but in the last 20 years, 2% seems like a very high hurdle.

Tchir also notes that "core" PCE would need to average 2.6% over the next six months for PCE to get back to 2% in short order. Of late, however, some Fed officials have started to move away from the idea that inflation would need to be running at 2% for the Fed to start raising rates. 

In a speech on Friday, Fed Chair Janet Yellen said there was a good chance the Fed would raise rates in 2015. On inflation, Yellen said:

I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.

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In its latest policy statement, the Fed said it expected inflation to move back to 2% over the medium term. 

In his note, Tchir included a version of this chart, with the red line showing core PCE and the blue line showing the Fed's target.

PCE target
FRED


Inflation
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