Image Source: PixabayLars Svensson has argued that monetary policymakers should “target the forecast”, which means they should set their policy at a position expected to lead to on-target inflation.

Early in 2024, a few high inflation readings led to concern that we might not be on track for a soft landing. Inflation eased later in the year, and in September the Fed began cutting interest rates. In recent weeks, however, 5-year inflation breakevens have been creeping upward, and yesterday they spiked up to 2.46%. To be clear, this interest rate spread is based on the CPI, which runs a bit hotter than the PCE index targeted by the Fed.  Nonetheless, it suggests that inflation is still expected to run above of the Fed’s 2% target. And while the Fed has a dual mandate, the labor market is also currently strong, and thus provides no justification for intentionally running inflation above target.Today, the Fed meets to discuss monetary policy. It will be interesting to see how they decide to react to the recent surge in TIPS spreads. If they adhered to Lars Svensson’s target the forecast maxim, you’d expect them to tighten monetary policy. It’s also worth considering how a NGDP futures targeting regime would handle this problem. Under current market conditions, I’d expect most investors to take a long position on NGDP futures, forcing the Fed to take a rather extreme short position and exposing the Fed to severe losses if NGDP growth overshoot the target. But I also believe that the Fed would be unwilling to accept that risk, and would tighten policy enough to restore credibility in the financial markets.PS. Many pundits believe that the election outcome was heavily influenced by public anger over inflation. If so, the bond market reaction to the election was certainly something to think about. If inflation is truly the issue that the public cares about most, then how should the media have described the market reaction to the election? How did the media describe the market reaction to the election? (To be clear, inflation is not the economic issue that I care about most.) In other words, never reason from an inflation rate change.More By This Author:When Should We Defer To Others? Germany, Japan And TelenganaReal Shocks And Recessions