Fed’s tough task: History shows inflation takes average of 10 years to return to 2%


After more than a year in which most professional forecasters and financial-market players regularly misjudged the persistency of inflation, they may now be missing out on one key fact.

History shows that inflation takes an average of 10 years to return to 2% once it breaks above 5%, according to Thanos Vamvakidis, a strategist for BofA Securities in the U.K. That’s based on decades worth of data across advanced countries. And it’s a much longer period than the consensus view, in which inflation in G-10 countries is expected to drop to 2% by 2024, Vamvakidis wrote in a note Wednesday.

Source: IMF, BofA Global Research

The ramifications of BofA’s view, coming just hours before the Federal Reserve is widely expected to deliver another aggressive rate hike and unveil the possible path of hikes going forward, is that investors may once again be underestimating the fortitude required for policy makers to bring the hottest inflation era of the past four decades to a heel. A few firms, such as SEI, which oversees $1.3 trillion in assets, see the likelihood that the central bank’s hiking cycle will end at a level that’s as high as 5%, twice as high as where interest rates sat before the Fed’s policy announcement Wednesday.

The annual headline inflation rate in the consumer-price index has been above 8% for months, and the narrower gauge which strips out food and energy costs showed no signs of a let up in August. Meanwhile, the rate of inflation over the past year based on the Fed’s preferred inflation measure, known as the personal-consumption expenditures price index, dropped to 6.3% for July; its narrower core measure came in at 4.6% for the 12-month period.

“The consensus today is too optimistic,” Vamvakidis wrote. “In a positive scenario, inflation starts to move in the right direction at a sufficient pace for central banks (CBs) to avoid a hard landing, even if inflation remains above 2% in the medium term. In a negative scenario, inflation is persistent and sticky on the way down, forcing central banks to a hard landing.”

“Our baseline is the positive scenario, but risks for the negative scenario are increasing,” the strategist said. Inflation has yet to peak, “labor markets are stretched, real policy rates are still deeply negative, fiscal policies are loose, and structural reforms are not even part of the policy discussions.”

In the minutes of their last meeting in July, policy makers acknowledged that inflation would likely stay uncomfortably high, and some indicated interest rates would probably need to stay in sufficiently restrictive territory “for some time.” Restrictive territory is defined as the level that would restrict economic growth, in order to combat high inflation.

Ahead of the Fed’s policy update Wednesday afternoon, financial markets were in wait-and-see mode, with all three major stock indexes

DJIA, +0.42% SPX, +0.59% COMP, +0.57%

higher in morning trading. Treasury yields stabilized, though the 10-year rate

TMUBMUSD10Y, 3.573%

slipped from an 11-year high.

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