STRATEGIST: Targeting 2% inflation is like asking the 5'4" kid to dunk

Inflation is not near the Fed’s target.

On Monday, the latest reading on “core” PCE, the Fed’s preferred measure of inflation which strips out the more volatile cost of food and gas, showed prices rose 1.4% over the prior year in February.

The Fed is currently targeting inflation running at 2%.

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

Here’s Tchir:

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 that there is a good chance the Fed will 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 per cent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.

In its latest policy statement, the Fed said that it expects 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.

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