COLUMN-Fed rate cut now signals 3% inflation is the new 2%: McGeever

By Jamie McGeever

ORLANDO, Florida, Sept 9 (Reuters) - The Federal Reserve is widely expected to cut interest rates next week even though inflation is still around 3%, a full percentage point above the official goal. This raises an uncomfortable question: is the central bank's 2% inflation target still viable?

Data on Thursday is expected to show that annual core CPI inflation held steady in August at 3.1%. Annual core PCE inflation, the Fed's preferred measure, was 2.9% in July.

Easing policy with inflation at this level would be a rare step.

Of course, the Fed cut rates late last year when core CPI was even higher at around 3.3%, though that move drew fire because unemployment didn't rise as Fed officials had warned and long-dated yields rose.

If you want to find the last time before this cycle that the central bank eased policy with core PCE inflation at 3%, you have to go all the way back to the early 1990s, before the Fed unofficially adopted its 2% target.

That's a long time ago, when the economy was in a very different place. The internet as we know it barely existed, there were no smartphones, and 'apps' was the abbreviation for 'appearances' in soccer players' stats.

So the prospect of the Fed easing policy for the second time in a year with core inflation at 3% is a big deal – and may be yet another sign that the economic orthodoxy of recent decades is being tested or trashed. Take your pick.

UNORTHODOX

Inflation hawks fear it's the latter. The federal government's debt and deficit are at record levels for non-crisis, peacetime, and there are fears that long bond yields could start climbing again.

But markets don't seem too worried.

To be sure, inflation fears are reflected in some asset prices, not least gold, which is up nearly 40% this year, printing record highs on a near daily basis.

But look around, and it's difficult to argue that financial markets are overly worried about the potential loosening of the Fed's 2% target.

Indeed, the 2s/30s yield curve may have steepened around 70 basis points this year to a four-year high of 134 bps last week, but the 30-year yield is actually down slightly this year.

Meanwhile, U.S. corporate bond spreads are at historic tights, and Wall Street continues to hit record highs.

Of course, equity markets have historically tended to sizzle as inflation has heated up, though usually not for long and certainly not once consumer inflation expectations become unanchored. We're not there yet, but we are at an interesting juncture.

HIGH EXPECTATIONS

Academic research suggests consumers are among the least accurate forecasters when it comes to inflation, but policymakers have long been loath to dismiss them. And right now, 2% is not on consumers' inflation horizon.

A New York Fed survey on Monday showed consumers' one-year outlook rose to 3.2% in August from 3.1% in July, while the three- and five-year forecasts were unchanged at 3% and 2.9%, respectively. The University of Michigan's latest one- and five-year forecasts are 4.8% and 3.5%.

So perhaps 3% is starting to become the new 2%.

U.S. President Donald Trump would certainly seem to support this, given his apparent desire to run the economy hot. And the Fed looks set to shrug off inflation risks – and ease in a 3% environment – for the second time in a year.

Is this a misstep by the Fed, or even policy error? Not necessarily.

'HYSTERIA AND DELIRIUM'

Retired strategist Jim Paulsen questions the "constant hysteria" around inflation exceeding the Fed's target. To get some perspective on this "2% target delirium," Paulsen notes that annual headline CPI has averaged 2.9% over the last two years and is currently only 2.7%. Price stability, anyone?

He also points out that from 1992 to 1999, a period often viewed as "economic nirvana," headline CPI averaged 2.6%.

"It's time to retire the 2% inflation target. We have always put smart, street-savvy, driven, and economically war-tested individuals on the FOMC. Let's let them use their venerable judgments to do their job without tying their hands to some random target which has never been well tested," Paulsen wrote on Monday.

A 3% inflation print on Thursday followed by a rate cut next week might suggest we are heading in that direction.

(The opinions expressed here are those of the author, a columnist for Reuters)