Inflation - It is still about minding the gap

There has been so much discussion about hitting the 2 percent inflation target that it is often good to go back to basics. Investors should keep in mind the simple rule that inflation cannot really rise above expectations unless the output gap is closed, not just for the US, but for the global economy. This goes back to classic macro and an expectations-augmented Phillips curve model. If inflation is below inflation expectations, it suggests that there is still an output gap. (See "Is Inflation Just Around the Corner? The Phillips Curve and Global Inflationary Pressures" by Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate in the 2019 AER Papers and Proceedings)

Close the output gap and there will likely be more inflation upside. If the gap is not closed, upward pressure will be limited. Additionally, the US will be hard pressed to see higher inflation if global inflation and output still languishing. The US is not an inflation island separate from the rest of the world.

If inflation is below the expectations, the output gap has likely not been closed. There is still slack in the economy. While capacity utilization is higher, it has taken a long time to close the employment gap which has dampened any possible surge in inflation.

The inflation gap is closing so there is a smaller difference between actual and expected inflation; however, there is still a problem that inflation expectations are low. Economic agents just do not believe that the combination of growth and monetary policy will lead to inflation strongly consistent with inflation targets.

The decline in the output gap and the closing of the inflation gap all suggests that Fed tightening made sense over the last few years. A close look at inflation expectations and CPI percentage changes tell us that the gap was closed. There may be concern that the gap may again increase, but the data, while switching sign, has does not suggest a change in the economic environment. Inflation is not that has to be addressed.