LONDON (Reuters) - Rapidly rising consumer prices as the U.S. economy re-opens after the pandemic have erased years of below-target inflation, intensifying questions about when the central bank will start reducing monetary stimulus. U.S. consumer prices rose at a compound annual rate of 3.00% per year over the two years to June 2021, the fastest two-year increase since October 2008, according to data from the Bureau of Labor Statistics. Core consumer prices excluding volatile food and energy items increased at a compound annual rate of 2.82% per year, the fastest increase for almost a quarter of a century. Comparisons with 2019 help avoid distortions caused by the first wave of the epidemic and widespread business closures in 2020, and underscore that faster inflation is not just due to baseline effects. In August 2020, the Federal Reserve committed itself to achieving an average inflation rate of 2% over time, as part of its review of longer-run goals and monetary strategy. At the time, senior policymakers noted inflation had been below target “persistently” in recent years, so it should be allowed to run modestly above target for some time to return the average to 2%. But they offered no guidance on when they believe the undershoot began, how big a price-level deficit they are seeking to correct, or how many years inflation will be averaged over in measuring compliance with the target. The recent surge in core consumer prices following the re-opening of the economy has now erased all the undershooting in core consumer price inflation since April 2009 (tmsnrt.rs/3xHaOI7). PCE VERSUS CPI In practice, the Fed has given itself a more expansionary target by employing the personal consumption expenditures (PCE) price index rather than the consumer price index (CPI) to define its objective. The PCE index generally rises more slowly than CPI for technical reasons, including calculation method and scope of coverage (“Focus on prices and spending”, Bureau of Labor Statistics, May 2011). Core PCE inflation has averaged 1.73% per year since the start of the century compared with an average of 2.01% for core CPI. Core PCE inflation has been below the 2% target for 74% of the time since the start of the century compared with only 46% for core CPI. This is one reason why the Fed perceives less inflation than consumers do. Even on the Fed’s preferred measure, however, the recent surge in prices has erased all the inflation undershooting going back to April 2015. BASELINE CHOICE Core PCE prices are still about 3.6% below where they were in June 2008, projected forward at 2% per year to June 2021. If the Fed decides to offset inflation undershooting all the way back to the financial crisis, more than a decade’s worth of price increases, it will give itself much more scope to allow inflation to overshoot in the short term. On its preferred PCE measure, the Fed could allow inflation to run significantly above target throughout 2022 and into 2023, which appears to be the intention for some top officials. Targeting average inflation over more than a decade would provide almost unlimited flexibility to maintain massive bond purchases and hold interest rates at ultra-low levels. But there is an open question whether the price level in 2008, set on the eve of the financial crisis, when global oil prices were peaking at a record level, is an appropriate baseline. There is no theoretical reason to prefer 2008 and a 13-year averaging period rather than any other baseline or averaging period. FED DISCRETION It is possible policymakers have decided to run an expansionary policy and are selecting baselines and averaging periods to give themselves flexibility to look-through above-target inflation rates. That points to a deeper problem with the average inflation targeting policy framework: without a clearer articulation of the averaging period, the target devolves into a purely discretionary system. A more discretionary approach to inflation would allow the Fed to shift its focus to maximising employment levels. But the price of that would likely be faster price rises over time, probably above the 2% target in the long run. Once inflation has been permitted to become entrenched at 2.5% or more for several years, the central bank would likely be reluctant to engineer a deep business cycle slowdown to bring it back to 2% or less. If the price level moved above its long run target, the Fed could simply shift the baseline and averaging period to limit the need for a painful monetary contraction, ensuring inflation averages above 2% in the long run. An average inflation target without a specified baseline or averaging period risks becoming no target at all. Related columns: - Faster U.S. wage rises will help entrench inflation (Reuters, June 15) - U.S. inflation will accelerate if recovery stays on track (Reuters, June 11) - Empty supply chain will keep global economy booming (Reuters, June 3) - Fed focus on jobs implies significant inflation overshoot (Reuters, May 18) Editing by Elaine Hardcastle Our Standards: The Thomson Reuters Trust Principles.