The U.S. Federal Reserve raised its key interest rate by 25 basis points last Wednesday as expected. And yet the 10-year Treasury yield fell almost 10 basis points in response.

Why is the yield curve flattening? Is the Fed raising rates too fast?

Surprising many, at her post-meeting press conference Federal Reserve Chair Janet Yellen brought up the topic of raising the inflation target - implying that the speed of Fed tightening could slow or even result in pushing interest rates lower.

The idea is controversial and she said she will wait for further economic research, adding that this is expected to be “one of the most important questions facing monetary policy around the world.”

Most advanced countries' inflation target remains at 2 percent. Despite all the unconventional monetary policy tools implemented in recent years, inflation has remained chronically low without hitting that 2 percent target.

The labor market, on the other hand, is improving - with the unemployment rate coming down and economic growth recovering. In the case of the U.S., we have achieved full employment

Typically in an environment of such loose monetary conditions, inflation would kick in rapidly. But evidence is that it has recently been falling.

To understand this conundrum, economists and central bankers have come up with different solutions - including this argument to raise the inflation target in times when central banks are struggling to create inflation. The thought is that, in an economy with super-low interest rates and maximum employment with no inflationary pressure, there is a new normal where the neutral rate is very low.

In this situation, prematurely tightening interest rates would not only squelch economic growth but central banks would be left with few policy tools to stimulate the economy because all methods would be exhausted. To avoid this, the idea is that the inflation target needs to be raised. Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, and prominent American economist Larry Summers are among those that support this view.

In fact, this debate is not new. But the idea has not gained much traction as there is not enough research on potential repercussions, which could include undermining the credibility and goals of the world's central banks.

  • In 2010 Oliver Blanchard, chief economist of the International Monetary Fund, brought up this idea, but Ben Bernanke, who was then Fed chair, dismissed it.
  • In 2014, the deputy governor of the Bank of England, Ben Broadbent, also supported this theory but his suggestions did not materially affect monetary policy decisions.
  • The Bank of Japan actually announced an increase of its inflation target to above 2 percent last September. But Governor Haruhiko Kuroda faced strong opposition to the move and complaints from Japanese economists and commercial bankers.

My View: It seems like there is a difference in the inflation target rate when central banks are trying to curb inflation versus when they are trying to create inflation. Perhaps the current flattening of the yield curve is signaling that the market is starting to embrace this controversial idea too – we'll have to wait and see.

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