The Federal Reserve’s new inflation regime

Forthcoming decisions on average targeting will determine future monetary policy

The Federal Reserve’s framework review of its monetary strategy and tools is approaching decision time, with announcements likely before mid-year. What should investors expect?

Early guidance from Fed vice-chairman Richard Clarida suggested that the review would probably result in evolutionary not revolutionary changes. More recently, however, the Federal Open Market Committee has discussed more profound innovations, notably a switch to average inflation targeting (AIT). Chairman Jay Powell said last month that this would represent an important regime shift for the central bank.

The fundamental objectives of any change in the format of the target are clear. Almost all members of the FOMC believe that the 2 per cent inflation target introduced in 2012 has resulted in an unintended downward bias to inflation in the long term.

Interest rates have often been constrained by the zero lower bound, resulting in periods when inflation has dropped well below 2 per cent. The Fed’s present mandate does not require it to compensate for these shortfalls with subsequent periods of inflation above 2 per cent, and the average inflation rate since 2012 has been persistently below 2 per cent. Inflation expectations have also dropped below the target.

The cumulative result has been that the price level (measured by the headline personal consumption expenditure deflator) has now fallen 5 per cent below that which would have been achieved if inflation had averaged 2 per cent from 2012 onwards.

The FOMC is clearly not willing to tolerate these shortfalls any longer. After the review it will adopt a new method of targeting that is intended to keep inflation at its 2 per cent target on average into the future. The committee believes this will reduce the likelihood that the US will get trapped in a cycle of deflation or persistently low inflation, following the depressing examples of Japan and the eurozone.

The main question is exactly how to change the inflation target definition to achieve this.

The most radical possibility would be to announce that inflation will average 2 per cent over long periods, with the calculation starting in 2012 when the original target was launched. This would be a logical starting date, but such a policy would require inflation to run at about 1 per cent above the target rate for the next five years, to compensate for the existing shortfall.

This may well be too ambitious for the central bank. Fulcrum economists have simulated the results of this policy using a new empirical model for the US economy (see box). They conclude that policy rates would initially need to be reduced by 50 basis points from current levels to shock inflation on to the required upward path.

But this would push unemployment down to about 2 per cent, which is well below the equilibrium rate. The implication is that monetary policy would then need to be sharply tightened. Policy rates would eventually have to rise to above 4 per cent, to get inflation back to its long-run 2 per cent target, with unemployment at its equilibrium rate. During this process, the economy would come almost to a standstill for a while.

These bumpy paths for short-run inflation, unemployment and policy interest rates are unlikely to be acceptable to the FOMC. Such a radical form of the AIT, while perhaps the most convincing in theory, is not likely to be adopted in practice.

There are two main candidates for a watered-down version.

  • The AIT could work over a shorter time, for example four years backwards and four years forwards. If implemented in mid-2020, the cumulative inflation shortfall from 2017 would only be about 1 per cent, and this could be eliminated over the period up to 2024 with a much smoother path for interest rates and the economy. However, the starting date would be arbitrary and hard for the public to understand. Furthermore, the formula would be fairly rigid, limiting the FOMC’s flexibility to amend its strategy in the face of unexpected economic or market events.
  • Several members of the FOMC have discussed an alternative that would allow policymakers more freedom of action. A new inflation target would aim for 2 per cent inflation over an unspecified long-term period, while keeping actual inflation within a 1.5 to 2.5 per cent band over shorter periods. This would keep inflation close to the familiar 2 per cent most of the time, while enabling the central bank to compensate for past shortfalls in a flexible manner, at their discretion.

Recent FOMC speeches indicate that a compromise similar to this last option could be accepted by most committee members, who are obviously reluctant to tie their hands into a rigid policy rule.

Under such a compromise, the FOMC would probably try to encourage inflation to rise to about 2.5 per cent in the next several years by holding policy rates at or below present levels for a long period. This would prepare for a future recession that could push inflation down to (say) 1.5 per cent, while keeping the long-run average inflation rate close to 2 per cent.

This result may represent only an evolutionary change, but would still correct much of the downward inflation bias that has been the major failing of the present framework.

The impact of a 2 per cent AIT from 2012

The most impressive new target mechanism from the point of view of restoring the credibility of the Fed’s 2 per cent inflation objective would be to compensate in full for the shortfall in inflation that has occurred since launch in 2012. However, this would lead to a very bumpy path for policy rates and the US economy (see this Fulcrum note). This volatility may persuade the FOMC to adopt a watered-down version of the average inflation mechanism.

Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on February 9 2020.
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