The problem with flexible average inflation targeting
Nobody — including the Fed — is clear on what it means when inflation is high
This piece is written by Milan the Intern, not the usual Matt-post.
You may not have noticed at the time, given everything else going on in the world, but back in August of 2020, something very important happened: Jay Powell gave a speech in which he announced that the Federal Reserve had updated its strategic framework, the central bank’s guidelines for conducting monetary policy. Instead of targeting 2 percent inflation annually, the Fed would target 2 percent inflation on average:
…the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
This was a BFD and has played a significant role in both the successes and failures of economic policy over the past few years.
Still, the announcement raises some questions. How much inflation does “moderately above 2 percent” entail? How long does “for some time” mean? That’s not because monetary policy is some sort of dark wizardry — it’s genuinely unclear what the new framework means in practice. This in turn is a problem for the economy since the Fed tries to make monetary policy predictable, which can’t really happen given the incredible levels of confusion and disagreement (even inside the Fed itself) over what the current framework actually means.
A brief history of monetary policy
Under the Federal Reserve Act, the central bank’s mandate is to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
The idea of a balance between price stability and maximum employment is called the Fed’s “dual mandate,” and it’s related to the idea in economics that there is (in the short-run at least) a tradeoff between lower unemployment and higher inflation. This is known as the Phillips curve,1 and the basic idea is that if unemployment is really low, workers will have a lot of bargaining power to demand raises, and firms will raise prices in order to pay for them. The rising cost of living causes workers to demand further raises and firms to further raise prices, which can cause an inflationary spiral if left unchecked. Conversely, low inflation can be caused by high unemployment as bargaining power is diminished. So central banks aim to strike a balance between promoting employment and controlling inflation.
In the 1970s, the United States and many other countries experienced very high inflation. That was checked across the developed world over the course of the 1980s largely via a very severe recession. In order to prevent a recurrence of that cycle, the Reserve Bank of New Zealand began officially targeting 2 percent annual inflation in 1989, with most other countries’ central banks following suit. Under Alan Greenspan, the Fed unofficially targeted 2 percent inflation but did not make the target explicit because Greenspan believed it beneficial for the Fed to reserve the right to “look through” certain things — essentially to have the option to blow off weird stuff.
When Ben Bernanke was Chair, the Fed made the 2 percent annual inflation target explicit, believing that it would enhance trust in their decision-making. The idea was that markets can more easily understand how the Fed would respond to a given situation if a framework is in writing, as opposed to hoping investors can read the chair’s mind.
But Timothy Lee of Full Stack Economics told me that under Bernanke (and later Janet Yellen), the Fed treated 2 percent as a ceiling rather than a target, “tapping the brakes” by raising rates when they believed inflation was getting close to 2 percent rather than when it went above 2 percent. So in practice, the Fed was targeting somewhere between 1.5 and 1.8 percent inflation. Indeed, after “the Great Inflation” of the 1970s, inflation rates steadily declined during “the Great Moderation,” and by the 2010s the Fed was consistently undershooting the 2 percent target.
That might seem great — after all, who doesn’t want lower prices? — but the flip side is the Fed was neglecting the maximum employment half of the dual mandate (recall that there is a tradeoff between the two). If you look at the data you’ll see that there was a prolonged period of elevated unemployment in the low-inflation aftermath of the Great Recession.
And that’s what the Fed’s new average inflation targeting framework was designed to correct.