Your best work yet, Milan!! Great explainer, thanks!
Maybe I am over-simplifying, but if the previous ceiling of 2% resulted in an average inflation of 1.5, why wouldn’t they just raise the ceiling to 2.5%?
Superb post, Milan. I haven’t thought about a lot of this stuff since MacroEcon in college, but it is probably some of the most important policy shaping America today.
Before I stat my dissent, let me say this is a better explanation of monetary policy than 99% of what on read on blogs, much less the next to worthless newspaper "economists."
"but if inflation is too low they can only cut rates down to zero before they run out of firepower"
That applies only to short term rates (which BTW the Fed never cut to zero ever during the Great Recession, their bad). The Fed also can also do QR, buying longer term liabilities of governments, Government backed securities like Fanny Mae, and even foreign exchange. [Some of that "can" might need to be made very explicit.] Treating the target as a ceiling was never supposed to happen. That was just the Fed mistake. [It's not clear to me, however, that THAT was the exact mistake. It's also possible that the constraint was not an inflation ceiling, but a reluctance to engage in enough QR to keep inflation at the average rate.]
I'm not sure that there was ever any conceptual ambiguity about FIAT being symmetrical, although it is very true that no one expected to see the downside come to the fore so quickly.
Part of the problem with the whole inflation discussion is lack of clarity about what inflation is FOR. It is NOT just an unfortunate result of trying to keep employment "full;" it is a WAY to keep employment (and this means employment of all the economy's resources not just labor) "full." "Full" employment requires a set of relative prices (perhaps not a unique set) that reflects all the real sources of demand and supply of the economy. When there are changes in the supply and demand, relative prices can adjust to keep employment "full." However there is a fly in this ointment; some prices are subject to formal or informal "contracts" that prevent them from adjusting downward. This is particularly the case with wages, but that's not the only case rental rates ted to fixed rate mortgages are another. So if a big change occurs (a big increase in the demand for computer chips for autos or a big increase in the international price of petroleum, or backup in US ports) AND relative prices need to change AND some absolute prices cannot go down, that means that on average prices need to go up: inflation. Too little inflation in relation the the size of the changes in relative prices needed and some markets will fail to clear: unemployment. The average target rate is (ought to be) the Fed's best guess at the average amount of inflation that is needed given the size and frequency of big changes.
How much of the current hubbub about inflation is just a coordinated push to deny Biden any credit for the excellent jobs numbers and the lack of cratering from COVID?
As you explain in your piece, employers and rich people hate full employment because it gives some bargaining power to labor. See Starbucks and Amazon. So, rich people drive the narrative on TV: the economy is a catastrophe. And when the rich people are also republicans, they have a second reason to try to minimize Biden's successes.
To my eyes, the current panic over inflation looks a lot like a moral panic, ie largely artificial and driven by people with an agenda.
One quibble: is it possible you originally wrote it back in March? The quoted line below was true then but it’s out of date now:
“the Fed raised rates by a quarter of a percentage point last week, with six more rate hikes expected in 2022.”
After raising policy rate by 0.25% in March, the Fed raised their policy rate an additional 0.5% last week, with five more meetings scheduled for the rest of 2022.
I suspect that if they hit the soft landing, and don't trigger a recession that brings inflation back to near-zero, what they will do, in effect, is go back to Bernanke-ism for 5-7 years, very-slightly under-shooting 2% for a long enough time that on a ten-year window, just before the inflation spike of '21-'22 falls out, you'll have your 2% average.
This is a solid explainer -- well done. My one quibble is the over-emphasis on clarity as a strong goal.
In my field of software engineering, I've worked for managers and organizations that fantasized about systems that would impose analogous kinds of clarity on complex systems or processes. The results were typically bleak: a lot of meetings, debate, and sometimes engineering effort to achieve very little net benefit.
Clarity, like most virtues, is good ... up to a point. For example, if one really wanted clarity, the Fed could implement a computer program that would take a variety of economic indicators and spit out the next interest rate adjustment. Most of us have read enough dystopian fiction to have a vague sense that rigid rule-based systems always, eventually fail to anticipate every possible situation.
With complex systems, you ultimately need to balance the rigidity of total clarity against the flexibility and wisdom that a decision making body of subject matter experts can bring to bear. I think we're better off with roughly as much clarity as we currently have from the Fed: general guidelines, yes, but enough ambiguity to allow experts to make decisions within those parameters.
Mathematically speaking, overshooting one year only means the Fed should undershoot the next if the window for the average is one year, which would be silly. Too long a window would also be silly because then annual changes would have little effect on that moving average. The Fed should specify a time window they’re using for their average (if they haven’t already).
Excellent piece. If I were them, I'd say two things. The pandemic was an extraordinary situation, so we're starting the new FAIT clock today. And going forward, it's symmetrical. Well, actually, I'd just say one thing. That we are now switching to 4% NGDPLT. But easy for me to say though.
The problem with flexible average inflation targeting
Very well done post, Milan.
Being able to explain complicated things in a clear way indicates a thorough grasp of the subject (and makes the reading pleasurable besides). Thanks!
Your best work yet, Milan!! Great explainer, thanks!
Maybe I am over-simplifying, but if the previous ceiling of 2% resulted in an average inflation of 1.5, why wouldn’t they just raise the ceiling to 2.5%?
Excellent, balanced post about a thorny and technically complex issue. Thanks Milan! Great work.
Excellent post.
Superb post, Milan. I haven’t thought about a lot of this stuff since MacroEcon in college, but it is probably some of the most important policy shaping America today.
Before I stat my dissent, let me say this is a better explanation of monetary policy than 99% of what on read on blogs, much less the next to worthless newspaper "economists."
"but if inflation is too low they can only cut rates down to zero before they run out of firepower"
That applies only to short term rates (which BTW the Fed never cut to zero ever during the Great Recession, their bad). The Fed also can also do QR, buying longer term liabilities of governments, Government backed securities like Fanny Mae, and even foreign exchange. [Some of that "can" might need to be made very explicit.] Treating the target as a ceiling was never supposed to happen. That was just the Fed mistake. [It's not clear to me, however, that THAT was the exact mistake. It's also possible that the constraint was not an inflation ceiling, but a reluctance to engage in enough QR to keep inflation at the average rate.]
I'm not sure that there was ever any conceptual ambiguity about FIAT being symmetrical, although it is very true that no one expected to see the downside come to the fore so quickly.
Part of the problem with the whole inflation discussion is lack of clarity about what inflation is FOR. It is NOT just an unfortunate result of trying to keep employment "full;" it is a WAY to keep employment (and this means employment of all the economy's resources not just labor) "full." "Full" employment requires a set of relative prices (perhaps not a unique set) that reflects all the real sources of demand and supply of the economy. When there are changes in the supply and demand, relative prices can adjust to keep employment "full." However there is a fly in this ointment; some prices are subject to formal or informal "contracts" that prevent them from adjusting downward. This is particularly the case with wages, but that's not the only case rental rates ted to fixed rate mortgages are another. So if a big change occurs (a big increase in the demand for computer chips for autos or a big increase in the international price of petroleum, or backup in US ports) AND relative prices need to change AND some absolute prices cannot go down, that means that on average prices need to go up: inflation. Too little inflation in relation the the size of the changes in relative prices needed and some markets will fail to clear: unemployment. The average target rate is (ought to be) the Fed's best guess at the average amount of inflation that is needed given the size and frequency of big changes.
How much of the current hubbub about inflation is just a coordinated push to deny Biden any credit for the excellent jobs numbers and the lack of cratering from COVID?
As you explain in your piece, employers and rich people hate full employment because it gives some bargaining power to labor. See Starbucks and Amazon. So, rich people drive the narrative on TV: the economy is a catastrophe. And when the rich people are also republicans, they have a second reason to try to minimize Biden's successes.
To my eyes, the current panic over inflation looks a lot like a moral panic, ie largely artificial and driven by people with an agenda.
This is a great piece.
One quibble: is it possible you originally wrote it back in March? The quoted line below was true then but it’s out of date now:
“the Fed raised rates by a quarter of a percentage point last week, with six more rate hikes expected in 2022.”
After raising policy rate by 0.25% in March, the Fed raised their policy rate an additional 0.5% last week, with five more meetings scheduled for the rest of 2022.
"tapping the breaks”
Ask your editor about this, Milan.
I suspect that if they hit the soft landing, and don't trigger a recession that brings inflation back to near-zero, what they will do, in effect, is go back to Bernanke-ism for 5-7 years, very-slightly under-shooting 2% for a long enough time that on a ten-year window, just before the inflation spike of '21-'22 falls out, you'll have your 2% average.
This is a solid explainer -- well done. My one quibble is the over-emphasis on clarity as a strong goal.
In my field of software engineering, I've worked for managers and organizations that fantasized about systems that would impose analogous kinds of clarity on complex systems or processes. The results were typically bleak: a lot of meetings, debate, and sometimes engineering effort to achieve very little net benefit.
Clarity, like most virtues, is good ... up to a point. For example, if one really wanted clarity, the Fed could implement a computer program that would take a variety of economic indicators and spit out the next interest rate adjustment. Most of us have read enough dystopian fiction to have a vague sense that rigid rule-based systems always, eventually fail to anticipate every possible situation.
With complex systems, you ultimately need to balance the rigidity of total clarity against the flexibility and wisdom that a decision making body of subject matter experts can bring to bear. I think we're better off with roughly as much clarity as we currently have from the Fed: general guidelines, yes, but enough ambiguity to allow experts to make decisions within those parameters.
Mathematically speaking, overshooting one year only means the Fed should undershoot the next if the window for the average is one year, which would be silly. Too long a window would also be silly because then annual changes would have little effect on that moving average. The Fed should specify a time window they’re using for their average (if they haven’t already).
Excellent piece. If I were them, I'd say two things. The pandemic was an extraordinary situation, so we're starting the new FAIT clock today. And going forward, it's symmetrical. Well, actually, I'd just say one thing. That we are now switching to 4% NGDPLT. But easy for me to say though.
1. The Fed had never brought inflation like this without triggering a recession.
2. A 2% inflation target is stupid. At 2% inflation you lose half the value of your money in a generation (35 years)
Very informative - thank you Milan. :)