Powell’s press conference came and went, discussing the Fed’s new approach to inflation targeting. In my opinion, not much has changed and we are simply faced with largely unnecessary debates about messaging – which rests on the dubious assumption that managing expectations can refine economic growth.
(For this article, I’m assuming that interest rate policy can be used to control inflation. I have serious concerns about this, but if we don’t assume that the central bank can fine-tune growth to match to arbitrary trajectories, the story is a little more plausible.)
I find the basic inflation target framework followed by some countries to be the most practical version. If we assume a central target of 2%, let’s just say the central bank definitely wants to keep inflation between 1% and 3%, and stay vague after that. (Yes, central banks usually have more stringent targets, but since nothing happens when they miss it, that’s okay. If the target was supposed to be 2%, just expect inflation to be 2% at the end of your forecast horizon.)
The alleged problem with the 2% target is that if the 2% level is treated as a ceiling during the expansion, then the cycle average will tend to be less than 2% – since inflation declines during the boom. recession and slowly recovering.
The Fed addressed this problem by adding a vague averaging clause. However, this was only a problem in the last cycle – inflation rebounded above target when expanding in various countries in previous cycles with inflation targeting. (Prior to 2008, central bankers in a few countries praised the great job they did in meeting their goal on average.)
The only practical difference in this change is that it gives the Fed more leeway to wait for rate hikes. However, this will only be truly true if the inflation experience is repeated. It is not a law of nature that inflation has to stay below 2% for a decade. Meanwhile, if inflation is in fact stable at a low level like in the last cycle, then the rate hike would be moderate and likely have no measurable effect on the economy.
Although the policy has been described as an average inflation target, I didn’t know how symmetrical the average was. (An earlier paper only dealt with spreads below an average of 2%.) If inflation has averaged 2.5% for an extended period of time, will the central bank attempt to reduce it to 1, 5% to compensate for this? Neoclassical models suggest that the central bank can follow a complex path for the rate of inflation. I doubt the inflation rate can be adjusted so easily in the middle of an expansion – deflations tend to be brought on by recessions. Does the central bank risk inducing a recession if the inflation rate is stable at 2% to fulfill the average inflation mandate? Otherwise, we have to accept that this is not really an average inflation targeting, it is just an adjustment to try to avoid the problems of the last cycle.
A simpler alternative to the average is to simply tell the central bank that it is happy with any inflation rate between 2% and 2.5%. If you want an objective function, it has a dead zone. That means the central bank will sort of target 2.25%, but won’t care if it strayed from that specific target. I wouldn’t consider this a big change, as it kind of described the trajectory of inflation in the pre-2008 cycles. (After all, some of the central banks have met their inflation targets on average.)
Allowing 2.5% inflation instead of 2% might scare some people off, but they are unrealistic. Adding just 0.5% to the average realized inflation rate would make a difference in the long run – a decade or more. Shifting the market basket means that price comparisons over such horizons are sketchy anyway. There is no indication that an entity is sensitive enough to the CPI to care about such a small difference. Businesses worry about their input costs (including labor) and their specific outputs. People are worried about inflation, the existence of websites that make money telling people “inflation is really 8%” tells us they have no idea how high it is. real price.
(c) Brian Romanchuk 2020