The Fed's New Approach to Price Stability
In 2012, the Federal Reserve Federal Open Market Committee (FOMC), led by former Federal Reserve Chairman Ben Bernanke, formally implemented an annual inflation target of 2 percent for the US economy. While the Fed had been loosely targeting inflation since its adoption of the 1977 dual mandate of price stability and maximum employment, with price stability generally understood to be annual inflation somewhere in the neighborhood of 2%, this was the first time the bank outlined a hard target to guide central bank decision-making.
However, because inflation can often be volatile and there are many different ways it can be calculated, many ridiculed the FOMC's decision to establish an official inflation target. Even after Chairman Bernanke made clear the new rule wouldn’t change the Fed’s approach all that much, and despite the fact that having the target increased transparency and added an additional layer of political accountability – both of which had broad appeal among the voting public – there were plenty of naysayers to the idea of a formal target.
In the years that followed, the Fed began missing the 2% mark and criticism ran abundant. From those in Congress who routinely fail to grasp the myriad of factors that impact monetary outcomes to talking heads capitalizing on any opportunity to increase their visibility by taking a swing at one of the country's most important institutions, nearly everyone had a bone to pick with the Fed.
In fact, since the rule's inception, the Fed has actually never hit 2 percent inflation. Not once. There are many reasons why but none of which are the result of poor decision-making on the part of the FOMC. The truth is that the Great Recession, and the low growth that followed, made monetary policy much more difficult to manage. Even after lowering interest rates to zero, embarking on multiple rounds of QE, and using forward guidance to communicate future policy rate changes, the Fed failed to bring inflation anywhere close to its 2 percent target—leading many to conclude the Fed is simply an incompetent institution altogether.
In reality, though, controlling inflation amid deflationary pressure — like that seen during the years coming out of the global financial crisis — is quite difficult. Had the Fed been given the power to deposit money directly into consumers’ bank accounts, or deposit money in Treasury’s bank account and force Congress to spend it, achieving 2 percent inflation would have been rather easy. But the Fed is currently prohibited from such moves. The future may bring a whole new approach to monetary policy— allowing the Fed more autonomy in how they go about achieving their goals— but for now things remain somewhat traditional. Even the Fed’s nontraditional policies of QE, extended swap lines, corporate bond backstops, and direct corporate lending are rather traditional when compared to other central banks in the developed world.
So taking all of this together, how should we interpret last week's Fed decision to begin targeting average inflation, given that the Fed continually missed its old inflation target? Will the change from a 2 percent inflation target to a 2 percent average inflation target prove detrimental to the central bank’s ability to meet its mandate of maximum employment and price stability? Truth be told, it’s not that big of a shift. Although there are differences in calculation, the new rule just gives the Fed more room to maneuver given the economic conditions of the day. When unemployment is high (like it is today), the Fed can adopt policies that allow inflation to run higher than 2 percent in order to bring down unemployment. If the economy is running hot and inflation is ticking upward (as in the case of 2004-2006), the Fed can tighten to bring inflation below 2 percent. As long as average inflation hovers around the target, any policies that help meet or maintain full employment are appropriate. (Note: the Fed was smart not to define the period in which the average number has to be achieved since this would force the FOMC to raise or lower rates to meet the average target, even if doing so is detrimental to the economy.)
Supporters of the new framework cite that the Fed actually has achieved its inflation target when averaged over a longer time horizon (e.g. 2005-2020), and that the new framework would only improve its ability to do so. Detractors voice concerns that the new rule just gives the FOMC political cover to keep interest rates low for longer periods, which could lead to higher inflation. There is truth in both assessments, but what is more important is that the new framework gives the Fed increased bandwidth to choose whether a policy geared toward reducing inflation or increasing employment is best for the US economy, given prevailing economic conditions.
For those concerned the new policy would lead to more dovish outcomes and persistently high inflation, keep in mind that we could use some inflation right now. The Fed struggled to spur inflation prior to Covid-19, and it’s only going to be harder now that the Fed has cut the policy rate to zero and is quite active in supporting capital market liquidity.
My take is that if the new approach gives the FOMC additional room to improve employment conditions, now and in the future, then we should all welcome the idea and trust the judgment of those on the committee. There will be hiccups along the way for sure, but we are entering a new world of economic uncertainty and we need innovative tools that allow the Fed to move more freely within its stated policy space.