Average inflation targeting > higher inflation

  • Markets expect Chairman Powell to signal a shift towards ‘average inflation targeting’
  • AIT makes sense in many ways, but also has weaknesses
  • The medium-term effect will be an acceptance of higher inflation 

Later today, Fed Chairman Jerome Powell will address (virtually, needless to say) the annual Kansas City Federal Reserve Jackson Hole Economic Policy Symposium. His speech has been trailed by hints, suggestions and expectations that the Fed will shift its targeting from a point target for inflation, to an interval, and from a given point in time, to ‘average inflation targeting’ (AIT), which looks at inflation from a longer perspective.

Both changes make sense and both give the central bank greater flexibility. Having an interval allows for temporary fluctuations around the target, where the fixation on a point could have circumscribed the monetary authorities’ ability to act, particularly in the face of a temporary fluctuation (e.g., a climate- or animal health-related sharp rise in food prices). The Swedish Riksbank originally operated with a 2±1% inflation target, then shifted to a 2% point target and has since 2017 moved back to an interval inflation target of “around 2%” with a tolerance of 1-3%. Similarly, average inflation targeting (also known as flexible inflation targeting by the Reserve Bank of Australia, which has practiced this since 1993) allows a central bank to ‘look through’ temporary events and focus on the medium-term horizon when setting policy. (A key difference between an interval target and AIT is that the interval does not contain any promise of compensation for fluctuations.)

Nevertheless, AIT comes with some weaknesses. The most important is the period over which inflation is averaged. This period is presumably set by the central bank itself, meaning that it can be subject to change in order to ensure that the target is achieved, or, rather, that deviations from target can be ignored. This is the same issue that afflicts politicians’ promises to balance the budget ‘over the cycle’. In other words, quis custodiet ipsos custodies?

A second weakness is that AIT implies a commitment to compensate for over- or undershooting the target. In this, it is somewhat similar to price-level-targeting. However, this assumes that one central bank leadership can credibly commit its successors to a certain policy. History shows that this is very unlikely to work for longer than a fairly short period. After all, circumstances change, and with Keynes, we hopefully change our minds.

In practice, what is more likely to happen, is that deviations from target will be accepted and ignored, if they are in the desired direction. Which this direction is, will vary according to circumstances at the time. Currently, as we know, inflation almost everywhere is undershooting central banks’ targets. Hence, deviations above target will be accepted, and, it is safe to say, not be compensated for. Potentially, they can be presented as compensation for current and previous undershooting. By contrast, continued undershooting will be seen as an incentive to increase the efforts to reach the target.

In other words, average inflation targeting, if indeed introduced, will be a further signal that a central bank, in the case, the Federal Reserve, is prepared to accept above-target inflation for some time. 

What is then the current inflation outlook?

Previous Comments have highlighted that rapid broad money growth is likely to cause higher inflation in 2021 and 2022 (and that inflation will remain at least somewhat elevated further out, but for different reasons). The latest broad money numbers from the world’s largest economies now show some moderation. US broad money growth has slowed from a three-month annualised rate of 72.3% in May to 25.7% in July, that in the EA from 21.1% in May to 11.3% in July and Chinese M2 growth from 14.7% in April to 6.2% in July. By contrast, in Japan, broad money growth continues to accelerate. 

However, it is important to bear in mind that broad money growth in the largest economies, with the exception of China, remains very high by both recent and historic standards: 22.9% in the USA in the year to July, 10.2% in the EA and 6.5% (a 30-year high) in Japan. Unless these numbers are followed by a very sharp slowdown, where the stock of broad money actually shrinks, the liquidity injection remains. At the moment, when economic activity has been restricted by the pandemic, increased liquidity has mainly shown up in asset price inflation. But economies are now reviving, and spending is picking up, meaning we should eventually see price pressures rising for both goods and services.

How likely is a monetary contraction? At the moment, we are seeing a number of countries finding that COVID-19 cases are once again rising after containment during lockdown. If anything, this is likely to lead to further both monetary and fiscal stimulus. Germany has already extended its furlough scheme for a year. No government or central bank is going to start to tighten policy in any significant way until they are certain that the virus really is in retreat. This will take some time.

Gabriel Stein