More on the new Fed policy

  • The new policy of average inflation targeting involves a loss of clarity.
  • Its credibility is questionable.
  • It means rather higher inflation than markets currently expect.

Last month the Fed switched to alternative inflation targeting (AIT), a change covered in a Stein Brothers Comment at the time. However, the change bears some more thinking about and there are a number of issues with it that should give rise to some disquiet.

It is generally agreed that any inflation measure, in the case of the Fed, the Personal Consumption Expenditure (PCE) deflator, is flawed. However, it has some advantages. It is relatively easy to understand, it is published monthly and it is immediately clear whether the central bank’s target has been met or not.

By contrast, AIT introduces a number of moving parts, that complicate the target and means that clarity is lost. For instance, if you aim to reach your inflation target over a period average, when do you start and stop? How long is the relevant period and is it susceptible to manipulation? (By contrast, price-level targeting, to which AIT is somewhat related, will have a defined target for the relevant inflation index and therefore gets around this uncertainty.)

The next issue is one of credibility. If we define ‘meeting your target’ as a period of twelve consecutive months during which inflation is at or near the target, then the Fed has undershot its target since early 2012. Now we are told that the Fed aims to exceed its own target, or, rather, that the target has de facto been raised to compensate for this. What makes the policy-makers so sure that they can reach the new, higher target?

As it happens, and at risk of seeming to contradict myself, readers of Stein Brothers Comments during the spring and summer know that I not only believe that the Fed will reach its target, I expect it to be exceeded in 2021 and 2022. In fact, since the second wave of the pandemic all but guarantees that monetary (and fiscal) stimuli will remain in place and possibly be increased, this is now more likely than before.

This brings us back to for how long inflation will remain above target and how high it will be. It seems that following the Fed’s announcement of the new policy, markets agree that the Fed’s new inflation target probably is around 2.5%. But is it?

As noted above, the Fed has actually on the whole undershot its inflation target since April 2012. If we compare the actual level of the PCE index with the one that would have been reached if inflation since then had constantly been on target, the cumulative shortfall is 5.5%. (In other words, the actual PCE index was 111.1 in July; the ‘ideal’ one would have been 117.4.) So assuming that the Fed were to achieve its inflation target by the end of 2020 (highly unlikely, given the state of the economy), there is about 5.5-6% of inflation foregone to compensate for. 

How long would this take? That is of course anyone’s guess. (For that matter, so too is the starting point.) But the compensation period cannot be too long. First, because if it is, there can be other events that throw it off its tracks. Second because it involves one Federal Open Market Committee attempting to bind its successors. Third, because the membership of the FOMC and, crucially, its priorities, may well change. And fourth, because the longer inflation remains at any one level, the more that level becomes entrenched as the new normal.

All this means that any compensatory overshoot of inflation would have to take place over a period probably not exceeding four or at most five years. And therefore, with a cumulative shortfall of 5.5-6% to make up for the Fed would have to aim at an annual average over this period of 3-3.5%. Leaving aside the question whether this is a stable rate, something history would argue against, are markets really prepared for that?

Gabriel Stein