Last week, the Federal Reserve announced changes in how it will target inflation. We will provide some context to this change in policy as well as consider some challenges ahead in policymaking.  Thank you for subscribing, and if you enjoy reading this, please forward the newsletter to your friends. ~ Kevin When some folks see these words, “Average Inflation Targeting” together their eyes get heavy.  However, often the consequential things in our lives are not necessarily the things we get excited about.  (Sorry that sounds like something a parent would say.) Once you read all the way through this newsletter you will be rewarded with a joke.  Economists know people follow incentives. Average Inflation Targeting is an important concept both in practice and in what it says about monetary theory.  First, we will take a look at economic theory, recent decades of practice, and then how this may play out.  Like most other aspects of our social world, there remain many unknowns and puzzles.  Among the unknowns are subjects we thought we understood, but over time we realize there are still more unknowns.  This is the case with how monetary policy affects inflation.  The general idea is that inflation follows when there is more money circulating in the economy than what is in line with the demand for purchased goods and services. The Federal Reserve’s statutory mandate is to manage inflation and secure full employment.  These guidelines from Congress are transformed into the Federal Reserve’s policy objectives.  For decades these objectives were sought through broad policy practices, namely trading government treasuries to hit a target short term interest rate.  Over time the Federal Reserve has adopted additional tools but, in practice and effect, the newer tools resemble the earlier ones.  These tools have been key during times of crisis like in 2008 and 2009, as well as today.

 The general assumption is that low-interest rates stimulate economic activity as well as inflation.  While there is robust support for this argument, I will assert that the inflation puzzle is not as complete as we had assumed. There may be parts of the puzzle we do not quite grasp, and we might not know what pieces are missing.  However, that does not mean that interest rates are inconsequential.  No one is arguing that.  Monetary policy, including interest rates, is a vital variable in explaining inflation.

Imagine you were working for the Federal Reserve and your goal was to hit a target for inflation of 2%.  Over the years you and your team should be pretty pleased because you have wound up close…at about 1.5%.  However, over time you get curious and ask why the result usually comes in under the target. George Mason University economist David Beckworth effectively illustrated this trend a few years ago through a target graphic, which reflects that academia and the Federal Reserve have been discussing this puzzle for about half a decade.

The proposed solution is to slightly adjust the targeting approach.  In other words, if we were looking at a target and routinely undershot the bullseye, we would adjust the sights.  In fact, if we were uncertain about precision we might aim slightly above the bullseye, assuming that on average we would get close to the target. This is why the Federal Reserve statement says it, “seeks to achieve inflation that averages 2 percent over time.” To achieve this objective, “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” James Bullard, president of the St. Louis Federal Reserve defended the revised approach.  “There was a perception both in markets, and perhaps in the policy making community as well, that 2% inflation was some kind of a ceiling,” he said. “Inflation expectations should be moved up a little bit now in markets in response to this.”  What Bullard (who is not alone) is introducing into this puzzle is the role that expectations have on inflation.  In other words, the behavior of consumers and businesses is impacted by a general assumption of inflation that is informed by their past.  As human beings, we incorporate expectations into a whole range of decisions.  Economists started incorporating this back into economic theory, as argued by Muth, in the 1960s.  While we can think of this expectation as a factor, it is not always easy to measure.  Thus, the reliance on the original monetary tool of interest rates.

This average inflation targeting approach is expected to be debated. But what is most likely to happen is that, over this decade, the Federal Reserve will be comfortable with inflation slightly above 2% (meaning brief periods of 2-3%) and will slowly raise rates to tamp down inflation.   In practice this could mean that the Federal Reserve delays for a few quarters what would have been assumed under the previous practices to be the proper time to raise rates to get closer to the 2% target on average. A few newsletters back I discussed some of the future challenges the U.S. faces with constrained monetary and fiscal tools as a result of the national debt. Some choices exist on paper but in practice are limited by the impact of the debt. This is a similar problem to the challenge policymakers faced this year when thinking about economic stimulus to support the economy while not simultaneously stimulating social activity that would spread a virus.  There were a range of policy choices that had to be fundamentally reconsidered.  I expect similar effects will be seen in the future with this constraint on monetary and fiscal policymaking, even assuming the figures and institutions reach an agreement. Promised Joke:

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I am enjoying the chance to share these newsletters with you in the form of the new podcasts and appreciate your continued feedback. You can reply to this email or leave your comments below.  I sincerely enjoy chatting and learning what folks think. Thank you ~ Kevin

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