In August 2020, Fed officials announced a new approach to monetary policy, which they called “Flexible Average Inflation Targeting.” The idea was to allow some variation in inflation in the short term, but aim for an average inflation rate of 2% in the medium to longer term.
What they actually did was something radically different. In 2021, the Fed pursued a highly stimulative, 1960s-style monetary policy in an attempt to “create jobs” by printing money. Just as in the 1960s, that policy led to high inflation.
The Fed later claimed that it had never intended to target the average inflation rate. Rather, the policy was aimed at making up for periods when inflation was below target, but not for periods when inflation was above target. I felt like a dummy because I had naively believed that an average inflation target meant an average inflation target.
Professor at the London School of Economics Ricardo Reis is certainly no dummy, and he had the same opinion as me:
So where could Reis and I have gotten this crazy idea that targeting average inflation meant targeting average inflation? Maybe from the Fed itself. In an article from April 6, 2021: Dallas Fed economists Enrique Martínez-García, Jarod Coulter and Valerie Grossman also claimed that the policy was symmetric:
Notably, the Fed has changed its language on inflation, replacing its promise of a 2 percent inflation target, saying instead that it will “[seek] to achieve inflation averaging 2 percent over time.”
This change is a substantial departure from the previous flexible inflation-targeting regime. Monetary policy under the inflation target was symmetric: the Fed would respond equally to overshooting and undershooting the target. The Fed is “letting bygones be bygones” because it is not trying to make up for past inflation deviations from target.
By comparison, targeting average inflation means that policymakers take these deviations into account and can allow inflation to rise modestly and temporarily above the target to compensate for past shortfalls, or vice versa.
Note that the phrase “vice versa” is italicized in the original. They felt this point was worth emphasizing.
In a recent tweet said David Beckworth suggests that Jerome Powell is leaning towards an abandonment of FAIT and a return to a flexible inflation targeting (FIT) regime:
David’s entire Twitter threat is worth reading. He points out that the FAIT policy was based on a long series of important articles that I wrote in the “Princeton Schoolof monetary policy. These articles emphasize the need for some kind of level-oriented regime, focusing on the price level or nominal GDP. These proposals aimed to correct very specific shortcomings in the previous inflation policy, which led to the major policy failure of 2008-2015.
So let’s see what happened here:
1. In 2020, the Fed adopted FAIT, based on highly respected research into what went wrong in 2008.
2. The plain meaning of the term ‘average’ suggests that the policy was symmetrical. I thought it was symmetrical. A Dallas Fed publication said the policy was symmetrical.
3. The policy did ensure a robust recovery, but ultimately caused too much inflation.
4. To the extent that the policy failed, it failed because it was not symmetrical. The Fed wanted to correct inflation undershoots, but not overshoots. It is not a matter of the Fed failing to achieve a flexible target for average inflation after trying very hard; they never even tried FAIT. They tried something completely different, 1960s-style monetary stimulus.
Unfortunately, in our culture words have an almost magical power, a talismanic power. If an institution announces that it will undertake policy The Fed announced it would do FAIT, did something completely different, and now (if Beckworth’s tweet is correct) appears to be on the verge of abandoning FAIT and replacing it with something much worse.
On the plus side, a cynic might argue that next time they might announce policy Y (FIT), but actually implement policy X (FAIT). Unfortunately, in order for these types of policies to work, they must be well understood by the financial markets, and at least somewhat credible.
I understand that the Fed feels the need to do something different after the 2021-2022 fiasco. So why not announce a policy that targets NGDP level at 4% per year? Given the long-term US growth rate of around 2%, that kind of policy will produce an average inflation rate of almost 2%, and will be more ‘flexible’ when there are supply shocks like Covid and the war in Ukraine.
P.S. In the 30 years prior to the average inflation target, PCE inflation averaged 1.9%. As of August 2020, it has averaged 4.2%, or 3.6% if averaged over five years to avoid disruptions from Covid-19.