During the period from 2021 to 2023, inflation was much higher than the Federal Reserve would have liked, and also much higher than predicted by the markets. Does this mean we can excuse the Fed for allowing inflation to exceed its target by a wide margin? The answer is no. I’ll try to explain why, using an example of what things would look like under both inflation targeting and price level targeting. We assume that the Fed’s inflation target is 2%.
Let’s assume the price level in March 2021 is 100. The Fed would like to see prices rise 2% per year, or 0.5% per quarter (three months). This is how they want to see the price level rise each quarter over two months. years (for simplicity I ignore compounding effects):
Case A: 100, 100.5, 101, 101.5, 102, 102.5, 103, 103.5, 104
Now suppose the Fed has underestimated quarterly inflation by 1% for eight consecutive quarters. They expected 0.5% and got 1.5%. Also assume that the Fed focused on inflation and “let bygones be bygones”:
Case B: 100, 101.5, 103, 104.5, 106, 107.5, 109, 110.5, 112
Over a two-year period (eight quarters), the price level rose by a total of 12%, much more than the 4% increase desired by the Fed. Annual inflation was 6%, much higher than the 2% target.
Now suppose the Fed has underestimated inflation by 1% per quarter for eight consecutive quarters. But now assume the Fed did this price level targetinginstead of focusing on inflation. That means that at every point in time the Fed was trying to achieve the price level path shown above in case A:
Case C: 100, 101.5, 102, 102.5, 103, 103.5, 104, 104.5, 105
Note that even though the Fed made exactly the same mistakes in cases B and C, the price level path in case C during each quarter is much closer to the ideal path shown in case A. Under price level targeting you have an additional 1% inflation in the first period, but after that inflation is 0.5% per quarter, or 2%/year. As a result, inflation in case C between March 2021 and March 2023 averages 2.5%/year, and not 6% as in case B.
In practice, there was an additional inflation of approximately 8% in the two years after March 2021. This happened even though the price level below the “average inflation target” should have been much closer to case C than to case B. words: the Fed has not adopted the policy regime it advertised to the public; it was not the intention to focus on the average inflation rate.
Were Covid supply problems and the war in Ukraine a valid excuse? Not at all. NGDP growth exceeded the 4% growth path even more than inflation exceeded the 2% trend line. The policy was far too expansive by any reasonable criterion. You also can’t blame the mistake on the fact that even the markets missed the magnitude of the inflation wave. Under both levels of targeting, or under a truly ‘average inflation targeting’ regime, these missed market forecasts would have caused only a small overshoot, as we see in case C.
P.S. I set the clock to March 2021 because by then the price level had recovered from the initial decline during the early stages of Covid and was back on trend.
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