History-dependent policy

Average Inflation Targeting

The Federal Open Committee’s first-ever comprehensive monetary policy review looks to be coming to an end. Since the announcement on November 15, 2018, the Fed has focused on strategies, tools, and communications practices, and engaged the public through numerous Fed Listens events, including a conference at which invited experts proposed new approaches (see our earlier post). At its July meeting, the FOMC discussed potential changes to its Statement on Longer-Run Goals and Monetary Policy Strategy—the “foundation for the Committee’s policy actions”—with the aim of finalizing those changes soon. And, Chairman Powell is scheduled to speak this week about the “Monetary Policy Framework Review” at the annual Jackson Hole Economic Policy Symposium.

Perhaps the most important issue on the review agenda is the FOMC’s inflation-targeting strategy. Since 2012, the FOMC has explicitly targeted an inflation rate of 2% (measured by the price index of personal consumption expenditures). A key objective of FOMC strategy is to anchor long-term inflation expectations, contributing not only to price stability, but also to “enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.” Yet, since the start of 2012, PCE inflation has averaged only 1.3%, prompting many policymakers to worry that persistent shortfalls drive down expected inflation (see, for example, Williams). And, with the Fed’s policy rate now back down near zero, falling inflation expectations raise the expected real interest rate, tightening financial conditions and undermining policymakers’ efforts to drive up growth and inflation.

In this note, we discuss one alternative to the current approach that has gained wide attention: namely, average inflation targeting. The idea behind average inflation targeting is that, when inflation falls short of the target, it creates the expectation of higher inflation. And, should inflation exceed its target, then it would reduce inflation expectations. Even when the policy rate hits zero, the result is a countercyclical movement in real interest rates that enhances the effectiveness of conventional policy….

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The case for a higher inflation target gets stronger

For several years, economists and policymakers have been debating the wisdom of raising the inflation target. Today, roughly two-thirds of global GDP is produced in countries that are either de jure or de facto inflation targeters (see our earlier post). In most advanced economies, the target is (close to) 2 percent. Is 2 percent enough?

Advocates of raising the target believe that central banks need greater headroom to use conventional interest rate policy in battling business cycle downturns. More specifically, the case for a higher target is based on a desire to reduce the frequency and duration of zero-policy-rate episodes, avoiding the now well-known problems with unconventional policies (including balance sheet expansions that may prove difficult to reverse) and the limited scope for reducing policy rates below zero.

We have been reticent to endorse a higher inflation target. In our view, the most important counterargument is the enormous investment that central banks have made in making the 2-percent inflation target credible. Yet, several lines of empirical research recently have combined to boost the case for raising the target….

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