The Federal Reserve adopts average inflation targeting

Changes to the Fed’s monetary policy approach

The Federal Open Market Committee (FOMC) released a revised consensus Statement on Longer-Run Goals and Monetary Policy Strategy on August 27, 2020¹. On the same day, Federal Reserve Chair Jerome Powell used his address at the Jackson Hole Symposium to explain the Fed’s latest thinking on monetary policy². Notably:

• The Fed will adopt a “flexible form of average inflation targeting”. The Fed wants inflation expectations to be anchored at 2%. To do so, the FOMC will seek to achieve inflation that averages 2% over time. The FOMC will consider a broad range of factors and not be bound by a mathematic formula or fixed period.
• The Fed will place strong emphasis on maximum employment. In paragraph 2 of the consensus Statement, “employment” was relocated before “inflation”. In paragraph 6, the words “balanced approach in promoting them”, which has traditionally been interpreted as giving equal weight to inflation and employment, have been struck. Furthermore, the Fed now describes maximum employment as a “broad-based and inclusive goal” – a strong signal that the Fed will pay attention to a broad array of indicators such as unemployment rates among lower-income and minority groups. In his remarks, Chair Powell highlighted that prior to the COVID-19 pandemic, Black and Hispanic unemployment rates reached record lows and the differentials with the white unemployment rate narrowed. In addition, the reference to the longer-run normal rate of unemployment was removed. It can be interpreted as giving the Fed more leeway to address “shortfalls of employment from its maximum level”.
• The Fed will review its monetary policy strategy, tools, and communication practices roughly every five years.
• The Fed is firmly committed to its congressional mandate and does not seek to change it.
• The inflation target stays at 2%.
• Chair Powell did not mention yield curve control or negative interest rate policy. It appears that neither will become part of the toolkit.

What does average inflation targeting mean?

The Fed did not specify a timeframe, so let’s take a 5-year average inflation target as an example³. If average inflation during the past two and a half years has undershot the 2% target, then the Fed will likely aim for inflation moderately higher than 2% over the coming two and a half years to bring the 5-year average closer to target⁴. An important (assumed) feature is favorable movements in inflation expectations: if annual inflation has undershot for a couple of years, then expectations of inflation for the subsequent years would move above target, thereby reducing the real interest rate⁵ and inducing more expansionary monetary policy.

Average inflation targeting is part of the family of “makeup” policies, including nominal GDP targeting, which is the theoretically preferred response when rates are near zero⁶. Optimally, the central bank promises to keep rates low for longer than it otherwise would, where the length of the “makeup” period increases with the severity of the recession.

Reasons for these changes

In early 2019, the Fed embarked on a review of its monetary policy strategy, tools, and communication practices⁷. The Fed sought to address three questions:

1. Can the Federal Reserve best meet its statutory objectives with its existing monetary policy strategy, or should it consider strategies that aim to reverse past misses of the inflation objective?
2. Are the existing monetary policy tools adequate to achieve and maintain maximum employment and price stability, or should the toolkit be expanded?
3. How can the FOMC's communication of its policy framework and implementation be improved?

These questions were in turn prompted by major economic developments:

1. The potential growth rate of the economy has declined.
2. The general level of interest rates has fallen both in the United States and around the world.
3. The record-long economic expansion that ended earlier this year led to the best labor market the United States has seen in some time where gains were more widely shared across society.
4. The historically strong labor market did not trigger a significant rise in inflation.

The decline in nominal interest rates and the neutral Federal funds rate has profound implications for monetary policy. As Chair Powell observed, with interest rates generally running closer to the effective lower bound even in good times, the Fed has less scope to cut the Fed funds rate and support the economy during a downturn. The result may be worse outcomes in both employment and price stability, with the costs falling hardest on those least able to bear them. The Fed has looked intently, as early as in 1999, into the limitations to monetary policy when rates are at or near zero – and average inflation targeting is the latest strategy as the Fed continues to hone and evolve its approach.

Further, persistent inflation undershoot is a serious problem. The FOMC believes that “inflation shortfalls that persist even in a robust economy could precipitate a difficult-to-arrest downward drift in inflation expectations.”⁸ An adverse cycle ensues when inflation expectations, lower in light of persistently low inflation in recent periods, contribute to low inflation in subsequent periods⁹. Low inflation expectations then feed into interest rates, leading to lower nominal rates, which means less scope for the Fed to cut rates and support the economy. Once set, such dynamics are hard to break. As such, the Fed wants to keep inflation expectations anchored at 2%.

Remarkably, the FOMC has developed a deeper conviction for a strong labor market. For Chair Powell, what lower-income and minority groups had shared in the Fed Listens events (what low unemployment had meant for their communities), were “just really striking”. Although the Fed had planned to announce the results of its review earlier this year, the plan was delayed by the pandemic. Undoubtedly, the devastating effects of the pandemic, felt sharply among the lower-income and minority groups, reinforced the FOMC’s conviction.

A flatter Phillips Curve¹⁰ – an equation showing an inverse relationship between inflation rate and unemployment rate – means that when unemployment is low, wages now rise less quickly than in the past when the Phillips Curve was steeper. This can be one of several justifications for the Fed to allow the labor market to improve without fear of overheating. Conceptually, a flatter Phillips Curve is double-edged in that if the economy overheats and inflation overshoots, the Fed will need to cause more unemployment to bring down inflation. As such, anchoring inflation expectations becomes doubly important for the Fed to stay accommodative and pursue a strong labor market. Last, that a strong labor market did not trigger a significant rise in inflation means that the Fed need not preemptively raise rates to ward off overheating, which was what the Fed had done especially in 2018. This marks an important evolution in the Fed’s thinking, and average inflation targeting allows the Fed to keep rates low for longer to promote a sustained recovery in the labor market.

Open questions

The incremental impact of average inflation targeting as compared to the former inflation targeting remains to be seen. Average inflation targeting produces superior theoretical outcomes because models assume that households and businesses believe that the Fed will keep rates low for longer and they bring forward their spending. Will these assumptions hold in reality? Perhaps more importantly, the Fed acknowledges that maximum employment is determined largely by non-monetary factors such as technology, demographics, labor force participation, etc. As such, even as the Fed cares profoundly for the broad social and economic benefits of a strong labor market, it alone cannot engineer that outcome without private sector participation and government action in such areas as healthcare and education.

Details of the new approach need to be ironed out. For instance, what will be the relative weights on employment and inflation? What will be the period for the average inflation target? Answers to these questions may surface in upcoming events such as the September 1, 2020 Brooking event that will feature Federal Reserve Governor Lael Brainard as well as former Federal Reserve chairs Ben Bernanke and Janet Yellen¹¹. Also, markets will pay close attention to the next FOMC meeting on September 15-16, 2020 for guidance on the how the revised Statement translates into policy action.

¹ The original Statement was released in January 24, 2012 under Chair Ben Bernanke. The revised Statement was unanimously adopted by members of the FOMC. https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf

²https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm

³https://www.chicagofed.org/~/media/others/events/2019/monetary-policy-conference/monetary-policy-strategies-svensson-pdf.pdf

⁴ Chair Powell did not specify what “moderately higher” inflation rate the Fed would be willing to tolerate.

⁵ Real interest rate is defined as nominal interest rate adjusted for expected inflation.

⁶https://www.brookings.edu/wp-content/uploads/2017/10/bernanke_rethinking_macro_final.pdf. Prior to adopting average inflation targeting, the Fed practiced flexible inflation targeting (i.e., not capping inflation at or below 2% without regard to broader economic conditions). Nonetheless, persistent shortfalls of inflation from target were treated as “bygones” without attempts to make up with future overshoots. Average inflation targeting explicitly makes up for inflation shortfalls. In models that incorporate the effective lower bound, makeup strategies lead to better outcomes on both employment and inflation objectives. See https://www.brookings.edu/wp-content/uploads/2017/08/kileytextsp17bpea.pdf for example.

⁷ The review comprised 15 Fed Listens events across the country to hear from representatives of business and industry, labor leaders, community and economic development officials, academics, nonprofit organization executives, etc.; a research conference on June 4-5, 2019 at the Federal Reserve Bank of Chicago with academic and non-academic speakers from outside the Fed; as well as rigorous research by internal staff. https://www.chicagofed.org/events/2019/fed-listens-conference-on-monetary-policy.

⁸https://www.federalreserve.gov/newsevents/speech/powell20190604a.htm

⁹ Workers may not push for wage increments and businesses may not increase their prices when inflation expectations are low.

¹⁰https://www.economist.com/schools-brief/2020/08/22/why-does-low-unemployment-no-longer-lift-inflation / https://www.econlib.org/library/Enc/PhillipsCurve.html

¹¹https://www.brookings.edu/events/how-the-fed-will-respond-to-the-covid-19-recession-in-an-era-of-low-rates-and-low-inflation/