A New Era for the Federal Reserve

A few weeks after issuing its “Statement on Longer-Run Goals and Monetary Policy Strategy” back in August, the Federal Open Market Committee (FOMC) met again yesterday, as it remains committed to providing stability to the economy during this COVID-19 pandemic. In another expected turn of events, the committee remained steadfast in its adherence to its maximum employment and price stability objectives, while acknowledging that the path of the economy remains uncertain owing to the present and future impacts of the virus.

According to the FOMC’s press release, the economy has seen a somewhat slow and steady recovery over the past few months. The FOMC stated that “financial conditions have improved . . . in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.” Inflation also continues to skate below the Fed’s target rate of 2 percent because of weaker demand and negative shocks to oil prices.

The FOMC also announced that it plans to keep its interest rate target around zero percent for the foreseeable future and beyond. In fact, according to the Fed’s quarterly “Summary of Economic Projections,” which states the FOMC’s projections for inflation, unemployment, and other macroeconomic indicators, forecasts for interest rates are stuck around that zero bound until at least 2023. Moreover, the committee also revealed that the Fed will continue to increase its holdings of Treasury and mortgage-backed securities in order to “smooth market functioning and help foster accommodative financial conditions.”

The other main policy item discussed during Wednesday’s meeting and press conference was the FOMC’s recent decision to move toward “average inflation targeting.” In its press release, the FOMC reinforced Chair Powell’s comments during his August 27 speech at the Jackson Hole meetings, where he announced the Fed would be switching to this modified monetary regime. The committee highlighted these changes, announcing that the Fed would adjust its long-standing 2 percent inflation target and opt instead to “achieve inflation that averages 2 percent over time.” The FOMC also stated, “Following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” Although this move was not explicitly referred to as an average inflation target by the FOMC, most have interpreted the announcement as such.

Unfortunately, the FOMC statement didn’t provide much clarity about how this target would be achieved, which led to a considerable amount of speculation regarding how Jerome Powell and the FOMC would address this change on Wednesday. Unfortunately, Powell didn’t offer much clarification, stating in the Fed’s press release that “the Committee will aim to achieve inflation moderately above 2% for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent.”

However, with the concurrent release of the Fed’s “Summary of Economic Projections,” some have rightly questioned whether or not this stated affirmation runs contrary to the inflation forecasts that have been laid out. Indeed, according to the Fed’s projections, inflation isn’t forecasted to hit the 2 percent threshold again until at least 2023. Not only does this run contrary to the intention of pushing inflation “moderately above” 2 percent, it also implies that the Fed expects to continue to undershoot its own target for the next few years. This would not fit the “makeup policy” that the Fed has aimed to achieve in the future.

Despite this discrepancy, if the Fed is successful in adopting an average inflation target, it will definitely be an improvement over the status quo. With a traditional inflation target, if the Fed undershoots and fails to meet its inflation goal for the year, there is no attempt to make up for this miss in the following year. This leads to a permanent decline in the price level, which in turn leads to a permanent decline in dollar incomes and the dollar size of the economy as a whole. If this trend of undershooting persists, this contraction can compound over a number of years and manifest itself as lower nominal GDP and incomes. Additionally, it also creates many other problems for households and businesses by disrupting mortgages, leases, loans and more. Many of these contracts are negotiated with a specific expectation of what the price level will look like in the future. If that expectation were thwarted by a trend of declining inflation and a central bank that won’t make up for past mistakes, the economic consequences could be dire.

Average inflation targeting, on the other hand, seeks to solve this issue by temporarily overshooting the target in order to return the average price level to its expected path. For example, if the economy observes inflation 0.5 percent below the target during one year, the Fed could credibly commit to running inflation 0.5 percent above the target the following year, or over the next couple years, in order to make up for the past shortfall. This would restore the price level to its previously expected path, thus stabilizing the expected dollar incomes and ensuring that the various contracts negotiated by households and businesses remain relatively unaffected.

Whether or not the Fed sticks to its guns on implementing this new average inflation targeting regime is yet to be seen. However, if this form of makeup policy proves to be effective in the months and years ahead, it could pave the way for an even more improved type of makeup policy, such as nominal GDP targeting.

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