What are the implications of having the Federal Reserve switch to Average Inflation Targeting?

The Federal Reserve began inflation targeting in Jan. 2012 when it announced that it would like to see the core Personal Consumption Expenditure Deflator, PCE (that excludes food and energy components) rise by about +2.0% per year. With average inflation targeting, it means that if inflation grew by less than 2.0% for a couple of years then it should be willing to tolerate and some might go so far as to say --- encourage inflation above this threshold so that over long periods of time, the growth in inflation approximates a 2.0% growth pace. The thought here is that by allowing the economy to run hotter and not worrying too much about inflation, the Unemployment Rates of “Persons of Color,” and others with “less schooling years” will have an opportunity to decline towards levels enjoyed by the general population, a laudable goal no doubt.

As a former Fed Economist, it is painful to admit that if inflation targeting was a baseball game, the Fed has struck out in 8 out of the last nine 9 games/years (since 2012) in trying to hit its annual target of 2.0% inflation when measured at the end of each year, on a year-over-year basis. Only in 2018 did it hit the ball solidly by achieving a 2.0% core PCE yearly inflation growth rate. But with average inflation targeting, the Fed will now be able to exceed its regular 2.0% growth target to offset its shortfalls without having to rush to raise short-term interest rates. The problem is that exceeding this growth rate has been a constant challenge for the Fed over the past couple of decades. For example, the last time that the core PCE deflator grew by 2.5% or even 2.34% occurred in 1993 and 2007, respectively!

In fact, since Jan. 2012, when the Fed officially began targeting inflation, this inflation metric has averaged just 1.6%. So, what does it mean when the Fed says it will be more serious about generating a core PCE inflation rate that averages about +2.0% over time? In practical terms, it is the equivalent of disconnecting your kitchen smoke alarm simply because you haven’t observed any fires in a long time and simply don’t want to be distracted with those annoying noises each time you are cooking a great meal! But an important question for U.S. Monetary Policy officials is whether we haven’t observed any kitchen fires simply because policymakers were more vigilant in preventing inflation by pursuing preemptive tactics (e.g., by raising short-term rates each time Unemployment Rates fell below a critical level)? Or did the lack of fires arise from the fact that the U.S. economy currently has enough anti-inflation barriers to prevent such problems? To be sure, many will agree that the wider presence of disruptive technology that often generates deflationary pressures or the waning influence of Labor Unions that has resulted in the elimination of most cost of living adjustment [COLA] clauses from many labor market contracts, has greatly reduced the risk of inflation even without the use of a traditional preemptive measures.

Only time will shed further light on this issue, but I do remember living during the 1970’s (during Fed Chairman Arthur Burns, 1970-1978 tenure), when the Fed went out of its way to promote growth without worrying about its resulting impact on inflation. The result was a core PCE inflation rate that peaked at 10.0% in 1973 which clearly was not a desired outcome. Sadly, Paul Volcker (the Fed Chairman from 1979 to 1987) was forced to push short-term rates to nosebleed levels to reverse the inflationary pressures that built up as a result of this ill-fated strategy pursued during the 1970s. To be sure, the Fed raised its federal funds rate to peak of 20% in June 1981. Only by comparing this figure to our current (near zero percent) fed funds rate today can one fully appreciate the magnitude of those historical policy actions.

Against this backdrop, a final question for policymakers is whether the U.S. economy has built in sufficient anti-inflation repellants that will allow the economy to run hotter (to generate what most will agree is a desirable objective) without posing an existential threat to our long era of price stability. Although no one will dispute the benefits of achieving lower Unemployment Rates for a greater number of people -- the more relevant question is whether U.S. Monetary Policy is the best tool to use to attain this desirable objective?