Fed’s Inflation Targeting Framework — A Policy Approach That Outlived Its Usefulness
Policymakers are discussing altering their inflation-targeting framework to allow for an equal amount of time for inflation to run above its target following periods when it ran below.
That would be a mistake. Adjusting the amount of time there is a deviation around an inflation target in order to hit an average inflation rate over time is a feeble attempt to fine-tune a policy framework that has not worked and has the potential to create more bad outcomes than good ones. Here’s why.
First, setting a preferred speed limit on inflation creates the impression that there is an "optimal" figure and policymakers know what it is. There is no research anywhere that concludes there is an optimal rate of inflation---let alone a 2% rate in the Fed’s PCE core rate, a price measure that is only used by policymakers to gauge general inflation.
All of the empirical research reaches the same conclusion; very low and very high inflation for sustained periods can lead to bad economic outcomes, but at what precise levels bad things happen in the economy is impossible to say.
Before policymakers make any changes to its inflation-targeting regime there should be a congressional review since policymakers never offered any evidence to justify the 2% price target as well as the fact that monetary policy nowadays has become the big political enchilada in US policy and any change has the potential to impact a number of stakeholders.
Second, it’s hard to prove there is any consistent relationship nowadays between PCE core inflation and economic growth. During periods of fast growth in the late 1990s core PCE inflation ran less than 2% and when growth was half as fast in the 2000s PCE inflation ran a little over 2%.
It would make more sense for policymakers to examine why their preferred measure of inflation (PCE) consistently runs below the more conventional measure (CPI) and whether it makes sense to shift their price targeting to the CPI measure that is widely used for inflation indexation in private contracts, Treasury securities and the tax code.
Third, correlation between inflation and recession has also disappeared. The last two recessions (2000/01 and 2007/09) occurred when general inflation was a little over 2% and it was financial imbalances and not inflation imbalances that triggered the bad outcomes. Based on recent experiences it’s unclear why policymakers are spending so much time on trying to hit a specific price target and so little time studying the causes of financial instability.
Fourth, policymakers have argued that by announcing an explicit price target that it will help anchor inflation expectations. Yet, there is no proof that consumer inflation expectations have been influenced by the Fed’s price target regime. Consumer inflation expectation remains stuck around the mid-2% area, well above the Fed’s target of 2% inflation—- and there has never been a single year in the past 25 years that consumer inflation expectations was at 2% or below.
At the same time, inflation targeting appears to have un-anchored investors expectations as people are investing nowadays on promises of easy money linked to the Fed’s commitment to hit a specific price target and not fundamentals of growth and profits.
Fifth, in the last 25 years, core PCE inflation has been at or above the 2% mark only 5 times. In other words, 80% of the time in the past 25 years reported PCE inflation underperformed in terms of what policymakers’ believe is optimal inflation. Does that mean policymakers need to let inflation run above 2% for 20 of the next 25 years?
Monetary policy requires a careful balancing of price stability and financial stability along with maximum employment. Price targeting has failed to deliver its promised inflation, while also creating new risks or distortions in the economy and finance. Policymakers need to consider a new way to conduct policy, with an increased emphasis on financial stability, and not tinker with a policy approach that outlived its usefulness.