By Mike Dolan
LONDON (Reuters) – The Federal Reserve’s widely panned and soon-to-be-revised “average inflation targeting” strategy may survive mostly intact after this year’s review – with a super wide lens showing some success despite the brickbats.
The decision five years ago to shift the emphasis of its 2% inflation goal to an average of that over an unspecified period now seems clumsy to many, or unfortunate timing at best. But a longer-term retrospective offers some solace.
Even though the Fed has mostly muffled the idea since – as multiple shocks saw inflation explode briefly in the interim – the 20-year average core rate of inflation based on the Fed’s favoured “personal consumption expenditures” (PCE) gauge is 2.1%.
And that’s even with the wild price swings of the post-pandemic period.
Of course, this misses the politically-toxic pain caused by rising prices in the past three years, the belated scramble to jack up borrowing costs to control it and – as January’s U.S. inflation readings attest – the fact prices are still running hot.
It also underscores an error in viewing success or failure solely through the rear-view mirror, especially if “averaging” simply papers over cracks. And, as some Fed peers contend, it sidesteps the art of preemptive policy that’s able to respond to shocks – likely a feature of highly uncertain years ahead.
A more useful statistic may be that the core PCE measure has averaged 3.5% over the past five years, with market and household inflation expectations gravitating closer to that rate than the Fed’s stated goal.
It’s this drift in expectations that likely most worries policymakers, suggesting any revised framework would pay more attention to these metrics than past inflation rates.
In a response to lawmakers this week, Chair Jerome Powell said this year’s five-year review of the Fed’s monetary policy strategy will reflect on the recent experience and added “we are going to be open to criticism and will make appropriate, discreet adjustments.”
There will certainly be no shortage of criticism or advice.
DOS AND DON’TS
A conference on the review at the Brookings think tank in Washington last summer concluded with an 11-point list of dos and don’ts.
One takeaway was that the Fed’s pursuit of its dual mandate of price stability and maximum employment may be unbalanced. It details targets for the former, but leaves definitions of the latter more nebulous. And that may well be firmed up this year.
And the yet basic concept of averaging inflation may remain.
The 2020 average inflation targeting, or AIT, move was rooted in concern that in undershooting its target for the prior 10 years the Fed tended to tighten policy too quickly on any nearing of the target, penalising cohorts of the population still out of work.
Averaging inflation over time – however woolly the timeframe – was supposed to allow the Fed to see through “temporary” overshoots to ensure employment was not being unnecessarily held back in what was then a sluggish economy.
And many have since partly blamed this approach for the Fed’s reluctance to tighten in 2021, even when core PCE inflation had already topped 5%.
“I don’t think they’d properly thought through the risk-reward of that policy shift,” Washington-based economist Phil Suttle wrote this week, adding too much weight was placed on the cost of low inflation and not enough on “the obvious point that it is hard to overshoot your inflation target by just a little.”
In a report late last year, UBS economists said they expect this year’s review to put inflation and employment “back on more equal footing”, with more weight being put on inflation expectations.
But they also said the gist of the AIT framework would likely survive for the most part, as Powell alluded to on Wednesday.
If so, this may mean that the Fed is inclined to allow some periodic undershooting of the inflation target to balance the average picture going forward.
And for that to happen, policy rates may need to remain firmly restrictive above the 3% to 3.5% “neutral rate” estimates long after monthly inflation prints actually do revert to the 2% goal, absent some major downturn in the labour market.
Whatever the analysis of January’s consumer prices, that suggests the bond market and the wider economy might need to brace for a hard-nosed Fed approach extending well beyond this year.
That’s apt to upset the new president, who has not been shy about offering Powell some advice.
How the Fed avoids tying its hands in the event of any new shock, however, will require deftness of language in the review that many feel was missing five years ago.
The opinions expressed here are those of the author, a columnist for Reuters
(By Mike Dolan; Editing by Jamie Freed)
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