On August 2020, Fed officials announced a new approach to monetary policy, which they called “Flexible Average Inflation Targeting”. The idea was to allow some variation in inflation in the short run, but aim for an average inflation rate of 2% in the mid- to longer run.
What they actually did was something radically different. In 2021, the Fed adopted a 1960s-style highly stimulative monetary policy in an attempt to “create jobs” by printing money. Just as in the 1960s, that policy led to high inflation.
Later, the Fed claimed that they had never intended to target the average inflation rate. Rather the policy aimed to make up for periods where inflation ran below target, but not for periods when it ran above target. I felt like a dummy, as I had naively believed that average inflation targeting meant average inflation targeting.
London School of Economics Professor Ricardo Reis is certainly no dummy, and he had the same view as I had:
So where could Reis and I have gotten this crazy idea that average inflation targeting meant average inflation targeting? Perhaps from the Fed itself. In an April 6, 2021 paper, Dallas Fed economists Enrique Martínez-García, Jarod Coulter and Valerie Grossman also claimed that the policy was symmetric:
Notably, the Fed changed its language on inflation, replacing its 2 percent inflation target commitment, and instead said it will “[seek] to achieve inflation that averages 2 percent over time.”
This change is a substantial departure from the previous flexible inflation-targeting regime. Monetary policy under inflation targeting was symmetric—the Fed would equally respond to overshooting and undershooting of the target. The Fed lets “bygones be bygones,” since it does not attempt to make up for past inflation deviations from target.
By comparison, average inflation targeting means that policymakers would consider those deviations and can allow inflation to modestly and temporarily run above the target to make up for past shortfalls, or vice versa.
Note that the phrase “vice versa” is italicized in the original. They thought this point was worth emphasizing.
In a recent tweet, David Beckworth suggests that Jerome Powell is leaning toward an abandonment of FAIT, and a return to a flexible inflation targeting (FIT) regime:
David’s entire twitter threat is worth reading. He points out that the FAIT policy was based on a long series of important papers that I have dubbed the “Princeton School” of monetary policy. These papers emphasize the need for some sort of level targeting regime, focusing either on the price level or nominal GDP. These proposals aimed to correct very specific flaws in the previous inflation targeting regime, which led to the big policy failure of 2008-15.
So let’s review what happened here:
1. In 2020, the Fed adopted FAIT, based on highly respected research into the question of what went wrong in 2008.
2. The plain meaning of the term “average” suggests the policy was symmetric. I thought it was symmetric. A Dallas Fed publication said the policy was symmetric.
3. The policy did generate a robust recovery, but it ended up creating too much inflation.
4. To the extent that the policy failed, it failed because it was not symmetric. The Fed aimed to correct inflation undershoots, but not overshoots. It is not a question of the Fed failing to achieve flexible average inflation targeting after trying really hard; they never even attempted FAIT. They attempted something entirely different, 1960s-style monetary stimulus.
Unfortunately, in our culture words have an almost magical power, a talismanic power. If an institution announces that it will undertake policy X, and then undertakes policy Y, any success or failure will be based not on the policy that was actually undertaken, rather it will be attributed to the policy that was announced. The Fed announced that it would do FAIT, did something entirely different, and now (if Beckworth’s tweet is correct) seems about to abandon FAIT and replace it with something far worse.
On the bright side, a cynic might argue that perhaps next time they’ll announce policy Y (FIT), but actually do policy X (FAIT). Unfortunately, in order for these sorts of policies to work they need to be well understood by the financial markets, and at least somewhat credible.
I understand that the Fed feels a need to do something different after the fiasco of 2021-22. So why not announce a policy of NGDP level targeting at 4%/year? Given the long run US growth rate of roughly 2%, that sort of policy will produce an average inflation rate of close to 2%, and it will be more “flexible” when there are supply shocks like Covid and the Ukraine War.
PS. In the 30 years before average inflation targeting, PCE inflation averaged 1.9%. Since August 2020, it has averaged 4.2%, or 3.6% if you take a five year average to avoid Covid distortions.
