Macro Matters: The Fed Should Regain Lost Ground on Inflation

Macro Matters: The Fed Should Regain Lost Ground on Inflation

Macro Matters: The Fed Should Regain Lost Ground on Inflation

In 2012, the Federal Reserve announced it would explicitly target a 2% inflation rate. While the central bank has done a great job bringing the economy closer to maximum employment (one part of its dual mandate), it has failed consistently to meet its inflation goal. The price index of personal consumer expenditures (its preferred inflation gauge) has undershot the target by a substantial margin over the last four years.

Rather than allowing bygones to be bygones, the Fed should aim to compensate for the miss and restore the credibility of its target. How? Allow inflation to overshoot in the coming years.

In 2012, the stage seemed set for a great performance: Headline and core PCE inflation rates were almost bang in line with the new target, and longer-term inflation expectations were stable at a rate consistent with 2% PCE inflation.

However, things have gone downhill ever since. Core PCE inflation has remained below the 2% target and headline inflation fell even further when oil prices slumped. And market-based measures of inflation expectations slipped significantly, too: The 10-year breakeven rate is just 1.4%. This means the market expects inflation to fall short of the Fed’s target by about one percentage point per annum over the next 10 years (assuming a CPI-PCE wedge of roughly 0.5%).

So what should the Fed do about it? Traditionally, central banks have tended to ignore rather than correct past misses of their inflation goals. This is exactly what the Fed implicitly signaled last year when it initiated a tightening campaign despite the persistent undershoot of its inflation objectives. However, to re-anchor inflation expectations, the Fed would have to signal that it aims to make up for the persistent past undershoot by allowing inflation to overshoot the target until the “price-level gap” has closed. Put differently, the Fed should switch from inflation targeting to price-level targeting or, more precisely, targeting a path for the price level that increases at an annual pace of 2%.

The price-level gap is the distance between the actual price level and the hypothetical price level that would prevail if inflation had been 2% per year since inception of the target. From January 2012 to this January, the core PCE price level has increased at a 1.5% annualized pace. Thus, the cumulative shortfall below the 2% target path over the past four years has been 2 percentage points. Thus, for example, inflation would have to be 4% this year to close the gap to the appropriate price level! More realistic options would be to let core PCE inflation run at an average annual 2.5% rate until 2020, or at 2.2% per year over the next 10 years.

But here’s the problem: The Fed doesn’t seem to have any intention to do so in the foreseeable future, judging by the FOMC’s dot plot and PCE inflation forecast. As long as this remains the case, it will be difficult for the Fed to restore the credibility of its inflation target.

Bottom line: The best way to restore credibility and re-anchor inflation expectations at the 2% target would be to shift to an explicit price-level target and announce that inflation will be allowed to overshoot until the current price-level gap has disappeared. To underscore their determination, FOMC participants would also have to revise lower their interest rate dot path, substantially. Don’t bet on this to happen at the upcoming March FOMC meeting. However, I believe there is a good chance that the Fed will have adopted this amended framework by the time of the fifth anniversary of the 2% inflation objective in January 2017.

For another take on the Fed’s inflation target, see Mihir Worah’s blog post “Should the Fed Raise Its Inflation Target?” and for more on our thinking on recent inflation data, see Jeremie Banet’s blog post “Run It Like It’s Hot.”


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