Last week marked a big event in central banking history and
economists will look back at Jay Powell’s speech on 27 August as the point at which the parameters of the three decade experiment
with inflation targeting were changed. Central banks have tended to adopt a
numerical target for inflation, usually centred around 2%, but in recent years
inflation has undershot this target. A variety of reasons have been put forward
for this. Many central bankers will argue that the adoption of inflation
targeting was one of the factors which squeezed the high inflation of the 1970s
and 1980s out of the economy. However, we can also add a number of exogenous
factors such as the opening up of China as the workshop of the world, the end
of the Cold War and more flexible labour markets.
Whatever the reason, there is a strong case for suggesting that the current regime which emerged in the wake of the high inflation of the 1970s and 1980s is no longer appropriate. For one thing, as currently practiced, inflation targeting contains an inbuilt asymmetry since central banks are more likely to react to inflation overshoots rather than undershoots for fear of being seen as soft on inflation, despite the fact that the target usually allows for some leeway around the central case. But we find ourselves today in an environment in which economies have taken the biggest hit in at least 90 years and inflation concerns are rapidly being put on the back burner as policy makers start to concern themselves with issues such as unemployment. Accordingly, the Fed announced last week that it will in future target maximum employment and “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” In effect, it will adopt a medium-term price level target – something many economists have devoted time to thinking about over the past decade.
This has a number of important implications for monetary policy in future. For one thing it effectively means that the Fed will be less likely to pre-emptively tighten policy in response to a perceived inflation pickup after a period of below-target inflation. At a time when real economy concerns are paramount this makes a lot of sense. But questions arise as to what the Fed means by the two parts of the phrase “inflation moderately above 2 percent” and “for some time?” Much of the early discussion about price targets tended to focus on short-term deviations of inflation from the target. Thus if an exogenous shock results in inflation averaging 1% over a year, inflation can run at 3% the following year in order that it averages 2% over the whole period. But if inflation averages 1% over a 10-year period, this would require a 3% rate over the next ten years in order to get the long-run average inflation rate back to 2% (chart). In such a case is 3% “moderately above 2%?” And does a ten year period represent “some time” or does this represent a whole different paradigm?
Whatever the reason, there is a strong case for suggesting that the current regime which emerged in the wake of the high inflation of the 1970s and 1980s is no longer appropriate. For one thing, as currently practiced, inflation targeting contains an inbuilt asymmetry since central banks are more likely to react to inflation overshoots rather than undershoots for fear of being seen as soft on inflation, despite the fact that the target usually allows for some leeway around the central case. But we find ourselves today in an environment in which economies have taken the biggest hit in at least 90 years and inflation concerns are rapidly being put on the back burner as policy makers start to concern themselves with issues such as unemployment. Accordingly, the Fed announced last week that it will in future target maximum employment and “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” In effect, it will adopt a medium-term price level target – something many economists have devoted time to thinking about over the past decade.
This has a number of important implications for monetary policy in future. For one thing it effectively means that the Fed will be less likely to pre-emptively tighten policy in response to a perceived inflation pickup after a period of below-target inflation. At a time when real economy concerns are paramount this makes a lot of sense. But questions arise as to what the Fed means by the two parts of the phrase “inflation moderately above 2 percent” and “for some time?” Much of the early discussion about price targets tended to focus on short-term deviations of inflation from the target. Thus if an exogenous shock results in inflation averaging 1% over a year, inflation can run at 3% the following year in order that it averages 2% over the whole period. But if inflation averages 1% over a 10-year period, this would require a 3% rate over the next ten years in order to get the long-run average inflation rate back to 2% (chart). In such a case is 3% “moderately above 2%?” And does a ten year period represent “some time” or does this represent a whole different paradigm?
As I argued in this post once we start to tolerate higher inflation the concept of price stability
begins to become eroded. There is thus a concern that the price level targeting
regime could result in inflation expectations becoming de-anchored. We might not
worry about this any time soon but it is a discussion which will doubtless be
taking place within the Fed. That said, at a time when government debt levels
have gone through the roof in many countries, no government is going to
complain about a little bit more inflation if it helps to alleviate the debt
burden.
One of the less discussed aspects of the change was that on the rules versus discretion spectrum, which has been a feature of monetary policy over recent decades, the Fed’s policy announcement is very much a step in the direction of discretion. It ascribes a greater weight to “the shortfalls of employment from its maximum level” where the Fed freely admits that “the maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time.” Full employment has always been a nebulous target, but it is about to become even more so and runs the risk of being whatever the Fed believes it to be in order to satisfy its current policy stance. For markets which have become used to interpreting mechanistic rules, this implies a rather more opaque central bank than we have become used to. It also suggests an enhanced role for forward guidance which is likely to become even more important as a policy tool.
Another important aspect of the new policy is that the central bank will be even less concerned in future with trying to fine tune the economy via monetary policy, since shortfalls imply a persistent deviation from the nebulous concept of maximum employment whereas deviations imply cyclical divergences. Whilst the Fed’s moves make a lot of sense from an inflation perspective, it also fits with the new realities of the post-Covid economy in which central banks will have to play their part in dealing with the resulting economic scarring. By explicitly committing to keeping rates low(er) for longer, the Fed is perhaps taking the first steps along the path towards financial repression.
However, it is important to be aware of some of the downsides. For one thing a policy of targeting price levels implies the potential for short-term inflation volatility if economic agents are not sufficiently forward looking and base their inflation expectations on extrapolation of current rates out into the future rather than the longer term goal of ensuring that price levels will eventually return to target. In addition, the standard objection in the literature is that there is likely to be greater output volatility under a price level targeting regime as the central bank does not attempt to moderate cyclical swings as frequently.
Nonetheless, it is likely that other central banks will eventually follow in the Fed’s footsteps and adopt a version of an average price level target with a focus on the real economy. However, it is unlikely to find much favour in the euro zone where the focus on short-term price stability remains paramount. But as Martin Sandbu points out in the FT the ECB has “treated its own legal mandate far too narrowly … There is a widespread misperception that the ECB is treaty-bound to the single duty of ensuring price stability … But beyond this, the ECB has a legal obligation to ‘support the [EU’s] general economic policies’” (a point I have made repeatedly in the case of the BoE). The ECB may not be a slave to monetary policy fashions but it is not the Bundesbank and has proved itself pretty flexible in its monetary dealings in the past. It just might take a while to get there.
One of the less discussed aspects of the change was that on the rules versus discretion spectrum, which has been a feature of monetary policy over recent decades, the Fed’s policy announcement is very much a step in the direction of discretion. It ascribes a greater weight to “the shortfalls of employment from its maximum level” where the Fed freely admits that “the maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time.” Full employment has always been a nebulous target, but it is about to become even more so and runs the risk of being whatever the Fed believes it to be in order to satisfy its current policy stance. For markets which have become used to interpreting mechanistic rules, this implies a rather more opaque central bank than we have become used to. It also suggests an enhanced role for forward guidance which is likely to become even more important as a policy tool.
Another important aspect of the new policy is that the central bank will be even less concerned in future with trying to fine tune the economy via monetary policy, since shortfalls imply a persistent deviation from the nebulous concept of maximum employment whereas deviations imply cyclical divergences. Whilst the Fed’s moves make a lot of sense from an inflation perspective, it also fits with the new realities of the post-Covid economy in which central banks will have to play their part in dealing with the resulting economic scarring. By explicitly committing to keeping rates low(er) for longer, the Fed is perhaps taking the first steps along the path towards financial repression.
However, it is important to be aware of some of the downsides. For one thing a policy of targeting price levels implies the potential for short-term inflation volatility if economic agents are not sufficiently forward looking and base their inflation expectations on extrapolation of current rates out into the future rather than the longer term goal of ensuring that price levels will eventually return to target. In addition, the standard objection in the literature is that there is likely to be greater output volatility under a price level targeting regime as the central bank does not attempt to moderate cyclical swings as frequently.
Nonetheless, it is likely that other central banks will eventually follow in the Fed’s footsteps and adopt a version of an average price level target with a focus on the real economy. However, it is unlikely to find much favour in the euro zone where the focus on short-term price stability remains paramount. But as Martin Sandbu points out in the FT the ECB has “treated its own legal mandate far too narrowly … There is a widespread misperception that the ECB is treaty-bound to the single duty of ensuring price stability … But beyond this, the ECB has a legal obligation to ‘support the [EU’s] general economic policies’” (a point I have made repeatedly in the case of the BoE). The ECB may not be a slave to monetary policy fashions but it is not the Bundesbank and has proved itself pretty flexible in its monetary dealings in the past. It just might take a while to get there.
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