Economics and Strategy
U.S. Outlook – Background on Inflation Target History
— Ward McCarthy, Chief Financial Economist
Since 1977 the Federal Reserve has conducted monetary policy with the objective of meeting the so-called “dual mandate” objectives of promoting maximum employment and stable prices. In January 2012, the FOMC announced that U.S. “inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”
The Fed announcement was a classic example of bad timing. Since the 2012 announcement, inflation met the Fed’s target for the first four months only to fall below target for 54 consecutive months. All-in-all, inflation has matched or exceeded the 2% target in only 15 of 85 months that the target has been in existence. Consequently, the Fed is gearing up for a discussion of alternative frameworks for inflation. Proposals include:
Maintaining the current 2% target regime
Raising the inflation target
Specifying an acceptable range around the 2% target
Specifying a range around 2% with an adjustable inflation target option
Average inflation targeting
Price level targeting
Temporary price-level targeting
Nominal GDP targeting
The common policy implication of these proposals is that it would prompt the Fed to keep rates lower for a long period of time.
Low U.S. inflation has not always been the primary problem with inflation. During the so-called “Great Inflation” of the 1970s and 1980s, the year-over-year change in the PCE deflator averaged 420 basis points above target. By comparison with the Great Inflation, the current low-inflation environment seems like a relatively minor issue. U.S. inflation has averaged 18 basis points above the 2% target since the mid-1980s. Similarly, since 2000, inflation has averaged 14 basis points below the 2% target including the sharp deflation periods of 2008-2011 and 2015-2016. Nonetheless, the Fed is looking for a way to fine-tune the inflation framework out of concern for Fed credibility, the possible effect of missing the target on inflation expectations and fear of persistent outright deflation.
There is no compelling body of empirical research or theoretical literature that points to 2% as being an optimal inflation rate for the U.S. economy. Former Fed Chairman Ben Bernanke acknowledged as much by saying he does not see “anything magical about targeting two percent inflation.” Bernanke embraced the 2% more because of “transparency and communication advantages of the approach and not as much on the specific choice of target.”
Nonetheless, 2% is a target that has been widely adopted by central banks as an empirical definition of price stability, although there are differences in approaches. For example, the Fed advertises its inflation target as being symmetric around 2%, while the ECB defines price stability as a year-over-year inflation “for the euro area of below 2%.”
The inflation framework discussion is taking place against the backdrop of the Fed’s effort to normalize monetary policy which complicates the issue. With the benefit of a fiscal tailwind and both objectives of the dual mandate “flashing green” for most of the year, the FOMC was able to raise the fed funds rate four times and shrink the size of the balance sheet by almost $375 billion. Now that U.S. inflation has fallen back below target, the objectives of normalizing the fed funds rate and meeting the inflation objective of the dual mandate are back in conflict.
There is concern that the normalization process will stall before the fed funds rate reaches a level that will allow the Fed to make a decisive rate policy response when the next crisis and/or recession occurs. Or, as Larry Summers put it, “monetary policy of the standard form (AKA lowering the fed funds rate) will lack room to do what it usually does.” Summers’ opinion is based on the empirical reality that the Fed lowered the fed funds rate by an average of more than 500 basis points in response to recessions since 1960, so the fed funds rate remains more than 200 bps below the level that history suggests is likely to be necessary for Fed rate policy to be able to do “what it usually does.” Summers goes so far as to suggest that one of the criterion for choosing a monetary framework is that it creates “enough room to respond to a recession…(and) foresee nominal interest rates in the range of 5% in normal times. How that is achieved seems to me to be a question of second-order importance.”
This is going to be an interesting debate.