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By Jean Yung
     WASHINGTON (MNI) - Months into the Federal Reserve's review of its monetary
policy framework, policymakers are skeptical that proposals to adopt an
inflation makeup strategy would work in practice, officials and Fed watchers
told MNI, with some speculating that the Fed might adopt only some features of
average-inflation targeting.
     Allowing inflation to temporarily run higher than target to compensate for
past misses has figured prominently among proposals to overhaul the Fed's
toolkit during the review, which it announced last November in order to consider
the best way to confront historically low interest rates and limited existing
policy options.
     But establishing the credibility of promises to bring inflation down to
meet a multi-year average once it has been permitted to rise above target may
prove difficult, absent a commitment to a Taylor Rule-type policy formula,
according to interviews with officials, senior staff and Fed watchers.
     Instead, the Fed might choose to re-emphasize the symmetric nature of its
2% goal after it wraps up the review in mid-2020, while also drawing attention
to deviations from target by three-year or five-year moving-average inflation,
Fed watchers said. They also speculated that the FOMC's quarterly projections
could also be permitted to show inflation rates slightly above 2%, signaling to
investors that the Fed would not be too concerned about modestly higher
inflation late in the business cycle.
     --MODEST BENEFITS
     Academic research on average inflation targeting shows it results in higher
price levels and inflation expectations, garnering the method support among
central bankers. But the benefits are modest and would take years to reap given
the very flat Phillips Curve, which has seen inflation fail to respond to low
unemployment and faster wage growth. Sometimes, such a regime could also lead
the Fed to adopt policies that could exacerbate the swings of the economic
cycle.
     David Reifschneider, special adviser to former Fed Chair Janet Yellen, and
David Wilcox, research director at Fed Board until 2018, found a simulation of
average inflation targeting shows it "could modestly help mitigate the adverse
consequences of the zero lower bound constraint" but that it did not
significantly improve labor market conditions or check disinflationary pressures
after a recession. Nor would inflation expectations quickly return to 2% in such
a scenario, they said in research published this month by the Peterson Institute
for International Economics, anticipating instead a probable "slow, grinding
process of reanchoring."
     The strategy could also sometimes exact heavy costs, they found. An average
inflation target rule would have called for holding the fed funds rate near 8%
from 2006 to 2008 "even as the housing market collapsed, financial stress
intensified, and the economy slipped into recession," because five-year average
inflation had risen well above 2% due to high oil prices ahead of that period.
     --COMMUNICATIONS HURDLES
     The effectiveness of an average-inflation regime would hinge on the Fed's
ability to credibly communicate its new framework so that expectations about the
economic outlook adjust accordingly -- something that economic models tend to
assume away. The Fed's goals and thresholds for changing course would have to be
well understood.
     Given that the method spans years, their commitments would bind not only
current officials but their successors.
     In principle, communicating the parameters of an average inflation
framework would be simple if the Fed committed itself to a policy formula, but
officials have roundly rejected repeated attempts by lawmakers to mechanically
tie interest rates to macroeconomic variables.
     Thus preserving the flexibility of the FOMC to make an independent
judgement on policy actions also constrains the degree to which the Fed can
commit itself to a makeup strategy.
--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com
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