MNI: Fed Review To Rebalance Inflation Targeting-Ex Officials

The Federal Reserve’s framework review that begins later this year is likely to yield modest but significant changes to the existing average-inflation targeting regime, putting more emphasis on the need to respond to inflation when it is too high as well as when it is too low, nearly a dozen former Fed officials and senior staffers told MNI in a series of interviews.

In particular, the review will consider what critics allege to have been the Fed’s slow reaction to a jump in inflation that began in 2021 and would eventually peak with annualized PCE about 7% and CPI above 9% in mid-2022. This, they say, was influenced by the revamping of the central bank’s framework in 2020, which stated that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”

The review could recommend some kind of trigger that would prompt the Fed to consider overriding the overshoot, such as for instance, 3-month annualized inflation rates suddenly hitting 3.5%, said Charles Evans, former Chicago Fed President.

“That gives you ample time to recognize what’s going wrong, evaluate the persistence of it and give you scope to make adjustments to the forward guidance,” Evans said. “It’s the question of why didn’t the Fed move earlier (in 2021) that most people are grappling with.” (See MNI INTERVIEW: Taylor Rule Supports March Cut-Ex-Fed's Tracy)

REFRAMING THE FRAMEWORK

The 2019-2020 review was aimed at addressing nearly two decades of below-target inflation, when official borrowing costs were constrained by the zero lower bound.

“The previous changes that were made were designed to address a very low interest rate environment. There was an implicit assumption that if inflation turns out to be high we all know what to do about that – we’re going to have to raise interest rates aggressively,” said James Bullard, former president of the St. Louis Fed.

However, he added, the need for such a response to higher inflation was not made sufficiently explicit in the Fed’s 2020 Statement On Long-Run Goals.

“Now with the revamp you have to do more so that part comes out. Basically you would have a paragraph that says if inflation is high we’re going to raise rates aggressively to return inflation to target, if inflation is very low we may take some of these unorthodox policies that were developed between 2009 and 2019,” Bullard said.

“If we can get the spirit of that together I think that would describe the framework that the policymakers are operating today.”

MORE SYMMETRIC

Vincent Reinhart, a former Fed director of monetary affairs at the central bank’s board, said the Fed would be likely to use this review to make flexible average inflation targeting more balanced – recognizing the threat of an overshoot as well as an undershoot.

“Now they know the two-sided risks of policy, so I expect the framework review to be more symmetric,” Reinhart said.

MNI reported last year that officials at the central bank would at least consider moving to an inflation target band that showed greater humility by recognizing that hitting 2% precisely is very hard on a consistent basis. (See MNI POLICY: Fed To Consider Shift To Inflation Target Band)

FAIT ACCOMPLI

Another former monetary affairs director at the Fed’s board, William English, said the old framework is sound but could use some “clarifying words” that make evident it is not intended to let policymakers ignore bouts of inflation.

“I want maybe for them to be a little clearer that that's a story about the zero lower bound and about getting stuck and about periods with very low inflation. It's not more generally, ‘we're okay with inflation above target or even aiming for inflation above target,’” he said.

Still, some former staffers worry about the practical implications of trying to average deviations from target over time.

“To me, targeting policy based on what happened in the past is a mistake from an investors’ point of view. You want them to believe inflation is going to be 2% going forward no matter what happens in the past to keep markets appropriately priced,” said Dean Croushore, former Philadelphia Fed economist.