MNI INTERVIEW: Fed's Average Inflation Target Loses Its Luster
University of Oxford economist Michael McMahon discusses the Fed's policy framework.
The Federal Reserve's average inflation targeting regime has proven to be more difficult to communicate and less beneficial in practice than in theory, University of Oxford economist Michael McMahon told MNI, urging the Fed to revise its framework to focus less on episodes of below-target inflation and better communicate its reaction function under different scenarios.
Flexible average inflation targeting, adopted in 2020 after an 18-month-long review of the policymaking framework, calls for a deliberate overshoot of the inflation target after a period of undershooting so that inflation "averages 2% over time." The Fed will begin a fresh review of its framework later this year.
In theory, knowing inflation will be higher and real rates lower, people should be more willing to invest and less likely to save, allowing activity to recover quicker and inflation to get back to target faster.
"In practice it has been much harder," McMahon said in an interview. "I’ve become more skeptical of the practical implementation of flexible average inflation targeting. The cost of communications are harder than I thought, and I’m more skeptical on the precise benefits of it."
IT'S CONFUSING
A new paper by McMahon and Anna Cieslak of Duke University's Fuqua School of Business found little evidence markets were deeply worried about the Fed's persistent undershooting of inflation in the years leading up to the Covid-19 pandemic -- the key reason for the 2020 shift in the strategy for achieving price stability.
But designing a flexible average inflation targeting system turned out to be complicated and communicating it even more so, said McMahon, also a research fellow of the Centre for Economic Policy Research and director of the Research Policy Network on Central Bank Communication.
How much of an overshoot officials would be willing to tolerate and how far back would they go to calculate the average rate of inflation were among preferences never pinned down.
"The lack of detail was intended to give flexibility, but if you don’t give the details, do you get the benefits of flexible average inflation targeting?" he said. "Communicating about it in a way that allows the sufficient amount of flexibility but doesn’t introduce confusion about how the Fed will react is a very much more nuanced thing."
SCENARIOS INSTEAD
Some also question whether the change prevented the Fed from reacting faster to rising inflation in 2021.
The FOMC's forward guidance in July 2021 that it would keep interest rates just above zero until the labor market hit maximum employment and until inflation had risen to 2% and was on track to "moderately exceed 2% for some time" -- in line with its new framework – delayed rate hikes until March 2022, some six months later than was ideal, some argue.
Central banks need to communicate their reaction functions -- to what conditions they'll react and how strongly -- but not go so far as to constrain themselves with forward guidance, McMahon said.
Discussing different economic scenarios and potential reactions to each, as former Fed Chair Ben Bernanke has recommended for the Bank of England, is one way of accomplishing this, McMahon said. (See MNI INTERVIEW: Fed Likely To Wait And See On Scenarios - Bordo and MNI INTERVIEW: Limits To Comms Benefits From Fed Scenarios)
INFLATION BAND
If the Fed moves in that direction, it could even scrap the imperfect "dot plot" or summary of economic projections, he said.
More broadly, central bank policy frameworks should be robust to a range of economic situations, he said. Average inflation targeting has useful features, considering global interest rates are likely to be much lower than 30 years ago. But the pandemic swiftly up-ended the problem of too-low inflation.
An alternative would be targeting an inflation band of 50 basis points around 2% without trying to make up for past deviations, but the change could again be hard to communicate credibly, McMahon said.
"We should take very seriously the zero lower bound constraint and how that limits monetary policy. Whether we should design our framework around it is another thing."