MNI POLICY: Fed To Consider Shift To Inflation Target Band

The Federal Reserve is likely to consider moving away from a singular inflation target of 2% and toward a band system possibly ranging from 1.5% to 2.5%, that allows for a wider, more realistic set of outcomes.

The next framework review is slated for 2025 but top policymakers have signaled they are already thinking about possible changes.

"I haven't heard anything or seen anything that would make me think that 2% is the wrong target. But whenever we next talk about policy I'd certainly be open to talking about a range as a concept,” Richmond Fed President Thomas Barkin told reporters earlier this year.

Still stung by the rapidity of the rise in post-pandemic inflation pressures, which officials initially argued were transitory, U.S. central bankers are looking back on their pre-Covid concerns about undershooting the 2% inflation goal by a couple of tenths of a percentage point as relatively quaint.

A shift toward a target band would be in line with the practice of many central banks around the world, including the Bank of Canada and the Reserve Bank of Australia. (See MNI: Fed Able To Tolerate Above-2% Inflation, To Keep Target)

FRAMEWORK UNDER SCRUTINY

The outcome of the last framework review in 2020, which calls for the Fed to make up for periods of shortfall by overshooting the inflation target, has come under fire from critics who say it prompted policymakers to wait too long before reacting to the inflation surge that began in mid-2021 and peaked in the summer of 2022.

Formulated after years of inflation hovering below the 2% inflation goal during the sluggish recovery that followed the Great Recession of 2007-2009, the new framework means the Fed would “apparently would not make up for overshoots of the target. The new framework did not seem even to contemplate the possibility of persistent strong inflation pressures,” according to ex-Fed vice chair Donald Kohn in a 2022 essay.

The Fed’s current forecasts for inflation to end 2023 around 3.3%, and not fully reach the 2% target until 2025, are a tacit admission that the goalposts of achievability have since shifted dramatically.

LESSONS LEARNED

Minneapolis Fed economist Abigail Wozniak told MNI’s FedSpeak podcast said the inflation experience of the last two years will certainly inform the next round of discussions inside the central bank, which while officially 1-½ years out are already effectively taking place.

“There will be some consideration given to what we just learned over the last two or three years about how an episode like this can work through the economy. There probably will be some rethinking about the underlying assumptions that contributed to that overhaul,” she said.

“But the spirit of the overhaul, of trying to make sure that we are allowing enough growth to happen in way that benefits the broadest set of folks who are trying to engage with the economy through work, that is a spirit that I think the Fed will carry forward and continues to be very much a part of the discussion.”

Allowing a little more inflation in exchange for a little more employment might be one way of doing that, and a rate target band could accomplish that.

Ex-Fed Vice Chair Richard Clarida, who oversaw the 2020 framework review, said the idea of a target range was contemplated but rejected at the time. But he said conditions have changed so much since then that the idea should be reconsidered.

“The Committee chose not to go down that road given the initial conditions because the concern was if the Committee were to define a range of 1.5 to 2.5[%] that could reinforce the view inflation would never get to 2 and then reinforce the challenge of inflation expectations sagging,” he told a Brookings conference in May. “But the initial conditions will be much different in 2024 and 2025 and I would hope the merits of seriously considering a range could be entertained.”