A Flexible Fed Means Higher Inflation
By James Mackintosh
Aug. 30, 2020 10:00 am ET
The Federal Reserve has just given itself a license to do pretty much whatever it wants.
Chairman Jerome Powell will no doubt disagree: His speech on Thursday set out a new target for average inflation of 2%. But because he ruled out any mathematical definition of the average, anything from serious deflation up to inflation of 3.2% over the next five years could count as success.
This isn’t really a problem. The broad thrust of the Fed’s new strategy is that it will be even more dovish, and interest rates will stay low for even longer. But—and it is a vital point—what the Fed is really saying is that we should trust that it won’t let inflation spiral out of control, so any overshoots of 2% won’t last long. The Fed wants people to believe inflation will be roughly 2% in the long run, and more precision than that isn’t really necessary.
Those who prefer their monetary policy to be governed by rules will be disappointed. The Fed used to let bygones be bygones, ignoring what had happened to inflation in the past as it pursued its goal of 2% in future. A catch-up strategy means that the failure to hit 2% for most of the past decade could be used to justify inflation above 2% for most of the next decade. The lack of a firm rule, though, means Mr. Powell isn’t tied to having to compensate for any future period above 2% by running below that for a while afterward.
Mr. Powell says the new approach is flexible. He isn’t kidding. Choose your period, and almost anything can be justified. Since 1960, inflation has averaged 3.2% (using the mathematically correct geometric, or compound, average of the Fed’s preferred inflation measure). A hawk applying a strict policy of inflation averaging could justify aiming for deflation for years to bring the long-term average back down to 2%. Some bygones will still be ignored.
The same mathematical problem bedevils what might appear to be more reasonable approaches. Should the average apply since the Fed adopted its target in 2012? Since Mr. Powell took over in 2018? Since five years ago? There is no correct answer, and the results are different enough to be significant for policy: Start from 2012, and the next five years need inflation of 3.2% to bring the average up to the goal. Start from Mr. Powell’s appointment, and it needs to be 2.3%, while starting five years ago would require inflation of 2.5%.
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