How an average works

The Fed leadership is often criticized for seeming to interpret their 2% inflation objective as a ceiling, rather than a target they aim directly at.  I am not sure that criticism is fair.  While inflation has been stuck below 2% for several years now, one could argue that the Fed leadership regrets this, that it is trying now to push inflation higher, and that it will be appropriately relaxed as 2% comes into view and is even exceeded.

But leaving aside whether the criticism is fair, I think it is understated in the sense that it takes as a given that the Fed should now aim for (only) 2% inflation and (merely) accept the risk of inflation briefly rising above 2%.  As I see it, the Fed should be going for an inflation rate meaningfully above its long-term objective during this, the mature, phase of the business cycle in order to compensate for the very high odds that inflation will end up stuck durably below 2% in the wake of the next economic downturn, which looms out there somewhere.

My point here has nothing to do price level targeting or trying to make up for past undershoots of the inflation objective.  The argument is entirely forward-looking and therefore orthodox on the point of bygones.  Looking forward from today, the Fed needs to have a credible plan to deliver 2% inflation, on average, through the cycle, going forward. After all, their now-formal inflation commitment clearly requires such a plan.

At the January 2012 FOMC meeting, the Fed leadership formally announced a policy objective that they had informally been pursuing since the early 1990s.  That is, they committed to delivering a 2% a year trend rise of the headline PCE price index over the medium to longer term.  And each of three January meetings since that date, they have reiterated that promise.

In fairness, the Fed has not made it fully explicit that the commitment is to deliver 2% inflation on average over time.  A critic of my take here might claim that the Fed has promised only to guide inflation towards 2% and is actually indifferent on the question of whether inflation deviations might be offsetting over time.  But if you read the relevant passage from the Fed’s statement of its objectives, it seems pretty obvious that they are referring to an average:

The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.

The tell is the reference to long-term inflation expectations. In order for them to equal – or be consistent with — the objective of 2%, the Fed would have to have a credible plan to deliver 2% inflation on average going forward.

If we take it as a given that inflation is likely to be lower during the next downturn and its aftermath then it will be during the mature phase of this expansion, then it follows directly that the Fed needs now to aim at an inflation rate above 2%. It need not get there quickly, but it does need to spend some time there before the next downturn. Or more to the point, it needs to plan to do this if it wants to be taken seriously on its stated inflation goal.

This simple arithmetic argument would hold even if there was no risk of a return to liquidity trap and incorrigibly low inflation after the next downturn.  And the presence of that risk only strengthens the argument.

One could go further and say, as others have, that the 2% inflation objective is too low in an environment of real-side stagnation and thus heighted risk of policy returning to the lower bound.  But that is not the argument I offer here.  I am simply taking the Fed’s quite orthodox inflation commitment at face value and pointing out that sticking with it requires them to aim at and then sustain an inflation rate somewhat above 2% during the mature phase of the business expansion, which we have entered.

The question is whether Fed the leadership understands how averages work. I interpret recently-low long-dated inflation breakevens as evidence the bond market fears the Fed might not.  I also side with those hoping the bond market is wrong.

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