Fed embarks on a rethink of its inflation target

Federal Reserve Board Chairman Jerome Powell speaks during a news conference yesterday in Washington, DC. The Fed raised short-term interest rates by a quarter percentage point as expected yesterday, with market watchers expecting one more increase this year and three more in 2019. - AFP

FEDERAL Reserve officials are considering whether to allow inflation to rise above their 2% target more often as they grapple with the likelihood that interest rates are likely to remain much lower than in the past.

The discussions are preliminary but are heating up now because the Fed formally kicks off a monthslong review of its policy framework with a national listening tour beginning this week in Texas.

Animating the review is the uncomfortable prospect that the Fed’s benchmark short-term rate could peak at or slightly above the current range between 2.25% and 2.5%.

Such low rates leave the Fed less room than in the past to cut rates in a downturn and increase the possibility they might be pinned near zero for longer in future recessions. In each of the last three downturns, the Fed lowered its benchmark by roughly 5 percentage points.

Low nominal rates leave the Fed with less room to ease in a downturn and increase the possibility rates might return to near zero in the next recession. A policy framework that is more relaxed about higher inflation would be one way to signal the Fed’s commitment to taking bolder action to boost growth after a recession.

“It’s a good discussion—to think about how we have policy space, particularly if interest rates through this cycle are not going to be much higher than they already are,” said Boston Fed President Eric Rosengren in an interview earlier this month.

Fed Chairman Jerome Powell could be questioned about the review when he testifies on Capitol Hill Tuesday and Wednesday.

Fed officials have said they could employ the unconventional stimulus tools they used after the 2008 crisis, including bond-buying programs. But some, including Fed Vice Chairman Richard Clarida, who is heading the review, have expressed misgivings about the programs’ effectiveness.

When central banks were first setting inflation targets in the 1990s, they were worried about inflation running too high and sought to establish expectations—for both business and consumers—that future inflation would be tame. Behind this approach was the belief that expectations play an important role driving actual inflation.

The Fed established a 2% inflation target in 2012, but inflation has run below that target for much of the recent expansion. Fed officials have defined this target as symmetric, meaning they would tolerate inflation running modestly above or below it. A measure of inflation that excludes volatile food and energy categories has averaged 1.6% since the target was adopted in 2012, though it has been running recently at 1.9%.

The risk that Americans could start expecting inflation to languish below 2% “calls for a reassessment of the dominant inflation-targeting framework,” New York Fed President John Williams said Friday at a conference in New York.

The Fed isn’t looking to raise the 2% target as part of its review, Mr. Powell said in December. Rather, “we are looking for better ways to achieve the inflation goal, for example, on a symmetric basis,” he said.

Changes in how the central bank defines its target could boost the power of monetary policy in a downturn, said Mr. Rosengren.

“You can have the exact same inflation target, but…how you measure it [can] give you more space,” said Mr. Rosengren. Right now, the Fed isn’t very specific about how it sets the target, he said. “Is it backward looking? Is it forward looking? Is it over a long period? Is it over a short period?”

With the current target, the Fed aims for 2% inflation every year, no matter what happened the year before—a “let bygones be bygones” approach.

A couple of alternatives are getting a serious look.

The first, a price-level target, would call for the Fed to react to what happened before. If inflation undershot 2% one year, the Fed would try to catch up by allowing an overshoot in the next.

Former Fed Chairman Ben Bernanke has proposed a modified version of a price-level target that would be used only after periods in which the Fed cut interest rates to zero. By switching to a price-level target in such episodes, the Fed would be essentially promising to keep rates lower for longer to ward off deflationary expectations.

The second approach, called an average inflation target, would be a hybrid of a price-level target and the current framework. It would target 2% inflation “on average” over the business cycle, meaning inflation would need to be a bit higher than 2% during good times to make up for an expected shortfall during downturns.

Mr. Williams, a leading advocate of the second approach, offered a simple example in a speech last fall. Imagine the central bank succeeds at keeping inflation at 2% during periods when the economy is expanding and interest rates aren’t constrained by being at zero. But 20% of the time, when the economy is in recession and interest rates have been cut to zero, inflation averages 1%.

The result is that inflation over the cycle averages 1.8%, below the desired 2% target. In turn, this pulls down expectations of future inflation, which makes monetary policy even less effective. In this environment, “monetary policy is always swimming upstream, fighting a current of too-low inflation expectations,” said Mr. Williams.

“It doesn’t sound like much of a change, but it is an important one because you’re no longer following a ‘bygones’ policy,” said William Dudley, who was New York Fed president from 2009 until last June. “If you miss below the 2% target, you’re going to try to make it up, and the Fed has not really said that up to now.”

An average inflation target could be more appealing than a price-level target because it would be easier to communicate. “It accomplishes a good portion of the benefits of the price-level target type of framework with a lot less complexity,” said Mr. Dudley.

Others see good reasons to stick with the current approach. It has worked well, said Cleveland Fed President Loretta Mester during a panel in Newark, Del., on Tuesday. “The bar has to be high for making a major change,” she said. - WSJ

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