Federal Reserve Chair Jerome Powell announced changes to the Fed’s monetary policy framework in his remarks at the annual Jackson Hole Economic Summit. Most notably, the Fed has decided to scrap its controversial Flexible Average Inflation Targeting (FAIT) regime in favor of a Flexible Inflation Targeting (FIT) regime. FAIT was adopted in August 2020, when the Fed last revised its framework. It had replaced an earlier FIT regime. Out with the old, in with the older.
The Fed’s monetary policy framework serves as the central bank’s operational blueprint: a set of principles and guidelines that govern how monetary policymakers respond to economic conditions and communicate their decisions to the public. Think of the policy framework as a (non-binding) monetary constitution for making interest rate decisions and signaling intentions to markets.
Central to this framework is the dual mandate from Congress: maintaining price stability and achieving maximum employment. For price stability, policymakers target 2 percent inflation as measured by the Personal Consumption Expenditures Price Index (PCEPI). Since maximum employment cannot be directly observed, the central bank aims for conditions that support the broadest possible participation in the labor market that is consistent with price stability.
Since some fluctuation in inflation may be desirable (e.g., following supply disruptions), the Fed has opted for a flexible rather than strict inflation target. With a strict inflation target, the monetary authority indicates it will attempt to deliver 2-percent inflation regardless of the circumstances. With a flexible inflation target, policymakers indicate they will take the circumstances into account. For example, they might look through supply disruptions they expect will cause the rate of inflation to rise temporarily. In other words, the flexibility of FIT gives the Fed some discretion, which they believe will result in better monetary policy.
In its last monetary policy framework review, which concluded in August 2020, the Fed adopted FAIT. At the time, Fed officials were concerned that inflation was too low. Inflation had been persistently below 2 percent since the Fed had officially adopted the target in 2012, and despite clarifying in its 2016 revisions that the target was symmetric—i.e., that it would be just as likely to overshoot its target as to undershoot it. With the 2020 move to FAIT, Fed officials committed to let inflation rise above 2 percent for a time following periods where inflation had fallen below 2 percent, in order to ensure inflation averaged 2 percent over time. They believed committing to a make-up policy would help anchor expectations on the target, and in doing so, make that target easier to hit.
Although the Fed did not indicate how it would respond if inflation were to rise above 2 percent in its official Statement on Longer-Run Goals and Monetary Policy Strategy, statements from Fed officials made clear that the FAIT framework was asymmetric: the Fed would only make-up for below-target inflation, not above-target inflation. At the time, no one was worried about high inflation. Inflation had been very low for more than a decade. Correspondingly, there was no concern that inflation expectations might rise above target.
The FAIT framework became outdated almost immediately. Inflation climbed above 2 percent in early 2021 and would not reach a peak until mid-2022. Any ambiguity related to the Fed’s asymmetric make-up policy was resolved. Powell clearly stated that the Fed had no intention of delivering inflation below 2 percent for a period, to ensure that inflation would average 2 percent. Rather, the Fed would merely bring inflation back down to 2 percent.
Many market watchers and economists were surprised to learn that FAIT was asymmetric, especially given the Fed’s insistence that FAIT would anchor expectations at target. Why would one expect inflation to average 2 percent if the Fed only intended to make up for periods where inflation fell below 2 percent? Since such a policy would tend to deliver more than 2 percent inflation, market participants would come to expect more than 2 percent inflation. And they did. Inflation expectations implied by bond prices have exceeded the Fed’s target in all but two months since the Fed adopted FAIT.
The newly-revised framework removes the Fed’s commitment to make up for past mistakes, essentially marking a return to the pre-2020 framework. Fed officials believe this policy will be easier to communicate to the public. For one, they will not have to explain why they will not let inflation fall below 2 percent, as would be required to ensure inflation averages 2 percent over time. Instead, they will be able to let bygones be bygones and aim at 2 percent on a go-forward basis.
A Missed Opportunity for Real Reform
The Fed’s return to the pre-2020 framework is disappointing. They could have used the opportunity to introduce a symmetric average inflation target or nominal income level target, both of which would tend to ensure that inflation averages 2 percent over time. Such a regime would have helped the Fed prevent inflation from rising so high in 2021 and 2022.
Throughout 2021, central bank officials generally believed inflation had risen due to supply disruptions associated with COVID-19 policies and the corresponding restrictions on economic activity. On its own, this negative supply shock would cause the level of prices to rise temporarily above trend, and then return to trend once those constraints eased.
The economy had been hit by a negative supply shock, to be sure. But it also suffered from a positive demand shock. Indeed, the supply shock had largely reversed by September 2021—and, still, inflation climbed higher. Rather than returning to trend, prices grew faster.
Had the Fed been targeting nominal income, misidentifying the shock would have been of little consequence. The positive demand shock would have pushed nominal spending above target, forcing the Fed to contract.
Had the Fed committed to a symmetric average inflation target, it is unlikely that they would have waited so long to contract. A symmetric average inflation target would have required the Fed to make up for above-target inflation. The further inflation rises above target, the more the Fed will have to contract. In order to avoid a large contraction, Fed officials would have likely begun contracting much sooner.
In both cases, it is relatively straightforward to communicate the policy—certainly easier than trying to explain a confusing asymmetric makeup policy.
Instead of introducing a new framework, the Fed has returned to the familiar. But the FIT approach has known problems. It does not anchor inflation expectations very well. And it does not discourage the Fed from responding to supply shocks. A symmetric average inflation target or nominal income level target would have been an improvement on these margins. Instead, we got old wine in new bottles. Expect the next major economic disruption to leave a sour taste in your mouth.