Fed takes inflation more seriously

This week Federal Reserve Chairman Jerome Powell asserted that interest rates would remain low for three more years, in keeping with a new policy that allows for temporary periods of above 2 percent inflation.

Has the Fed raised its inflation target? Not really. But you'd be forgiven for believing so. The new Fed policy can more accurately be described as an increased determination to implement its 2 percent target, as well as an implicit acknowledgement of past Fed mistakes.

Here is what actually happened: Back in 2012, the Fed set an explicit 2 percent inflation target, after informally targeting that rate for several decades. During the 2010s, however, the inflation index used by the Fed (personal consumption expenditure, or PCE, inflation) averaged only 1.5 percent. The newly announced policy, dubbed "average inflation targeting," is aimed at assuring that the Fed actually achieves its 2 percent target, on average, over the long run.

Thus, the Fed did not raise its inflation target, rather it adopted new procedures aimed at avoiding a persistent undershoot of its target.

The previous failure to hit the long-run 2 percent inflation target was caused by two distinct problems, both of which were addressed by Powell in a recent speech.

First, the Fed will no longer let bygones be bygones when it misses the target. Instead of always aiming for 2 percent inflation in the short run, it will intentionally allow temporary over- or undershoots as needed to make up for past misses. This week, the Fed endorsed Powell's policy initiative, with a decision to keep interest rates near zero and allow the economy to run hotter than the previous policy would have allowed.

Second, the Fed will rely less on Keynesian "Phillips Curve" forecasting models, which in turn rely on the theory that inflation is caused by tight labor markets. Those models did poorly in the late 2010s, when even 3.5 percent unemployment did not trigger higher inflation. Instead, the Fed will refrain from tightening monetary policy until there are clear indications that inflation is rising.

This new policy approach occurred after a long review process, necessitated by the challenges created by a zero-interest rate environment during the Great Recession, similar to the challenge it faces today. Prior to 2008, the Fed could pretty easily keep inflation close to 2 percent by adjusting its interest rate target up or down. Once interest rates fell to zero, however, the Fed had to rely on alternative policies such as quantitative easing. Fed officials were reluctant to pursue these policies too aggressively, and hence inflation fell short of 2 percent during most of the recovery from the Great Recession.

Academic studies suggest that average inflation targeting can make Fed policy more effective at zero interest rates. The basic idea is that if financial markets understand that the Fed will allow future inflation to overshoot 2 percent during a recovery to make up for below-2 percent inflation during a recession, then the real cost of borrowing during recessions will be lower. (Recall that the "real" interest rate is the market rate minus inflation expectations. Raise inflation expectations and you reduce the perceived real cost of borrowing.)

The Fed is a cautious institution, and academic studies alone do not motivate major changes in its policy. Jay Powell was also powerfully influenced by the Fed's failure to achieve sustained 2 percent inflation during the later 2010s. The Fed had relied on Phillips Curve forecasting models when it began raising rates in late 2015, and those models - which suggested that higher inflation was imminent - proved to be flawed.

By 2019, when the Fed cut rates despite a booming economy, Powell was already beginning to move away from an academic model-based policy and rely more on market forecasts of the economy.

One can view the new policy as the Fed admitting that it erred in raising rates in late 2015. Powell's pragmatic understanding that the Fed's models had proved inadequate made him receptive to economists who had argued that the 2015 rate increases were a mistake - albeit because they advocated targeting average inflation rates, a policy where inflation is allowed to run hot to make up for periods where inflation undershoots 2 percent.

Perhaps this analogy would help to clarify the two factors motivating the policy shift. A driver puts too little pressure on the accelerator pedal when driving up a steep hill. One passenger says the driver underestimated the steepness of the hill, while another passenger suggests the driver overestimated the power of the engine. Perhaps both were correct.