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Why average inflation targeting matters

Summary:
The FT has a new piece by Gavyn Davies discussing the possibility (likelihood?) that the Fed will soon adopt average inflation targeting. To see why it matters, consider the Fed’s current policy stance under two scenarios: 1. Inflation targeting: The Fed should probably cut rates, but it’s debatable.2. Average inflation targeting: The Fed should cut rates, and it’s not even debatable. Those two cases might not look so different. But it just so happens that the Fed has opted not to cut rates right now, even though it’s likely that a rate cut is appropriate. So Fed policy would change if we switched to average inflation targeting. Jay Powell hinted at this in his recent press conference: Over time, an average inflation targeting framework would be different than our current

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The FT has a new piece by Gavyn Davies discussing the possibility (likelihood?) that the Fed will soon adopt average inflation targeting. To see why it matters, consider the Fed’s current policy stance under two scenarios:

1. Inflation targeting: The Fed should probably cut rates, but it’s debatable.
2. Average inflation targeting: The Fed should cut rates, and it’s not even debatable.

Those two cases might not look so different. But it just so happens that the Fed has opted not to cut rates right now, even though it’s likely that a rate cut is appropriate. So Fed policy would change if we switched to average inflation targeting. Jay Powell hinted at this in his recent press conference:

Over time, an average inflation targeting framework would be different than our current framework in the sense that it wouldn’t be—there would be some aspect of trying to make inflation average 2 percent over time, which means if it runs below 2 percent for a time it has to run above to bring the average. So, that is a different framework. Our current framework is one where we say, we or would be equally concern with deviations of inflation from target on either side. But that isn’t—that doesn’t suggest an intention specifically to have those deviations be symmetric. In other words, that would—consistent with—that would be having all the deviations to be on one side, which is what we’d had actually. So I think it is a change in framework, and over time it would lead to a different approach to policy.

Let’s assume that Jay Powell is frustrated with the persistent undershooting of the Fed’s 2% inflation target and wants to do something about it.  But a substantial portion of the FOMC believes current policy is appropriate because inflation is only modestly below 2% and with a strong economy is likely to rise over time.  The policy hawks also believe that lower rates could trigger excesses in asset markets.  So the Fed is standing pat for the moment.

Switching to average inflation targeting would be a way of forcing the Fed’s hand.  FOMC members could no longer say we are only slightly below the inflation target and likely to hit the target in the near future.  This would push the Fed toward a more expansionary policy stance.

If the Fed does adopt average inflation targeting this summer, it will be a good indication that the Fed thinks money is currently too tight.  This action would likely be linked to an easing of monetary policy.  Trump continues to be very lucky.

PS.  I am seeing a surge in articles discussing the unusually long business cycle expansion.  In the future, we will see many more such articles and  people will cite factors such as a lack of financial crises.  Actually, there were 9 recessions from 1945 through 1982, and virtually no financial crisis.

Once I’m gone I hope you’ll remember that I was the one who said business cycles would become much less frequent in the future, and I told you why.  The others will attribute the lack of recessions to good luck, but then they never saw it coming.

PPS.  Judy Shelton has been nominated for a position at the Board.  She shares the same weaknesses as the earlier Moore and Cain nomination.  She switched from being very hawkish during the period of high unemployment in the early 2010s to being very dovish today when unemployment is low.  Beside those three, the only other person I know who made that switch was Donald Trump.  Hmmm.. .

In defense of Shelton, in 1994 she correctly pointed out that FDIC was likely to create reckless lending by banks:

Shelton’s views on the Federal Deposit Insurance Corporation have also drawn criticism. In her 1994 book, “Money Meltdown,” Shelton advocated for ending federal deposit insurance, which most economists credit with restoring faith in the banking system following the Great Depression. Shelton called it a government subsidy that distorted financial markets. “Depositors no longer have to make judgments about the competence of bank management or the characteristics of the loan portfolio,” she wrote.

In my view, FDIC was the number one cause of the 2008 financial crisis (with the exception of monetary policy).  Unfortunately, I expect her to backtrack on this issue in the upcoming confirmation hearings.  Her answer to this question will determine whether I support her nomination.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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