Why the Fed's new inflation goal can help avoid the mistakes of 2018: Morning Brief

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Average inflation targeting really just means higher future inflation.

unveiled the Fed’s long-awaited new policy framework.

Previously, the Fed had simply targeted core inflation of 2% —measured as core personal consumption expenditures which excludes volatile components like energy and food prices — a level above which inflation has been only briefly over the last decade.

And when inflation did move above 2% in 2018, the Fed raised rates four times.

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led to a stock market selloff and raised doubts about the health of the post-financial crisis expansion. In 2019, the Fed reversed course and cut rates three times before eventually taking interest rates to 0% amid the pandemic.

said in a speech on Thursday.” data-reactid=”40″>“In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average,” Powell said in a speech on Thursday.

“Thus, our approach could be viewed as a flexible form of average inflation targeting… Of course, if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act.”

Barron’s columnist Matt Klein noted Thursday.” data-reactid=”42″>But back in 2018, the Fed thought both that inflation would remain above target for the next couple years and that by raising rates they were aiding the economic expansion, as Barron’s columnist Matt Klein noted Thursday.

said in a June 2018 press conference following a meeting of the Federal Open Market Committee. “In particular, we think that gradually returning interest rates to a more normal level as the economy strengthens is the best way the Fed can help sustain an environment in which American households and businesses can thrive.” (Emphasis added.)” data-reactid=”43″>“For the past few years, we have been gradually raising interest rates, and along the way we’ve tried to explain the reasoning behind our decisions,” Powell said in a June 2018 press conference following a meeting of the Federal Open Market Committee. “In particular, we think that gradually returning interest rates to a more normal level as the economy strengthens is the best way the Fed can help sustain an environment in which American households and businesses can thrive.” (Emphasis added.)

FOMC’s economic forecasts showed the median expectation for Fed officials pegged inflation above 2% at the end of 2018, 2019, and 2020.” data-reactid=”44″>That same day, the FOMC’s economic forecasts showed the median expectation for Fed officials pegged inflation above 2% at the end of 2018, 2019, and 2020.

noted Thursday on Twitter, in 2018 the Fed’s forecasts clearly spoke to a view that without raising rates the economy would overheat and force the Fed to aggressively and hastily raise rates later.” data-reactid=”45″>As University of Oregon economist Tim Duy noted Thursday on Twitter, in 2018 the Fed’s forecasts clearly spoke to a view that without raising rates the economy would overheat and force the Fed to aggressively and hastily raise rates later.

In essence, then, the Fed’s prior views on inflation combined with mistaken forecasts about the economy created a scenario in which monetary policy was unduly tightened. This is the kind of situation the Fed’s new framework should be able to better cope with.

interest rates are not rising anytime soon. And this new approach also outlines what the Fed expects the post-pandemic recovery will look like. Which is to say, similar to the last economic expansion.

“Chair Powell emphasized in his speech that the very low unemployment rates of the final two years of the cycle which ended this year brought great benefits to minorities, reducing inequality, and did not trigger higher inflation,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.

“The Fed is now of the view that this will be a feature of the next cycle too, so policy will not be tightened merely in anticipation of inflation which might not materialize.”

Of course, our review of the Fed’s economic expectations circa 2018 leaves something to be desired when it comes to the central bank’s forecasting ability. But the Fed’s policy map six months into this recession is now clear. Rates are staying low until inflation perks up. And once inflation starts rising — if it even starts rising — the Fed plans to be very patient to raise rates.

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