In the first of a series of reports examining how the Fed’s framework and toolkit may evolve in the coming years, we look at potential changes to the Fed’s current inflation target. After watching inflation average less than 2% over the past two decades, officials would like to see it run slightly higher in order to provide more space to cut real interest rates during future recessions. To facilitate 2% inflation on a more sustained basis, Fed officials are assessing the merits of average-inflation targeting or price-level targeting. With past misses on inflation no longer treated as “bygones,” actual inflation and inflation expectations should run higher. As a result, nominal interest rates should be higher, the yield curve should steepen and the dollar should depreciate, all else equal.
Monetary Policy Review Underway at the Fed
By most measures, the current economic expansion in the United States, which is currently in its tenth year, is on solid footing. Nevertheless, officials at the Fed are starting to think about strategies to better achieve its dual mandates of price stability and maximum employment throughout the business cycle, and to combat future downturns.
For example, Richard Clarida, the Vice Chairman of the Federal Reserve Board, discussed the Fed’s ongoing review of its policy strategy and tools in a recent speech.1 Clarida noted that the “neutral” interest rate (so-called r*) appears to have fallen in the United States over the past decade or so. In that regard, the mid-point of the Fed’s target range for the fed funds rate is only 2.38% at present, and it appears that the Federal Open Market Committee (FOMC) may be nearing the end of its tightening cycle, if it has not been reached already. With only 200 bps or so of room to cut rates, would the Fed have enough traditional “ammunition” to combat the next recession?
The limited capacity to stimulate growth is unlikely to be an issue unique to the current business cycle. In this series of reports, we will look at some of the new strategies and policy tools that the Fed may employ in the future as well as the implications of some of those potential changes. Future reports will analyze negative interest rates, renewed asset purchases (i.e., quantitative easing) and the Fed’s output gap framework. We should stress that the strategy review at the Fed is ongoing, and that the FOMC has not yet made any changes to its monetary strategy or policy toolkit. But we think it is prudent to discuss some potential changes to the way the Fed may operate going forward so that readers are prepared for those changes if and when they occur.
Is the Fed’s Current Inflation Target “Broken”?
The United States Congress has tasked the Fed with a mandate of promoting “stable prices,” although Congress did not explicitly define the term. Congress also gave the Fed the goals of “full employment” and “moderating” long-term interest rates. In contrast, the government of New Zealand in 1989 gave its central bank a single mandate of an explicit inflation target (midpoint of a 1% to 3% target range), and governments in Canada and the United Kingdom gave their respective central banks similar inflation targets in the following decade. The Fed did not adopt an explicit inflation target of 2% until 2012.2
Broadly speaking, the proliferation of inflation targets for central banks at the end of the 20th century was for the most part a means for them to bring inflation lower. The pioneers of explicit inflation targeting, including governments in New Zealand, Canada and the United Kingdom, introduced inflation targeting during periods when inflation was high and authorities wanted to reduce it. An explicit target was thought to demonstrate a central bank’s commitment to low inflation and improve its ability to do so by reining in inflation expectations. For the most part, central banks–the Federal Reserve included–were successful in their efforts to reduce inflation from the rates that prevailed throughout the 1990s and the early years of the current century.
But some observers could reasonably argue that central banks have been too successful in reducing inflation. In the wake of the Great Recession, the risks to “stable prices” have generally been skewed toward mild deflation rather than unacceptably high inflation. For example, CPI inflation in Japan has averaged just 0.5% even though the Bank of Japan currently has a “price stability” target of 2%. The primary objective of the European Central Bank is “price stability,” which it defines as an inflation rate that is “below, but close to, 2% over the medium term.” Yet the core rate of CPI inflation, which is a good measure of underlying inflationary pressures in an economy, has not been “close to” 2% for a decade (Figure 1). In the United States, core PCE inflation has been running below the Fed’s 2% target for almost the entirety of the current cycle and has averaged just 1.6% since the end of the Great Recession (Figure 2).
An extended undershoot of a central bank’s inflation target can lead to depressed inflationary expectations that can make it difficult for the central bank to raise the realized inflation rate. The practical issue of depressed inflationary expectations and abnormally low inflation is that it limits the central bank’s ability to reduce real interest rates to stimulate economic activity during a downturn. A central bank can run out of conventional “ammunition” when its policy rate nears the effective lower bound (ELB) near 0%. Consequently, the Fed’s policy review is intended to identify ways to strengthen its credibility in generating 2% inflation over the business cycle and give the FOMC more recession-fighting capability when future downturns arrive. We now turn to four potential changes that the Fed could make to its inflation target.
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