Does the Fed treat 2% inflation as a ceiling?
By Scott Sumner
The Fed says no.
Many Fed critics say yes.
I say that it’s too soon to say.
Let’s look at PCE inflation (the index targeted by the Fed) over the past 15 years:
Inflation has exceeded 2% in seven years and fallen short in eight years. That’s consistent with a symmetrical target. So why do critics like David Beckworth argue that the Fed treats 2% as a ceiling?
The real problem is quite recent. The Fed has fallen short of 2% in 6 of the past 7 years, and 8 of the past 10 years. My view is that the shortfall around 2009-10 was intentional, as the critics maintain. But I also believe that the more recent errors have been mistakes, and that the Fed does sincerely favor a symmetrical 2% target.
Fed critics seem to have “Occam’s razor” in their favor. Isn’t the simplest explanation that the Fed is aiming for 2% or less, rather than that they make repeated mistakes?
In fact, I believe Occam’s razor works in the opposite direction, in favor of my hypothesis. In this earlier post I pointed out that over the past decade the private consensus forecast has also consistently overestimated future inflation. My theory is that both private forecasters and Fed economists made the same mistake, relying too heavily on “Phillips Curve” models of inflation.
In contrast, Fed critics need an excessively complicated explanation:
1. The Fed has not had a low inflation bias over the past 15 years, but did adopt such a bias roughly 10 years ago.
2. Private sector forecasters consistently
underestimated overestimated inflation over the past decade for reasons unrelated to the bias in Fed policy, perhaps excessive reliance on the Phillips Curve.
3. The Fed made similar mistakes to private sector forecasters, but for completely unrelated reasons. Unlike private sector forecasters, the Fed knew they were likely to undershoot 2% inflation, but lied and claimed they were on track in order to please . . . . someone.
Many people have a lot of trouble with my claim that the Fed innocently made repeated errors in the same direction. But any theory must be consistent with the private sector forecasters making the same sorts of systematic errors. So for me, Occam’s razor points to an honest mistake being the most likely explanation for the repeated undershoot of inflation. I don’t need the three assumptions (above) that the Fed critics need for their theory.
I’ve made similar arguments over the past year or two, and also suggested that I was looking for the Fed to do a better job in the future. Despite the slightly above 2% inflation last year, I don’t believe the problem has been solved, indeed I expect inflation to again fall below 2% in 2019.
BTW, the TIPS markets have been more skeptical of the claim that 2% inflation was on the way, and the TIPS markets have thus been more accurate than either the Fed or private sector economists.