How will we know if average inflation targeting is working?
By Scott Sumner
The Fed recently decided to switch to average inflation targeting, which means making up for past misses of its 2% inflation target by allowing temporary over or undershoots of inflation. So how will we know if it’s a success?
I see two key criteria:
1. Does the new policy result in roughly 2% inflation over the long run?
2. Does it address the dual mandate by making inflation less cyclical?
For example, during the 2010s, inflation mostly ranged from 1% to 2%, averaging about 1.5%. Under the new policy, you could imagine inflation ranging from 1.5% to 2.5%, averaging 2%. If that’s all that changed, and inflation remained exactly as cyclical as before, that would count as a policy success.
Now suppose that under the new policy, inflation ranged from minus 2% in recessions to plus 6% in booms, averaging 2%. In that case, they would achieve their first objective and fail at their second objective. Recall the guy who drowned in a lake that averaged 3 feet in depth.
On the other hand, inflation volatility is not necessarily bad if it is associated with more stable NGDP growth. After all, the Fed’s dual mandate implies that inflation should be above 2% during recessions and below 2% during booms, which is also an implication of NGDP targeting.
Thus the second criterion might be reframed as:
2. Does average inflation targeting make NGDP more stable?
As long as NGDP does not become more unstable, then raising the average inflation rate from 1.5% to 2% would count as a win for the Fed. After all, 2% is their target.
[Of course there’s an interesting separate question of whether 2% is the right figure, or whether they should be targeting inflation at all. FWIW, I believe 2% is reasonable, but I don’t like having any inflation target. I’d prefer an NGDP target.]
To summarize, the effectiveness of average inflation targeting will depend on how it is implemented. If the Fed is serious, it shouldn’t be difficult to move average inflation closer to 2%, at least relative to the 2010s. The trickier problem is to also make NGDP more stable, or at least no more unstable than before. The Fed’s job would have been easier if it had opted for price level targeting, but they are extremely conservative when making policy changes. One tiny step at a time.
PS. Commenter Garrett suggested that the Fed should now invest in long-term inflation swaps, a market that is now forecasting below 2% inflation. Does anyone know a reason why that’s a bad idea? It’s rare where you can bet on something where you control the outcome of the bet.
PPS. You might think the Fed could profitably bet on interest rates as well. Contrary to popular opinion, however, the Fed has little control over interest rates. Indeed if they successfully target inflation at 2%, then they have no control over interest rates (which become “endogenous”.) Inflation is different—the Fed really does control inflation.