A commenter recently asked me about my criticism of Fed policy during 2021. During that year, I was not particularly critical of Fed policy. So is it fair for me to now suggest that Fed policy was too expansionary during 2021? The answer is yes, but clearly that requires some explanation.
When the Fed announced its new policy of flexible average inflation targeting (FAIT) back in August 2020, I saw the policy as an improvement over the previous “let bygones be bygones” approach to inflation targeting. I still believe that to be the case. It would have been an improvement, and indeed (as St. Louis Fed President Jim Bullard once suggested) this sort of policy would be close to NGDP level targeting.
But the Fed never implemented FAIT. Even worse, in 2021 they knew that they had no intention of implementing FAIT, at least as most people understand the term. I mistakenly assumed that the Fed intended to keep the average inflation rate close to 2%, by offsetting near-term inflation overshoots with longer run periods of below 2% inflation. I assumed they intended inflation to average roughly 2% during the 2020s.
But that’s not the way the Fed looked at things. The Fed only intended to make up for inflation undershoots, not overshoots. This asymmetric policy led to the wildly overly expansionary monetary policy of 2021-22.
Can the Fed’s mistake be excused by the “flexible” part of FAIT? No. The Fed might argue that the flexible aspect of the policy allows them to refrain from offsetting supply side driven inflation. But the rapid growth in NGDP (to a position well above trend) makes it clear that supply shocks were not the primary problem—the Fed allowed far too rapid growth in aggregate demand. If there are not even willing to offset demand overshoots, then “average” inflation targeting means nothing.
Economists like Bob Hetzel and Tim Congdon correctly saw that the Fed had no intention of giving up discretion, and was engaged in an overly expansionary monetary policy. I naively assumed that they were sincere about targeting the average inflation rate.
You might wonder if it is important to determine why I was wrong about Fed policy. The point is not to allocate reputation points—I lose points there regardless of why I was wrong. The point is to learn from mistakes and improve policy going forward. Thus suppose the Fed had adopted the policy I favored, and then things turned out poorly. In that case, I might want to begin advocating a different approach to monetary policy. But that’s not what happened here. The Fed refused to adopt average inflation targeting, and it made a serious policy error precisely because it failed to do average inflation targeting. The events of 2021-22 make me even more firmly convinced that FAIT would be a big improvement over discretionary inflation targeting. It’s a pity it was never tried. (NGDP level targeting would be still better.)
People often ask me whether I favor higher or lower interest rates. I’m not in the business of guessing where interest rates should be, and prefer that rates be set by the market. Unfortunately, the Fed has decided to use short-term interest rates as an instrument of monetary policy. In that case, the Fed uses rate cuts as a signal of expansionary intent, and rate increases as a signal of contractionary intent. In that environment, I might occasionally suggest a rate change when policy is obviously off course. But I don’t have any overall view on where interest rates should be. I’m in the business of offering advice on monetary regimes, not interest rate setting.
If the Fed has a proper monetary regime in place (as I wrongly assumed they had in 2021), then you probably won’t find me criticizing the Fed’s interest rate setting. In the case of 2021, my fundamental error was not in misjudging where interest rates should be, it was in assuming that the Fed was targeting the average inflation rate. For that reason, “Monday morning quarterbacking” on my part is entirely appropriate. The Fed should have done better. Under an actual policy of flexible average inflation targeting, the big inflation overshoot of 2022 would never had occurred, as markets would have preemptively pushed up long-term interest rates in 2021.
As an analogy, consider two types of errors that a ship captain might make. First, they might set the steering wheel at a position that leads the ship to miss its target port–say New York. Second, the captain might be secretly steering the ship toward Boston when they were supposed to be aiming for New York. In 2021, the Fed made the latter error. It wasn’t so much that they set rates at the wrong level to achieve 2% inflation during the 2020s, the deeper problem is that they abandoned the commitment for inflation to average 2% during the 2020s.
I’m in the business of suggesting the proper port to aim for, not second guessing how the captain should handle the steering wheel.
READER COMMENTS
Spencer
Jan 15 2023 at 11:29am
re; “the Fed allowed far too rapid growth in aggregate demand”
AD = M*Vt not N-gDp. The growth in M exceeded any prior outlier. And Vt accelerated in historical proportion to the surge in M. That lead to the June top in inflation.
Garrett
Jan 17 2023 at 4:51pm
AD = M*V = P*Y = NGDP
Andre
Jan 15 2023 at 11:58am
“I mistakenly assumed that the Fed intended to keep the average inflation rate close to 2%, by offsetting near-term inflation overshoots with longer run periods of below 2% inflation.”
If we get a couple of years of 10% inflation, how is the Fed supposed to stick to FAIT? What does the ‘corrective’ inflation path (to bring the average back to 2%) look like?
Scott Sumner
Jan 15 2023 at 1:37pm
The point is to prevent that from occurring with FAIT. But yes, it would require an extended period of below 2% inflation, if they are serious. But even with NGDP level targeting, the same dilemma applies. If it’s 10% in one year, then you need some painful undershooting going forward. So don’t overshoot so strongly!
Michael Rulle
Jan 22 2023 at 10:57am
Also, FAIT would greatly diminish the probability of 10% inflation precisely because your point. Powell spelled out his FAIT plan as his term was coming to an end and he was certainly concerned about being reappointed. Maybe that is why he lied (or was unbelievably unaware of what he was doing)—although it made no sense. I will never figure out Powell as he completely changed his way of thinking and appeared to be unaware that he did. He was a great disappointment to me as I actually believed we had a real Monetarist in charge. He plus “COVID theory” created chaos——although it does appear it might be less than I once feared.
Spencer
Jan 15 2023 at 12:53pm
Treasury-Federal Reserve collaboration like in 2020-2022 reflected the abolition of the 1951 Treasury-Federal Reserve Accord.
Travis Allison
Jan 15 2023 at 1:47pm
If the Fed were to only offset only demand side inflation, how would the Fed determine which part is supply side inflation and which part is demand side? The only way I can think of is use NGDP. So the Fed couldn’t use the PCE as a target.
Scott Sumner
Jan 16 2023 at 12:50pm
Yes, I believe NGDP is a good indicator, at least in the short run. If they wish, they can focus on PCE inflation in the very long run.
Warren Platts
Jan 15 2023 at 9:36pm
There can be important strategies when it comes to steering as well. A few years ago I had a job geosteering horizontal gas wells in the Marcellus formation. A very stressful job because you got a $3 million well riding on your decisions.
You can be drilling along nicely in the designated target zone, but it then becomes apparent that you’ve drilled out of the target zone. But it may not be immediately clear whether you are above or below your target. The problem is you’ll never be right 100% of the time. You will make mistakes; thus the task is to make the right mistakes, if that makes any sense.
For example, say you’re fairly sure you’re above the target. Do you steer down? Well, that’s what you should do if you KNOW you’re right. But what if you’re wrong? Then you very well could drill down into the Onodgaga limestone, which is the death zone. At that point they either have to pull out of the hole, cement back & redrill, or else give up a significant percentage of the eventual production. Either way it’s very expensive mistake.
In such situations, it’s sometimes better to go against your better judgement & steer up just in case you’re unknowingly drilling down into the death zone. If you steer up & you’re wrong, the error will soon become manifest, but no serious damage will have been done & then you can recorrect to get back down to the target.
I think maybe that’s sort of what the Fed people might have been thinking. If you err on the side of creating too much inflation, that would soon become evident & then they can steer back down. But if they erred in the other way, a major recession might have ensued.
Scott Sumner
Jan 16 2023 at 12:52pm
Too much inflation can also cause recessions. They key is stability–minimize errors in either direction.
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