So long as the Fed leaves markets guessing, inflation expectations will continue to rise.
So long as the Fed leaves markets guessing, inflation expectations will continue to rise.
S eptember marked the fifth consecutive month of inflation at or above 4 percent. The Personal Consumption Expenditures Chain-type Price Index (PCEPI), the Fed’s preferred measure of the price level, grew 4.4 percent from September 2020 to September 2021. PCEPI inflation has averaged 2.98 percent on an annual basis since January 2020, just prior to the pandemic.
Fed officials and many economists have pointed to temporary supply constraints to explain the recent uptick in inflation. The supply constraints are real. And the Fed’s average-inflation targeting framework permits prices to rise above trend during such temporary anomalies. But that doesn’t mean all is well. Indeed, the Fed’s failure to communicate how long it will tolerate inflation exceeding 2 percent risks setting an expectations trap.
Average-inflation targeting has at least two potential advantages over traditional inflation targets, whereby the central bank aims for a specific rate of inflation — say, 2 percent — each period. If a collapse in nominal spending brings inflation below 2 percent, an average-inflation-targeting central bank must not only bring inflation back to 2 percent, but also let it run above target until prices reach their pre-recession trend levels. If the central bank has anchored expectations on its target, it might prevent — or, at the very least, mitigate the severity of — a recession by promptly restoring the price level to its 2 percent growth path. Under a traditional inflation target, the same nominal-spending shock would push prices below what had been expected, reducing production and employment as a consequence.
If supply constraints temporarily undermine our ability to produce some goods or services, an average-inflation-targeting central bank might permit the price level to rise by more than 2 percent to reflect the greater scarcity. It need not insist on hitting 2 percent each period, by means of a painful monetary contraction, as it would under a traditional inflation target. It must only ensure inflation is equal to 2 percent on average. When supply disruptions subside, and our ability to produce improves, prices will fall — offsetting the above-average inflation previously realized.
The Fed officially adopted its average-inflation target in August 2020, after much deliberation and a series of town-hall meetings. “In order to anchor longer-term inflation expectations,” its Statement on Longer-Run Goals and Monetary Policy Strategy explains, “the Committee seeks to achieve inflation that averages 2 percent over time.” The statement does not, however, specify the length of time over which the Fed typically aims to hit its average-inflation target. And Fed officials have not yet clarified how long they will allow inflation to remain elevated.
Although high inflation in the face of supply constraints is consistent with the Fed’s average-inflation target, it is also consistent with a much less sanguine prospect: that the Fed will permit elevated inflation long after the current supply issues have been resolved. This ambiguity, when coupled with the Fed’s lack of clarity regarding the period of time over which inflation is likely to remain elevated, risks setting an expectations trap.
Without a clear statement from the Fed, market participants are left guessing as to when inflation will fall. As inflation remains elevated month after month, market participants gradually revise their beliefs from “the Fed is committed to its 2 percent average inflation target” to “the Fed has abandoned its 2 percent average inflation target.” As they do, expectations of future inflation rise.
Inflation expectations have already begun to rise in bond markets. The difference between traditional and inflation-protected Treasuries, known as the breakeven inflation rate, averaged 2.50 and 2.34 percent over the five- and ten-year horizons from July 1 to October 1, 2021. On November 1, bond-market participants were pricing in around 2.86 percent average inflation over the next five years and 2.50 percent average inflation over the next ten years.
If inflation expectations rise above target and get priced into long-term contracts, the Fed will face a difficult decision. On the one hand, it might stick to its guns and bring the average rate of inflation back down to 2 percent once supply disruptions subside. But doing this would require undermining market expectations, likely resulting in a recession.
On the other hand, the Fed might meet market expectations where they are. By delivering a rate of inflation in line with market expectations, the Fed would avoid a painful downturn in economic activity. But it would also acquiesce to a higher average inflation rate and the higher costs of inflation associated with that rate.
The Fed should take two steps to reduce the risk of an expectations trap. First, it should more clearly state how long it will allow inflation to remain elevated in order to discourage market participants from revising their expectations upward before then. Second, it should improve its longer-run goals and monetary-policy strategy.
The Fed could improve its longer-run goals and monetary-policy strategy by clearly stating the period of time over which it aims to achieve 2 percent inflation on average. It might amend this period of time — with clear and timely statements — to reflect the particular supply or demand disturbances encountered. But it needs to establish a salient benchmark to keep market participants from making wild guesses.
A better solution would be for the Fed to replace its average-inflation-targeting rule with a nominal gross domestic product (NGDP)–level target. An NGDP-level target boasts the same advantages of an average-inflation target presented above. But, unlike an average-inflation target, it does not typically require changing the target rate each period to suit the circumstances. Under an NGDP-level target, market participants can form stable expectations about their nominal income and remain confident that higher or lower inflation will be temporary, so long as NGDP continues to grow along the Fed’s target path.
The Fed adopted its average-inflation target, in part, to anchor expectations. That does not appear to be working. If it is not careful, it will find itself in an expectations trap. It should improve its communication in the near term and its monetary-policy framework in the long term. Otherwise, Fed officials will have some very difficult decisions to make.