The Fed and Inflation: Wrong on Average

Q uick as a flash, the Federal Reserve switched from dovish to hawkish on inflation. The Fed initially planned to wind down bond purchases by June of 2022 and raise its interest-rate target later that year. Now, the central bank says its balance sheet will stop growing in March, with rate hikes to follow shortly thereafter. The Fed’s willingness to make drastic changes in the face of new inflation data is encouraging.

But we’re not out of the woods yet. The Fed still hasn’t solved a more fundamental problem than inflation: its own lack of credibility. Markets could be in store for a bumpy ride, and the Fed’s comparatively new “average” inflation target is to blame.

The Fed’s congressional mandate is full employment and stable prices. Our central bank’s most recent interpretation of “stable prices” is average inflation targeting, which it adopted in August 2020. This means the Fed shoots for a long-run average inflation rate of 2 percent. If it undershoots some years, it’s supposed to overshoot in others, and vice versa. This strategy looks great on paper. In practice, it’s a recipe for irresponsible monetary policy.

Here’s the theory. Market participants can do the best for themselves and for the economy when they can predict the dollar’s long-run purchasing power. If I know what the price level will be in 30 years, I’m more likely to write long-term contracts today. If the central bank doesn’t promise to correct its errors — if it allows inflation to run below 2 percent for a long while, as the Fed did in the decade after the 2008 financial crisis — then money’s purchasing power can diverge markedly from my expectations. That’s bad for planning. But if the Fed promises to average out its mistakes, then I can be much more confident about the dollar’s future value. This confidence is a prerequisite for long-term investments, and hence robust economic growth.

The problem is central bankers are human beings, not computers. (More’s the pity.) Average inflation targeting only works if markets believe the Fed will overcorrect after good-faith mistakes. But this is a heroic assumption. Do we really think, to correct for the current bout of high inflation, the Fed will purposefully tighten monetary policy to deliver below-target inflation in the years ahead? Political realities nix that option. Central bankers who tried would find themselves reprimanded by cranky politicians whose electoral cycles coincided with the requisite tightening. As Jerry Jordan and William Luther write in an American Institute for Economic Research study, “The United States ranks in the bottom quartile of countries on several measures of central bank independence.” Congressional committees can pillory monetary policy-makers during hearings and threaten the Fed with legislative inconveniences. Given House Financial Services and Senate Banking regularly feature testimony by central bankers, and Congress has amended the Federal Reserve Act more than 200 times already, these aren’t idle threats.

But our problems are bigger than partisan politics. Average inflation targeting gives the Fed wiggle room to evade responsibility. Despite the policy change, the Fed hasn’t specified a benchmark trajectory for the price level, against which its performance can be judged. Before we can say whether the central bank is doing a good job, we need to know, “Average, compared to what?” Don’t expect the Fed to come clean about this. Bureaucrats — including central bankers — are no friends of concrete evaluation metrics. As long as the Fed keeps markets guessing about the trajectory of money’s purchasing power, it can maintain plausible deniability. In response to abnormally high inflation, monetary policy-makers can reply: “Our policy’s not wrong. We’re just making up for periods of low inflation!” This matters because we can’t predict how strongly the Fed will push back against dollar devaluation. The most likely outcome is the Fed lowers inflation in the neighborhood of 2 percent, while being cagey about how much — or whether — they need to make up for surging prices in 2021.

Three Fed economists go hunting. They spot a buck and shoot. The first misses a foot to the left. The second misses a foot to the right. The third whoops with joy, “All right! We got him!” Expect a similar triumphant announcement from the Fed, despite the fact it’s never told us what it’s trying to hit. Average inflation targeting means never having to say you’re sorry. Small wonder central bankers like it.