What Goes Up Must Come Down

Ramesh Ponnuru did an excellent job explaining how monetary policy went off track in 2021. The Fed did a good job of stimulating the economy during 2020, which led to a fast recovery. In 2021, however, the Fed overstimulated the economy, leading to excessively high inflation. The key error, in my view, was the Fed’s asymmetric interpretation of its policy of flexible average-inflation targeting.

During 2020, inflation actually ran well below the Fed’s 2 percent target rate, as a weak economy led to falling commodity prices. Some catch-up inflation was appropriate in 2021, to promote a faster recovery. But the logic behind average-inflation targeting is symmetrical and suggests that periods of inflation above 2 percent should be followed by periods where inflation runs below 2 percent.

In 2021, Fed chairman Jay Powell should have emphasized that any near-term inflation overshoot would be followed by a period of below–2 percent inflation, so that the average inflation rate would remain close to 2 percent for the 2020s as a whole. Instead, he made it quite clear that the Fed’s averaging approach applied only after inflation undershoots.

The logic behind average-inflation targeting is quite powerful. It is not just a question of making up for past mistakes; a commitment to average-inflation targeting makes the initial deviation from the 2 percent–target path smaller than otherwise. If inflation starts to rise above 2 percent, then financial-market participants will drive interest rates higher in anticipation of future Fed actions to push inflation down below 2 percent. These rate increases will immediately slow spending, thus preventing the economy from overheating as much as it would without that policy commitment. Without a symmetric approach to average-inflation targeting, the Fed’s policy will have an inflationary bias.

Scott Sumner Ralph G. Hawtrey Chair of Monetary Policy Mercatus Center at George Mason University

Correction

The Week (June 13) asserted that Joshua Katz, then a professor of classics at Princeton, wrote a controversial article that was published in the Wall Street Journal. In fact, it was published in Quillette.