Two Federal Reserve officials highlighted the benefits of an approach to monetary policy called average inflation targeting, which would entail accepting overshoots of the central bank’s 2 per cent price goal to make up for times when inflation was too low.
San Francisco Fed President Mary Daly and John Williams, who preceded her in that role before shifting to run the New York Fed last year, both mentioned the tactic during presentations at a conference in New York sponsored by the University of Chicago’s Booth School of Business. The event is previewing themes that will dominate a year-long review of the Fed’s policy framework that kicks off in Dallas on Monday.
A paper presented at the conference explored the interaction between wages, tight labor markets and inflation and concluded that the so-called Phillips Curve, which describes this relationship, was dormant but not dead. Policy makers agreed, but stressed that the risks to their inflation goal was also one of public belief after a long period of undershooting 2 per cent.
“Inflation expectations matter more now,” Daly said in her presentation. “Inflation has been below our target” for a long time. The central bank must make sure “that people understand this is a symmetric goal and that we need to make sure that we hit it on average. This is another thing that is important.”
Fed Vice Chairman Richard Clarida, among six U.S. central bankers speaking publicly at the conference on Friday, also stressed the importance of well-anchored inflation expectations and spelled out that retaining the 2 per cent target was a “given.”
“Persistent inflation shortfalls carry the risk that longer-term inflation expectations become poorly anchored,’’ he said in remarks, noting that average inflation targeting would be among the options reviewed by the Fed this year without saying if he was a fan.
The concept of average inflation targeting is a relatively new conversation within the U.S. central bank. Under previous Chair Janet Yellen, officials treated inflation misses as “bygones” and did not commit to making them up with an overshoot to average 2 per cent over time. The Fed though did spell out in its policy goals that the target was “symmetric.”
The Fed’s preferred price index has averaged 1.5 per cent since the economic expansion began in June 2009. The most recent 12-month reading was 1.8 per cent for November at a time when the unemployment rate is just 4 per cent and wages are gradually rising.
Fed officials are concerned the persistent miss is starting to erode expectations. Williams showed slippage in three different such gauges and said that “this persistent undershoot of the Fed’s target risks undermining the 2 per cent inflation anchor.”
He stopped short of recommending average inflation targeting in his prepared comments. But under questioning from the audience, he noted that in order to average 2 per cent over a number of years “you are going to have to be over the target roughly half the time and under it roughly half the time. ”
Inflation undershoots are more likely now than in the past because a variety of factors. Population aging and diminishing risk appetites have contributed to a decline in the so-called neutral rate of interest which neither slows nor speeds up growth. That in turn increases the likelihood the Fed will run again into the so-called zero-lower bound, when interest rates are cut to zero before they can sufficiently stimulate a slumping economy and prevent inflation from falling below its target.
For that reason, Williams said, “something like an average inflation targeting” would help achieve the target over time. “During downturns when policy is constrained inflation will be a little low. During times of economic expansion and booms, like today, inflation would be expected to be above 2 per cent,” he said.