12-10-2024
As William Shakespeare conveyed in The Tempest, sometimes to appreciate our current situation we need to revisit how we got here. This is true in life and also in monetary policy.
An important milestone for the Federal Reserve was January 2012 when it issued its “Statement on Longer-Run Goals and Monetary Policy Strategy.” In this framework, the Fed announced that the Personal Consumption Expenditures (PCE) deflator was its preferred inflation measure and that it interpreted its mandate of “stable prices” to mean a PCE inflation rate of 2 percent. This framework provided markets with more clarity on how the Fed would measure its success at meeting the inflation side of its dual mandate. The hope was that the framework would also help to “anchor” inflation expectations at the Fed’s long-run goal.
The next 8 ½ years were a challenge for the Fed in terms of living up to its commitment to have PCE inflation average 2 percent. The figure below shows the Dallas Fed Trimmed Mean inflation rate in this period after the framework announcement. I use the Trimmed Mean as it is a better measure of the underlying trend inflation.
With the exception of the second half of 2019 and the first half of 2020, trend PCE inflation was consistently below the Fed’s 2 percent target. The average for the 8 ½ years was 1.75 percent.
The Fed announced that in 2019 it would undergo a framework review. The concern was that under its current operating guidelines the Fed may continue to undershoot its inflation target. If this persisted, there was the risk that long-run inflation expectations would drift below 2 percent, making the Fed’s job of hitting its target even more difficult. In addition, the Committee believed that the long-run neutral policy rate had declined from 4.25 to 2.50 percent over the period since its framework was announced. This meant that the Fed would have less running room to cut rates if the economy needed easier monetary policy.
On August 27, 2020, the Fed unanimously approved a revised framework. A key element of the revision is the following:
“In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods where inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to anchor inflation moderately above 2 percent for some time.”
The Committee did not elaborate on how much above 2 percent is consistent with “moderately” or how long a period of time is consistent with “some time.” This new approach was called “flexible average inflation targeting.”
So, as Covid-19 took a grip on the U.S. economy, the Fed was concerned about persistently missing its inflation target — on the low side — and willing to allow inflation to run above 2 percent in order to offset the earlier inflation underruns.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
