05-19-2025
In August 2020, the Federal Reserve adopted a new operating framework called Flexible Average Inflation Targeting, or FAIT. This indicated that the Fed would aim to achieve an average PCE inflation rate of 2 percent “over time.” When the Fed adopted FAIT, the problem faced by the Fed was that they had been consistently missing their 2 percent inflation target – on the low side. As I discussed in an earlier post, the adoption of FAIT may have delayed the Fed’s decision to increase its policy rate as inflation rose in 2021.
The Fed is conducting another framework review and FAIT may be dropped or modified. However, if the Fed continues to embrace FAIT, that has implications for its conduct of monetary policy over 2025. In a “twist of FAIT,” the Fed is still missing its 2 percent inflation objective, but it is now on the high side. While the Fed has not defined what it means by “over time,” five years seems like a reasonable time window for the Fed to hit its inflation target on average.
The chart below shows the backward-looking five-year compound average PCE inflation rate beginning in August 2020 when FAIT was adopted. By June of 2021, the five-year average PCE inflation rate had risen back to the target of 2 percent. Since then, the five-year average has continued to rise, reaching 3.91 in February 2025. It edged down slightly to 3.89 in March of 2025. This means that the Fed has been missing its five-year FAIT target for the past 21 months. In addition, the current miss of 1.89 on the high side is more than three times larger than the earlier miss of 0.52 on the downside when FAIT was adopted.
The Fed adopted FAIT to help anchor long-term inflation expectations. The concern over inflation expectations is even more important today. The danger now is that inflation expectations may drift above 2 percent, complicating the Fed’s effort to lower inflation. In addition, the current tariffs — to the extent that they remain in place — act like an adverse supply shock to the economy.
When dealing with an adverse supply shock, the Fed has to decide whether it is more important to pursue its price stability mandate or its maximum sustainable growth mandate. It can’t support both sides of its dual mandate at the same time. In this scenario, a decision to support growth will exacerbate inflation pressures. A decision to support price stability will exacerbate the growth slowdown. Which side of its mandate should the Fed prioritize?
Given its recent poor performance on inflation as evidenced by its FAIT track record, the Fed has to remain focused on the price stability side of its dual mandate. This is the only way to keep inflation expectations from becoming unanchored. In addition, unless the Fed in its framework review is willing to throw FAIT to the wind, (regardless of the tariff outcome) its near-term goal is not to bring PCE inflation down to 2 percent, but instead to bring its FAIT average down toward 2 percent. This means aiming to undershoot 2 percent inflation. An implication is that in benchmarking the stance of monetary policy using a Taylor rule, a number less than 2 percent should be used to calculate the inflation gap. This means that monetary policy needs to be more restrictive than if the Fed was achieving its FAIT target.
Markets are pricing in two 25-basis point cuts in the Fed’s policy rate over 2025. While this number of cuts is down from earlier projections, these expectations don’t line up with the primary task at hand for the Fed over this year. It’s important for the Fed and markets to get on the same page.
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. He regularly contributes insightful posts about financial markets to Daniels Insights.
