Fed: An average inflation target with maximum leeway

At the virtual Jackson Hole Symposium today, Chair Powell announced the long-expected outcome of the Fed’s monetary policy framework review. The Fed now “seeks to achieve inflation that averages 2 percent over time,” rather than 2% inflation as a fixed goal. What this means in practice is that:

“following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

(Emphasis ours.)

In some regards, the new commitment is stronger than expected, in saying the Fed would aim to achieve, not merely tolerate, inflation above 2%. However, notably lacking was a specific time horizon, or as Powell in his speech put it, “we are not tying ourselves to a particular mathematical formula that defines the average,” and that “if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act.” This leaves market participants to judge how the Fed would respond to various scenarios. Such vagueness might disappoint those who hoped for a stronger commitment to the Fed’s new goal, however it is perhaps understandable given the challenges the Fed – and central banks globally – have faced in generating inflation, and given that such an average target is still a relatively novel concept. We judge that the primary goal with this move was to raise inflation expectations, first among market participants (which respond rapidly), and ultimately among businesses and consumers (which respond much more slowly). Whether the Fed is successful or not will determine whether a stronger commitment will prove necessary in future. Indeed, the Fed has now committed to reviewing its framework every five years from now on; if it has not achieved its average 2% objective over the next five years, we are likely to see a strengthening of its commitment. For the time being, the Fed clearly wishes to keep some flexibility in how it interprets this objective.

No immediate implications for monetary policy – As Chair Powell stated at the July FOMC press conference, the change to the Fed’s longer run goals statement is more about “codifying how the Fed is already operating” rather than introducing an entirely new policy regime. In other words, monetary policy was already likely to have remained highly accommodative even after inflation recovers back to 2%. Some key unanswered questions for us are: 1) from when will this new framework apply? (i.e. will the Fed take into account the past few years of inflation undershoot?), and 2) what happens if inflation is persistently above 2% for a time – will the Fed then try to engineer below 2% inflation? We expect Powell to be pressed on these (and other) questions at the next FOMC press conference on 16 September.