(Bloomberg Opinion) -- For over a year, all the big central banks have been reviewing their policy frameworks. The Federal Reserve recently announced the results of its deliberations at the virtual Jackson Hole symposium. Inflation targeting is to be replaced by, well, inflation targeting — or, to be more precise, by “average-inflation targeting.”
Bearing in mind that the long-run inflation target hasn’t changed — it remains at 2% — what does this amount to? Is it a damp squib, a substantive pragmatic response to new conditions, or just something to say after a highly publicized review made it necessary to come up with a fresh idea?
The difference between the old approach and the new can certainly be exaggerated. Before this change, most people, if asked whether the Fed was meeting its target of 2% inflation, would have looked at past inflation averaged over some period. In other words, the Fed’s accountability was already cast in terms of average inflation.
Nonetheless, the two approaches aren’t identical. In principle, inflation targeting continuously pursues a future inflation rate of 2%, ignoring any past deviations; average-inflation (or price-level) targeting tries to “make up” past deviations of inflation from target. In this way, average-inflation targeting provides greater certainty about the future price level. But committing in advance to make up shortfalls or overruns of inflation may result in greater volatility of employment and output. Which approach is better depends on the shocks hitting the economy and the period over which inflation can be expected to return to the long-run target.
Fed Vice Chairman Richard Clarida, who led the review, affirmed that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” This raises all sorts of questions that will be put to Chairman Jerome Powell at his next press conference. For how long, and how far, does inflation have to be below target to trigger a change in the effective target? Will the new effective target be announced? Is this new approach symmetric? Would above-target inflation lead to a tighter policy in the future in order to keep inflation below target for a while, even if this damaged real activity and employment?
Above all, there’s the question of credibility. If the Fed has tried hard and failed to push inflation up to its 2% target, why would markets believe it would succeed in going further? Olympic high jumpers who fail to clear 2 meters on their first two attempts do not then ask for the bar to be raised to 2.5 meters.
The crucial point is that tolerating inflation above or below target for a period requires an economically credible narrative to justify the policy. Inflation targeting should not be regarded as a purely mechanical response to measured inflation. For example, the Bank of England, following a depreciation of sterling’s effective exchange rate of around 25% during the financial crisis, stated that it would tolerate inflation above target for two to three years in order to accommodate a higher price level provided that domestically generated inflation did not rise. The condition was met and inflation duly returned to target. Explaining why inflation was likely to rise, and why it was sensible to accept that to avoid an even deeper recession, made the policy credible. In this case, trying to compensate for the inflation overshoot by aiming at subsequent below-target inflation would not have made sense.
The successful exercise by central banks of “constrained discretion” depends upon their ability to understand what’s driving the economy. After the financial crisis, the critique of inflation targeting was that it had failed to take into account the factors that undermined financial stability and led to a banking crisis and the Great Recession. Today the critique is that central banks should aim at higher inflation in order to deliver a stronger stimulus. Then, as now, the problem was less the high-level policy framework than the need to understand what was happening.
If there are significant disequilibria in asset prices, saving rates or balance sheets, then at some point their correction may lead to large movements in inflation and employment, as we saw in the financial crisis. Changing the target won’t help if the underlying analysis is faulty. The weakness of the economic models used by central banks is that surprises are seen not as failures of the model but as “exogenous” shocks that are, in effect, outside policy makers’ remit. Yet the role of a central bank’s policy committee is to provide the missing analysis, and answer the question, “What’s going on here?”
So which is it — damp squib or responsible pragmatism? Given Powell’s straightforward style and admirable transparency, I’ll plump for the latter. Yet the fact remains, the framework for monetary policy is not what matters most. The real challenge is to understand the forces driving the economy — and to recognize that they cannot be tamed by central-bank action alone.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mervyn King was governor of the Bank of England from 2003 to 2013. He is the Alan Greenspan Professor of Economics at NYU Stern School of Business and professor of law at NYU School of Law, and author (with John Kay) of “Radical Uncertainty: Decision-Making Beyond the Numbers.”
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