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Fed Study Says Average Inflation May Be Better Way to Reach Goal

Fed Study Says Average Inflation May Be Better Way to Reach Goal

Average inflation targeting may be an effective tool in the current economic environment, where sluggish price increases have forced central banks to keep interest rates low, constraining the tools at their disposal in times of crisis, according to economists at the Federal Reserve Bank of San Francisco.

The tool is “a monetary policy framework that is well suited for the current environment,” economists Renuka Diwan, Sylvain Leduc and Thomas Mertens wrote in an Economic Letter, published Monday.

The U.S. central bank last year embarked on a review of its policy strategy and average inflation targeting is one of the options it is looking at during this so-called framework review. Chair Jerome Powell, speaking at a July 29 press conference, said deliberations would be wrapped up in the “near future.”

Fed Study Says Average Inflation May Be Better Way to Reach Goal

The Fed targets inflation at 2% in an effort to keep prices from rising too quickly, as happened in the 1970s and 1980s. In the past decade, however, price growth has struggled to reach the target. To try and raise prices, the Fed kept interest rates relatively low, limiting how much it could ease monetary policy when the coronavirus pandemic disrupted the economy earlier this year.

At the moment, the Fed doesn’t try to make up for past inflation misses. But under average inflation targeting, if price growth was too low over a period of time, the Fed would aim to overshoot it in the future to make up for the past underperformance.

“Average inflation-targeting frameworks can alleviate downward pressures on inflation and output and thus anchor inflation expectations closer to, or even at, the target,” the economists wrote.

The Fed’s current system of inflation targeting can exacerbate already-subdued prices as households and businesses expect low inflation to continue into the future and adjust their behavior accordingly. With average-inflation targeting, households and businesses could expect periods of higher inflation following those of lower prices.

“The underlying mechanism is thus similar to forward guidance but can be applied more systematically because inflation overshooting is codified in the framework,” the economists wrote. “As a result, future inflation promises might be viewed as more credible.”

The risk would be that the Fed would have to frequently adjust the degree that inflation overshoots the target over time, eroding its credibility among investors and businesses.

©2020 Bloomberg L.P.