The Fed Can Avoid Pitfalls of an Average-Inflation Target

(Bloomberg Opinion) -- As the Federal Reserve rethinks how it carries out monetary policy, some observers fear that change could have unintended, and negative, consequences.

One change the Fed is considering is clarifying that it will try to hit its target of 2% annual inflation on average, so that if inflation runs at 1% in one period, the Fed will aim for 3% inflation in the next period. I have argued that this change would have several advantages, such as increasing the predictability of the price level, but also has pitfalls that the Fed should take steps to avoid.

In a recent column in the Wall Street Journal, James Mackintosh mentions three of the pitfalls. Considering them in turn highlights the necessity of moving toward an average target in the right way.

Inflation is typically lower during a recession than an economic expansion. If the Fed were to try to hit its average by raising inflation further during booms, then it would be making the economy’s cycles more severe. It would be better to attempt to make inflation countercyclical, using booms as an opportunity to bring it down.

Where the Fed now alters interest rates in order to keep inflation near its target, it could instead aim to keep the total amount of spending throughout the economy growing at a steady rate. Countercyclical inflation would follow as a matter of course.

The growth of spending levels equals the inflation rate plus the real economic growth rate. A spending growth target of 4.5% would yield 2% inflation if the economy grew at 2.5%. Holding spending growth constant, a higher real growth rate implies a lower inflation rate.

Two of Mackintosh’s concerns about an average-inflation target would not apply if the Federal Reserve took this spending-centered approach.

A policy of averaging inflation, he writes, “could stop the Fed from taking action to slow an unsustainable boom that follows a period of slow price rises, because it is still making up for undershooting in the past.” He’s thinking of a scenario in which low growth and low inflation are followed by faster growth and higher inflation – which is the usual pattern.

His worry is that the Fed would try to make up for an inflation undershoot during a recession with an overshoot during a boom. Targeting a steady growth rate in the level of spending would avoid this mistake.

Mackintosh worries as well about asset-price bubbles: “Broadly speaking, the Fed’s rates would be lower at the peak of a boom than under the current policy, which could make financial markets even more prone to bubbles.”

Again, he is considering a central bank that let inflation run below target during a recession and tries to make up for it during a boom by pushing interest rates down to achieve above-target inflation. If it instead tried to hit its average in a countercyclical way, then it would be less inclined than it is now to cut interest rates during a boom.

Mackintosh’s third concern points to another way a central bank would have to implement a new policy intelligently. “[I]t might be seen as unfair by a young adult told she has to pay more for a car loan because the Fed is trying to keep inflation low to compensate for overshooting when she was still a child.”

The question this concern raises is: Over how long a time scale should a central bank seek to correct past mistakes? Since the goals of setting the target and fixing errors are to promote stability, predictability and credibility, the answer should be in keeping with those goals.

Those goals counsel in favor of correcting for errors as rapidly as possible and, at a certain point, letting bygones be bygones. If spending grows by 3.5% next year, the Fed could strengthen the perception that it will anchor spending and inflation over the long term by shooting for 5.5% the year after. Trying to correct for the undershoot of 10 years ago, on the other hand, would be destabilizing.

None of which is to dismiss Mackintosh’s cautions. The potential drawbacks of an average-inflation target are real -- but the Fed can and should avoid them.

To contact the editor responsible for this story: Katy Roberts at kroberts29@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.

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