Economic Flash

Fed Shifts to Flexible Average Inflation Targeting

by Craig Dismuke, Dudley Carter

Fed Shifts to Flexible Average Inflation Targeting

In coordination with Fed Chair Powell’s speech at the annual Jackson Hole Symposium this morning, the Fed has released a unanimously approved Statement on Longer-Run Goals and Monetary Policy Strategy (link).  The initial policy position was formed in 2012, seen  then as a mechanism to deliver additional forward guidance.  The current policy Statement concludes a year-and-a-half long review of how the Fed approaches its 2.0% inflation target and maximum employment.

The Statement reflects the need for monetary policy to address an evolving U.S. economy. In his speech (link to text), Fed Chair Powell highlighted three key changes: 1) expectations for long-run economic growth in the U.S. have declined, 2) the general level of interest rates in this new economic environment is expected to be lower, and 3) inflation has proven to be less responsive to a tightening labor market evidence by the pre-virus relationship.

In response to the changing economic dynamics, the Fed has now adopted an average-inflation-targeting approach to policy.  With this new framework, the Fed will “seek to achieve inflation that averages 2 percent over time,” according to the new Policy Statement.  Practically, this means 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.”

Chair Powell provided more clarity on how officials expect to implement this new scheme, indicating that there will not be a specified time horizon for achieving an average 2 percent inflation and there will not be a formulaic approach.  He also clarified that overshoots will be allowed that are “moderate” (not defined) and for “some time” (not defined). Powell said, “our approach could be viewed as a flexible form of average inflation targeting.”  As it relates to the flattening of the Phillips Curve and the changing definition of full employment, Powell indicated that the Fed will not set an unemployment rate target but will use its tools to promote a strong job market.

This policy announcement was largely expected.  Coming at a time when inflation has persistently run below the Fed’s 2% target (see Chart below), the shift to a policy which allows for a subsequent overshoot is clearly a dovish move.  Given this change, the Fed would be justified in easing policy further to address the long-running shortfall in inflation.  Moreover, the September Summary of Economic Projections now becomes even more intriguing.    

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