Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, December 23, 2018

Does the Fed have a symmetric inflation target?

It's well-known that the Fed has been undershooting its inflation 2% target every year since 2012 (ironically, the year it formally adopted a 2% inflation target). This has led some to speculate whether 2% is being viewed more as a ceiling, rather than a target, as it is with the ECB. The Fed, however, continues to insist that not only is 2% a target, it is a symmetric target.  But what does this mean, exactly? And how can we judge whether the Fed has a symmetric inflation target or not?

These questions came to me while listening to Jay Powell's recent press conference following the FOMC's decision to follow through with a widely anticipated rate hike. At the 16:15 mark, reporter Binyamin Appelbaum (NY Times) asked Powell the following question:
BA: You're about to undershoot your inflation target for the seventh straight year and you forecast that you're going to undershoot it for the eighth straight year...Can you help us to understand why people would be advocating restrictive monetary policy at a time of persistent inflation undershoots? 
Here is how Powell responded:
JP: Well, we as a committee do not desire inflation undershoots and you're right -- inflation has continued to surprise to the downside -- not by a lot though -- I think we're very close to 2% and, you know, we do believe it's a symmetric goal for us -- symmetric around 2% -- and that's how we're going to look at it. We're not trying to be under 2% -- we're trying to be symmetrically around 2% -- and, you know, I've never said that I feel like we've achieved that goal yet. The only way to achieve inflation symmetrically around 2% is to have inflation symmetrically around 2% -- and we've been close to that but we haven't gotten there yet and we haven't declared victory on that yet. So, that remains to be accomplished. 
While this answer sounded reasonable on some level, it did not satisfy the very next inquisitor, Jeanna Smialek (Bloomberg):
JS: Just following up on Binya's question...I guess if you haven't achieved 2% and you don't see an overshoot -- which would sort of be implied by a symmetrical target -- what's the point of raising rates at all? 
Powell replied to this by making reference to the strength of the economy -- growth well above trend, unemployment falling, inflation moving up to 2%, and a positive forecast. In this context, the rate hike seemed appropriate. Again, a sensible sounding answer -- but did it answer the question actually posed?

As I reflected on this exchange, I felt something amiss. And then it occurred to me that people might be mixing up the notion of a symmetric inflation target with a price-level target.

In her question above, Jeanna suggested that if the Fed has a symmetrical inflation, then we should be expecting an overshoot of inflation. But the intentional overshooting of inflation is not inflation targeting -- it is price-level targeting. With an inflation target, one should be expecting inflation to return to the target--not beyond the target.

This would have been a fine answer to Jeanna's question, but isn't it inconsistent with the earlier reply to Binyamin? In that response, Powell left us with the impression that the FOMC has failed to achieve its symmetric inflation goal -- that success along this dimension would consist of actually observing inflation vary symmetrically around 2%. I'm not sure this is entirely correct.

To my way of thinking, an inflation target means getting people to expect that inflation will eventually return to target (from below, if inflation is presently undershooting, and from above, if inflation is presently overshooting). A symmetric inflation target simply means that the rate at which inflation is expected to return to target is the same whether inflation is presently above or below target. To put it another way, symmetry implies that the FOMC should feel equally bad about inflation being 50bp above or below target. Along the same line, persistent inflation overshoots and overshoots should be equally tolerated (given appropriate conditions).
Should a successful symmetric inflation targeting regime generate inflation rates that average around target? It's hard to see how it would not in the long run and if the shocks hitting the economy are themselves symmetric (this is not so obviously a given, but let me set it aside for now). Does missing the inflation target from below for roughly a decade imply that the FOMC has failed to implement a symmetric inflation targeting regime? Powell's mea culpa above suggests yes. But again, I am not so sure.

As I said above, the success of an inflation targeting regime should be measured by how well inflation expectations are anchored around target. By this measure, the FOMC has managed, in my mind, a reasonable level of success (2015-16 looks weak). The following diagram plots the PCE inflation rate (blue) against expected inflation (TIPS breakevens) five years (red) and ten years (green) out.

In my view, the fact that realized inflation has persistently remained below target does not necessarily imply the absence of a symmetric inflation target. Let's take a look at the FOMC's official view on the matter, originally made public on January 24, 2012 in its Statement of Longer-Run Goals and Monetary Policy Strategy. Let me quote the relevant passage and highlight the key phrases:
The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability...
It seems clear enough that the real goal here is to keep longer-term inflation expectations anchored at 2%.  The idea is that if inflation expectations are anchored in this manner, then the actual inflation rate today shouldn't matter that much for longer-term plans (like investment decisions). If inflation turns out to be low, you should be expecting it to rise. If it turns out to be high, you should be expecting it to fall. Nowhere does the statement suggest we should be expecting under or over shooting -- a characteristic we would associate with a price-level target. As for the phenomenon of persistent under or over shoots, the statement makes clear that the Committee would be equally (symmetrically) concerned in either case.

If one accepts my definition of symmetric inflation target then, unfortunately, we do not yet have enough data to judge whether the Fed's inflation target is symmetric. The policy was only formally implemented in 2012. Since then we've only observed a persistent undershoot and the conditions leading to these persistent downward surprises. Would the FOMC be equally tolerant of letting inflation surprise to the upside for several years should economic conditions warrant? It seems that we'll have to wait and see.

1 comment:

  1. Good post.

    I don't think it matters whether the shocks are symmetric. I think it matters that the Fed's forecast errors are unbiased (as they should be)?