Average Inflation Targeting: Positive For Markets, Less So For Consumer Prices

At Jackson Hole today Chair Powell announced a move to average inflation targeting, reflected in changes to the Statement of Longer Run Goals and Monetary Policy Strategy. The key sentence on inflation now reads: ‘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 begs two questions.

First, is it credible? Once inflation has risen above 2%, how will we know how far it will go and when the Fed will step in? Powell’s guidance was somewhat vague: ‘Of course, if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act.’

The economists’ skit about the central banker who tries to credibly commit to being irresponsible and cannot has been around since the late 1990s. In fact, Michael Woodford discussed that very issue at the 2012 Jackson Hole symposium. Woodford argued that a formal commitment to keeping policy loose until inflation or unemployment crosses a threshold could strengthen its credibility. 

Forward guidance, including outcome-based guidance, has been part of the Fed toolkit since the early 2000s but falls short of the commitment Woodford recommends. And the Fed is unprepared to tie itself to a specific rule to increase its credibility. Powell stressed today that, ‘In seeking to achieve inflation that averages 2% over time, we are not tying ourselves to a particular mathematical formula that defines the average’.

Second, will the Fed credibility ever get tested? It would be nice if inflation could actually get above 2%, but I am unsure it will anytime soon – at least not on the Fed’s own devices. As Powell candidly acknowledged today, ‘Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2% inflation, but these forecasts were never realized on a sustained basis’.

The example of the BoJ is not encouraging. After repeatedly failing to engineer a rise in inflation, the BoJ committed to inflation overshooting in September 2016 while simultaneously switching from reserves targeting to yield curve control, largely because it had run out of bonds to purchase. Yet, Japanese inflation remains stubbornly well short of the 2% target.

Central banks’ lack of inflation success suggests that factors beyond their reach are at work, for instance workers’ loss of bargaining power that is keeping the Philips curve flat. In addition, a skewed income distribution implies that income growth accrues mainly to high-income households with high propensity to save. That is, in an inegalitarian society, income and money growth fuel more the demand for financial assets than that for goods and services (see Three Conditions For a Lasting Inflation Acceleration, 16 July 2020). Several recent academic papers make similar points.

Indeed, if the Fed consumer price track record has been mediocre, that of financial asset price inflation has been stellar. The combination of SPX multiples close to historical highs (ignoring periods of zero or negative earnings) and double-digit unemployment is unheard of in the era of modern central banking. The disconnect between asset prices and fundamentals largely reflects the Fed’s and other central banks’ stubborn pursuit of unattainable inflation. Since the Fed sees its policies transmitted through financial conditions, implementation of inflation targeting effectively means providing a put to markets. The combination of put, low inflation, and repressed bond yields makes for a low equity risk premium and high valuations. And average inflation targeting implies that the Fed will be able to engage in even more flogging of the proverbial dead horse.

The Fed has tried to reach out to the real economy by establishing corporate and SME (main street) credit facilities. Consequently, the corporate sector has gone on a borrowing binge while corporate investment has stagnated. SME interest so far has been tepid, with borrowing a tad short of $38bn – a minuscule fraction of the Fed’s nearly $7tn balance sheet. The reality is that Fed easing is passing by large swaths of the US population because low rates do not get transmitted to small borrowers and most households do not own stocks: 10% of US households own 75% of US financial assets.

Today’s market reaction makes sense to me only somewhat. The Fed move adds upside to already expensive equities, so a moderately positive SPX response seems reasonable. On the other hand, it is unclear that either consumer inflation or GDP growth will be impacted much, so I am unsure what to make of today’s move up in BEs. Time will tell, but I doubt very much that today’s Fed decision alone will usher in an era of sustained consumer inflation.