For years monetary policy arguments have turned on whether the central bank should do more to stimulate the economy or whether trying would only generate excessive inflation. Recently, though, people have begun to wonder whether the Fed has the power to do either. After years of having an unofficial inflation rate target of between 1.7% and 2%, in 2012 the Federal Reserve committed to a goal of 2% inflation per year.
Yet as shown in the chart below, the Fed has not achieved its goal. Inflation has been below 2% since early 2012 (using the Personal Consumption Expenditures [PCE] price index). Even with a small margin of error, the Fed has been substantially below its 2 percent target 86% of the time from 2012 to the present.
There are three options to explain how the Fed could so consistently undershoot its inflation target.
- Perhaps it is not possible for the Fed to achieve 2% inflation.
One reason for consistently undershooting their inflation target would be that the Fed does not have the tools necessary to achieve their goal. This is clearly not the case as history is full of central banks increasing inflation when they want to. The hyperinflation of the Weimar Republic between the world wars and Zimbabwe more recently should leave little doubt about the ability of central banks to inflate. Nor does this fact change in a liquidity trap. As James Hamilton argued way back in 2008, the Fed could just print money to buy up all the U.S. Public Debt, and any other asset it desired. Such a strategy would eventually lead to inflation.
If the Fed can inflate but isn’t, then…
2. perhaps the Fed really does want 2% inflation, but they keep making mistakes that result in less than 2% inflation.
While Hamilton’s argument shows that it’s possible to inflate, doing so under current circumstances may require the Fed to use unconventional methods since the Federal Funds Rate is near zero, and there may be a learning curve associated with these new tools. Indeed, the Fed has introduced a host of new tools and methods, from new lending facilities, to quantitative easing, and has announced and backed away from others (e.g., the Evans Rule). It could be the case that the Fed doesn’t yet have enough experience with these new tools (and their interactions) to achieve their goal.
While mistakes are certainly a possibility…
3. Perhaps the Fed doesn’t really want 2% inflation.
When given the option, economists usually prefer to study what an individual or organization does rather than what it says it is trying to do. I may say I want to go to the gym, but if I haven’t been to the gym in months, my actions speak louder than my words.
Similarly, if the Fed says it wants 2% inflation, but yet consistently undershoots, then perhaps they don’t really want 2% inflation. But if the Fed doesn’t want 2% inflation, what does it want? I’ve created a webtool that allows for the interactive investigation of this type of question. Using the webtool, a good argument can be made that the Fed has had a 1.5% inflation level target since 2008. An inflation level target is different from an inflation target because with level targeting, any over or under shooting is corrected whereas with a target, any over or undershooting is water under the bridge. For example, suppose the Fed was aiming for 2% inflation last year but inflation was 3%. With a level target, the Fed would then aim for just over 1% inflation this year (because they had an extra 1% inflation last year), whereas with a non-level target, the Fed would still aim for 2% inflation this year. In other words, an inflation level target forces the Fed to correct any errors, whereas an inflation target ignores any errors.
As the first graph nearby shows, starting in 2008, the Fed has been within a small margin of error of a 1.5% inflation level target for just under a decade (2008 to 2016). This graph uses the Personal Consumption Expenditures excluding food and energy (PCEPILFE). (Food and energy are notoriously volatile, so their inclusion tends to add a lot of unnecessary noise).
When including food and energy, the Fed is within a small margin of error 87% of the time.
In sum, while it is certainly possible that the Fed really does have a 2% inflation target per year, their actions over the past 8 years are more consistent with a 1.5% inflation level target.
If that’s true, it’s not the Fed’s power to achieve 2% inflation that has been overestimated. It’s its will.