Today, I want to explain the reasons for the current high inflation. Not part of inflation due to supply problems; Rather, the part caused by excessive nominal expenditure, is sometimes called excessive overall demand.
The approximate reason for this excessive spending is obviously an overly expansive monetary policy. But I am deeply interested in the cause; Why has the Fed allowed spending to rise so quickly? I would point out that the fundamental problem is the Fed’s wrong policy framework.
In 2020, the Fed has adopted the Flexible Average Inflation Target (FAIT). That’s actually a great idea! So why didn’t it work? The problem is that the Fed has interpreted FAIT in a very strange way. They have decided to revise their 2% inflation target to 2% inflation in the future, but have decided to revise the 2% inflation overshoot below 2% inflation in the future. That is why the Fed has not adapted its policy to where we are.
But why did the Fed make this mistake? The deep problem is that the Fed does not understand its role in the economy. It sees itself as a kind of fireman, fixing mysterious “shocks” that occasionally hit the economy. In fact, the Fed, like a firebrand, is sometimes excessive or under-stimulating at nominal cost. This creates business cycles and volatile inflation.
But why is confusion over the role of the Fed leading them to an asymmetrical form of FAIT, correcting inflationary undershoots but not overshoots? The answer is not clear at all, and has not really come to me until today. So here’s my theory:
Suppose you take the Fed’s fireman approach. Why might that asymmetrical FAIT seem more attractive? The answer is quite simple; The recession is much more painful than the boom. When there is a recession in the economy, production is low and so is the quality of life. You want to fix the problem as soon as possible, and FAIT allows for a faster recovery than a typical “let’s go fast” method of noticing inflation. In contrast, periods of economic overheating are much less expensive, as employment and costs are much higher. The main problem with overheating booms, in fact, is that they increase the likelihood of a recession in the future.
[As an aside, supply side inflation is more painful than demand side inflation (and is politically very unpopular as we now see), but in this post I’m only addressing excess nominal spending, i.e. the inflation from excess demand.]
If I believe that the Fed solves the problem caused by a kind of fireman, a mysterious economic “shock”, then I will also support an asymmetrical FAIT. In that case, I would be less critical of the Fed’s mistakes in 2021. Even in that case they would have increased the rate very slowly (earlier), but the error would have been forgivable.
But I believe the Fed, like the arsonists, is pushing the economy through volatile monetary policy. It is unforgivable. And we’ll see, that’s why the Fed has to take one Symmetrical Completed policy.
The real reason for adopting FAIT (or better yet NGDP level targets) is the lack of rapid economic recovery; This is to prevent recession from happening in the first place. I use italics because that’s the focal point of this post, and actually most of my blogging over the last 13 years. The mere expectation that the Fed will quickly bring the economy back to the trend line will make the recession much lighter than otherwise, as current nominal spending relies heavily on future nominal spending. Investment projects canceled in a deep protracted recession will not be canceled if a rapid recovery trend after the recession is expected to return to the line.
But this argument is completely symmetrical. If the Fed is expected to offset the normal NGDP growth period with a future period of normal NGDP growth, the initial excess heat will be less dramatic. Even if the Fed slows to raise rates during an unexpected rise in inflation, the markets will do their job for them. Long-term interest rates will rise sharply in anticipation of Fed policy measures needed to hit the 2% average inflation target. You fix the overshoots with future undershoots because overshoots are not painful, But prevent overshoots from happening (Or at least lighten them up).
In 2021, I was very complacent about inflation because I thought the Fed actually had a symmetrical policy. (Actually Some people at the Federal Reserve You also seem to see the policy as symmetrical.) I assumed that the Fed will do whatever it takes to ensure that inflation averages 2% in the long run. I thought the average inflation target meant the average inflation target.
In retrospect, the Fed has done an extremely bad job of communicating its policy changes. There was little discussion about the new policy that would lead to future inflation More than 2% on average. Much of the discussion suggests that this will ensure an average inflation rate of 2% over time, rather than the 2% inflation experienced in the 2010s. Instead, they should have gone from one extreme (very low inflation in the 2010s) to the other extreme (very high inflation in the 2020s). They should have gone from an average of 2% inflation to 2% inflation.
Jim Bullard once suggested that the “flexible” part of FAIT should be interpreted as something like the NGDP level target. I wish the Fed had a purpose. Under NGDPLT, you allow average inflation to fluctuate from 2% during a supply shock, as long as NGDP growth is on track. This will allow for a slightly higher inflation during the current supply push, but without the current overheating. If the Fed wants to correct what went wrong in 2021, it should declare that FAIT will be symmetrical from now on, and the “flexible” part of FAIT implies that some changes in inflation will be allowed to stabilize NGDP growth.
Of course the simple solution would be to move directly to NGDPLT. But the politically easy way would be to do a FAIT that has mimicked the NGDPLT for a decade or two, and then formally change the policy if it seems to work. Given that the Fed has worsened its inflation targeting policy over the past 12 months, now is not the time to formally abandon inflation targets.