The Federal Reserve is considering a monetary policy shift from its flexible inflation forecast targeting to one of several strategies known as make-up strategies. See my earlier blog posts on the reasons for this review and potential economic and market implications.
Make-up strategies explicitly require central banks to make up for past misses of their inflation target. Different make-up strategy monetary policy ideas have been proposed on the central bank conference circuit. These can mainly be divided between price level targeting (PLT), average inflation targeting (AIT) and temporary price level targeting (TPLT). All the strategies work essentially through the same mechanism: raising short-term inflation expectations above the target.
PLT, AIT and TPLT
PLT commits to make up any deviation from the inflation target by leaning in the opposite direction in the future. AIT commits to achieving an average inflation level over a set period of time. As the period over which inflation is averaged gets longer, the monetary policy strategy converges from inflation targeting to PLT. Both PLT and AIT include past inflation outcomes in monetary policy decisions of the present policy stance.
Under TPLT, the central bank would temporarily switch toward PLT when interest rates reach their floor, and revert back to its standard flexible inflation targeting once it has made up for the temporary inflation shortfall. The strategy – put forward by former Fed Chair Ben Bernanke in a 2017 blog post – essentially introduces a temporary change to the central bank’s monetary policy norms.
It aims to balance the pros and cons of price level targeting versus traditional inflation targeting. According to economic models, TPLT can provide sufficient stimulus when interest rates can’t be lowered any further while avoiding excessively loose monetary policy and an overheating economy later. See the Policy paths charts below.
Make-up strategies such as the AIT favored by New York Fed President John Williams and San Francisco Fed President Mary Daly would allow the Fed to let the U.S. economy – and its financial sector – run hot. Rather than repeatedly stressing its patient policy attitude, the Fed would begin to openly welcome inflation overshoots – reinforcing its dovish tilt. The Fed would stop trying to move interest rates up toward neutral for an extended period of time. Such a strategy shift could mean that the Fed’s commitment to lower-for-longer rates becomes more credible than it was during previous episodes of forward guidance or quantitative easing.
The Fed’s credibility
Make-up strategies require markets to believe central banks can create inflation. Central bank credibility is threatened by the problem of “time inconsistency” – a situation whereby a central bank has an incentive to promise inflation overshoots, but then possibly breaks this promise due to concerns over the welfare costs to the economy or the political backlash. Without credibility, it is unlikely the Fed could engineer sizeable swings in short-term inflation expectations, which have been falling over the past decade. If central banks can cause a big enough rise in short-term inflation expectations and so pull down real interest rates, they are less likely to be limited by an interest-rate floor in future. This then stabilizes longer-term inflation expectations.
A move toward a make-up strategy could have considerable repercussions for financial markets, provided that the new strategy is credible and well understood. The Fed has never deliberately fore-casted a material inflation overshoot. Market participants would have to change their understanding of how the Fed would use monetary policy in any given situation. Much would depend on whether short-term inflation expectations can move decisively above target when recent inflation has been below target (and vice versa). Additional ramifications could result from markets changing their expectations of the range of long-term macroeconomic outcomes and the near-term policy path of the Fed.
Stay tuned for the next blog in this series, in which I will discuss in more detail the potential market implications of these make-up strategies. And read more macro insights in our Macro and market perspectives.