Monday , August 19 2019
Home / EconLog Library / Does the Fed treat 2% inflation as a ceiling?

Does the Fed treat 2% inflation as a ceiling?

Summary:
The Fed says no. Many Fed critics say yes. I say that it’s too soon to say. Let’s look at PCE inflation (the index targeted by the Fed) over the past 15 years: Inflation has exceeded 2% in seven years and fallen short in eight years.  That’s consistent with a symmetrical target.  So why do critics like David Beckworth argue that the Fed treats 2% as a ceiling? The real problem is quite recent.  The Fed has fallen short of 2% in 6 of the past 7 years, and 8 of the past 10 years.  My view is that the shortfall around 2009-10 was intentional, as the critics maintain.  But I also believe that the more recent errors have been mistakes, and that the Fed does sincerely favor a symmetrical 2% target. Fed critics seem to have “Occam’s razor” in their favor.  Isn’t the

Topics:
Scott Sumner considers the following as important: , , , , ,

This could be interesting, too:

Scott Sumner writes How has Keynes’s liquidity trap theory held up over time?

Scott Sumner writes Easy credit and tight money

SchiffGold writes The Fed Has the US Economy on Life Support

Don Boudreaux writes Some Links

The Fed says no.

Many Fed critics say yes.

I say that it’s too soon to say.

Let’s look at PCE inflation (the index targeted by the Fed) over the past 15 years:

Does the Fed treat 2% inflation as a ceiling?Inflation has exceeded 2% in seven years and fallen short in eight years.  That’s consistent with a symmetrical target.  So why do critics like David Beckworth argue that the Fed treats 2% as a ceiling?

The real problem is quite recent.  The Fed has fallen short of 2% in 6 of the past 7 years, and 8 of the past 10 years.  My view is that the shortfall around 2009-10 was intentional, as the critics maintain.  But I also believe that the more recent errors have been mistakes, and that the Fed does sincerely favor a symmetrical 2% target.

Fed critics seem to have “Occam’s razor” in their favor.  Isn’t the simplest explanation that the Fed is aiming for 2% or less, rather than that they make repeated mistakes?

In fact, I believe Occam’s razor works in the opposite direction, in favor of my hypothesis.  In this earlier post I pointed out that over the past decade the private consensus forecast has also consistently overestimated future inflation.  My theory is that both private forecasters and Fed economists made the same mistake, relying too heavily on “Phillips Curve” models of inflation.

In contrast, Fed critics need an excessively complicated explanation:

1. The Fed has not had a low inflation bias over the past 15 years, but did adopt such a bias roughly 10 years ago.

2.  Private sector forecasters consistently underestimated inflation over the past decade for reasons unrelated to the bias in Fed policy, perhaps excessive reliance on the Phillips Curve.

3.  The Fed made similar mistakes to private sector forecasters, but for completely unrelated reasons.  Unlike private sector forecasters, the Fed knew they were likely to undershoot 2% inflation, but lied and claimed they were on track in order to please . . . . someone.

Many people have a lot of trouble with my claim that the Fed innocently made repeated errors in the same direction.  But any theory must be consistent with the private sector forecasters making the same sorts of systematic errors.  So for me, Occam’s razor points to an honest mistake being the most likely explanation for the repeated undershoot of inflation.  I don’t need the three assumptions (above) that the Fed critics need for their theory.

I’ve made similar arguments over the past year or two, and also suggested that I was looking for the Fed to do a better job in the future.  Despite the slightly above 2% inflation last year, I don’t believe the problem has been solved, indeed I expect inflation to again fall below 2% in 2019.

BTW, the TIPS markets have been more skeptical of the claim that 2% inflation was on the way, and the TIPS markets have thus been more accurate than either the Fed or private sector economists.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

Leave a Reply

Your email address will not be published. Required fields are marked *