An influential member of the Federal Reserve’s board of governors has called for the central bank to set temporary inflation targets above its current goal of 2 per cent, to make up for periods when inflation runs below target.
In remarks at the US Monetary Policy Forum in New York on Friday, Fed governor Lael Brainard referred to this policy as “flexible inflation averaging”.
The comments offer the clearest sign yet that the Fed intends to re-examine how its monetary policy committee approaches its inflation target, as it prepares to release conclusions from an 18-month policy review this summer.
“By committing to achieve inflation outcomes that average 2 per cent over time, the committee would make clear in advance that it would accommodate rather than offset modest upward pressures to inflation in what could be described as a process of opportunistic reflation,” she said.
“This approach will help move inflation expectations back to our 2 per cent objective, which is critical to preserve conventional policy space.”
As both interest rates and inflation have dropped over the long term, Fed policymakers have worried that they have little room to use their traditional tool of short-term interest rates to encourage growth in the next downturn. After three cuts last year, the fed funds rate is currently 1.5 to 1.75 per cent.
At the same time, policymakers have pointed out that consumer and business expectations for inflation may have become “anchored” — stuck, and therefore impervious to central bank intervention. Since the financial crisis, the Fed has consistently had difficulty meeting its inflation target of 2 per cent.
A report prepared for the forum on so-called non-traditional tools — such as central bank asset purchases and the longer-term policy commitments known as “forward guidance” — noted how some countries had hesitated after the financial crisis to roll them out and that early, aggressive use of these tools was more effective.
Ms Brainard endorsed acting early and decisively.
“For monetary policy to be effective, it will be key for policymakers to communicate their strategy clearly in advance to the public, to act early and decisively, and to commit to providing the requisite accommodation until full employment and target inflation are sustainably achieved,” she said.
In her remarks, Ms Brainard laid out a three-part response to a future recession. First, she proposed the Fed should act quickly. Second, it should commit to capping interest rates on Treasuries over the short and medium term. Third, it should offer forward guidance that it intended to overshoot its inflation target until it had reached an average of 2 per cent over time.
Several Fed policymakers have discussed so-called make-up strategies, in which the central bank would commit to pushing inflation above target for periods, to make up for time spent below 2 per cent. Such a policy would require “making it clear that it’s acceptable that to average 2 per cent, you can’t have only observations that are below 2 per cent,” Eric Rosengren, president of the Federal Reserve Bank of Boston, told the Financial Times in December.