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Abu Dhabi, UAESunday 16 December 2018

US inflation policymakers probably aim higher than 2 per cent

There is enough scepticism about Fed discretion that a change in the target that looks arbitrary would cement the case for rules-based policy for many

Jerome Powell, Federal Reserve chairman. Andrew Harnik/AP
Jerome Powell, Federal Reserve chairman. Andrew Harnik/AP

The Federal Reserve will never admit to aiming for inflation above 2 per cent, but that's probably what policymakers want.

You'll know it when they start saying things like "the symmetric target remains 2 per cent inflation, but we do not want to miss to the downside".

Saying you don't want to fall short of the 2 per cent target is a way of saying you will be aiming higher. Imagine a perfect world where a central bank could hit its 2 per cent inflation target each year with a standard deviation of 0.25 per cent. Inflation would be below 2 per cent half the time and above the other half. To guarantee that there is, say, only a 10 per cent chance of being below 2 per cent, officials would have to aim for about 2.3 per cent.

A major debate within the Fed on how to interpret the target in coming years is far more important than whether it raises interest rates three or four times this year (the market is pricing in just under three hikes). This discussion is becoming more critical because inflation is approaching the 2 per cent target faster than officials expected.

The plain text meaning of a 2 per cent inflation target is that bygones are bygones. In other words, even if you only achieve 1.5 per cent inflation for 10 years, you would still aim for 2 per cent in year 11. There is an alternative view that you should try and make up for some of the misses so as to more or less average 2 per cent over the business cycle. This is close to price level targeting, or a hybrid. It sounds pretty good, if you are willing to swallow the implication that a string of inflation overshoots should be offset by future undershoots. That is much less fun.

My expectation is that Fed policy makers will never expressly state they are aiming for, say, 2.25 per cent to 2.5 per cent inflation for a couple of years. But they will tolerate the level. The reasons for ambiguity are partly political and partly institutional. I doubt they want to explain to Congress that they have unilaterally changed the target. There is enough scepticism about Fed discretion that a change in the target that looks arbitrary would cement the case for rules-based policy to many in Congress. Even Democrats, who normally have a greater inflation tolerance than Republicans, would push back if that extra bit of inflation delivers additional stimulus that benefits the Trump administration politically.

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The Fed also doesn’t want to be accused of sabotaging the supply-side impact of tax reform. If inflation picks up because the tax cuts initially stimulate demand, supply-side advocates will argue for patience on tightening until the supply side kicks in and mitigates the inflation response. The supply-side boost may or may not come, but the Fed does not want to be seen as responsible for its failure.

Similarly, an easy money regime implied by a higher inflation target will weaken the dollar and help anchor inflation at higher levels than current ones. Some Fed officials see this as an advantage. Tolerating a weaker dollar avoids the perception that the Fed is fighting the Trump administration on trade policy as well as tax policy. The Fed isn't political, but it is politically aware.

The arguments against explicitly admitting to aiming for above 2 per cent inflation:

1 Institutionally, Fed officials would have a hard time gaining a consensus. There are many hawks, and Chairman Jerome Powell will face fewer dissents if any deviation from the 2 per cent target is informal, temporary and deniable as an objective.

2 They are not sure how inflation expectations would respond if realised inflation hits 2 per cent and they endorse a faster pace. It’s not as if the unemployment rate is 8 per cent. If you advocate above-target inflation when the unemployment rate is close to 4 percent, reasonable observers could draw the conclusion that you want above target inflation.

3 If the Fed is tolerant of above-target inflation for a while, without being explicit on the tolerance, it can choose when to roll it back without having to justify multiple target changes.

It may be too early in Mr Powell's tenure to signal this tolerance anytime soon. And rather than doing so explicitly, he may choose an Alan Greenspan-like ambiguity along the lines of “above target inflation if necessary but not necessarily above target inflation”, leaving it to listeners to interpret as they wish.