From 2021 to 2023, inflation was much higher than the Fed had hoped for, and much higher than the market expected. Does that mean the Fed is okay with allowing inflation to run significantly above target? The answer is no. Let me explain why using an example of how things would be under both inflation targeting and price level targeting. Assume the Fed’s inflation target is 2%.
Assume the price level in March 2021 is 100. The Fed wants prices to rise by 2% a year, or 0.5% every quarter (three months). The Fed projects how the price level will rise each quarter over two years. Year (for simplicity, compound interest effects are ignored):
Case A: 100, 100.5, 101, 101.5, 102, 102.5, 103, 103.5, 104
Now assume that the Fed underestimated quarterly inflation by 1% for eight consecutive quarters. They expected 0.5% and got 1.5%. Let’s also assume that the Fed sets an inflation target and that “bygones are bygones.”
Case B: 100, 101.5, 103, 104.5, 106, 107.5, 109, 110.5, 112
Price levels rose a total of 12% over two years (eight quarters), well above the Fed’s desired annual inflation rate of 4% and well above its 2% target.
Now suppose that the Fed underestimated inflation by 1% each quarter for eight consecutive quarters. But suppose now that the Fed had been targeting price levels rather than targeting inflation. This means that at every point in time, the Fed was trying to achieve the price level path shown in Case A above.
Case C: 100, 101.5, 102, 102.5, 103, 103.5, 104, 104.5, 105
Even though the Fed made errors of exactly the same magnitude in cases B and C, each quarter the path of price levels in case C moved much closer to the ideal path depicted in case A. Please pay attention. Price level targeting would result in an additional 1% inflation in the first period, but subsequent inflation would be 0.5% per quarter, or 2% per year. As a result, in Case C, the inflation rate from March 2021 to March 2023 averaged 2.5%/year, instead of 6% as in Case B.
In fact, there has been approximately 8% additional inflation in the two years since March 2021. This occurred even though under “average inflation targeting” the path of the price level would have been much closer to case C than to case B. In other words, the Fed did not adopt the policy regime it advertised to the public. We did not intend to target average inflation.
Were the coronavirus supply problems and the war in Ukraine valid excuses? Not at all. NGDP growth is above the 4% growth path more than inflation is above the 2% trend line. The policy was too expansive by any rational standard. Nor can you blame that mistake on the fact that even the markets missed the magnitude of the inflation that would occur. In both level targeting and a true “average inflation targeting” system, such a market misprediction would have caused only a small overshoot as seen in Case C.
PS. I started watching in March 2021. By this time, price levels had recovered from the initial decline during the early stages of Covid and were back on trend.
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