Ever since the Reserve Bank of New Zealand adopted inflation targeting, it became part of all developed central banks mandates. By targeting a certain level for inflation, central banks make sure that inflation is high enough not to threaten the zero level and low enough not to create hyperinflation.
The problem with inflation targeting is that there is no rules-based system to apply to send inflation to target. The 2% level is considered appropriate by central banks in the developed world, but that is not an easy target to achieve.
For example, the Bank of Japan tries for decades to send inflation back to 2%. It keeps failing, showing how conditions for each economy are different, and different tools are needed for inflation targeting.
Price stability, in the eyes of a central bank in the developed world, refers to inflation hovering around the 2% level. To prepare for the next economic turnaround, some central banks are willing to let inflation overshoot the target. But that is easier to say than to do.
Average Inflation Targeting Innovation
The average inflation targeting innovation is that a central bank like the Fed is willing to let inflation overshoot the target (i.e., the 2% target) in order to bring average inflation up to the target.
The problem with traditional inflation targeting comes from the difficulty the Fed had in sending inflation to its target in economic expansion. Despite strong employment in the last years, the Fed had difficulties reaching its price stability mandate. Therefore, in a recession, it will have room to ease to the effective lower boundary (i.e., the zero level) of less than 2%.
A recession like the one created by the coronavirus pandemic is unusual both in scope and in size. The Fed did reintroduce the quantitative easing measures, but large asset scale purchases tend to depress the long-term yields – something viewed as unsustainable in the long run.
Another crisis, another innovation. Ahead of the Jackson Hole Symposium, there is chatter in the market that the Fed may hint that it is willing to let inflation overshoot. In other words, as explained in this article, this means a shift from inflation targeting to average inflation targeting.
If the markets are convinced that the Fed is able to contain inflation further down the road, the move will be seen as proactive. On the other hand, if the opposite happens, the Fed plays with fire.
Powell’s Jackson Hole speech this week is decisive.