Fed's Symmetric Inflation Approach May Benefit Markets

(Bloomberg Opinion) -- As the Federal Reserve prepares for its final monetary policy meeting of the year next week, a push to actually achieve target inflation on a symmetric basis is under active consideration by central bankers. Such a dovish shift would push the Fed toward embracing an even lower for longer interest-rate policy following the next recession – whenever that happens.

Moreover, be aware of the potential for the Fed to start targeting an inflation rate exceeding 2% as soon as next year, providing more of a tailwind for the economy and financial markets than currently anticipated.

Although the Fed has a 2% symmetric inflation target, it does not attempt to generate symmetric inflation outcomes. What that means is that policy makers strive for an inflation rate of 2% over the medium term, but they do not attempt to make-up for past misses. For example, if actual inflation were 2.5%, the Fed would not attempt to push inflation down to 1.5%. Instead, it would simply set policy such that inflation fell back down to 2%.

The “symmetric” part of the inflation target means only that they care equally about above-target or below-target inflation. In other words, if inflation is at 1.5%, the Fed's policy response will be equal in magnitude to 2.5% inflation. The Fed's current inflation framework contributed to the persistently below target outcomes experienced since the Fed announced the target in 2012. Random shocks to inflation have been predominantly negative and the Fed doesn't set policy to offset those shocks with above-target inflation. Consequently, core inflation has averaged 1.6% since the Fed began inflation targeting.

The persistent undershooting likely contributes to declining inflation expectations. Fed Chairman Jerome Powell and his colleagues have repeatedly stressed the importance of stable inflation expectations while fretting that those expectations may have edged lower. Slower inflation limits the effectiveness of rate policy during a recession, in part because policy rates will be starting at a lower point in the next recession, providing less room to cut rates.

In his Oct. 31 press conference, Powell said the Fed is actively “thinking about ways that we can make that symmetric 2% inflation objective more credible by achieving symmetric 2% inflation.” This suggests the Fed intends to respond to persistently low inflation by targeting an average inflation rate of 2% over time. The Fed could only achieve this outcome if it allows sustained overshooting of the target after periods of low inflation.

Fed Governor Lael Brainard provided additional guidance last week on what we might expect from the Fed's policy review. Rather than a formal make-up strategy in which the Fed attempts to compensate exactly for past deviations from the inflation target, Brainard advocated a somewhat looser strategy of adopting an offsetting target range. If actual inflation has been in the range of 1.5% to 2% for five years, the Fed should target a range of 2.0% to 2.5% for the next five years.

Over the long-term, a commitment to symmetric 2% inflation outcomes would lead to a lower for longer period of easy monetary policy in the wake of the next recession. The Fed would not be quite so eager to tighten policy to hit the inflation target from below and instead delay the initiation and pace of timing such that inflation rose above target.

In the near term, the search for symmetric 2% inflation outcomes may reinforce the Fed's push for easy policy even if the economy rebounds from the current soft patch. Recall Powell's clear hesitation to consider reversing recent rates cuts until the Fed see “inflation as moving up or in danger of moving up significantly.”

So, considering the Fed's concern that inflation expectations may have drifted downward, we could soon see a major policy change. At the conclusion of the Fed's review process in the middle of next year, the Fed could begin targeting inflation in the range of 2.0% to 2.5% as it actively tries to offset the recent inflation shortfalls. Such a shift would be dovish to current expectations. 

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

©2019 Bloomberg L.P.