The Federal Reserve on Thursday said it will adopt flexible average inflation targeting into its monetary policy framework, which will allow inflation to rise “moderately” above its 2% target.
If that sentence above makes no sense, then the Fed has already run into a problem with implementing its new policy.
“I think average inflation is a more difficult concept,” said former Fed economist Vincent Reinhart, now chief economist at Mellon.
At the center of the Fed’s change is managing expectations on where prices are headed in the future. The idea: if consumers and firms expect that prices will rise in the future, consumers may stimulate more spending with firms raising prices today.
But setting inflation expectations presents a major communication challenge for the central bank, a ubiquitous subject in finance circles but mostly unknown to the average American.
A Pew Research survey from 2014 found that only 24% of Americans could identify the chair of the world’s most powerful central bank, with over 10% of Americans confusing the central bank for the Supreme Court.
Jerome Powell, who is the current chairman of the Federal Reserve, admitted in May that “most people have better things to do with their life than to understand the details of central banking.”
Cleveland Fed President Loretta Mester says one issue involves communicating to two different audiences: Wall Street and Main Street.
“I do think that's a challenge,” Mester told Yahoo Finance August 28. “I don't think that's an easy thing to do.”
Not too high, not too low
Inflation is loosely defined as the increase in prices. Most Americans who remember the 1970s will recall the boogeyman of stagflation (slow growth but rising prices), which underscores the Fed’s institutional fear of inflation that is too high.
But at the same time, the Fed worries of inflation that is too low, which can signal weaker consumption and investment (aggregate demand), even if the central bank has made borrowing costs cheap (through lower interest rates).
That has been the Fed’s dilemma since adopting its 2% target on its preferred inflation measure (core personal consumption expenditures) in 2012. Over the last eight years the Fed has averaged inflation of only about 1.6%, touching 2% only briefly in 2018.
The Fed hopes it can raise inflation expectations by messaging that it will not immediately raise rates if inflation runs “moderately” above its target at times.
But the University of California at Berkeley’s Yuriy Gorodnichenko posits that even if consumers expect higher inflation expectations, spending may not increase because households could perceive higher inflation as a sign of a bad economy.
In a paper presented at the Fed’s Jackson Hole conference this week, Gorodnichenko noted that the Fed needs clear communication to create the link between higher inflation expectations and actual spending behavior. The paper floated using “simple” and “transparent” communication directly to households, suggesting that social media from the Fed itself could be more effective than reading about policy through news stories - like the one you’re reading right now.
Bank of Canada Governor Tiff Macklem sympathizes with the idea of clearer communication from central banks, known at times for deliberately muddling its policies with academic jargon.
“Monetary policy works better when people understand it,” Macklem said in a speech delivered at the same conference.
With the Fed targeting higher inflation, Gorodnichenko recommends that the Fed be direct about its desired outcome. For example, the Fed could emphasize its desire to raise inflation expectations and economic activity, instead of droning on about the academic underpinnings of its policy instruments.
For the time being, the key for the Fed is getting inflation in a sweet spot that is neither too high nor too low.
“They don’t want to be very clear about that, except they don’t want people to expect that suddenly they’ll go to 4 or 5% to make up for a number of years where they were at 1.5% or 2%,” said former Fed Governor Randall Kroszner.
And for all the challenges that lie ahead for the Fed on delivering on higher inflation, the new framework will hopefully be a marginal improvement over the old one, says Peterson Institute for International Economics president Adam Posen.
Posen criticized the old framework for pre-emptively raising rates between 2015 and 2018, a time when preserving accommodative monetary policy could have led to faster improvements in unemployment.
“They’re moving to committing to trying to do better but it’s going to be vaguer communication,” Posen told Yahoo Finance. “I’m not sure on balance that’s worse - I think it may be better.”
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.