Chief economist update: Moving target

What's a central bank to do if after so many years of policy accommodation it still couldn't hit its target? Move the goalpost, of course.

The US Federal Reserve has cut interest rates three times (by 75 basis points) last year from 2.5% to 1.75%. The stats show that half of its dual mandate - full employment and stable (2% target) inflation - is responding.

The US unemployment rate is at a 50-year low of 3.5% (November 2019) but inflation as measured by the Fed's preferred inflation gauge - the PCE price index - remains off-target, registering just 1.5% growth in the year to November.

Unlucky perhaps, but this inflation measure had been below the Fed's 2% target for 13 months straight.

It could be the US central bank's regret for its relatively aggressive action - "normalising" monetary policy by raising the fed funds rate from 0.25% in 2015 to 2.5% in 2018.

To be fair, the PCE price index was heading and even rose above the Fed's inflation target at the time. The rules of the central bank game dictated and justified the Fed's move.

However, the series of rate increases has again brought inflation back below target (to 1.9% in November 2018 - prompting the Fed pause a few months later, followed by outright rate cuts).

To avoid a repeat of the same mistake, there are now whispers that the Fed is considering implementing a policy being termed, average inflation targeting (AIT).

Under AIT, the Fed would target inflation over 2% to offset years when inflation had been below target. My interpretation is that it would let inflation run by as much as 2.5% or 3.5% or 4% to make up for below-target inflation in previous months/years.

But just as the old saying goes, "the road to perdition is paved with good intentions". Certainly, this "bright idea" could prevent a repeat of 2018 experience when the Fed tighten too fast and too much that it killed off the green shoots of inflation.

Then again, by moving the goalpost in order to hit its target, the Fed is sacrificing its credibility. Instead of its aim at providing greater transparency and clearer forward guidance to financial markets and economic agents, this "idea" if adopted only muddies the waters.

For instance, what would be the highest inflation rate the Fed will tolerate after six months, 12 months, 24 months, or more, of below-target annual growth in the PCE price index?

Factset's latest report indicates that financial markets are betting on the Fed to rip roar on inflation. "FT said investors are piling into Treasury inflation-protected securities, or TIPS, as Fed is considering the idea of letting consumer price increases run above target..."

Funny that, because at about the same time that the Fed is pondering to let inflation loose and hang free, the AFR reports: "A growing number of economists believe the Reserve Bank of Australia should reduce its 2 to 3 per cent medium-term inflation target ... to between 1 and 3%".

That is, the RBA should start raising interest rates if measured inflation breaches the 2% mid-point (instead of the current 2.5%) and vice-versa.

Sure, the Fed and the RBA will have a better chance of achieving their inflation targets by moving their respective goalposts but this comes at a price of their credibility.

Link to something ntkT5KyT