June 3, 2019 / 6:18 AM / 23 days ago

Explainer: The Fed wants ideas on how to target inflation

WASHINGTON (Reuters) - The Federal Reserve is convening experts to discuss overhauling how the world’s most powerful central bank manages the U.S. economy.

FILE PHOTO: Federal Reserve Board building on Constitution Avenue is pictured in Washington, U.S., March 19, 2019. REUTERS/Leah Millis

Fed policymakers and economists meeting in Chicago for a June 4-5 research conference will weigh options on how to best target inflation, part of a year-long review of the central bank’s policy framework.

The Fed plans to decide later in the year whether it will make changes to its framework.

WHY ARE THEY DOING THIS?

The Fed announced a 2% inflation target in January 2012 but since then inflation has almost always been lower. This has shaken policymakers. Besides potentially signaling malaise, weak inflation keeps interest rates low and could give the Fed less room to cut rates in the next recession.

Policymakers also worry about lost credibility. Experts think the Fed gets much of its power to stimulate the economy from the public believing it will deliver on its promises. If the Fed can’t deliver on inflation, its power might wane.

The Fed’s current approach - flexible inflation targeting - entails raising and lowering interest rates to keep inflation as close as possible to 2% while making allowances for what it views to be temporary factors affecting prices. They are debating whether there is a better way.

WHAT ARE THE LEADING ALTERNATIVES?

Two related approaches are price-level targeting and average-inflation targeting.

Under both, the Fed would commit to letting inflation run above target to make up for periods below target. This could fix the perceived flaw in current policy that it makes it too easy to let inflation undershoot the target for long periods.

Under price-level targeting, the Fed would pick a starting point and draw a line into the future that would show where prices would be if they rose 2% a year. If the Fed had done that in 2012, it would currently be so far below target that getting back on track would require 2.5% inflation over the next decade.

Because of the challenges of explaining such a wonky approach to the public, average-inflation targeting has recently generated more excitement. New York Federal Reserve President John Williams has argued the Fed could just aim for inflation to average 2% over a given period, allowing inflation to run above target during periods of strong economic growth to offset times when prices are weak. That might be easier to explain.

WHAT’S THE MOST OUT-THERE IDEA UNDER DEBATE?

Even proponents of nominal gross domestic product, or NGDP, targeting say it may be too radical.

Instead of targeting prices, policymakers would try to target a level of economic output. For example, the Fed might have said in 2012 it wanted output to rise 4% per year, including inflation. It would bet that over time this would amount to about 2% inflation plus 2% growth in the amount of goods and services produced.

The advantage is that central bankers wouldn’t have to guess if deviations from their inflation target are temporary. The disadvantage is that a scenario could arise where policymakers feel obliged to tolerate 4% inflation and zero growth in actual goods and services.

For Congress, which gave the Fed its mandate of fostering stable prices, the whole idea might look odd. NGDP targeting advocate James Bullard, who heads the St. Louis Federal Reserve Bank, concedes it is so experimental it could unleash chaos in financial markets.

Curiously, if the Fed had adopted a 4% NGDP target in 2012, policy would be about on track today.

WILL ANYTHING COME OF THIS?

Maybe not and certainly not immediately. Fed Chair Jerome Powell has said the bar will be high for making changes to the central bank’s framework. The ideas being kicked around may work in theory but not in the real world.

For example, experts say a pledge by the Fed to allow inflation to make up lost ground will only be effective if the public believes that higher inflation really lurks around the corner. And that may not be easy. For the past 10 years, central banks the world over have failed to deliver on inflation goals.

Reporting by Jason Lange; Editing by Dan Burns and Andrea Ricci

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