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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.