The Fed’s targeting the wrong forecast13th March 2019
David Beckworth has a nice interview with Ryan Avent, which touches on a number of monetary issues. In the final part of the interview they both suggest that the Fed may be treating their 2% (PCE) inflation target as a sort of ceiling, rather than the symmetrical target the Fed claims to be aiming at.
I share their frustration, but I suspect the problem lies elsewhere. I believe the Fed would actually prefer that PCE inflation average 2%. Instead, I suspect the Fed is consistently missing its target in recent years because they are relying on a flawed (Keynesian) model, which bases its inflation forecasts on concepts such as the Phillips Curve. They would have been much more successful if they had instead relied on market forecasts. (Of course NGDP level targeting is far superior to inflation targeting.)
Lars Svensson has argued that the Fed should target its own internal forecast of inflation. Two facts lead me to believe that this is exactly what they are doing. First, the Fed sees the world in a very “conventional” way. It’s a big institution full of mainstream economists. Second, mainstream economists have been forecasting roughly 2% PCE inflation over the past 11 years, since the US entered the Great Recession. Here are the 11 most recent forecasts of PCE inflation over the next two years, in each case representing the 4th quarter forecast from the Philadelphia survey of private sector economists:
(The data shows the date of the forecast, then the next year inflation rate, then the two-year forward inflation rate.)
2018:Q4 2.1% 2.1%
2017:Q4 1.8% 2.0%
2016:Q4 1.9% 2.0%
2015:Q4 1.8% 1.9%
2014:Q4 1.8% 1.9%
2013:Q4 1.9% 1.9%
2012:Q4 2.0% 2.2%
2011:Q4 1.7% 2.0%
2010:Q4 1.4% 1.8%
2009:Q4 1.3% 1.8%
2008Q4: 1.8% 2.2%
The Fed believes that its policy affects inflation with a long lag. So it seems reasonable to assume they set policy with the goal of getting inflation on target in the second year. In that case, they’ve almost perfectly targeted the Philly Fed consensus, where expected 2-year forward inflation averages 1.983% over the 11-year period. That’s not 2.0%, but it’s extremely close.
Actual PCE inflation has been much lower (averaging 1.5% from 2008:Q4 to 2018:Q4), but that’s not because the Fed was secretly targeting lower inflation; it’s because they used bad forecasts.
If the Fed had instead targeted something like TIPS spreads, minus 0.25% to account for the fact that CPI inflation runs about 0.25% above PCE inflation, then they would have done a far better job of hitting their inflation target. The TIPS spread is not perfect, with sudden oil price changes biasing it slightly, and a small risk spread, but it’s better than relying on professional forecasters.
PS. Pat Horan and I have a new piece on MMT.
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