The Fed Must Think Creatively Again

NEW HAVEN – The transitory inflation debate in the United States is over. The upsurge in US inflation has turned into something far worse than the Federal Reserve expected. Perpetually optimistic financial markets are taking this largely in stride. The Fed is widely presumed to have both the wisdom and the firepower to keep underlying inflation in check. That remains to be seen.

For its part, the Fed counsels patience. It is so convinced that its bad forecast will eventually turn out to be correct that it is content to wait. No surprise there: The Fed telegraphed such a response with the “average inflation targeting” framework that it adopted in the summer of 2020. In doing so, the Fed indicated that it was prepared to forgive above-target inflation to compensate for years of below-target inflation. Little did it know what it was getting into.

In theory, average inflation targeting seemed to make sense – an elegant arithmetic consistency of undershoots balanced by overshoots. In practice, it was flawed from the start. It was an inherently backward-looking approach, heavily conditioned by a long experience with slow growth and low inflation. The Fed believed, as did many, that the pandemic shock of early 2020 was cut from the same cloth as the 2008-09 global financial crisis, underscoring the possibility of yet another anemic, disinflationary recovery that could push already-low inflation dangerously toward deflation.

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