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Targets vs. ceilings at the Federal Reserve


Three econometricians go hunting. They spot a deer. The first econometrician shoots and misses a foot to the left. The second shoots and misses a foot to the right. The third shouts, “We got it!”

Although inflation is firming up a bit, the Federal Reserve Open Market Committee decided not to raise interest rates on Wednesday. As I explain below, they made the right call.

The figure shows two core inflation measures, the consumer price index and personal consumption expenditures price index, both sans volatile food and energy prices. The horizontal lines show the Fed’s targets for both measures: 2 percent for the core PCE translates into roughly 2.5 percent for the core CPI.

What’s generating the nudge up in price growth? As the job market tightens up, wage growth may be showing signs of life, though the trend is still wobbly. Rents are growing, as that part of the housing market has been pretty tight for a while. Apparel and health care are showing a bit more pricing power. Oil, which is not in the core but still bleeds through a bit, may have carved out a bottom, though at less than $40 a barrel, it’s still putting downward pressure on prices.

Still, shouldn’t the Fed react to this firming trend by further tapping the brakes? What were they thinking?

Readers of this column may expect me to answer my rhetorical question with: They were right to hold and engage in the alliterative exercise that Fed governor Lael Brainard calls “watchful waiting.” I will not disappoint, but not solely for the main reason I’ve articulated in the past: the need to not just get to full employment, but to stay there long enough for the benefits of growth to have a chance to reach those for whom the recovery is something they hear about more than they see in their paychecks.

That’s all still true, of course, but the thing I’d like to stress right now is that this firming of inflation, if it sticks, is an extremely welcome event. What has been so worrisome in recent years is the extent to which the Fed seemed to have lost the ability to hit its inflation target, as you see in the figure. This recent tick up shows they may finally be getting closer.

Which brings up the arithmetic point behind both this post and that hilarious (not…) joke above. The Fed has been very explicit about the fact that its inflation target is a target, not a ceiling. And hitting a target in this context means that if you’ve been below it for some time, you’ve got to spend some time above it. Like the nerdy deer hunters, you have to hit the target on average.

Fed economists make this point themselves in various places. In their recently updated statement of their long term goals, they wrote: “The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep inflation expectations firmly anchored thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.”

The symmetry implications were not lost on former Fed economist Andy Levin, who points out that “the Fed is now crystal-clear that its inflation objective serves as a point target, not a ceiling.”

Were 2 percent on the core PCE a ceiling, and you believed the above trends had momentum, you might be compelled to raise rates. But if 2 percent is a target, as all of this rhetoric suggests, then you’d want to stand pat, as the committee did yesterday, though they clearly reserved the right to return to rate increases in forthcoming meetings.

Understanding the difference between a target and ceiling is important both for the economy, as we need to avoid disinflation (persistently low inflation which is unresponsive to monetary stimulus), and to the Fed’s credibility. As put it in a note the other day, “any central bank that tolerates undershooting of its target but not overshooting is missing its target on average.”

Economist Josh Bivens agrees and offers a cogent warning about the risks of the persistent downside misses: “the past years’ undershooting of wage and price inflation should be matched by an equivalent overshoot as the decent job growth in recent years continues to keep this damage from congealing into permanence.”

I recently wrote a (mildly) critical piece on negative interest rates by central banks, asserting that their use was the banks’ way of “implicitly admitting that they’ve lost control of inflation.” Perhaps that was premature, at least in the U.S. case, but no one can yet be sure.

For now, patience is warranted, as hitting the inflation target clearly implies some months of overshooting it. The deer may escape unharmed, but the economy, and more importantly the people in it, will be better off.