Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Average Inflation Targeting
Transcript
- Lucas: So the Federal Reserve has an inflation target of 2 percent. That part everyone knows. But what happens when inflation has been running below 2 percent for years — like it did through most of the 2010s — and the Fed wants to signal that it'll let inflation run a little hotter to make up for lost ground? Luna: That's exactly the logic behind average inflation targeting — or AIT. The Fed adopted it in August 2020, right in the middle of the pandemic. Lucas: Right. Before that, the Fed used a simple symmetric 2 percent target. If inflation was below target, they would ease policy — but they weren't explicitly committing to overshoot later to bring the average up. AIT changed that by saying: after periods where inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time. Luna: And that phrase 'for some time' is doing a lot of work. It's intentionally vague — the Fed didn't specify a fixed averaging period like five years or ten years. Lucas: Exactly. They called it a 'flexible form of average inflation targeting.' And that flexibility is both a strength and a weakness. Let's look at what happened after 2020. Inflation surged in 2021 and 2022, topping out above 9 percent in June 2022. Suddenly the Fed wasn't worried about undershooting — it was scrambling to bring inflation down. Luna: So the first real test of AIT came in exactly the opposite scenario from what it was designed for. The framework was built to address a low-inflation world, but the post-pandemic world was high-inflation. Lucas: Precisely. And that created a communication challenge. Critics argued that AIT made the Fed too slow to raise rates in 2021 because it was still in 'makeup mode' — wanting to let inflation run above 2 percent to compensate for the previous decade of undershooting. But the Fed's leadership, including Chair Powell, has said that was not the case — that the framework didn't prevent them from acting aggressively when inflation appeared. Luna: Do you buy that? I mean, the Fed did wait until November 2021 to start tapering asset purchases, and didn't raise rates until March 2022. That's later than many central banks. Lucas: It's a fair question. But I think the bigger factor was uncertainty about the persistence of inflation. The supply-chain shocks were expected to be transitory. That call turned out wrong, but it wasn't purely a framework issue. Still, AIT did add some noise to the signals the Fed was sending. Luna: And what about the other side — after inflation peaked, did AIT play any role in the tightening cycle? For example, the Fed kept rates high through 2024 even as inflation came down. Lucas: That's more about the lagged effects of policy and the Fed's commitment to bringing inflation fully back to target. AIT doesn't say you should accept inflation above target indefinitely — it says you should aim for 2 percent on average. Once inflation was clearly above target, the Fed's job was to bring it down. And they did: the PCE inflation rate, the Fed's preferred measure, fell from a peak of 7.1 percent in June 2022 to around 2.3 percent by late 2024. Luna: So in practice, AIT became somewhat dormant during the tightening phase. But now that inflation is close to target, does AIT come back into play? Lucas: That's the interesting question for 2026. If inflation stabilizes at, say, 2.1 or 2.2 percent, the Fed could say 'mission accomplished.' But what if the economy weakens and inflation drifts below 2 percent? Then AIT says the Fed should let it run above 2 percent later — but that's hard to communicate when the immediate problem is low inflation. Luna: And it's not just the Fed. The Bank of Japan has been grappling with a similar challenge for decades. They've had periods of deflation and very low inflation, and they've tried various forms of commitment to overshoot — but without a formal AIT framework. Lucas: The Bank of Japan actually introduced something close in 2016 with its 'overshooting commitment' — pledging to expand the monetary base until inflation exceeded 2 percent and stayed above. But that was tied to a specific quantitative target, not an average. And it didn't work well — inflation stayed stubbornly low until the recent global inflation spike. Luna: So what's the verdict? Is AIT a useful tool or a distraction? Lucas: I think the concept makes theoretical sense. If a central bank has a symmetric target but always undershoots, inflation expectations can drift downward. AIT is a way to anchor expectations more firmly at 2 percent by committing to make up for lost ground. The problem is execution — defining the averaging period, communicating the strategy, and actually following through when the economy throws you a curveball. Luna: And there's also the question of credibility. If the Fed says it will let inflation run above 2 percent for a while, but then when it does, they quickly raise rates — as happened in 2022 — the market might not believe future promises. Lucas: That's a real risk. Some research suggests that the Fed's AIT framework didn't significantly boost inflation expectations during the low-inflation years. And the rapid tightening cycle may have eroded the framework's credibility. But to be fair, the pandemic was an unprecedented shock. No framework could have predicted that. Luna: Let's talk about the global perspective. The European Central Bank concluded its own strategy review in 2021 and adopted a symmetric 2 percent target — but explicitly rejected average inflation targeting. Why? Lucas: The ECB's concern was that AIT can be too complicated to communicate across 20 different countries with different economic cultures. They preferred a simple, clear target that emphasizes symmetry — meaning they are equally concerned about inflation above and below 2 percent. They also worried that AIT might tie their hands too much. Luna: So the Fed went with flexibility, the ECB went with simplicity. Which approach is likely to win out over the next decade? Lucas: I'd watch what the Bank of Canada and the Reserve Bank of Australia do. They're both conducting framework reviews this year and next. If they adopt something like AIT, it could signal a broader shift. But if they stick with symmetric targeting, the Fed's experiment might remain an outlier. Luna: You know, speaking of experiments — one thing we really value on this show is the freedom to explore these nuanced topics without any commercial interruptions. We keep the podcast ad-free because we think it lets us go deeper. Lucas: Absolutely. And that's only possible because some listeners choose to support us directly. If you've been getting value from these episodes, you can find the link at buy me a coffee dot com slash fexingo. No pressure — just a way to keep this independent. Luna: And it makes a real difference. Every contribution helps us keep the lights on and the topics coming. Now back to central banks. Lucas: So where does AIT go from here? The Fed is scheduled to conduct its next framework review in 2026, and it's widely expected that AIT will be reassessed. Some Fed officials, like Minneapolis President Neel Kashkari, have suggested the framework worked well and should be retained. Others, like former Governor Christopher Waller, have been more critical. Luna: I've seen estimates that the Fed's next review might result in a hybrid approach — keeping the spirit of AIT but with a clearer averaging period, like the five-year average the Reserve Bank of New Zealand uses. Lucas: That would be a logical compromise. A five-year average would give the Fed a concrete benchmark while still allowing for flexibility. For example, if inflation averaged 1.5 percent over a five-year period, the Fed would need to run inflation above 2 percent for a while to bring the average up to 2 percent. That's more transparent than 'for some time.' Luna: But wouldn't that create a mechanical rule? The Fed has always resisted strict rules-based approaches. Lucas: Yes, but a five-year average is not a rule — it's a reference point. The Fed would still have discretion in how and when to make up for past misses. And it would help anchor expectations more concretely. The key is that the framework must be credible, and credibility requires clarity. Luna: So as we look ahead, the big question is: will the Fed stick with AIT, modify it, or abandon it? And what signal would that send to markets? Lucas: If the Fed abandons AIT entirely, it might be seen as admitting the framework failed its first real test. But if they keep it with modifications, it shows a willingness to learn and adapt. My hunch is they'll keep the core idea but add more specificity — perhaps around the time horizon. Luna: And that would make the Fed's approach more like what economists call 'makeup strategies' — which is really what AIT is at heart: a promise to make up for past misses. Lucas: Exactly. And no matter what framework they choose, the ultimate goal remains the same: to keep inflation low and stable, and to support maximum employment. AIT is just one tool in the toolbox. The challenge is using it wisely.