The Fed’s Targeting The Wrong Forecast

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.

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