In the period from 2021 to 2023, inflation soared to levels far beyond what the Federal Reserve had hoped for. This unexpected surge in inflation was also significantly higher than what had been forecasted by the markets. Many have questioned whether the Fed should be forgiven for allowing inflation to overshoot its target by such a large margin. However, the answer is a resounding no. To understand why, let’s explore how things would have looked under both inflation targeting and price level targeting, assuming the Fed’s inflation target is 2%.
Let’s start by assuming that the price level was at 100 in March 2021, with the Fed aiming for a 2% annual increase in prices, equivalent to a 0.5% quarterly rise. In an ideal scenario of inflation targeting, the price level would have increased as follows over two years:
Case A: 100, 100.5, 101, 101.5, 102, 102.5, 103, 103.5, 104
Now, let’s consider a scenario where the Fed consistently underestimated quarterly inflation by 1% for 8 consecutive quarters under inflation targeting:
Case B: 100, 101.5, 103, 104.5, 106, 107.5, 109, 110.5, 112
In this case, the total increase in the price level over two years would have been 12%, with an average annual inflation rate of 6%, significantly higher than the target of 2%.
However, if the Fed had adopted price level targeting instead, aiming to achieve the price level path shown in Case A at every point in time, the outcome would have been different:
Case C: 100, 101.5, 102, 102.5, 103, 103.5, 104, 104.5, 105
Despite making the same errors in forecasting inflation as in Case B, the price level path in Case C closely aligns with the ideal path shown in Case A. Under price level targeting, the inflation rate averages 2.5% per year between March 2021 and March 2023, a much lower rate compared to the 6% inflation seen in Case B.
In reality, there was approximately an extra 8% inflation in the two years following March 2021. This occurred despite the Fed’s adoption of “average inflation targeting,” which should have resulted in a price level path closer to Case C than Case B. It is clear that the Fed did not adhere to the policy regime it had communicated to the public, as it did not truly target the average inflation rate.
The Covid-related supply chain disruptions and the Ukraine War cannot serve as valid excuses for the Fed’s policy missteps. Not only did inflation overshoot the target, but nominal GDP growth also exceeded the 4% growth path by a significant margin. The policy stance was undeniably too expansionary by all measures. Blaming the inflation surge on missed market forecasts is also unjustified, as under either level targeting or a genuine average inflation targeting regime, market forecast errors would have resulted in a minimal overshoot, similar to what we see in Case C.
In conclusion, the Fed’s failure to effectively manage inflation during the 2021-2023 period cannot be excused. The discrepancy between the intended policy regime and the actual outcomes highlights the need for a more proactive and consistent approach to monetary policy. By learning from past mistakes and embracing more accurate targeting strategies, the Fed can work towards ensuring price stability and economic prosperity in the future.
