Does the Fed need to adjust its inflation target?

Matt O’Brien, in an article in the Washington Post yesterday, states that the Federal Reserve needs to rethink its inflation target of 2%. He says that, instead of having an annual inflation target of 2% or below, the Fed should target an average inflation rate of 2%. “The Fed, then, needs to be like a cop that doesn’t give us a ticket (raise rates) as soon as we go over 55 mph (2 percent inflation), but rather lets us get up to 65 or 70 mph (2.5 or 3 percent inflation) before it does anything.”

O’Brien believes that this slight change in approach would allow the Fed more flexibility in responding to economic conditions, instead of reacting to inflation or inflation expectations by driving interest rates higher than necessary. He cites Australia as an example of a country with national banking policy using the “average” approach, and states that Australia hasn’t had a recession since 1991.

Brian Cheung of Yahoo Finance yesterday quoted Fed Chairman Jerome Powell as saying that “inflation expectations are now the most important driver of actual inflation.” He also provided a graphic that shows that since the Fed implemented the 2% target, the annual inflation rate has stayed below 2%. This observation has the Federal Reserve rethinking its approach to the 2% inflation target, to possibly allow excessive inflation in the future when the economy is going well, so that it will be able to raise rates sufficiently high and still be able to keep them above zero when the recession comes.

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