Federal Reserve chairman Jerome Powell has announced the outcome of the Fed’s Review of Monetary Policy Strategy, with revisions to the key statement that guides US monetary policy. While the shift to average inflation targeting might sound similar to the Australian approach, the new strategy will result in a more activist Fed that will put pressure on the RBA to lift its game.
The Fed’s revised Statement on Longer-Run Goals and Monetary Policy Strategy commits US monetary policy to “achieve inflation that averages 2 per cent over time”. Previously, US monetary policy effectively treated the 2 per cent inflation goal as a ceiling rather than a central tendency for its preferred measure of inflation.
The new formulation envisages that “following periods when inflation has been running persistently below 2 per cent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time”.
In practice, this should see the inflation rate averaging somewhat higher relative to recent experience, where US inflation has persistently undershot the 2 per cent goal.
This sounds similar to the formulation in Australia’s Statement on the Conduct of Monetary Policy, which commits the RBA to achieving an inflation rate of 2-3 per cent, on average, over time.
However, it is not just the mid-point or central tendency of the two inflation targets that differs. While the RBA’s inflation goal is notionally higher than the Fed’s, the Fed has now adopted a very different approach to inflation target misses.
As deputy governor Guy Debelle once explained, the RBA’s average “refers more to the distribution of inflation outcomes than to a strict average of CPI outcomes. That is, the intent is that over the course of the business cycle, the bulk of the distribution of year-ended inflation outcomes should lie between 2 and 3 per cent, not that the annualised average inflation rate from the start of the business cycle to the end should necessarily lie between 2 and 3.”
The Fed’s revised approach is closer to the second of these interpretations. Instead of treating previous inflation target misses as bygones, as the RBA does, the Fed will now seek to make up for previous misses.
This is a step in the direction of price-level targeting, where the process of making up for past misses keeps the price level on a steady long-run 2 per cent growth path. By contrast, the RBA’s approach allows for permanent deviations from that path as previous monetary policy mistakes are effectively written off.
While the Fed and RBA have undershot their respective inflation goals in recent years, the Fed’s revised approach will make this less likely by mandating corrective policy actions.
The Fed’s revised strategy also flags a more flexible approach to achieving full employment. The Fed and RBA have over-estimated the unemployment rate consistent with their inflation objective in recent years. This partly explains why they have undershot their inflation targets.
While both have recognised this mistake, the Fed has now changed its approach to targeting full employment. The RBA has simply recalibrated its approach to a new guess at the unemployment rate consistent with its inflation goal.
Under its current approach to inflation targeting, the RBA has increasingly failed deputy governor Debelle’s criterion for the distribution of inflation outcomes within the target range. Inflation under governors Macfarlane and Stevens was within the target range about 50 per cent of the time and undershoots and overshoots were broadly symmetrical. By contrast, governor Lowe has seen inflation persistently below the target he agreed with the government.
Compared to the Fed, the RBA’s response to the pandemic shock has been timid, driven by Lowe’s conviction that monetary policy has less to contribute at low interest rates.
While the RBA readily concedes there is more it could do, it lacks conviction in the efficacy of its existing policy instruments, despite a wealth of overseas experience to the contrary. Instead, the RBA has handballed the job of stabilising the economy to the government and fiscal policy.
The over-reliance on fiscal relative to monetary policy is reflected in the Australian dollar exchange rate, which began appreciating immediately after the RBA implemented its current policy stance in March and is now near highs for the year, with some market economists forecasting a multi-year appreciation to around 0.80 US cents.
The Fed has learned something from its past mistakes and is now committed to a more activist approach to deliver on its mandate. This will put pressure on the RBA to lift its game or leave Australia with a monetary policy that is too tight both in absolute terms and relative to the US.