Can Fed, ECB Fully Adjust Their Monetary Strategies?

The Federal Reserve introduced flexible average inflation targeting (FAIT) in 2019-20 to improve performance in a low interest rate world. The Fed believed it had a problem with low inflation, as its preferred measure of inflation had averaged just over 1.5% between 2010 and 2019. The review committing the central bank to a flexible average inflation target put a clear asymmetry into US monetary policy. If inflation overshot the target, it would be treated as a bygone, while if it undershot, it would not be bygone. The Fed would be slower to raise rates, allowing an overshoot to occur.

The Federal Open Market Intervention (FAIT) has been criticized for not being robust enough to handle various economic situations and policy challenges. Former Fed Vice-Chair Don Kohn suggested that the central bank should produce a framework that is “robust to a variety of circumstances” such as periods of high inflation and the Zero-Lower Bound (ZLB). However, it is unlikely that FAIT was responsible for most of the inflation experienced by the US and others.

A robust framework for a monetary strategy should include inflation averaging 2% and policymakers being aggressive enough to keep inflation expectations near 2%. Most analysts agree that the Fed’s mistake was in not acting aggressively enough with big supply shocks and should think more about its interpretation of its current strategy. The ECB’s monetary policy strategy strikes a balance between symmetric commitment to the 2% target and forceful or persistent monetary policy action to prevent negative deviations from the inflation target from becoming entrenched.