Evaluating Two Decades of Inflation Targeting

Since the mid-1990s, the Federal Open Market Committee (FOMC) has had an implicit or explicit annual inflation target of 2%. In August, the FOMC revised its monetary policy framework to say that the Fed would seek an average inflation target of 2% over the long run, as noted in a recent Economic Synopses essay.

Carlos Garriga, senior vice president and director of research, and Matthew Famiglietti, a research associate, used the revision of the framework as an opportunity to evaluate how successful the Fed has been at achieving its dual mandate (price stability and maximum employment) over the past 25 years.

“So far, the FOMC has done a reasonably good job, in a statistical sense, of keeping unemployment low and prices stable in the era of inflation targeting outside of large recessionary events, including the dot-com bubble, the Great Recession, and the COVID-19 pandemic,” the authors wrote.

A Simple Illustration of Success Rate

To assess the Fed’s success rate concerning monetary policy, the authors examined how often the U.S. economy had a given unemployment and inflation combination over the period January 1995 to August 2020.

For inflation, they looked at the core personal consumption expenditures price index (core PCE), which excludes prices on food and energy to mitigate short-term volatility. For unemployment, they considered periods when unemployment was under 6% to be periods of high levels of employment, but also expanded the bound to 8% to account for periods of economic recovery or moderate recessionary periods.

They pointed out a few of the inflation-unemployment combinations, including:

• For 30.5% of the time, core PCE inflation was in the 1.75%-2.25% range, and unemployment was below 6%.
• For 46.4% of the time, core PCE inflation was in the 1.5%-2.25% range, and unemployment was below 6%.
• For 52.9% of the time, core PCE inflation was in the 1.5%-2.25% range, and unemployment was below 8%.

“In light of this evidence, one can argue that for approximately half the time in this recent era of monetary policy, the FOMC has been well within a reasonable range of its dual mandate,” the authors wrote.

The authors also looked at headline PCE inflation and noted that using the more volatile measure suggests that the Fed was significantly less effective in anchoring inflation. For only 32.1% of the time, headline PCE inflation was in the 1.5%-2.25% range while unemployment was less than 8%.

“There are pros and cons to selecting a less-volatile measure such as core PCE, and this can have large implications for evaluating the effectiveness of Fed policy during this period,” they added.

The New Framework

Under the new monetary policy framework, the FOMC is communicating that it will begin to tolerate short-run inflation moderately exceeding 2% for some time in order to achieve inflation that averages 2% over the long run. This suggests that the distribution of inflation-unemployment combinations could shift to tolerate inflation above 2%, Garriga and Famiglietti noted.

“The credibility of the target made this a very unlikely outcome in the past, but the new guidance could deliver more inflation outcomes above the current inflation target,” they said. “To what degree the FOMC can accomplish this remains an open question.”

Additional Resources

• Economic Synopses: A Simple Evaluation of Two Decades of Inflation Targeting: Lessons for the New Monetary Policy Strategy
• On the Economy: Market-Based Measures of Inflation Risks
• On the Economy: How Well Do Consumers Forecast Inflation?