Article by Michael Gregory, CFA, Deputy Chief Economist, originally published on 8 March 2019 as a Feature by BMO Capital Markets.
Last November, the Federal Reserve announced that it will review the “strategies, tools, and communication practices it uses to pursue its congressionally-assigned mandate of maximum employment and price stability.” The review will include “outreach to a broad range of interested stakeholders”, with public events to occur throughout this year. The Fed officially adopted inflation targeting in January 2012, and this will be its first formal review.
The Bank of Canada has been following an inflation-targeting policy framework since February 1991. Eyeing the 2021 renewal of the latest (five-year) agreement with the Government of Canada on the joint commitment to the inflation target, the Bank is, again, engaged in reviewing the framework for potential improvement, as it has done ahead of previous renewals. While the 2% target for the 12-month change in the CPI has not changed for the past 28 years, other aspects of the framework have been tweaked as part of these reviews. For example, in 2001, the BoC changed its guiding core inflation rate from the total CPI excluding food, energy and indirect taxes to the total excluding the eight most volatile components along with indirect taxes. The preferred core inflation rate was changed again in 2016 to the set of three metrics: CPI-common, CPI-median and CPI-trim.
These separate reviews are occurring amid two common major developments that are prodding some serious thinking about (and research on) modifying policy frameworks. First, since the recession, inflation has underperformed persistently relative to the target. Second, estimates of the neutral policy rate have fallen materially.
The Fed targets the 12-month change in the PCE price index, with guidance provided by the core measure (the total excluding food and energy). In December, headline inflation was 1.7% y/y, with the core rate at 1.9% (Chart 1), once again a bit below the 2% target on both fronts. Indeed, looking at the period beginning one year after the end of the recession (to allow some time for lingering recession-related disinflationary pressures to subside), there have been no core inflation readings above 2.1%, while more than three-quarters of the outcomes have been below 1.9% with nearly 60% under 1.7% (Table 1). The average core inflation rate has been 1.6% (the same as the median), with the average headline inflation rate at 1.5% (also the same as the median).
Canada’s performance has not been much better. In January, headline CPI inflation was 1.4% y/y (Chart 2), with the average of the three preferred core rates at 1.9% (which we’ll refer to as the “core”). Identical to the U.S. situation, there have been no core inflation readings above 2.1% since June 2010 (Table 2). Meanwhile, more than 70% of the outcomes have been below 1.9% with more than half under 1.7%. The average core inflation rate has been 1.6%, the same as in the U.S. but with a slightly higher median (1.7%). The average headline inflation rate has been 1.5%, also the same as in the U.S. but, again, with a slightly higher median (1.7%).
There are common explanations for inflation’s underperformance such as residual economic slack, aging populations and technology-enabled disruption. Although these are credible explanations, the fact that neither country is able to post 2% (or higher) headline or core inflation after approaching a decade of economic expansion— with a legacy of chronic inflation underperformance in tow—is starting to erode confidence in the policy frameworks. Just ask the bond market, which seems to be betting on inflation underperformance persisting indefinitely.
The Fed and BoC reviews are asking the question: Is the current framework of always aiming for 2% inflation over the medium term—regardless of what happened in the past (bygones are bygones)—becoming inadequate to attain 2% outcomes and risking re-anchoring inflation expectations at sub-2% levels? The question becomes more pertinent given the emergence of low neutral policy rates.
The FOMC’s range of projections for the longer-run, or neutral, fed funds target rate has fallen considerably since first published in 2012 (Chart 3). From a 3.75%-to-4.50% range with a 4.25% median, it has dropped to 2.50%-to-3.50% with a 2.75% median. The longer-run median projection has fallen 150 bps in just seven years. The Bank of Canada estimates the neutral rate also runs in a 2.50%-to-3.50% range, which is nearly 200 bps below what was estimated in the early 2000s. The issue surrounding low neutral rates is that during economic downturns and central bank easing cycles, you are more likely to hit the effective lower bound (ELB) for policy rates (which now seems to be a small negative rate rather than zero) and, potentially, not provide sufficient monetary accommodation to readily return inflation to target, even allowing for less-precise unconventional tools such as quantitative easing. This could result in chronic inflation underperformance —which smacks of the current situation.
There are frameworks that address this issue, such as “average-inflation targeting” or “price-level targeting”. In them, any persistent undershoot of the 2% target caused by policy rates being constrained by the ELB or secular disinflationary forces would be made up by promoting a controlled overshoot of the target in future years. Bygones would no longer be bygones. The Bank of Canada studied these frameworks leading up to the 2011 renewal and concluded that they would, theoretically, make monetary policy more effective, but it would be hard to build credibility (convincing individuals that a controlled overshoot would never become uncontrolled). But that was a decade ago, and the BoC will be studying these history-dependent frameworks again, as will the Fed, as part of their current reviews. Stay tuned.
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