The Fed’s Average Inflation Target (AIT) will soon tell the Fed to aim for DEFLATION

Back in April I warned that given the massive expansion of the US broad money supply we could very well be heading from double-digit inflation in the US later in 2021 or 2022.

At that time inflation was at 1.6% (March). Today we got inflation for June – and now inflation is at 5.4% and core inflation is at the highest level in 30 years.

So far my inflation simulation seems to be pretty much on track.

But that is not the topic for this blog post – at least not the main topic. Rather I want to discuss what the latest inflation numbers imply for Fed policy going forward.

Back In August 2020 at the online Jackson Hole conference Fed chairman Jerome Powell announced a revision to the Fed’s long-run monetary policy framework by re-framing this goal as an average inflation target (AIT) of 2% over the long-run.

This means that the Fed will tolerate inflation running above (below) 2% for a period if it in periods years has undershot (overshot) it’s target.

This was by many – including myself – interpreted as the Fed for some time could tolerant inflation above 2% as inflation since the outbreak of the Great Recession in 2008-9 far mostly have been below 2%.

The Fed, however, was not very clearly in telling us anything about the the timeframe – is it an average over 2 years, 5 years or even 10 years? We simply don’t know even though it by some Fed officials have been hinted that it probably was 4-5 years.

Where are we now?

The timeframe of course is relevant if we want to judge whether the Fed should ease or tighten monetary conditions going forward.

But lets say we want to give the Fed a lot of room to ease monetary policy and allow inflation to overshoot on the upside.

We can do that by saying that we will take the entire period after 2008 where inflation has been below a 2% trend path.

If we look at the US price level measured by CPI less food and energy then we can compare the actual development in the price level with a 2% trend path.

The starting point is the time, which gives the Fed the most room to overshoot inflation going forward. We get that by starting the 2% “target” path in the Autumn of 2010.

The graph below shows that.

We see that for a long time – particularly from 2013 to 2019 the Fed was undershooting the 2% inflation target. However, just before the Covid-19 pandemic (and the lockdowns!) hit in 2020 the price level was actually back at the 2% target path.

But when the shock hit in 2020 we saw the price level drop below the 2% path, which obviously justified monetary easing.

HOWEVER, we now see that the price level is well-ABOVE the 2% target path.

Consequently, if the Fed is serious about the AIT then US consumer prices should be growing SLOWER than 2% annualized until the price level (CPI core) gets back to the 2% target path.

Presently (June) the US prices level (CPI core) is around 1.5% above the target path and if the trend in inflation over the past year continues in the coming three months then the price level will be 2% above the target level in the Autumn. If my simulation (from) April continue to be correct then it will be an even larger ‘gap’.

This effectively means that in a few month the AIT will actually imply that the Fed should target DEFLATION going forward.

I very much doubt that the Fed will do that and therefore within a few months the Fed will have to revise it’s AIT framework.

One can only wonder what effect that will have on the Fed’s overall credibility.

Leave a comment


  1. James Alexander

     /  July 13, 2021

    What happens if you use Core PCE, the Fed’s actual target measure and not CPI?

  2. Benjamin Cole

     /  July 19, 2021

    A few times in Australia in the past 20 years, inflation got into the 4% range, but then drifted back down to the RBA’s 2%-3% range target. So what?

    This time is different, and we are talking about the US and not Aussie, but there are some one-offs out there, like housing, oil, and the strangest labor market of all time. Used cars.

    Another oddity is that other nations and central banks are below inflation targets, such as Aussie, China, Japan, Indonesia, and even Europe just reported 1.9% inflation, which is not way out there.

    Expectations? Don’t ask me why, but consumers in Japan have been expecting inflation to come back for 20 years, according to consumer surveys. It never did.

    US macroeconomists have spent 40 years predicting higher inflation and interest rates…and they went the other way.

    So does central bank credibility matter? Expectations?

    Probably not. I am selling hot dogs today. If I am selling out, I raise my prices. If I am left with stock, I lower my prices. What the Fed may or may not do….

    Used cars prices are going up because people have money to buy cars, and (maybe) public transit is viewed as unsafe. I do not think used cars buyers are saying, “You know that speech that Jerome Powell gave. He seemed unsure of himself.”

    Another odd tidbit: Core annual CPI prices never got above 9% in the US, in the inflation era.

    Housing prices are a misery, that’s for sure. The solution there, unfortunately, is not found in the Fed, but in thousands and thousands of zoning laws across the US.

    That’s a problem without a solution. The Fed might be better off with the RBA’s 2% to 3% target.

  3. Benjamin Cole

     /  July 20, 2021

    Add on:

    The view from Morgan Stanley, as of today:

    “Global Macro Strategy: All About the Money Supply”

    The relationship between money and CPI inflation is as tenuous as the relationship between labor market slack and CPI inflation. But people still worry about inflation when money supply increases. We dive deep into the pool of money floating around and emerge dry, without worry.

    The Federal Reserve’s narrow M2 measure and the broader Divisia M4 measure of the US money supply reached levels this year not seen even in the 1970s.

    While most acknowledge the loose empirical relationship between the money supply and inflation, the “money multiplier” and “velocity of money” still enter the public discourse invariably when the money supply rises quickly.

    We debunk the money multiplier concept as it applies to a modern monetary system, explain how loans create deposits, and analyze what has driven the money supply higher – banking deposits.

    We discuss how banks have been using this deposit base and the implications for inflation. We don’t think banks have added much to the inflationary impulse.

    We look at how consumers are spending the money that eventually ended up in deposit accounts and the effect it has had on inflation.

    Consumer spending has affected prices in understandable ways. Prices have risen most where spending has been highest: on durable and non-durable goods.

    We find it hard to conclude that the dramatic increase in the money supply drove inflation higher. Rather, higher prices have been due to a combination of supply shortages amidst an unprecedented consumer demand substitution between goods and services.


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