Inflation Targeting: Could Bad Luck Explain Persistent One-Sided Misses?

from the Richmond Fed

— this post authored by Andreas Hornstein, Joe Johnson, and Karl Rhodes

In January 2012, the Federal Open Market Committee set an explicit inflation target of 2 percent, but the annual inflation rate has been 0.25 percentage points or more below that target for the past 10 quarters. Extended periods of one-sided misses are common among inflation-targeting countries, but it is not clear whether these persistent deviations are caused by structural changes, bad policy, or bad luck. Analysis of the statistical properties of the inflation process in the United States suggests that bad luck remains a plausible explanation for the FOMC’s current string of one-sided misses.

Explicit inflation targeting is a fairly new feature of U.S. monetary policy. The FOMC announced an explicit inflation target of 2 percent in its January 2012 statement of longer-run goals and policy strategy. The committee said “that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures (PCE), is most consistent over the longer run with the Federal Reserve’s statutory mandate” of promoting price stability and maximum employment.

Soon after the FOMC set that target, the annual inflation rate (headline PCE inflation in all references) fell below 2 percent and stayed there. Inflation has remained below target for 13 straight quarters and at least 0.25 percentage points below target for 10 consecutive quarters. Since 2000, the United States has experienced one other such episode – a string of above-target misses from the second quarter of 2004 through the third quarter of 2006. (See Figure 1.) At that September 2015, EB15-09 Economic Brief EB15-09 – Federal Reserve Bank of Richmond Inflation Targeting: Could Bad Luck Explain Persistent One-Sided Misses? By Andreas Hornstein, Joe Johnson, and Karl Rhodes In January 2012, the Federal Open Market Committee set an explicit inflation target of 2 percent, but the annual inflation rate has been 0.25 percentage points or more below that target for the past 10 quarters. Extended periods of one-sided misses are common among inflation-targeting countries, but it is not clear whether these persistent deviations are caused by structural changes, bad policy, or bad luck. Analysis of the statistical properties of the inflation process in the United States suggests that bad luck remains a plausible explanation for the FOMC’s current string of one-sided misses. Page 1 time, the FOMC did not have an explicit inflation target, but for comparative purposes, we are assuming that the committee had an implicit target of 2 percent from 2000 through 2011.

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Source: https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_brief/2015/pdf/eb_15-09.pdf