The Fed's One-Sided Inflation Rule: Counterbalance Low Inflation But Not High Inflation

The Federal Reserve's approach to inflation, whether it exceeds or falls below the target, is asymmetrical. In a formal policy framework, policymakers have determined that if inflation remains below the target for an extended period, they are willing, if not inclined, to allow inflation to surpass the target for a few years. This aims to maintain average inflation close to the target. However, in cases where inflation exceeds the target over multiple years, there is no obligation to offset the excess. The issue with this one-sided rule is that it leads to unequal outcomes and demonstrates a clear bias in policymaking, which could have repercussions in the future.

In 2020, the Federal Reserve made a significant policy shift by adopting a new inflation policymaking mandate. This shift states that 'Following periods when inflation has been persistently below 2 percent, the appropriate monetary policy will likely aim to achieve moderately above 2 percent for some time,' is designed to ensure that inflation averages 2% over time. Yet, in practice, this has created a one-sided rule: force inflation higher when it runs below target, but never force inflation lower when it runs considerably above target.

Four years before the Fed changed its policy response to inflation, core CPI inflation averaged 2.1%, with three of four years over 2% and one year under. In the last four years (assuming 2024 inflation matches its first eight months rate), core CPI has averaged 4.6% or over 1000 basis points over the 2% target.

A similar overshoot script occurs with the PCE core price index. In the past four years, core PCE has averaged 4%, or 800 basis points overshoot. In the four years before the change in 2020, core PCE ran at an average rate of 1.7%, or 100 basis points below the target.

Only in the Fed's math-world does an 800 basis point overshoot in PCE inflation offset a 100 basis point undershoot, and the trade-off of the traditional measure of inflation (CPI) is ever more skewed, from 1000 basis points to zero.

At this week's FOMC policy meeting, the financial markets expect policymakers to lower official rates by 25 basis points, with an outside chance of a more aggressive cut of 50 basis points. If policymakers vote for lower official rates, it will clearly show a one-sided inflation policy rule.

Inflation trends change yearly, and another period of higher-than-target inflation than the markets and Fed expect can't be ruled out. The fact that policymakers have never accomplished their initial inflation goal adds to the uncertainty.