Targets vs. Projections

There is a widespread view that the Fed’s “longer run projections” for the inflation rate can be interpreted as targets that the Fed will attempt to hit. The logic goes something like this. Suppose (as we shall presume) that the Fed has some target for the inflation rate but that it does not announce that target explicitly. The Fed will do its best to hit that target. It may not hit the target exactly: it may undershoot the target, or it may overshoot the target. Since the Fed is aiming directly for the target, the Fed is equally likely to undershoot the target by any given amount as to overshoot the target by the same amount. Therefore the target itself is also the Fed’s best “average” guess as to what the actual inflation rate will be. Thus, if the Fed makes a forecast (or a “projection”), we can conclude that the forecast is equal to the target.

Unfortunately, there is a flaw in this logic. The fact that the Fed is aiming directly for the target does not imply that the Fed is equally likely to undershoot as to overshoot the target by any given amount. If you’re driving directly down the middle of a lane but the right side of the lane is more slippery than the left, you’re more likely to skid to the right than to the left. From the Fed’s point of view, the possibility of undershooting its target should be considered more “slippery” than the possibility of overshooting the target.

If the Fed overshoots its target, it can tighten policy and push the inflation rate back toward its target, just as, if you start to veer to the left, you can turn the steering wheel to the right and get back in your lane. If the Fed undershoots its target, it may find itself in the same sort of liquidity trap that it is in today. In that case, policy may become ineffective, and the Fed may not be able to correct the undershoot. If you skid to the right, where the road is icy, then turning the steering wheel to the left immediately will not help you get back in your lane. So while your “target” is the middle of the lane, an “average forecast” would have to account for the fact that you’re more likely to miss that target on the right than on the left. Similarly, the Fed is more likely to undershoot its target than to overshoot.

So a target and a forecast are not the same thing. If the Fed were to release both a set of targets and a set of forecasts for future inflation rates, the targets should be higher than the forecasts. And if (as it has in fact done) the Fed releases only forecasts (or projections) and not targets, then, if we are to take the Fed at its word, and if the Fed agrees with the logic of my last paragraph, then we should conclude that its implicit inflation targets are higher than the inflation rates that appear in its projections.

Unfortunately, even if the Fed does agree with my logic, I don’t think we can take the Fed at its word. My impression is that the Fed is playing a language game in which all parties have implicitly agreed that the word “projection” will be used to mean “target.”

If this is true, then it’s bad news, because it means that the average expected inflation rate over the “longer run” will be less than the Fed’s projected “central tendency” of 1.7% to 2%. And more specifically, it means that the risk of deflation will never be entirely gone. If you’re on a four-lane highway and the right shoulder is icy, you’re better off driving in the left lane, where there is minimal risk of veering onto the icy part. But the Fed has declared its intention to keep driving in the right lane – at less than 2% inflation, right next to that icy place where a severe recession (much like the one we are currently experiencing) could render policy ineffective.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.