Average Inflation Targeting Research Articles

Determinacy and E-Stability with Interest Rate Rules at the Zero Lower Bound

We evaluate and compare alternative monetary policy rules, namely average inflation targeting, price level targeting, and traditional inflation targeting rules, in a standard New Keynesian model that features recurring, transient zero lower bound regimes. We use determinacy and expectational stability (E-stability) of equilibrium as the criteria for stabilization policy. We find that price level targeting policy, including nominal income targeting as a special case, most effectively promotes determinacy and E-stability among the policy frameworks, whereas standard inflation targeting rules are prone to indeterminacy. Average inflation targeting can induce determinacy and E-stability effectively, provided the averaging window is sufficiently long.

Would Households Understand Average Inflation Targeting?

Yes, they would. We collect medium- and longer-term inflation expectations from 9,000 individuals in Germany. Unconditionally, the average probability mass is well-centered around the ECB’s inflation aim of 2%. In a randomized control trial, we subject groups of respondents with information about a hypothetical alternative ECB monetary policy regime akin to the Federal Reserve’s flexible average inflation targeting (AIT). Inflation expectations significantly increase for the treated individuals. When provided with additional assumptions about current inflation, individuals update their expected inflation path in line with the central banks’ intentions. Individuals with a high trust in the ECB’s ability to achieve price stability adjust their inflation expectations particularly strongly. We assess the economic significance of our findings by comparing two model economies under different monetary policy strategies, calibrated to match the difference in medium-term inflation expectations from our survey results. Inflation is six times less volatile and the frequency of hitting the lower bound of interest rates substantially reduced under AIT.

Determinacy and E-stability with Interest Rate Rules at the Zero Lower Bound

This paper examines the uniqueness and learnability of rational expectations equilibrium when the policy rate is occasionally pegged at the zero lower bound (ZLB). We consider a model that features recurring, transient ZLB regimes and compare various interest rate rules which respond to inflation, price level, and average inflation in addition to output. In this environment, determinacy conditions ensure a unique equilibrium, given the recurrence of ZLB events, and E-stability conditions can rule out deflationary spirals under learning. We fi nd that price level targeting, including nominal income targeting as a special case, most effectively promotes determinacy and E-stability among the policy frameworks, while the economy under a standard inflation targeting rule is prone to indeterminacy. Average inflation targeting can promote determinacy and E-stability very effectively, provided that the measure of average inflation is sufficiently backward looking.

Average Inflation Targeting: Time Inconsistency and Ambiguous Communication

Average Inflation Targeting: Time Inconsistency and Ambiguous Communication

Average Inflation Targeting: Time Inconsistency and Intentional Ambiguity

Average Inflation Targeting: Time Inconsistency and Intentional Ambiguity

Macroeconomic stabilisation and monetary policy effectiveness in a low-interest-rate environment

The secular decline in the equilibrium real interest rate observed over the past decades has materially limited the room for policy-rate reductions in recessions, and has led to a marked increase in the incidence of episodes where policy rates are likely to be at, or near, the effective lower bound on nominal interest rates. Using the ECB's New Area-Wide Model, we show that, if unaddressed, the effective lower bound can cause substantial costs in terms of worsened macroeconomic performance, as reflected in negative biases in inflation and economic activity, as well as heightened macroeconomic volatility. These costs can be mitigated by the use of nonstandard instruments, notably the joint use of interest-rate forward guidance and large-scale asset purchases. When considering alternatives to inflation targeting, we find that make-up strategies such as price-level targeting and average-inflation targeting can, if they are well-understood by the private sector, largely undo the negative biases and heightened volatility induced by the effective lower bound.

Macroeconomic Stabilisation and Monetary Policy Effectiveness in a Low-Interest-Rate Environment

The secular decline in the equilibrium real interest rate observed over the past decades has materially limited the room for policy-rate reductions in recessions, and has led to a marked increase in the incidence of episodes where policy rates are likely to be at, or near, the effective lower bound on nominal interest rates. Using the ECB's New Area-Wide Model, we show that, if unaddressed, the effective lower bound can cause substantial costs in terms of worsened macroeconomic performance, as reflected in negative biases in inflation and economic activity, as well as heightened macroeconomic volatility. These costs can be mitigated by the use of nonstandard instruments, notably the joint use of interest-rate forward guidance and large-scale asset purchases. When considering alternatives to inflation targeting, we find that make-up strategies such as price-level targeting and average-inflation targeting can, if they are well-understood by the private sector, largely undo the negative biases and heightened volatility induced by the effective lower bound.

The Princeton School and the Zero Lower Bound

In the early 2000s, a small group of economists at Princeton University revived the debate over liquidity traps and developed a framework for monetary policy at the zero lower bound. Paul Krugman’s 1998 Brookings paper provides the basic model that underlies much of the new view, but work by Ben Bernanke, Michael Woodford, Gauti Eggertsson, and Lars Svensson also played an important role in reshaping our view of stabilization policy at the zero bound. By the late 2010s, their ideas had begun to influence policy at the Federal Reserve. Research by Krugman and other Princeton School members provided the rationale for the Fed’s new policy of flexible average inflation targeting, which is the most important shift in the Fed’s policy regime in several decades. Comparing the Princeton School to other recent developments such as market monetarism and NeoFisherism helps to illuminate both sets of ideas.

The Deflationary Bias of the ZLB and the FED’s Strategic Response

The paper shows, in a simple analytical framework, the existence of a deflationary bias in an economy with a low natural rate of interest, a Zero Lower Bound (ZLB) constraint on nominal interest rates and a discretionary Central Bank with an inflation mandate. The presence of the ZLB prevents the central bank from offsetting negative shocks to inflation whereas it can offset positive shocks. This asymmetry pushes average inflation below the target which in turn drags down inflation expectations and reinforces the likelihood of hitting the ZLB. We show that this deflationary bias is particularly relevant for a Central Bank with a symmetric dual mandate (i.e. minimizing deviations from inflation and employment), especially when facing demand shocks. But a strict inflation targeter cannot escape the suboptimal deflationary equilibrium either. The deflationary bias can be mitigated by targeting “shortfalls” instead of “deviations” from maximum employment and/or using flexible average inflation targeting. However, changing monetary policy strategy risks inflation expectations becoming entrenched above the target if the natural interest rate increases.

The Deflationary Bias of the ZLB and the FED's Strategic Response

The paper shows, in a simple analytical framework, the existence of a deflationary bias in an economy with a discretionary Central Bank, low natural rate of interest and a Zero Lower Bound (ZLB): the presence of the ZLB prevents the central bank from offsetting negative shocks to inflation which pushes average inflation below the target; this drags down inflation expectations and reinforces the likelihood of hitting the ZLB. We show that this deflationary bias is particularly relevant for a Central Bank with a symmetric dual mandate (i.e. minimizing from inflation and employment), especially when facing demand shocks. But a strict inflation targeter cannot escape the sub-optimal deflationary equilibrium either. The deflationary bias can be mitigated by targeting shortfalls instead of deviations from maximum employment and/or using a flexible average inflation targeting. However, changing monetary policy strategy risks inflation expectations becoming entrenched above the target if the natural interest rate increases.

Heterogeneous Labor Market Effects of Monetary Policy

This paper analyzes the heterogeneous effects of monetary policy on workers with different levels of labor force attachment. Exploiting variation in labor market tightness across metropolitan areas, we show that the employment of populations with lower labor force attachment--Blacks, high school dropouts, and women--is more responsive to expansionary monetary policy in tighter labor markets. We develop a New Keynesian model with heterogeneous workers that explains these results. The model shows that expansionary monetary shocks lead to larger and more persistent increases in the employment of low attachment populations when the central bank follows an average inflation targeting rule and when the Phillips curve is flatter. These findings suggest that the Federal Reserve's recent move from a strict to an average inflation targeting framework will especially benefit workers with lower labor force attachment.

Policy Rule Forward Guidance Following the COVID-19 Recession

The Federal Open Market Committee’s revised Statement on Longer-Run Goals and Monetary Policy Strategy implements flexible average inflation targeting and mitigates shortfalls, rather than deviations, of employment from its maximum level. We first show how the Taylor, balanced approach, and balanced approach (shortfalls) rules in the Monetary Policy Report could be modified to be consistent with the revised statement. Federal funds rate prescriptions from the consistent rules are both closer to the liftoff from the effective lower bound in December 2015 and provide a closer fit to the actual federal funds rate than the rules currently included in the Report. We then compare prescriptions from the rules with the Committee’s forward guidance. While all of the rules prescribe liftoff from the effective lower bound before the Committee’s 2024:Q1 prescription, the prescribed liftoff with the balanced approach (consistent) rule is closest to the Committee’s. Finally, we consider longer-run scenarios. While the gap between the federal funds rate prescribed by the consistent rules and the Committee’s framework is about 2.5 percent in 2023:Q4, it is eliminated by 2026:Q2.

Distributional Considerations for Monetary Policy Strategy

We show that makeup strategies, such as average inflation targeting and price-level targeting, can be more effective than a flexible inflationtargeting strategy in overcoming the obstacles created by the effective lower bound in a heterogeneous agent New Keynesian (HANK) model. We also show that the macroeconomic stabilization benefits from such alternative strategies can be substantially larger in a HANK environment than in a representative agent New Keynesian model. We argue that gains in employment outcomes from switching to an alternative strategy would generate disproportionate improvements for historically disadvantaged households and thus have potentially long-lasting effects on the economic well-being of these groups.

Average Is Good Enough: Average-Inflation Targeting and the ELB

The Great Recession and current pandemic have focused attention on the constraint on nominal interest rates from the effective lower bound. This has renewed interest in monetary policies that embed makeup strategies, such as price-level or average-inflation targeting. This paper examines the properties of average-inflation targeting in a two-agent New Keynesian (TANK) model in which a fraction of firms have adaptive expectations. We examine the optimal degree of history dependence under average-inflation targeting and find it to be relatively short for business cycle shocks of standard magnitude and duration. In this case, we show that the properties of the economy are quantitatively similar to those under a price-level target.

Average Is Good Enough: Average-Inflation Targeting and the ELB

The Great Recession and current pandemic have focused attention on the constraint on nominal interest rates from the effective lower bound. This has renewed interest in monetary policies that embed makeup strategies, such as price-level or average-inflation targeting. This paper examines the properties of average-inflation targeting in a two-agent New Keynesian (TANK) model in which a fraction of firms have adaptive expectations. We examine the optimal degree of history dependence under average-inflation targeting and find it to be relatively short for business cycle shocks of standard magnitude and duration. In this case, we show that the properties of the economy are quantitatively similar to those under a price-level target.

A Toolkit for Solving Models with a Lower Bound on Interest Rates of Stochastic Duration

This paper presents a toolkit to solve for equilibrium in economies with the effective lower bound (ELB) on the nominal interest rate in a computationally efficient way under a special assumption about the underlying shock process, a two-state Markov process with an absorbing state. We illustrate the algorithm in the canonical New Keynesian model, replicating the optimal monetary policy in Eggertsson and Woodford (2003), as well as showing how the toolkit can be used to analyse the medium-scale DSGE model developed by the Federal Reserve Bank of New York. As an application, we show how various policy rules perform relative to the optimal commitment equilibrium. A key conclusion is that previously suggested policy rules – such as price level targeting and nominal GDP targeting – do not perform well when there is a small drop in the price level, as observed during the Great Recession, because they do not imply sufficiently strong commitment to low future interest rates (“make-up strategy”). We propose two new policy rules, Cumulative Nominal GDP Targeting Rule and Symmetric Dual-Objective Targeting Rule that are more robust. Had these policies been in place in 2008, they would have reduced the output contraction by approximately 80 percent. If the Federal Reserve had followed Average Inflation Targeting – which can arguably approximate the new policy framework announced in August 2020 – the output contraction would have been roughly 25 percent smaller. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Revisiting the Nexus Between Inflation Targeting and the Build-Up of the Financial Imbalances

The outbreak of the recent global financial crisis in 2007-2008 of the most developed economies, has spurred criticism that inflation targeting central banks may have neglected the build-up of financial imbalances. In other words the global financial and economic crisis highlights that central banks should be more effective in mastering financial instability, and should achieve an explicit goal of financial stability beyond their traditional emphasis on low inflation. In this paper, we aim to assess whether inflation targeting (IT) actually mattered as regards financial stability. Our empirical evidence has been conducted on a group of 41 emerging economies from which 20 economies adopt Inflation Targeting policy and 21 non Inflation Targeting economies as a group of control, over the period 2000-2017. To do this, we evaluate the time varying treatment effect of the IT's adoption on the banking system stability. Additionally using a variety of propensity score matching methods, we show that, on average inflation targeting has an insignificant effect on lowering banking system instability.

Average inflation targeting and interest-rate smoothing

We study the welfare implication of average inflation targeting as a simple interest-rate rule, in which the monetary authority adjusts its short-term policy rate in response to the output gap as well as average inflation deviation from its target instead of reacting to the contemporaneous inflation rate as in a Taylor-type rule. We find that the welfare improvement achieved by switching to average inflation targeting from a standard Taylor rule is modest with a high degree of interest-rate smoothing, whereas it is significant without interest-rate smoothing. We show that average inflation targeting is welfare-improving in the same way as interest-rate smoothing by making the conduct of monetary policy history-dependent. Thus, the high degree of monetary policy inertia in the estimated interest-rate rules in many advanced economies implies that the welfare gain from adopting the average inflation targeting rule would be minimal.

Average Inflation Targeting and Household Expectations

Using a daily survey of U.S. households, we study how the Federal Reserve’s announcement of its new strategy of average inflation targeting affected households’ expectations. Starting with the day of the announcement, there is a very small uptick in the minority of households reporting that they had heard news about monetary policy relative to prior to the announcement, but this effect fades within a few days. Those hearing news about the announcement do not seem to have understood the announcement: they are no more likely to correctly identify the Fed’s new strategy than others, nor are their expectations different. When we provide randomly selected households with pertinent information about average inflation targeting, their expectations still do not change in a different way than when households are provided with information about traditional inflation targeting. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Average Inflation Targeting and Household Expectations

Using a daily survey of U.S. households, we study how the Federal Reserve’s announcement of its new strategy of average inflation targeting affected households’ expectations. Starting with the day of the announcement, there is a very small uptick in the minority of households reporting that they had heard news about monetary policy relative to prior to the announcement, but this effect fades within a few days. Those hearing news about the announcement do not seem to have understood the announcement: they are no more likely to correctly identify the Fed’s new strategy than others, nor are their expectations different. When we provide randomly selected households with pertinent information about average inflation targeting, their expectations still do not change in a different way than when households are provided with information about traditional inflation targeting.