Joseph G. Carson

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Federal Reserve has spent over a year conducting a review of its monetary policy strategy, tools, and communication process. The review was an academic re-assessment of an academic experiment called inflation targeting. The new framework of inflation averaging is an extension of the inflation-targeting regime, with a longer timeline.

This decision on inflation targeting moves monetary policy closer to a rule-based framework. A rule-based framework creates the premise that there are no legitimate objectives besides the item being targeted.

Inflation targeting was never supposed to become a rule-based framework. Proponents of the practice argued it would help increase the "transparency" of conventional monetary policy and emphasize the commitment toward maintaining a low and steady inflation environment.

Inflation targeting has never delivered the macroeconomic results that were promised. That's because it has no practical foundation, focuses on a narrow set of prices that are not entirely market-determined, and creates an uneven playing field between the economy and finance. Inflation averaging will compound the errors.

First, mandating an inflation rate of 2% has no theoretical justification.

There is no such thing as an "ideal" or steady rate of inflation. Policymakers have never offered any empirical evidence to justify a 2% inflation target because none exists.

Research and actual experiences show that an inflation rate too high or too low for an extended period can create imbalances and bad economic outcomes. But that range is very wide.

In the mid-to-late 1990s reported core consumer price inflation averaged more than 100 basis points above the inflation rate of the last decade and the macro performance in terms of growth, job creation and wage gains was far superior.

Policymakers have the freedom to change their operating framework. But any framework should be grounded with solid research and not made up with "alternative" facts to support its use as a policy tool.

Second, inflation targeting falsely assumes there is absolute perfection in price measurement.

Subtle changes in the prices and quality of goods and services make price measurement at times a "best guess". Every year government statisticians face new products, changes in old products, shifts in demand, and company pricing strategies.

One of the most complex issues in price measurement is the pervasiveness of item replacements. Item replacement refers to a process whereby government statisticians must select and price a different product because the one previously included could not be found. Previous studies have found that some items are replaced more than once a year and annual replacement rates could be as high as 30% for products.

But item replacements are uneven year-to-year and therefore so too is the judgment component of reported inflation. As a result, price changes that are down or up a tenth or a quarter of a percent from year to the next should be considered nothing but statistical noise. But a rule-based inflation-targeting framework will compel policymakers to fiddle with the stance of policy to account for the noise in price measurement.

How is it that policymakers nowadays have fallen in the trap of placing so much importance on a single statistic to conduct monetary policy?

Third, the Fed's inflation-targeting regime mistakes indirect measures of inflation for direct ones.

A critical aspect of the design of price targeting is the selection of the price series. The price series must be timely and a direct measure of inflation.

The consumer price index (CPI) is the only direct measure of consumer prices. But policymakers have opted to use the personal consumption deflator (PCE). The PCE deflator is not a direct measure of prices since 70% of the prices come from the CPI. The other 30% is based on non-market prices.

Four of the past 5 years, the core CPI has exceeded the 2% target. The only year it missed was 2018 when it was 1.8%. That small undershoot from the 2% target is not statistically significant and certainty not large enough to trigger a change in the stance of monetary policy.

Over the same 5-year period, core PCE ran nearly 75 basis points below the core CPI rate. Almost all of that difference can be explained by the "invisible" prices, or prices for items that are in the PCE but not in CPI.

Does it make sense to base policy decisions on "invisible" prices?

Fourth, inflation targeting lacks balance in anchoring consumer inflation expectations with investor expectations.

The announcement of an inflation target is intended to reduce uncertainty over the future course of inflation and anchor people's inflation expectations. It is hard to prove that the formal announcement of inflation targeting has had any impact on people's inflation expectations.

According to the University of Michigan's consumer sentiment survey, people's one-year inflation expectations have fluctuated between 2.5% and 3% for the past 20 years, moving above or below the range during an economic crisis or oil shocks. Perhaps people are unaware of the Fed's 2% inflation target or that "experienced" inflation consistently higher than reported inflation.

But investors are readily aware of the Fed's inflation target. Every little tweak in the Fed's policy statement on inflation and its impact on official rates triggers almost an instant reaction on the part of investors.

One of the inherent weaknesses of inflation targeting is the inability to balance consumer and investor expectations. That is, as policymakers attempt to simultaneously hit an arbitrary price target and anchor inflation expectations they are inadvertently un-anchoring investor expectations as it eliminates the fear of higher interest rates, encouraging extreme speculation and risk-taking in the financial markets.

Why do policymakers only focus on people's inflation expectations and not people's/investor's asset price expectations as well since both have become unstable at times resulting in bad economic outcomes?

Informal and formal price targeting has been in the Fed's tool kit for the past 25 years or so. The effects on income and portfolio flows are not similar to conventional monetary policy. At the end of 2019, the market value of equities in people's portfolios stood at 3X times workers income, up from 1X times in the mid-1990s.

The shift to inflation averaging compounds the unevenness. That's because inflation averaging will extend the period of low-interest rates, encouraging more speculation and risk, increasing gains in finance over the economy.

A critical review of the pros and con's inflation targeting will have to wait for the next crisis. It usually takes three crises before policymakers realize something is fundamentally wrong with their framework.

By then there will be a number of new academic papers that will highlight the flaws of inflation targeting/averaging, expanding on those that are listed in this article while adding others as well.


Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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Federal Reserve has spent over a year conducting a review of its monetary policy strategy, tools, and communication process. The review was an academic re-assessment of an academic experiment called inflation targeting. The new [...]

"Averaging" Inflation Does Not Eliminate The Flaws In The Fed's Policy Approach; It Compounds Them

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The sharp drop in operating profits in 2020 mirrors the decline of 2008. But the mix of profits is markedly different, with the bulk of the decline centered in non-financial industries.

The crisis of 2020 is centered more so in the general economy unlike the financial/banking crisis of 2008. That means the policy response requires more fiscal stimulus than monetary ease.


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Painting By The Numbers 

In Q2, the GDP measure of operating profits showed a decline of 11% and that comes on the heels of a 12% drop in Q1. The two-quarter decline of 23% nearly matches the 25% decline in operating profits in Q4 2008 during the Great Financial Recession.

But there are two key differences; first, the 2020 occurred over two quarters, while the decline in 2008 occurred in one; and second, the 2020 decline is almost entirely concentrated in non-financial companies while finance accounted for the bulk of the decline in 2008.

S&P 500 companies operating profits show a bigger decline, a different quarterly pattern, but a similar mix. According to the data compiled by S&P, operating profits for the largest companies declined 33% over the past two quarters. But the decline was concentrated in Q1, dropping 50% from the Q4 levels, while Q2 profits showed a gain of 36% over Q1.

The detailed industry profit data from S&P shows that the big turnaround from Q1 to Q2 is centered in finance. The financial sector lost money in Q1 but posted an increase in Q2. The GDP profit data also shows operating profits in finance rebounded sharply in Q2, rising 11%.

Trading gains and losses are considered part of S&P operating profits, but not in the GDP measure of operating profits. But the financial sector posted gains under both accounting frameworks. So trading gains are not the primary reason for the Q2 rebound in profits in finance.

The 25% decline in non-financial industries operating profits over the past two quarters is much more severe than the 15% drop in Q4 2008. Industry details from S&P show the weakest performers are energy, consumer discretionary, and industrials. Detailed non-financial industry data from GDP are not yet available.

The GDP data does show that the aggregate level of operating profits for non-financial companies stood at $966 billion in Q2. That's a decline of $330 billion from Q4 2019 and represents the lowest level of operating profits since 2011. Real profit margins for non-financial companies are estimated at 10.5%, the lowest level since 2009.

At mid-year 2020, non-financial firms employ nearly 10 million more workers compared to 2011. But that's after they have already shed more than 10 million workers since the start of the year.

Reports that previously laid-off workers are being told that they will not be rehired should not come as a surprise. Many firms don't have the level of profitability to support re-hiring. Lack of confidence in the future trends in business conditions also plays a role as the pandemic continues to disrupt businesses as does the on-and-off-again support from governmental policies.

Congress appropriated more than $3 trillion in fiscal stimulus, a record amount, to people and businesses. But that federal support abruptly ended on July 31st when Congress and the White House could not agree on a second round of stimulus. Failure to extend federal stimulus payments removes at least $750 billion a month from what people were seeing in terms of cash flow in Q2.

Equity investors have been betting that the combination of monetary ease and fiscal stimulus will build a strong and long bridge to keep the economy running until a vaccine is medically approved. With broad equity averages at record highs, the bulls have won the argument for now.

But what happens as the fiscal well runs dry, companies are operating with record debt levels and the monetary spigot is not pouring out liquidity, as fast as it was a few months back?

Cracks in the bull case are quickly starting to emerge. The consumer confidence index for August dropped 7 points to 84.8. That's a new low for 2020, reversing the federal stimulus-related gains of the prior three months.

People's assessment of labor markets turned sharply negative, consistent with the million-plus jobless claims being filed week after week. People are also expressed concern about their financial well-being at the same time the S&P 500 hit a new record high.

The equity market is not the economy, but the direction of the economy will ultimately determine if the equity market can maintain the lofty levels for the simple reason investors are banking on better news in corporate earnings. But without a new round of fiscal stimulus, it's hard to see how corporate earnings can meet bullish investor optimism.


Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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The sharp drop in operating profits in 2020 mirrors the decline of 2008. But the mix of profits is markedly different, with the bulk of the decline centered in non-financial industries. The crisis of 2020 is centered more so in the [...]

2020 Drop In Operating Profits Mirrors 2008: Different Mix Shows The Need For More Fiscal Support

USD/EUR exchange rate uncoupling from interest rate differential

Widespread downgrading of 2025 GDP outlook

Trade and fiscal policy uncertainty has exploded with the new administration

Much lower US electricity costs gives it a competitive advantage

Wage growth slowing in the US and Euro area; elevated and sticky in the UK

Stagflation-lite: Blue Chip forecasts below-trend growth and elevated inflation

US policy gyrations boosting policy uncertainty worldwide

Expected tariff hikes have boosted inflation expectations

US and Japan ended 2024 on solid ground in contrast to Europe

US economy expected to outperform other major economies in 2025

Only modest evidence of AI-related surge in US productivity growth

Previous Trump tariffs fading. A boost from new tariffs ahead?

Heavy US manufacturing states underperforming while Sun Belt states outperforming

Rising long-term yields a global phenomenon

US financial market concerns shifting from growth to inflation

Economic activity is picking up in the US but remains lackluster abroad

Policy uncertainty has surged since the US national elections.

Recent turnaround in US economic surprises leading to increases in rate-cut expectations

The outlook has brightened in the US, while it has dimmed for other major economies

Headline US PCE inflation elevated by sticky services prices

US and global equity prices have recently diverged

US leading global upturn in economic surprises

Blue Chip forecasters look for further significant monetary easing apart from Japan

Recent rise in global supply chain pressures could augur a pickup in global inflation pressures

Underperforming German economy generating increased policy uncertainty relative to Europe and the US

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Paul L. Kasriel

The CHIPS (Creating Helpful Incentives to Produce Semiconductors) Act was signed into federal law on August 9, 2022. The CHIPS Act provides various subsidies for the production of semiconductors in the US. Semiconductors are an integral component in numerous kinds of equipment, including defense equipment. A major impetus for passing the CHIPS Act was national security.

The encouragement of domestic semiconductor production seems to be coming to fruition. In the advance estimate of Q1:2025 real GDP, released on April 30, 2025, the annualized change in the production of real information processing equipment skyrocketed to 69.3%, as shown in Chart 1.

250430X1.jpg

Those who are in the economic forecasting “profession” likely had penciled in a large increase in their forecast of Q1:2025 information processing equipment in that there was a large increase (29% annualized)  in the production of semiconductors in the Federal Reserve’s Q1:2025 industrial production report (see Chart 2). The Federal Reserve also provides monthly data on the production of semiconductors. The monthly annualized percent changes in semiconductors are plotted in Chart 3. As you can observe, in both Q1:2024 and Q1:2025, the surges in semiconductor production were “front loaded” in the sense that January increases were much larger than the subsequent February and March increases. (I’ll leave it to reader(s) as to why I am highlighting the January 2025 increase.)

250430X2.jpg

250430X3.jpg

So, we might say “mission accomplished” in terms of the CHIPS Act stimulating the domestic production of semiconductors. But the current presidential administration has indicated that it wants to scrap the CHIPS Act and replace it with tariffs on imported semiconductors. If it ain’t broke, why fix it? Subsidies or tariffs – which one would be better for aggregate economic welfare? Tariffs on semiconductors would penalize all of the consumers of the end products in which semiconductors are a component. Moreover, domestic producers of semiconductors would have an incentive to raise their prices under the umbrella of higher-priced imports subject to the tariff. Government subsidies to semiconductor producers are not free. Current or future taxpayers will bear the cost of the subsidies. But should not the cost of national security be “socialized”? My bet is the cost of the government subsidizing the semiconductor sector is less than the cost of imposing tariffs on imported semiconductors. Hmm, this might apply to other things deemed important for national security such as steel and aluminum.

Good Bye Mr. CHIPS?

Charles Steindel

The Federal Reserve Bank of Philadelphia’s state coincident indexes in March were a touch firmer than in February, but not robust. In the one-month changes, West Virginia was on top with a .77 percent gain, while South Dakota, Indiana, Montana, and South Carolina were also up more than .5 percent. Nine states were down, with Connecticut’s .23 percent drop being the largest. Over the three months ending in March, five states were down, with Massachusetts off .48 percent (Connecticut and Rhode Island also showed declines, obviously suggesting some softness in southern New England). West Virginia was up 2.06 percent, and South Carolina, Montana, Indiana, and South Dakota also rising more than 1 percent. Over the last twelve months, Iowa and Michigan were down, and twelve others saw increases of less than one percent. No state had an increase higher than four percent, and only four were at or higher than three percent. Utah’s index rose 3.33 percent, while Michigan was down 1.48 percent.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .61 and 2.44 percent. Both measures appear to be a bit weaker than the state numbers.

State Coincident Indexes in March 2025

March was another month of little change in state labor markets. The sum of payroll changes among the states was close to the national result, and revisions eliminated most of the gap initially seen for February. Six states saw statistically significant gains in jobs in March, with Pennsylvania increasing by 20,900 and Missouri up .5% (Texas reported a larger, not statistically significant, gain than Pennsylvania). A few states had insignificant declines.

Three states (Connecticut, Massachusetts, and Virginia) had statistically significant changes in their unemployment rates, with Connecticut’s .2 percentage point rise being the larges. Indiana reported a significant .2 percentage point drop. The highest unemployment rates were in Nevada (5.7%), DC (5.6%), Michigan (5.5%) California (5.3%), and Kentucky 5.2). Hawaii, Montana, Nebraska, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0%, while South Dakota’s 1.8% was yet again the lowest in the nation.

Puerto Rico’s unemployment rate was unchanged at 5.3% and the island’s job count moved up by 800.

State Labor Markets in March 2025

Viewpoints: September 2020

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"Averaging" Inflation Does Not Eliminate The Flaws In The Fed's Policy Approach; It Compounds Them

2020 Drop In Operating Profits Mirrors 2008: Different Mix Shows The Need For More Fiscal Support