How Does the Fed Manage Inflation? It’s FAIT
The Fed has changed the way it thinks about inflation. Here’s what the new average inflation target policy means.
Along with supporting “maximum sustainable employment,” the U.S. Federal Reserve (the Fed) aims to maintain price stability—that is, to control inflation and prevent prices from rapidly rising or falling. But a shift to a more flexible policy could allow inflation to run higher (and for longer) than it has since the 1970s.
The Fed’s Inflation Outlook: Leaving It to FAIT
In August 2020, the Fed adopted a flexible average inflation target (FAIT). Instead of attempting to keep the rate fixed right around 2% as it had in the past, the Fed announced it would tolerate higher inflation, so long as the average stayed at 2% “over time.”
FAIT (Flexible Average Inflation Targeting)
A policy that allows inflation to rise and fall to meet an average target over time, rather than a set target
Managing monetary policy and money supply to keep inflation at a constant level
PCE (Personal Consumption Expenditures) Price Index
The Fed’s preferred, consistent measure of inflation over time, based on a survey of businesses that captures the price changes in all final goods
The goal of the flexible strategy is to help head off prolonged periods of lower-than-average inflation. It also allows the Fed more room to maneuver when something unexpected happens in the economy. The COVID-19 pandemic is a classic example.
A 2% average may not seem so different from the original 2% target. But because the Fed hasn’t defined how long “over time” might be, inflation could potentially rise (or fall) more drastically and faster than it has in decades.
How Has the Fed Previously Controlled Inflation?
The Fed (the U.S. central bank) aimed for a set 2% target inflation rate, as measured by annual price changes (PCE, Personal Consumption Expenditures). According to the Fed, that rate would help it meet its “dual mandate” to maintain maximum sustainable employment and stable prices.
The Fed had maintained an unofficial 2% policy starting as early as 1996 (see Figure 1), similar to other central banks’ inflation targets. It wasn’t until 2012, in the aftermath of the financial crisis, that the Fed announced it was officially targeting the 2% rate.
The Fed attempted to keep inflation at a constant level by adjusting its monetary policy and money supply. This “inflation targeting” may prompt the Fed to raise the federal funds rate whenever inflation approaches 2%.
A higher federal funds rate increases borrowing costs, which can slow economic growth and prevent inflation from rising.
Figure 1 | Right On Target? Inflation and the Fed's Target Rates
Source: FactSet. Data as of 11/29/2021. Average annual inflation. Rates of inflation are calculated using the current Consumer Price Index from the Bureau of Labor Statistics (BLS).
Inflation Expectations: What’s Different (and How to Prepare)
Millennial and Gen Z consumers—and investors—have never experienced the shock of significant inflation on their current and future finances. And their parents and grandparents haven’t felt such pain at the gas pump and grocery store since the 1980s.
The change in the Fed’s inflation-targeting method sets up a different environment than many investors are used to.
It could be time to take one or more of these steps:
Check your spending and, if needed, look for ways to adjust your budget.
Confirm or update your financial goals. You might decide to delay your retirement date so you can build up your nest egg, or perhaps put off a home purchase—or take the plunge now while interest rates remain low—because of rising prices.
Review your investments with the possibility of higher inflation for a longer time in mind. Consider whether you’re diversified enough for this situation or if you have any investments that offer the potential for inflation protection.
Being aware that something has changed—and could affect you over the long term—is a good place to start preparing for what might be ahead.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.