Adjusted average inflation rate

What Is Adjusted Average Inflation Rate?

The Adjusted Average Inflation Rate refers to a monetary policy framework where a central bank aims to achieve an inflation rate that averages a specific target over time, rather than strictly hitting that target in any given period. This approach falls under the broader financial category of Monetary policy. The primary goal is to anchor inflation expectations around the target, allowing for periods when inflation runs above the target to compensate for previous periods when it fell short, and vice-versa. This contrasts with traditional flexible inflation targeting, which largely treats past deviations from the target as "bygones."

History and Origin

The concept of inflation targeting gained prominence among central banks in the early 1990s, with New Zealand, Canada, and the United Kingdom among the first to adopt it. Germany had already implemented many elements of this approach earlier. The Federal Reserve, the central bank of the United States, officially adopted an explicit 2% inflation target in January 2012 as part of its "Statement on Longer-Run Goals and Monetary Policy Strategy."²⁴, ²⁵

However, following the 2008 Global Financial Crisis, many economies, including the U.S., experienced prolonged periods where inflation persistently ran below central banks' targets, even with historically low interest rates²², ²³. This posed challenges, as the "zero lower bound" on nominal interest rates limited the ability of central banks to provide further economic stimulus. In response, a comprehensive review of monetary policy strategy was undertaken by the Federal Reserve, concluding in August 2020. This review led to a significant shift, with the Federal Open Market Committee (FOMC) announcing that it would seek to achieve inflation that "averages 2 percent over time."²⁰, ²¹ This evolution, known as Average Inflation Targeting (AIT) or Adjusted Average Inflation Rate, aims to ensure that "following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."¹⁸, ¹⁹ This adjustment was designed to better anchor longer-term inflation expectations and enhance the Federal Reserve's capacity to promote maximum employment and price stability¹⁷.

Key Takeaways

• The Adjusted Average Inflation Rate is a monetary policy strategy where a central bank aims for inflation to average its target over time, compensating for past deviations.
• It allows for periods of above-target inflation to make up for previous periods of below-target inflation.
• This approach was adopted by the Federal Reserve in 2020 to address challenges posed by persistently low inflation and the effective lower bound on interest rates.
• The goal is to firmly anchor long-term inflation expectations around the target, fostering greater economic stability.
• It is a key component of modern monetary policy frameworks designed to achieve both price stability and maximum employment.

Formula and Calculation

The Adjusted Average Inflation Rate does not have a single, universal formula because the "average" period is often flexible and determined by the central bank's discretion, often looking at past deviations. However, the underlying calculation of inflation itself typically relies on a price index, such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) price index (the Federal Reserve's preferred measure).

The inflation rate is generally calculated as the percentage change in a price index over a specific period. For example, to calculate the annual inflation rate:

Where:

• (\text{CPI}_{\text{Current Year}}) = Consumer Price Index for the current period.
• (\text{CPI}_{\text{Previous Year}}) = Consumer Price Index for the previous period.

In the context of an Adjusted Average Inflation Rate, a central bank might monitor the average of these annual inflation rates over a rolling period (e.g., eight quarters) or assess how current and projected inflation deviates from the long-term target, with the understanding that future policy actions will aim to bring the average back to the target.¹⁶

Interpreting the Adjusted Average Inflation Rate

Interpreting the Adjusted Average Inflation Rate involves understanding that temporary deviations from the target are not necessarily seen as policy failures, but rather as part of a dynamic strategy to achieve the target over a longer horizon. If a central bank has a 2% average inflation target and inflation has been consistently below this for several years, the central bank might intentionally allow inflation to run moderately above 2% for a period to bring the long-term average back into line. This flexibility aims to make the central bank's long-term commitment to its price stability mandate more credible, especially in environments where conventional tools, such as lowering interest rates, are constrained by the effective lower bound. It encourages market participants and the public to maintain inflation expectations consistent with the long-run target.¹⁵ This is crucial because well-anchored expectations can prevent self-fulfilling prophecies of either deflation or runaway inflation, helping to maintain stable economic growth.

Hypothetical Example

Imagine a hypothetical economy where the central bank has adopted an Adjusted Average Inflation Rate target of 2%.

• Year 1: Due to an unexpected economic slowdown, inflation falls to 1%. The average over time begins to dip below 2%.
• Year 2: Inflation remains low at 1.5% as the economy struggles. The cumulative average for the past two years is ((1% + 1.5%) / 2 = 1.25%), still below target.
• Year 3: The central bank, operating under its Adjusted Average Inflation Rate framework, decides to keep interest rates lower for longer, signaling its intent to allow inflation to overshoot the target. As the economy recovers, inflation rises to 3.5%. The average for the three-year period is now ((1% + 1.5% + 3.5%) / 3 = 2%).
  In this scenario, the central bank allowed a period of higher inflation (3.5%) to offset the earlier periods of below-target inflation, thereby achieving its 2% target on average over the three years. This demonstrates the "make-up" aspect of the Adjusted Average Inflation Rate, which aims to reinforce the long-term purchasing power of the currency.

Practical Applications

The Adjusted Average Inflation Rate framework is primarily a tool for central bank monetary policy. Its practical applications are seen in:

• Setting Interest Rates: Central banks, such as the Federal Reserve, use this framework to guide decisions on benchmark interest rates. If past inflation has been below target, they might keep rates lower for longer, even as the economy strengthens, to encourage inflation to moderately exceed the target.¹⁴
• Managing Inflation Expectations: By explicitly committing to averaging the target over time, the central bank aims to reinforce the public's belief that prices will remain stable in the long run. This helps prevent deflation or uncontrolled inflation, which can disrupt financial markets.¹³
• Economic Stabilization: This policy provides greater flexibility to respond to economic shocks. During downturns where inflation falls, the framework allows for a more accommodative stance, reducing the likelihood of hitting the "zero lower bound" on interest rates, which can limit the effectiveness of monetary policy.¹¹, ¹²
• Communication Strategy: It guides central bank communication, providing a clearer rationale for policy actions that might otherwise appear to deviate from a strict point target. This transparency enhances accountability and helps shape market behavior. The Bureau of Labor Statistics (BLS) plays a crucial role in providing the underlying Consumer Price Index (CPI) data, which is widely used to measure inflation and inform policy decisions.¹⁰

Limitations and Criticisms

While the Adjusted Average Inflation Rate offers increased flexibility, it is not without limitations and criticisms. One significant challenge lies in defining the "average" period. If the central bank does not clearly communicate the horizon over which the average is calculated, it can create uncertainty among market participants and potentially undermine the credibility of the policy.⁸, ⁹

Another criticism is that a central bank might find it difficult to convincingly commit to allowing inflation to "overshoot" the target. If, after a period of undershooting, inflation starts to rise, there could be public and political pressure to curb it, potentially leading the central bank to deviate from its stated average target. This could harm the central bank's credibility. Some argue that measuring inflation accurately, particularly under dynamic economic conditions or during periods of supply shocks, can be surprisingly challenging, which might complicate the implementation of an average targeting strategy.⁶, ⁷ The International Monetary Fund (IMF) has also noted the complexities of accurately measuring inflation and its various components.⁴, ⁵ Additionally, the effectiveness of the Adjusted Average Inflation Rate relies heavily on how well inflation expectations are anchored; if expectations become de-anchored, the policy's ability to influence economic outcomes could diminish.

Adjusted Average Inflation Rate vs. Inflation Targeting

The primary difference between the Adjusted Average Inflation Rate and traditional inflation targeting lies in how past deviations from the target are treated.

While traditional inflation targeting focuses on hitting a specific inflation rate at all times, the Adjusted Average Inflation Rate acknowledges that achieving the target perfectly in every period might not be feasible or desirable, especially when interest rates are very low. Instead, it permits temporary overshoots or undershoots to ensure that the long-term average aligns with the desired inflation objective. This distinction is crucial for understanding the nuances of modern monetary policy frameworks.

FAQs

What is the main purpose of the Adjusted Average Inflation Rate?

The main purpose is to ensure that inflation averages a specific target over time, especially after periods when it has run persistently below that target. This helps to firmly anchor long-term inflation expectations.

Which central bank uses this policy?

The Federal Reserve adopted the Adjusted Average Inflation Rate (or Average Inflation Targeting) as part of its updated monetary policy framework in August 2020.

¹, ²### How does it differ from a fixed inflation target?
A fixed inflation target aims to hit a specific percentage (e.g., 2%) in every period, letting past deviations go. The Adjusted Average Inflation Rate explicitly seeks to compensate for past deviations, allowing inflation to run above or below the target temporarily to achieve the target on average over a longer period.

Does this mean inflation will always be higher?

No, it does not mean inflation will always be higher. It means that if inflation has been too low for some time, the central bank might aim for it to be moderately above the target for a period. Conversely, if inflation has been too high on average, they would aim for it to be below the target. The goal is to average out to the target over the long run, thereby maintaining price stability.