Fed's inflation strategy likely to hold despite criticism

On Wednesday, Federal Reserve Chair Jerome Powell indicated that the central bank's "average inflation targeting" (AIT) strategy, which has faced significant scrutiny, may largely remain in place after a comprehensive review set for this year, Reuters reported.

Despite the criticism, the Fed's 20-year average core rate of inflation based on the "personal consumption expenditures" (PCE) gauge is 2.1%, aligning closely with their 2% inflation goal. However, the recent spike in inflation has brought political and economic challenges, with January's U.S. inflation readings showing persistent price increases.

The AIT approach was adopted in 2020 to allow for periods of higher inflation to balance out times when the target was undershot, with the aim of supporting maximum employment. However, the strategy has been partly blamed for the Fed's delayed response to rising inflation in 2021, when core PCE inflation exceeded 5%.

Critics argue that the framework did not adequately consider the risks of overshooting the inflation target.

Economists from UBS anticipate that this year's review will seek to balance the focus on inflation and employment more equally, with increased attention given to inflation expectations. These expectations have recently averaged closer to 3.5% over the past five years, which could influence the Fed's future policy decisions.

As the Fed prepares to adjust its monetary policy strategy, it may continue to maintain policy rates above the estimated 3% to 3.5% neutral rate to ensure inflation reverts to the 2% target, barring significant labor market downturns. This suggests that the bond market and the broader economy might expect a more stringent stance from the Fed extending beyond this year.

The upcoming review will also consider the dual mandate of price stability and maximum employment, possibly clarifying the latter's definition. The Fed's ability to adapt to new economic shocks will be a critical aspect of the review, necessitating careful language to avoid the pitfalls of the original AIT framework's introduction.

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