Yahoo U: Inflation Targeting

The Federal Reserve will roll out strategies to restore the U.S. economy. Yahoo Finance's Brian Cheung weighs in.

Video Transcript

ADAM SHAPIRO: So the big news last week is that the Federal Reserve intends on overshooting its 2% inflation target. But why would the Fed want more inflation? And how exactly does the Fed plan on doing that? Yahoo Finance's Brian Cheung explains all of that in this week's Yahoo U. Brian?

BRIAN CHEUNG: Well, Adam, you can almost think of it like a game of ring toss. But before we get into that, at the Jackson Hole Conference last week, as you mentioned, the Federal Reserve did say that it will allow inflation to, quote, "moderately overshoot its 2% target after periods where it has persistently run below its target." So we all know what inflation means. It means how much prices rise. So let's take a look at exactly what the numbers look like.

So this is inflation as measured by core personal consumption expenditures, which is the Fed's preferred measure of inflation. This is a measure of personal consumption expenditures. This is the Fed's preferred measure of inflation.

And you have to keep in mind that in 2012, the Fed began targeting 2% inflation. So that's the level that the Fed feels is low enough to make sure that inflation doesn't skyrocket. And again, 2% is that line right there. Now, inflation, though, is also a proxy, though, for consumption and investment, which is a major driver in any growing economy, which is why the Fed is also not targeting zero inflation.

But here's the problem-- you can see from the chart here, even though the Fed has said it wants 2% inflation, the economy has persistently undershot that over the last eight years. It's come in at about 1.6%. Actually, I may have drawn that a little bit too high. But why does this matter, though, the shortfall between the 2% target and where core personal consumption expenditures have come in over the last eight years?

Well, again, as I mentioned, you can think of this almost like a game of ring toss. So let's say you're shooting for a peg that's 10 feet away from you, right. I'm shooting three rings and they all fall short. And, by the way, this is the first time that I've worn a tie during the quarantine here.

But you're going to say, all right, if I undershot the peg, I'm just going to calibrate, right? I'll get my swagger back. You just gotta let me shoot here.

So I'm going to take seven more shots. All of them, all 10 have now fallen short of the peg. So anyone that's watching this is going to go OK, you know what, I think there might be a serious problem here. And I don't think it has anything to do with the peg, which hasn't moved. I think it has something to do with the guy that's throwing the peg.

Now, if you're spectating this whole disaster, you're going to think a few things, right? First of all, that Brian can't credibly catch the peg, right? He can only undershoot it. Sorry, let me go back. Now, that's going to lead to, well, Brian's hot trash at this ring toss game, OK? And then the last thing you're going to think is no one's going to want to play this ring toss game with Brian.

So let's take it back to the Fed, right? Think of the peg now as 2% inflation. And think of the rings as undershooting that target. So the interpretation, if the Fed is doing this, is a few fold.

First of all, that the Fed can't credibly hit its 2% inflation target. Next, there is also the fact that low interest rates just haven't been as effective at getting consumption and investment up to the 2% target, which the Fed said it wanted to get to. That was the case post-crisis until the Fed began raising rates in 2015. The last kind of conclusion here, though, is that if the Fed says it wants to get 2% inflation, it delivers accommodative policy but it doesn't get there. Maybe that suggests that the Fed will have less power to counteract future downturns.

So what's the solution to all this? Well, if you think-- if you think of it in terms of the ring toss game, maybe it's just giving a little bit more oomph in the toss, right? Maybe if you keep undershooting it, just give it a little bit more strength and it'll maybe hit the mark right there, right on top of the peg.

And that's exactly what the Fed is doing here. So last week on Thursday, Chairman Powell made that big speech that everyone was tuned into. And the big announcement or change in the statement was that following periods when inflation has been running persistently below 2%-- again, undershooting-- appropriate monetary policy will likely aim to achieve inflation moderately above 2%, which is overshooting for some time. And that's called flexible average inflation targeting, which you may have heard him use in that speech.

Now, as I wrap up here, there are a few questions that remain about all of this, right? First of all, how long will the Fed allow itself to overshoot its target? How much is it going to try to overshoot that?

If you're thinking about the peg, is that one foot beyond the peg? Is that two feet beyond the peg? Maybe three feet beyond the peg?

But there's a problem with the institutional fear of runaway inflation. I don't need to rewind to the late '70s for a lot of people watching this to show that inflation can be a very, very dangerous thing for an economy. But the Fed can get it right-- not too high, not too low. The idea is that it can hook its rings right there on the peg, which would add a little bit of credibility to the Fed, and maybe get a real game going. Adam?

ADAM SHAPIRO: Brian Cheung's Yahoo U's also post to the YahooFinance.com web page. So you can get a refresher on the course in time for the extra exams.