Based on the case study
Inside the Fed: The Fed’s New Monetary Policy Strategy
, the Federal Reserve adopted Average Inflation Targeting (AIT) in August 2020, a strategy in which the Fed seeks to achieve 2% inflation on average over time rather than each year, allowing temporary overshoots or undershoots to offset past deviations.
Suppose the U.S. economy experiences three consecutive years of 1.2% inflation, followed by a supply-driven rebound. Under the Fed’s pre-2020 monetary policy framework, it would continue aiming for 2% inflation regardless of past outcomes. Under the new AIT strategy, how would the Fed’s likely response differ, and what are the theoretical implications for inflation expectations and real interest rates?
Possible interpretations of the Fed’s likely response and implications:
The Fed could tighten monetary policy during the recovery to preempt potential overshooting, demonstrating long-term credibility and keeping inflation expectations anchored near 2%.
The Fed could maintain a strict 2% inflation ceiling regardless of past outcomes, which would raise the real interest rate during recovery and aim to keep inflation expectations static.
Alternatively, under AIT the Fed could tolerate inflation above 2% temporarily to offset prior undershoots. This approach could raise inflation expectations, reduce the real ex‑ante interest rate (for a given nominal rate), and reinforce automatic stabilization even if nominal rates remain unchanged.
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