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The Fed's Hidden Message

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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The U.S. Federal Reserve's latest economic projections contain an encoded message crucial to understanding the central bank's policies: Inflation has been stuck below the Fed's target in part because officials don’t actually want to get it back up.

It's important to recognize that the Summary of Economic Projections, released four times a year, does not consist of forecasts about the real world. Instead, each member of the policy-making Federal Open Market Committee is asked to pretend that he or she has complete control of monetary policy. Under this assumption, they submit their baseline assessments of how the economy will develop.

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If, for example, you were a monetary policy hawk who thought the Fed was keeping interest rates too low, your economic forecast might include excessive inflation. In your projection, however, you get to choose your own policy. So your submission will feature the higher interest rates that you think are needed to keep inflation in check -- not the outcome that you actually expect.

This suggests caution in interpreting the famous "dot plot," which summarizes projections for the Fed's short-term target interest rate. First, as I’ve pointed out, each submission reflects only the participant's own “I get to be dictator” world. Even for Chair Janet Yellen, that world isn’t the necessarily same as the real world in which officials hash out policy together. Second, monetary policy is data-dependent: The projections can and should change depending on actual economic developments, and the adjustments may have to be large.

For all their shortcomings, though, the projections can be useful. The participants' imagined policy freedom makes their choices very informative about their goals over the next two to three years. If, for example, the median projection for inflation in 2018 is 2 percent, we can conclude that the median policymaker is aiming to return inflation to 2 percent by the end of that year.

What's surprising is that -- judging from the latest projections -- more than half of the participants are comfortable with inflation remaining below the Fed’s 2 percent target for another two years, and at least four are OK with missing the target through 2018. That's highly unusual, given that many central banks around the world systematically aim to return inflation to their targets within two years (see page 4 of this letter from the Bank of England for an example of what I mean).

U.S. inflation has been below target for nearly four years. This outcome is sometimes viewed as a sign of monetary policy impotence. But the Fed's projections tell us that many, if not most, officials are actually aiming to keep inflation below target for an extended period of time. In other words, low inflation in the U.S. reflects a lack of will, not tools.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at narayana1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net