A New Framework for Targeting Inflation: Aiming for a Range of 2 to 3.5 Percent

In response to a decade of persistently low employment and inflation, the Federal Reserve in 2019 changed its framework to Flexible Average Inflation Targeting (FAIT). This current framework allows inflation to temporarily overshoot the Fed’s 2 percent inflation target, but still requires the Fed to bring inflation back to 2 percent. However, given the experience of both the slow recovery from 2010 to 2019 following the Great Recession, and the high inflation following the COVID-19 disruption and recovery, a 2 percent inflation target is not an adequate framework for achieving both maximum employment and price stability.

This brief calls for changing the Federal Reserve’s policy framework to target an inflation range of 2 to 3.5 percent, using the core personal consumption expenditures (PCE) deflator. In this new framework, the Fed should also target employment shortfalls and see through the effect of sectoral supply shocks on inflation. This framework would have several benefits:

• A range of 2 to 3.5 percent inflation would generate higher employment on average. During a recovery, the Fed can overshoot 2 percent when raising inflation from below, minimizing the risk of tightening before full employment is reached. When bringing inflation down from high levels, a target range allows inflation to settle at a moderate level while maintaining high employment levels, minimizing the risk of overcorrecting and generating a recession.
• An inflation range preserves price stability. Keeping demand-driven inflation at or below 3.5 percent prevents accelerating dynamics, and if full employment is achieved at only 2 percent inflation, a range does not require the Fed to raise inflation.
• Supply shock–driven inflation does not generate self-sustaining inflation, so the Fed should not tighten monetary policy in response to large sector-specific supply shocks. The Fed also does not need to react to small fluctuations in inflation due to noise or small shocks.
• International evidence suggests that ranges with upper bounds of 3 and 4 percent produce generally stable inflation outcomes.

This framework is informed by a model of a nonlinear Phillips curve, which this brief develops in detail. Under a nonlinear Phillips curve, the relationship between inflation and unemployment is not constant: when aggregate demand is low, changes in demand mostly affect output and employment while inflation remains low and stable. However, when the economy is closer to full employment, further increases in demand mostly contribute to inflation. This means that in times of high demand, central banks can cool demand-driven inflation with small effects on output and employment. Compared to the current framework, an inflation range of 2 to 3.5 percent better allows the Fed to keep the economy close to full employment while still minimizing the risks of accelerating inflation dynamics.

Much of the inflation over the last year has been driven by sector-specific supply issues. Negative supply shocks in one sector of the economy can raise price levels, and interest rate policy is poorly suited to address these sector-specific shocks. Therefore, this framework calls for “seeing through” supply shocks: the Fed should raise interest rates in response to demand-driven inflation but not in response to price increases from sector-specific supply shocks.

Lastly, this framework calls for maintaining the Fed’s emphasis on addressing shortfalls in employment, rather than a symmetric employment target. Due to the nonlinear nature of the Phillips curve, inflation may be near 2 percent even when employment is far below its maximum. The Fed should therefore wait until inflation has materialized to declare that the economy is close to maximum employment.