Average Inflation Targeting Explained

An average inflation targeting framework allows a central bank to pursue inflation averaged over a multi-year period rather than hitting a fixed target (typically 2%) every year, creating room for temporarily higher inflation after periods of undershooting, and shifting policy during low-inflation recoveries.

The difference from point-targeting

Under a traditional point-target framework, a central bank commits to keeping inflation at 2% year after year. If inflation falls to 0.5% in one year (below target), the bank must still bring it back to 2% the next year, regardless of whether economic slack exists. This creates a “pressure valve” problem: each year stands alone, with no memory of past misses.

Average inflation targeting flips this logic. The central bank targets 2% inflation as a rolling average over (say) five years. If inflation was 0.5% in year one, the target path now implicitly allows for inflation averaging 3.5% over years two through five to hit the 5-year average of 2%. This is not a guarantee—the bank can achieve the average with 2.5% every year if it prefers—but it creates a legitimate option to run inflation temporarily higher without breaching the framework.

Why the Fed adopted it in 2020

The Federal Reserve formally shifted to average inflation targeting in 2020, during the COVID recession and its aftermath. The motivation was clear: the 2008 financial crisis and subsequent recovery saw inflation persistently below the 2% target for over a decade. Strict point-targeting had kept the Fed tightening whenever inflation appeared, even amid persistent slack, contradicting the goal of supporting employment.

Average inflation targeting offered an intellectual escape: the Fed could acknowledge that it had missed the inflation target on the downside for years and could, in principle, allow inflation to overshoot to compensate—without abandoning the framework. In practice, this meant the Fed could hold interest rates lower for longer after a crisis, supporting employment and growth without worrying that every month of above-target inflation breached its mandate.

Policy mechanics during recovery

The real effect becomes apparent during and after a recession. Suppose inflation falls to 1% during a downturn. Under point-targeting, the Fed must tighten to bring inflation back to 2% immediately. Under average targeting, the Fed can ask: what’s the rolling 5-year average now? If it’s 1.8% (due to the low-inflation shock), the target window allows for 2.2% inflation next year to bring the 5-year average back to 2%. This gives the Fed cover to maintain accommodative policy while the economy recovers.

This is why average inflation targeting is sometimes called a “flexible” framework. Flexibility does not mean the target is vague; it means the target is realized over a period, not a point in time. The bank’s credibility rests on hitting the average, not on micro-managing every quarter.

The anchoring question

A central concern is whether allowing temporarily higher inflation unanchors inflation expectations. If people and businesses believe the bank will run inflation hotter for years to offset past shortfalls, they may demand higher wages, set higher prices, and expect higher future rates—creating a self-fulfilling cycle of sustained high inflation. Average inflation targeting relies on the public’s belief that the 2% target is truly the long-run anchor; the bank is simply distributing how it gets there over time.

The Federal Reserve’s credibility—built over decades of inflation-fighting—helps anchor expectations even with this framework. But if inflation runs materially above 2% for too long, or if the bank is perceived as using “average targeting” as cover for chronic looseness, expectations can drift. At that point, the central bank faces the same tightening pressure as under point-targeting, only with the added awkwardness of having promised higher inflation.

Comparison to other flexible frameworks

Average inflation targeting is not unique. Many central banks use forward guidance and communication to shift policy without rigid rules. The European Central Bank, for example, maintains some flexibility without formally adopting average targeting. Japan has experimented with overshooting targets during periods of persistent undershooting. Australia’s central bank has historically used a band rather than a point (2-3% rather than exactly 2%).

What distinguishes average inflation targeting is its explicit, time-defined structure: the bank commits to averaging over a named window (commonly 5 years), making the framework transparent and measurable.

Practical limits and criticism

Some economists argue that a 5-year averaging window is too short to matter in practice. If inflation overshoots significantly in years one and two, the Fed will face political and market pressure to tighten in years three through five, short-circuiting the averaging. In reality, average inflation targeting may function more as a communication device—a way to signal that the Fed won’t panic at every temporary overshoot—than as a binding constraint.

Critics also note that average inflation targeting does not automatically solve the zero lower bound problem (when nominal rates fall to zero). Even with permission to run inflation hotter, the Fed might lack sufficient tools if rates are already at zero. The framework works best when there is room to cut rates further, which is not always the case.

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