Average Inflation Targeting vs Inflation Targeting

In standard inflation targeting, the central bank aims to keep inflation at a fixed point—usually 2 percent—and tightens policy when it overshoots, eases when it undershoots. In average inflation targeting (AIT), the central bank commits to letting inflation overshoot for a period to make up for prior undershoots, as long as the average over (typically) five years hits the target. This simple distinction changes how aggressive monetary policy becomes after recessions, when inflation is already low.

The Intuition Behind Average Targeting

Traditional inflation targeting assumes that overshooting and undershooting are equally bad. If inflation is supposed to be 2 percent and runs at 1 percent for two years, then 3 percent for one year, the standard framework treats both deviations as policy failures.

Average inflation targeting flips the intuition. If inflation has been 1 percent for two years, it has undershot the target by 2 percentage points total (1 point × 2 years). To bring the five-year average back to 2 percent, inflation can overshoot by roughly 1 percentage point for two years, or 2 percentage points for one year. This “makeup” restores the average without requiring perpetual undershooting to balance prior overshoots.

The Federal Reserve formally adopted AIT in August 2020, explicitly allowing inflation to overshoot the 2 percent target during the recovery from the COVID recession as a way to offset a decade of undershooting since 2008.

How Average Inflation Targeting Changes Policy Decisions

Under standard inflation targeting, once inflation reaches the target, the central bank tightens policy to prevent it from rising further. A 2-percent-inflation reading triggers interest-rate hikes.

Under AIT, if the five-year average is still below 2 percent, the central bank can allow inflation to rise above 2 percent for a time. It does not tighten until either the average approaches the target or inflation expectations become unanchored.

This creates a dramatic difference in post-recession behavior. After the 2008 financial crisis, inflation fell sharply and stayed low. Standard targeting would have called for aggressive accommodation (near-zero rates) until inflation rose, then normal rates once it hit 2 percent. AIT says: keep rates low even as inflation approaches and slightly exceeds 2 percent, because the prior decade of undershooting creates room for an overshoot.

Practically, this meant the Federal Reserve could justify keeping the federal funds rate near zero from 2008 through 2015, even as inflation occasionally edged above 2 percent, because the five-year average was still below target.

Credibility and Inflation Expectations

The success of AIT depends on credibility. If households and firms believe the central bank will allow temporary overshoots as part of a makeup period, they won’t panic and demand higher wage growth or price hikes the moment inflation exceeds 2 percent. Inflation expectations remain anchored at 2 percent, even if realized inflation temporarily overshoots.

Conversely, if markets doubt the central bank’s commitment to the makeup period—if they suspect the central bank will tighten early to prevent an overshoot—the central bank gains no credibility benefit, and inflation expectations drift upward.

The Fed’s 2020 announcement of AIT was an attempt to build this credibility: by explicitly committing to a makeup period, it signaled that an overshoot would be tolerated, not punished. The goal was to lift inflation expectations (which were then stuck around 1.5 percent) and accelerate the return of inflation to 2 percent.

Symmetric vs Asymmetric Frameworks

Average inflation targeting is sometimes called “symmetric” because it treats overshoots and undershoots symmetrically—if you undershoot, you’re permitted to overshoot later to cancel it out. Standard inflation targeting can be asymmetric if, in practice, central banks tighten aggressively to prevent overshoots but ease slowly to permit undershoots.

For example, a central bank might tighten hard if inflation hits 2.5 percent but accept 1.5 percent as normal. This asymmetry can bias inflation downward over time. AIT attempts to create a level playing field by explicitly allowing both undershoots and overshoots to average out.

The Makeup Period Window

AIT requires specifying how long the makeup period can last. The Fed uses an implicit five-year window. If inflation has been 1 percent for two years and must average 2 percent over five years, the next three years must average roughly 2.67 percent. This is feasible but constrains how much the central bank can tighten before “overshooting” becomes dangerous.

If the makeup period extends longer (say, ten years), overshoots can be smaller and more gradual. If it shrinks (to three years), overshoots must be larger to offset undershoots. The window choice reflects a tradeoff between stability and flexibility.

Challenges and Criticisms

Critics argue that AIT is difficult to operationalize because the five-year average is retrospective—you only know if you’ve hit it after five years. In real time, a central bank cannot be certain whether an overshoot will be temporary (and part of makeup) or permanent (and dangerous).

During 2021–2022, when inflation surged, markets questioned whether the Fed would tolerate overshoots or pivot to tightening. The fed’s June 2022 decision to raise rates aggressively—while inflation remained well above 2 percent—suggested it had abandoned the makeup period, eroding credibility in the AIT framework.

Another concern: AIT can justify excessive accommodation when inflation is low, leading to asset-price bubbles. By keeping rates low to support a makeup period, central banks might inflate housing or equity prices, creating financial stability risks that offset any benefit from stable inflation expectations.

Practical Adoption and Global Divergence

The Federal Reserve is the only major central bank to formally adopt AIT. The European Central Bank, Bank of England, and Bank of Japan maintain traditional point inflation targets. This divergence reflects differing views on whether makeup periods improve credibility or simply add unnecessary complexity.

Some economists argue that if a central bank has strong credibility, it doesn’t need a makeup period—it can simply tolerate transitory overshoots and move on. Others contend that explicitly committing to makeup periods anchors expectations more firmly than implicit tolerance.

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