Flexible Average Inflation Targeting

The flexible average inflation targeting framework commits a central bank to achieve a target inflation level over the medium term as an average, rather than at every point in time. It permits inflation to run above target during weak labour markets and below target during booms, smoothing the trade-off between price stability and employment support.

Targeting an average, not a point

Conventional inflation targeting typically specifies a target rate, such as 2 per cent, and expects the central bank to keep inflation close to that rate in the near term. Flexible average inflation targeting loosens this requirement: instead of aiming for 2 per cent in every quarter or year, the central bank aims for an average of 2 per cent over several years.

The implication is immediate: if inflation has run below 2 per cent for a period—say, averaged 1.5 per cent over three years—the central bank will run policy loose enough to permit inflation above 2 per cent for a time to make up the shortfall and restore the long-run average. Conversely, if inflation has averaged 2.5 per cent, the central bank will tolerate below-target inflation until the average normalises.

This averaging approach differs philosophically from standard targeting. Standard targeting prioritises returning to the target level quickly if inflation misses. Flexible average targeting accepts that temporary misses are optimal—they reflect deliberate policy choices to manage the unemployment cost of disinflation or the credibility benefit of avoiding permanent below-target outcomes.

The employment rationale

The Federal Reserve formally adopted flexible average inflation targeting in August 2020, shortly after acknowledging the severe employment losses from the COVID-19 pandemic. The shift reflected frustration with standard targeting: for a decade after the 2008 financial crisis, inflation remained stubbornly below the Fed’s 2 per cent target, yet the Fed kept rates low to support employment recovery. Critics argued that literal adherence to a point target for inflation would have required unacceptably tight policy and prolonged unemployment.

Flexible average inflation targeting formalized what the Fed believed it should be doing: allowing inflation modestly above target when labour markets are weak, accepting the near-term price rises as a necessary consequence of supporting employment. The framework acknowledges the dual mandate explicitly—the central bank is not solely bound to hit an inflation target regardless of employment consequences.

Commitment and credibility

A key tension lurks within flexible average targeting: how does a central bank prevent the public and financial markets from suspecting that “flexible” is a euphemism for “we’re abandoning inflation discipline”? If agents believe the central bank will always prioritise employment over price stability, inflation expectations may drift upward and become unanchored.

The Federal Reserve addressed this by emphasising that average inflation targeting is a long-term framework, with the averaging window measured in years, not months. The Fed also reiterated its commitment to a 2 per cent long-run target, meaning that overshoots are temporary and will be reversed. The goal is to prevent deflation and disanchored expectations while allowing flexibility over business cycles.

Empirically, inflation expectations have remained remarkably well-anchored—close to 2 per cent in long-term surveys—even as the Fed held rates at zero and ran enormous quantitative easing programmes. This suggests that markets have confidence in the Fed’s commitment to long-run price stability, even within the flexible framework.

Versus strict average inflation targeting

It is important to distinguish flexible average targeting from a pure arithmetic average rule. A mechanical rule might say: “If cumulative inflation shortfall over the past five years equals 2 per cent, the central bank must run above-target inflation until it is recovered.” This is automatic and rules-based but potentially perverse—it could compel loose policy even if new shocks or structural changes make the previous average obsolete.

Flexible average inflation targeting retains judgement. The central bank uses the average as a framework and guideline, not an arithmetic straitjacket. If the economy has experienced a permanent negative demand shock that changes the relationship between inflation and employment, the central bank can re-evaluate whether the old averaging window is still relevant. The word “flexible” signals that the central bank retains discretion over application, even within a stated framework.

Global adoption and scepticism

Most major central banks still operate under standard inflation targeting or variants emphasising price stability as the primary objective. The European Central Bank, the Bank of England, and others have not formally adopted flexible average inflation targeting. The ECB emphasised in recent years that it aims for 2 per cent symmetrically—meaning it will tighten to avoid above-target inflation as forcefully as it eases to fight below-target inflation, which sits uneasily with explicit flexibility toward overshoots.

Some economists argue that flexible average inflation targeting is simply honest communication of what central banks do anyway: allow temporary above-target inflation to ease the employment cost of recovery. Others contend that formalizing flexibility weakens the inflation-fighting credibility that central banks spent decades building in the 1980s and 1990s. The debate reflects fundamentally different views on how much central bank credibility is a scarce resource that must be guarded, versus a resilient property that can withstand flexibility if the central bank remains clearly committed to long-run stability.

Implementation in practice

Since adopting flexible average inflation targeting, the Federal Reserve has faced tests of its commitment. In 2021–2022, inflation rose sharply, reaching levels not seen in decades, partly due to supply shocks and partly due to the Fed’s accommodative policy. Critics asked whether the Fed had abandoned its framework in favour of loose policy justified post hoc as flexibility. The Fed ultimately tightened aggressively, raising rates from zero to over 5 per cent in less than a year.

This sequence raises a question: did the Fed genuinely commit to allowing above-target inflation as part of flexible average targeting, or did it adopt the framework rhetorically while retaining the option to tighten whenever it deemed fit? The answer likely lies between: the Fed believed flexible average targeting was appropriate in the COVID recovery context, given the severity of employment losses, but retained the flexibility to re-evaluate and tighten if inflation proved more persistent than expected.

See also