In August 2020, the world of central banking witnessed a paradigm shift. The Federal Reserve, under the leadership of Chair Jerome Powell, unveiled its new monetary policy framework: Flexible Average Inflation Targeting (FAIT). This was not a minor tweak but a fundamental evolution of the Fed’s decades-long inflation-targeting regime. Born from the lessons of the post-2008 era—a period of stubbornly low inflation, declining neutral interest rates, and a perceived erosion of the Fed’s policy arsenal—FAIT was designed to be more patient, more accommodative, and more focused on the broad labor market.
Its arrival was perfectly timed for a world grappling with the economic devastation of the COVID-19 pandemic. It provided the theoretical justification for the most aggressive monetary support in the Fed’s history. However, just over a year later, this new framework was tested by a fire it was not explicitly designed to fight: the most severe inflation surge in over 40 years.
This article provides a deep, expert analysis of the FAIT framework. We will explore its intellectual origins, its core mechanics, and the dramatic real-world stress test it endured between 2021 and 2023. By examining its performance against the backdrop of a transformed global economy—marked by persistent supply shocks, deglobalization, and fiscal dominance—we aim to answer the critical question: Is the Fed’s Flexible Average Inflation Targeting still fit for purpose in this new era?
Part 1: The Genesis of FAIT – Why the Old Rules Were Broken
To understand FAIT, one must first understand the problems it was meant to solve. For decades, the Fed operated under an implicit, and later explicit, 2% inflation target. The principle was simple: if inflation rose above 2%, the Fed would tighten policy to cool the economy; if it fell below, it would ease policy to stimulate it.
This model began to crack after the Global Financial Crisis (GFC).
1. The “Lower Bound” Problem and the Phantom of Low Inflation:
For much of the 2010s, inflation consistently ran below the 2% target. This created a critical problem. With the policy interest rate (the Fed Funds Rate) hovering near zero, the Fed had limited room to cut rates to fight a future recession. This “effective lower bound” (ELB) meant the primary tool of monetary policy was often out of commission. Furthermore, persistently low inflation expectations risked becoming entrenched, a deflationary mindset that is notoriously difficult to escape, as seen in Japan.
2. A Flawed Phillips Curve:
The traditional relationship between unemployment and inflation (the Phillips Curve) appeared to break down. Despite unemployment falling to multi-decade lows, wage growth and inflation remained surprisingly muted. This suggested that the economy could run much “hotter” than previously thought without triggering runaway inflation. The old framework, which preemptively tightened policy at the first sign of falling unemployment, risked prematurely choking off a recovery and leaving potential employment gains on the table, particularly for marginalized groups.
3. The 2020 Strategy Review: A Intellectual Shift:
The Fed’s 2020 public review of its monetary policy strategy was a transparent and data-driven process. Its conclusion was clear: the old model was no longer sufficient. The new framework, FAIT, was built on three revolutionary pillars:
- “Average” Inflation Targeting: The Fed would seek to achieve inflation that averages 2% over time. This implied that following periods where inflation had run below 2%, the Fed would now tolerate and even encourage periods of inflation moderately above 2% for some time. This was a commitment to make up for past misses, aiming to push inflation expectations firmly back to the 2% anchor.
- “Flexible” Interpretation of Maximum Employment: The Fed formally adopted a “shortfall”-based approach to employment. Instead of preemptively hiking rates because unemployment might fall too low and cause inflation, it would wait for clear evidence of rising inflation before acting. This was a direct response to the broken Phillips Curve and a commitment to a broad-based and inclusive goal of maximum employment.
- Enhanced Communication: The framework emphasized the need for clear, simple communication to guide public expectations, which are a powerful determinant of actual inflation.
In essence, FAIT was a framework for a disinflationary world. It was designed to be more dovish, more patient, and more supportive of the labor market. It was a masterpiece of modern central banking theory. Then, the real world intervened.
Part 2: The Great Stress Test – FAIT Meets the Inflation Tsunami (2021-2023)
The rollout of FAIT coincided with unprecedented fiscal and monetary stimulus in response to the COVID-19 pandemic. The framework’s inherent patience and its tolerance for inflation overshoots provided the perfect justification for maintaining ultra-accommodative policy deep into the economic recovery.
Initially, this seemed prescient. The Fed, along with most private forecasters, characterized the initial inflation spike in early 2021 as “transitory”—a natural result of supply chain bottlenecks and pent-up demand that would quickly resolve itself. FAIT’s flexibility allowed the Fed to look through this temporary noise, avoiding a policy mistake of tightening too early.
However, the “transitory” narrative proved to be a catastrophic miscalculation. A perfect storm of factors turned a temporary spike into a persistent surge:
- Unprecedented Fiscal and Monetary Stimulus: The combination of massive government spending and near-zero interest rates flooded the economy with demand.
- Persistent Supply Chain Disruptions: COVID-related lockdowns, shipping logjams, and semiconductor shortages proved more durable than anticipated.
- The Energy and Commodity Shock from the Ukraine War: Russia’s invasion sent food and energy prices skyrocketing, creating a classic cost-push inflation scenario.
- A Tight Labor Market and Rising Wages: The rapid recovery led to a sharp drop in unemployment and significant wage pressure, contributing to demand-pull inflation.
This was the ultimate test for FAIT, and the framework’s design flaws were brutally exposed.
The Critical Weakness: The Lack of a Clear Timeframe and Trigger Mechanism
The most significant criticism of FAIT was its vagueness. While it committed to averaging 2% inflation, it deliberately did not specify:
- Over what time period the average would be calculated.
- By how much, or for how long, inflation could overshoot.
- What specific economic triggers would warrant a policy response.
This lack of a predefined “reaction function” created two major problems during the crisis:
- Communication Challenges and a Loss of Credibility: The Fed’s persistent use of the “transitory” label, backed by FAIT’s inherent patience, led markets and the public to believe the Fed was behind the curve. When it became undeniable that inflation was not transitory, the Fed was forced into a sudden and aggressive pivot, damaging its hard-won credibility. A more rules-based framework might have prompted an earlier, more gradual response.
- The Difficulty of Fighting Supply-Shock Inflation: FAIT was conceptually designed for a demand-deficient economy. The tools of monetary policy (interest rates) are blunt instruments for dealing with inflation driven by supply constraints and geopolitical events. Hiking rates cannot unclog a port or reopen a Ukrainian wheat field. The Fed’s aggressive tightening campaign, while necessary to curb demand, risked causing unnecessary economic damage because it was the only tool available to tackle a multi-faceted problem.
By mid-2022, the Fed had effectively placed FAIT on hold. The focus shifted from fostering a period of above-target inflation to a single-minded crusade to restore price stability, echoing the Volcker-era playbook. The framework designed to prevent the mistakes of the last war was ill-suited for the new, more complex battlefield of the 2020s.
Part 3: A World Transformed – The New Economic Realities Challenging FAIT
The post-pandemic world looks fundamentally different from the disinflationary environment in which FAIT was conceived. Several structural shifts now challenge the framework’s core assumptions.
1. The Return of Supply-Shock Driven Inflation:
The era of hyper-globalization and just-in-time supply chains, which helped suppress inflation for three decades, is likely over. Geopolitical fragmentation, the push for supply chain resiliency (“friend-shoring”), and the energy transition are inherently inflationary. They increase costs and reduce the efficiency gains that characterized the pre-2020 world. A framework like FAIT, which lacks a clear strategy for distinguishing between demand-pull and cost-push inflation, is at a disadvantage in this environment.
2. The Re-emergence of Fiscal Dominance:
For years, the world was in a state of “monetary dominance,” where central banks set policy independently of government debt concerns. The pandemic and subsequent industrial policies (like the CHIPS Act and Inflation Reduction Act) have ushered in an era of large, active fiscal policy. When governments run large, persistent deficits, it can force central banks into a difficult position: either tolerate higher inflation or raise interest rates to dangerous levels, potentially destabilizing the government debt market. FAIT does not explicitly account for this fiscal-monetary interaction.
3. Sticky Inflation and Shifting Inflation Dynamics:
The inflation of 2021-2022 has morphed. While goods inflation has cooled, services inflation—particularly in shelter, healthcare, and hospitality—has proven remarkably sticky, largely tied to a robust labor market. This suggests that the inflation genie is partly out of the bottle and that returning to a stable 2% may be more difficult and require a higher “sacrifice ratio” (unemployment needed to reduce inflation) than FAIT’s architects assumed.
4. The “Higher for Longer” Interest Rate Paradigm:
The pre-2020 consensus on the neutral interest rate (r) has been shattered. Structural forces like deglobalization, demographic shifts (aging populations), and the green transition may have pushed r permanently higher. If true, the “lower bound” problem that FAIT was designed to solve may be less acute in the coming years, potentially reducing the framework’s primary rationale.
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Part 4: The Path Forward – Evolution, Not Revolution
Given these profound challenges, is FAIT obsolete? The answer is likely no, but it requires significant refinement. Throwing out the framework entirely would be an overreaction and would create damaging policy uncertainty. However, a “one-size-fits-all” approach is no longer viable. The Fed must evolve its strategy.
Potential Reforms and Enhancements to FAIT:
- Clarify the “Average” with a Defined Make-up Strategy: The Fed could adopt a more formal, price-level targeting approach. For example, it could commit to a five-year rolling average of 2% inflation. This would provide much greater clarity to markets. If inflation undershoots for two years, everyone would know the Fed is explicitly targeting a commensurate overshoot in the subsequent three years, and vice-versa.
- Incorporate a Dual-Mandate Dashboard: Instead of relying on a single inflation number (PCE), the Fed could adopt a dashboard of indicators, including measures of supply chain pressure, wage growth, and market-based inflation expectations. This would help it better distinguish between different sources of inflation and calibrate its response more effectively.
- Formalize a “Supply Shock” Clause: The framework could include explicit guidance on how the Committee will respond to large, identifiable supply shocks. This might involve greater tolerance for a temporary overshoot caused by energy prices, coupled with a commitment to look at core measures of inflation when making policy decisions.
- Enhance Coordination with Fiscal Authorities: While maintaining independence, the Fed’s framework should acknowledge the new reality of active fiscal policy. This doesn’t mean direct coordination, but rather a more sophisticated public dialogue about the inflationary impacts of fiscal decisions and the limitations of monetary policy in offsetting them.
- Re-emphasize the Symmetry of the Target: The Fed must relentlessly communicate that 2% is a symmetric target, not a ceiling. The painful experience of 2022 may have re-established the Fed’s inflation-fighting credibility, but it risks creating a hawkish bias where the Fed tightens policy at the first whiff of 2.5% inflation, thereby repeating the pre-2020 mistakes FAIT was meant to correct.
Conclusion: A Framework Tempered by Experience
The Federal Reserve’s Flexible Average Inflation Targeting framework was a well-intentioned and intellectually robust response to the economic realities of the 2010s. Its initial test, however, came not in the disinflationary environment for which it was built, but in a fiery crucible of supply-shocks and surging demand.
While FAIT provided the flexibility needed to support the economy through the pandemic, its lack of precision contributed to a critical delay in the inflation fight, revealing vulnerabilities in its design. The new economic era of deglobalization, supply-side volatility, and fiscal activism demands a more nuanced and resilient monetary policy framework.
Therefore, FAIT is not unfit for purpose, but it is incomplete. Its core principles—patience, a focus on average outcomes, and a commitment to inclusive employment—remain vital. The path forward is not to discard it, but to harden it. By incorporating clearer guidance, a more formal make-up strategy, and a more sophisticated understanding of modern inflation dynamics, the Fed can evolve FAIT from a framework designed for the last war into a robust and credible guide for the complex economic battles that undoubtedly lie ahead. The lesson of the past few years is not that the framework was wrong, but that the world is more unpredictable than any model can capture. The true test of the Fed’s expertise will be its ability to learn, adapt, and refine its most powerful tool: its guiding philosophy.
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FAQ Section
Q1: What is the main difference between the Fed’s old 2% inflation target and FAIT?
The old target was essentially a ceiling. If inflation looked like it might rise above 2%, the Fed would preemptively raise rates. FAIT treats 2% as a symmetric average. After a period of low inflation, the Fed will now allow inflation to run moderately above 2% for some time to make up for the past shortfall, demonstrating a more patient and accommodative approach.
Q2: Did FAIT cause the high inflation we saw in 2022?
FAIT was not the primary cause of the high inflation, which was largely driven by massive fiscal stimulus, supply chain issues, and the energy shock from the Ukraine war. However, FAIT’s design—specifically its tolerance for overshoots and lack of a clear reaction function—contributed to the Fed’s slow initial response, allowing inflation to become more entrenched than it might have otherwise.
Q3: Is the Fed still using the FAIT framework today?
Officially, yes. The Fed has not formally abandoned the framework announced in 2020. However, in practice, since late 2021, the Fed has been operating in a crisis-fighting mode focused solely on quelling inflation. The “average” and “flexible” aspects have been put on hold until price stability is secured. The future of FAIT will be a key topic in the Fed’s next strategy review, likely leading to a refined version.
Q4: What is “price-level targeting,” and how is it different from FAIT?
Price-level targeting is a more rigid form of average inflation targeting. It commits to hitting a specific price level path over time. For example, if inflation is 1% one year (prices fall below the path), the central bank must then target 3% the next year to return to the path. FAIT is a softer, more qualitative version of this, without a strict mathematical formula, which was a source of its vagueness.
Q5: Could a return to a Taylor Rule or a similar fixed rule be better than FAIT?
Rules like the Taylor Rule provide clear, formula-based guidance for setting interest rates based on inflation and economic output. Their strength is their transparency and predictability. Their weakness is their inflexibility; they cannot easily account for novel situations like a pandemic or a major supply shock. The most likely future is a hybrid approach where the Fed uses such rules as inputs for its decisions within a flexible framework like a refined FAIT, rather than following them slavishly.
Q6: What does “r*” (r-star) mean, and why is it important for FAIT?
“r*” (pronounced “r-star”) is the neutral real interest rate—the theoretical rate that neither stimulates nor restrains the economy when inflation is on target. In the pre-2020 era, r* was believed to be very low, justifying low policy rates and creating the “lower bound” problem that FAIT was designed to circumvent. If r* is now higher, the Fed will have more conventional policy room in a downturn, potentially reducing the need for FAIT’s extreme patience.
