When the dog doesn't bark

How non-events bias our thinking

Do you understand inflation targeting? OK, how about this claim:

During 2025, 2% inflation was an appropriate target for Fed policy.

Is that correct? I don’t think so, as the Fed has a flexible inflation target where they try to look through supply shocks. So how about this claim:

During 2025, it was appropriate to allow inflation to run slightly above 2% due to supply shocks.

Is that correct? Again, I don’t think so. There were supply shocks during 2025, but they were mostly positive supply shocks. Because Fed policymakers try to “look through” supply shocks and focus on aggregate demand, it was appropriate for inflation to run below 2% during 2025. This is a claim that makes sense:

During 2025, PCE inflation was 2.9%. Given the Fed’s announced monetary policy goals and given that 2025 was a year of falling oil prices and rapid productivity gains, an appropriate inflation rate would have probably been in the 1.5% to 1.8% range. Thus, inflation was more than one percentage point too high in 2025.

How often do you see Fed policy explained in that fashion? How about “never”? That tells me that hardly anyone actually understands the meaning of a 2% inflation target that looks through unusual movements in aggregate supply. Many people understand that it is appropriate for inflation to run above 2% during years when there are adverse supply shocks. Very few people—even very few economists—seem to understand that inflation should run below 2% during other years, that is, periods not marred by adverse supply shocks.

In other words, Fed policy has recently been even worse than it might look if you focus solely on recent PCE inflation rates.

Now we are in 2026, and it is possible (but not yet certain), that this will end up being a year of adverse supply shocks, akin to 2022. If it is, then it would be appropriate for inflation to exceed 2% in 2026. The real problem was 2025, when inflation ran 2.9% during a time when it should have been well below 2%.

This sort of biased reasoning occurs in many areas of life. I see sports fans excusing the poor performance of a team by referring to “injuries”, even during seasons when the team’s level of injuries doesn’t exceed the league average. And sports fans often overlook the fact that when their team is unusually healthy, it ought to be doing even better than usual. Subconsciously, they tend to regard 100% health as normal, and as a result they are usually overly optimistic about the potential of their team.

Consider fiscal policy, where the budget deficit has been running at a rate of around 6% of GDP over the past three years. Is that sustainable? You might be tempted to assume the deficit continues at a rate of 6% of GDP and then look at what happens to the ratio of total public debt to GDP going forward.

Unfortunately, it is easy to overlook the dog that didn’t bark. The last three years saw no recessions, no pandemics and no wars. They were unusually good years from a fiscal perspective. Even if deficits of 6% of GDP were just barely sustainable (and they probably are not), there would be no reason to assume that our current fiscal trajectory is sustainable.

No reason, that is, unless you believe the end of history has arrived and that we’ll never again have a recession, war or pandemic. The past three years have seen peace and prosperity and hence are not at all typical.

Someday soon, the dog may resume his barking.

Photo by Putri Ayusha on Unsplash