Last week, the Fed updated its approach to managing inflation. Rather than maintain its old target of keeping inflation under 2%, it has now moved to allowing inflation to average 2%. This obviously suggests there will be times where the Fed is comfortable with inflation over 2% in order to achieve the average.
Naturally, when we get to one of those periods where inflation reaches 3 or 4%, there will be people panicked that we won’t be able to bring it back under 2% very easily.
This is a valid concern and is why having strong, clear messages such as “under 2%” are so effective. They lend credibility which is especially useful when managing a target that can be altered by people’s expectations.
Where Have We Seen This Before?
Perhaps some of you have guessed where I’m going with this (well, actually the title gave it away, didn’t it?). The Fed’s historic messaging on inflation is very similar to Progressive’s 96% combined ratio target!
Progressive has very effectively messaged to its organization (and investors) that the way they manage growth and profitability is to grow as fast as they can as long as they can produce a 96 CR or better.
However, Progressive eventually ran into the same problem as the Fed. Their results were coming in too far below the target and never above it. Thus, Progressive was essentially operating under the constraint of grow as fast as you can subject to a 93 or 94 CR.
What had become apparent is no individual state manager wanted to produce a result worse than 96 out of fear they would be viewed as underachieving. The problem with that is a normal distribution around 96 would cause some states and products to be in the low 90s and some closer to 100.
However, the tail was essentially chopped off above the 96 because individuals always want to manage their incentives which means acceptable growth was being left on the table.
Long Run vs. Short Run Goals
Then CEO Glenn Renwick addressed this issue in his 2009 Annual Letter. At that time, Progressive was producing combined ratios closer to 92 and growth had slowed. He had the same problem as the Fed: overachieving on his constraining goal was limiting potential for growth.
As a result, he amended the 96 CR goal for the direct business as follows:
However, under certain high growth new business scenarios, we would be happy to see the reported monthly and calendar-year combined ratios go above 96 for our Direct business, as long as our new and renewalGlenn Renwick, 2009 Annual Letter
business consistently meets predefined targets that ensure a lifetime result at or below 96.
Renwick shifted the CR target from one that needed to be met every year to one that needed to be met over the long run. In other words, it needed to be met on average.
Effectively Tying Metrics To Strategy
Not only did this loosen some growth restraints, it also helped send an important new message to the field. Lifetime profitability was now the most important metric.
This meant any incentive to find customers who maybe you could overcharge for a year in a tight market but would leave you on the next renewal were less desirable than those who might start out at a 98 but had a higher likelihood of sticking around for five years (and thus amortizing the customer acquisition cost).
Note, this was also around the same time Progressive rolled out its customer profiles (e.g. the Robinsons) to focus the company on moving away from its traditional low retention younger drivers to higher retention families with multiple vehicles. So it was very strategic for the company to revise the thinking around the 96 target to reflect the new strategy.
What followed was a period of renewed growth as CRs edged up (though they’ve still yet to successfully manage to get too close to the 96 = the new norm is around 94) and improvement in policy life expectancy.
Can the Fed Emulate Progressive?
Obviously, the Fed’s job is much harder. They don’t need to change the behavior of their employees. They have to account for the reaction functions of citizens, politicians, investors, and other central banks around the world with their own agendas.
Progressive was focused on an antiquated goal and needed an adjustment to recalibrate. The Fed has been trying to create inflation for over a decade with no success.
Like the Bank of Japan, they have learned expectations of future inflation have been hard to budge. The hope is that markets will heed the message the way a Progressive state manager would in response to new incentives.
The problem is, if it doesn’t, the Fed can’t fire the market. All they can do is hope to persuade. They certainly have a better chance to succeed than they did with the old message, but only time will tell if they have done enough.