From Its Own Ashes, An Inflation Target May Rise

The idea of a U.S. inflation target, already on life support before the Federal Reserve's recent rate cut, has probably flat-lined now that the Fed's main concern is keeping the economy out of recession and not adding new policy rules.

But targeting could come back to life even stronger down the road, if supporters at the Fed play their cards right. That's because they can plausibly argue that having a numeric target right now would be useful amid uncertainty over the Fed's inflation-fighting credibility. Fed watchers had expected the arrival of Ben Bernanke as Fed chairman in early 2006, and fellow inflation-target supporter Frederic Mishkin as a governor later that year, as virtual assurance of an inflation target regime, in some form. Many other central banks including the European Central Bank and Bank of England already have them. The Fed has a dual mandate of stable inflation and maximum sustainable employment, yet no specifics of where either should be. The Fed was once assumed to have a comfort zone for annual inflation of between 1% and 2% as measured by the price index for personal consumption expenditures excluding food and energy, though that was never official. That seemed on its way to changing. Last year, the Fed created a committee to review its communications strategy. The discussions, according to Fed meeting minutes, included the "advantages and disadvantages of quantifying an inflation objective." Several Fed officials, meanwhile, spoke approvingly of inflation targets in 2006 and into this year, even if they seemed to differ on the exact number. In June, Bernanke said the Fed was making "very good progress" in its communications strategy discussions. The idea has always been controversial on Capitol Hill. Yet the time for consensus both inside and outside the Fed is when monetary policy and the economy are stable. That was the case from mid-2006 until recently, when the fed funds rate was steady at 5.25% and the economy, while slowing, wasn't anywhere near recession. All that has changed. A housing and credit crunch has raised fears of recession, and the Fed last week responded by lowering the federal funds rate for the first time in over four years, by 50 basis points to 4.75%. "They kind of missed a window of opportunity (in late 2006 and early 2007) when things were quiet and the Fed wasn't moving" interest rates, said Ethan Harris, chief U.S. economist at Lehman Brothers.

Target Would Have Helped Anchor Expectations

Ironically, now is when an inflation target would do the most good by anchoring inflation expectations, which appear to be rising. In a speech on inflation targeting in 2003 when he was a Fed governor, Bernanke said, "short-run stabilization of output and employment is more effective when inflation expectations are well anchored because the central bank need not worry that, for example, a policy easing will lead counterproductively to rising inflation and inflation expectations rather than to stronger real activity." That line of reasoning in 2003 "would apply to a 'T' right now," said JPMorgan economist Michael Feroli. Yet various measures of Wall Street's confidence that the Fed will keep inflation low - the dollar, gold, oil, and breakeven spreads between nominal and inflation-linked Treasurys - suggest officials lost their handle on inflation expectations in the wake of last week's rate cut. That may, in turn, undo any economic good from rate cuts. To make matters worse, not only doesn't the Fed have a target to anchor expectations, even its long-assumed 1% to 2% goal is losing traction. In a speech Friday, Fed Vice Chairman Donald Kohn cited forecasts noted that most advanced economies are expected to post inflation rates between 1% and 3% this year, and referred to that as "good performance." Mishkin noted in a paper Friday that most major economies "have inflation rates around the 2% level, which is consistent with what most economists see as price stability." That would seem to put the Washington-based Board at odds with regional presidents like Jeffrey Lacker of Richmond and William Poole of St. Louis, who have said they prefer inflation around 1.5% over the long term. If the one-two punch of an aggressive rate cut, combined with remarks signaling that the Fed's inflation preferences may have risen, have damaged the central bank's credibility in the absence of a target, there may be a longer-term benefit: the case is that much stronger for one down the road. Imagine this scenario: the Fed manages to stabilize output by early next year and core PCE remains at or under 2% - it's running at a 1.9% year-over-year rate through July. An emboldened Bernanke then makes his semiannual Congressional appearance in early 2008 and repeats what he said when he backed inflation targets four-and-a-half years ago, but this time with current events as support: "The Fed is currently in a good and historically rare situation, having built a consensus both inside and outside the Fed for good policies. We would be smart to try to lock in this consensus a bit more by making our current procedures more explicit and less mysterious to the public," Bernanke said in March 2003.