Should The Fed Set An Open Target For Inflation?

The head of the Philly Fed Bank, Charles Prosser, spoke out yesterday in favor of having the FOMC establish public, explicit targets for inflation to be used in guiding monetary policy.

This re-opens a debate that’s been going on (albeit in the muted tones of Fed-speak) for many years.  Should the Fed set open targets for inflation?  Should they just lay some numbers out there, for example a 1-year and a 5-year forecast, along with a message to the effect of, “Here’s what we’re hoping for; if it looks like we’re not going to get there, then we’re going to start pushing or pulling to get it there.”

Ben Bernanke was openly calling for it, even writing books about it, while Greenspan was still running things.  Now Mr. Bernanke is like an incoming congressman just itching to pull a specific piece of legislation out of his pocket as soon as the timing is right.  Only the timing hasn’t been right ever since Bernanke took up his new post.  Because in this case, bad timing = favorable economic conditions.  In short, you never mess with a winning streak.  So far, by and large, the economy of the last year has been a good one.

The main argument in favor of inflation targeting is that it gets everyone on the same page, and that reducing overall uncertainty in the markets is a good thing. 

So what are the drawbacks to setting an open target?

First and foremost, it means putting something out there to be judged on.  An actual figure for the media, and congress, and investors to all pore over, expound upon, criticize, and ask more questions about.  These are all things that most folks would not choose to increase in their job description.

The second problem is irrevocably tied to the first.  What happens to the credibility of the FOMC if they can’t hit the “target” for a few years, or they meet a target that sends the economy reeling due to an unexpected side effect?  Bernanke often talked about the positive examples of other central banks, central banks that had used a target for money supply growth as an implicit target for inflation growth, as the two moved in general lock-step.  This is not the case any more in the U.S., which is why the Fed stopped setting money supply targets a few years ago. 

Could the Fed turn into a lowly-regarded bureaucracy that is perceived to not really know how to steer the economy?  Could they get bogged down in trying to explain advanced macroeconomic theory to an audience that by and large either doesn’t understand, doesn’t want to, or has their own agenda to push?  All these elements are dangers, and could be why Greenspan realized that it was in the long-term interests of the Fed to remain somewhat open, and somewhat vague.  Because part of steering the world’s largest and most complex economy lies in appreciating how unpredictable it can be.

For everyone who chooses to follow the guidance and statements that are issued by the Federal Reserve, the “comfort zone” levels are known.  We get what they are trying to do – we have for years under the examples set by Greenspan – and even if a 1-2% inflation figure was made “explicit”, economists and analysts would still debate the impending rate activity at the next FOMC meeting.  They would still debate for the same reason they do now – not everyone agrees on the magnitude of economic growth, or on how much effect x amount of change to short-term rates will have on inflation and growth. 

The Fed, by keeping their long-term goals known, and their short-term goals open to constant re-interpretation, probably gives itself the best opportunity to remain a venerable market force. 

But if the economy does get rattled in the next year, or we do enter a recession, look for Bernanke to try and use this as a forum for his explicit target agenda.  It may please the markets in the short-term, but in the long run it could take valuable power away from the Federal Reserve.

Ryan Barnes