A Subtle Shift in FOMC Policy
At his second press conference, Chairman Bernanke was asked whether the Fed would ever institute an explicit numerical inflation-targeting policy. In responding, he confessed he has always been a fan of that type of monetary policy. Recent adjustments in some of the Fed’s communications suggest that the Chairman may be gaining a few more Federal Open Market Committee (FOMC) participants on his side. Adopting an inflation target is a topic that has gotten a lot of attention lately, and a review of the Committee’s most recent minutes and the public discourse should help shed some light on why.
The minutes of recent FOMC meetings show that at least some FOMC members have been considering the costs and benefits of an explicit inflation target as an official policy goal. As expressed in the minutes, “a few participants noted that the adoption by the Committee of an explicit numerical inflation objective could help keep longer-term inflation expectations well anchored.” This statement is not a new development, however, as it has appeared in each of the last three sets of minutes published. Perhaps more important was a change in the Chairman’s interpretation of the Committee’s inflation projections.
In the past, the Fed has argued that in order to maintain price stability—one half of its dual mandate—it must achieve a rate of inflation that is consistent with the mandate over the medium term. Until recently, this rate was not specified but was implicitly understood by market participants to be 2 percent, or just a little bit less. Because inflation is approaching that level and economic growth is still below its long-run trend, some contention has emerged as to whether the Fed will stick to that implicit, mandate-consistent target or let inflation rise to spur growth.
Speaking at his April press conference, Chairman Bernanke pointed out that the longer-run projection for inflation submitted by FOMC participants for the April meeting was 1.7 percent to 2.0 percent. He went on to say that because the outlook for inflation is determined almost entirely by monetary policy, the projections could be interpreted as “the inflation rate that Committee members judge to be most consistent with the Federal Reserve’s mandate.” Those projections were dependent on the assumption of appropriate monetary policy, but in linking the FOMC’s projections to its role in determining inflation, Chairman Bernanke gave an explicit definition of what was considered a mandate-consistent level of inflation at that time. Naturally, these longer-run projections are likely to change over time as economic conditions evolve. Still, here is a specific definition of where policy is trying to guide inflation rates in the medium term. Giving this type of policy guidance offers several advantages, one of which would be to anchor inflation expectations, which have been very volatile in the past few years.
With this recent development, it seems as if the Fed has very nearly adopted an unofficial inflation-targeting policy. Even though making it official would be a new policy for the Fed, it has been implemented in several other countries, largely with positive results. The 2010 Annual Report of the Cleveland Fed noted the advantages of instituting an explicit numerical target, and it also outlined some of the success stories in other countries. Although the Fed is currently doing about as well as other nations in stabilizing its price level (see chart below), other advantages might include more leeway in policy decisions with anchored inflation expectations and enhanced transparency and accountability.
One concern that has been raised about an explicit inflation target is that it seems to favor the price stability part of the Fed’s mandate over the full employment part. This issue has been addressed in a number of different ways (see, for example, the Cleveland Fed’s 2010 Annual Report and Chairman Bernanke’s June press conference transcript ). Ultimately, a more stable inflation trend will reduce uncertainty for businesses and consumers, and make the economy more conducive for employment growth.