Fed Meeting to Pose Question
Of Setting Clear Inflation Rate
Issue of Numerical Objective
Is on Next Week's Agenda,
But Greenspan Is Resistant
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
January 27, 2005
As Federal Reserve officials prepare to raise interest rates again to keep inflation from rising, they are grappling anew with an old question: Should they aim for a specific inflation number?
On the agenda for next week's two-day meeting of Fed policy makers is a discussion of whether the Fed should set a numerical objective for inflation and, if so, what it should be, according to people familiar with the matter. The Fed ponders such long-term topics twice a year, and no formal decision is likely. Nor is an explicit, public inflation target on the table.
The Fed is required by law to maintain stable prices, but it doesn't quantify that objective as a specific inflation rate. Doing so needn't be the same as setting an explicit target, which implies a duty to adjust interest rates when inflation goes above or below the specified range. Still, if Fed officials can ultimately agree on a number -- a big if -- it would be an important change from its generally successful practice of letting investors infer from its actions what constitutes acceptable inflation.
Many central banks have committed to meeting an explicit target for inflation, believing a target makes them more transparent, credible and accountable. But the Fed is unlikely to join them under Chairman Alan Greenspan, who thinks a target limits his discretion to respond to differing risks as he sees fit.
The issue probably won't affect near-term monetary policy. Mr. Greenspan has defined price stability as a zone where inflation no longer materially affects companies' or individuals' decisions. At 1.5% by the Fed's preferred measure, inflation is now "roughly consistent with a working definition of price stability," Federal Reserve Bank of Cleveland President Sandra Pianalto said last week, expressing a view shared by most of her colleagues on the 19-member Federal Open Market Committee, the central bank's policy panel. The Fed wants to keep inflation in that zone, by raising its target for the federal funds rate, now 2.25%, until it no longer stimulates spending and thus poses a long-term risk of inflation.
But the issue may become more pressing if inflation drifts higher this year, and investors start to wonder how much, if at all, the Fed will raises interest rates in response.
Mickey Levy, chief economist at Bank of America, notes that in May 2003, the Fed declared that any further fall in inflation -- then running at a little over 1% -- would be "unwelcome," in effect announcing a floor for inflation. The Fed's fear was that further declines would raise the risk of deflation, or falling prices. "While they have revealed through action and statement their lower bound [for inflation] they have not had the opportunity or been forced to reveal their upper bound."
An informal survey by The Wall Street Journal found some uncertainty over the Fed's tolerance for inflation. Six of eight firms that closely watch the Fed believe it has an implicit inflation target range. Four -- Goldman Sachs, Bank of America, Macroeconomic Advisers and Morgan Stanley -- say it is 1% to 2%, as measured by the price index of personal consumption excluding food and energy. (The Fed believes that index measures the cost of living more accurately than the better-known consumer-price index.) A fifth, ISI group, says it is 1.5% to 2.5%. Merrill Lynch says 1.5% to 2%, and J.P. Morgan Chase and Lehman Brothers say there isn't any implicit target.
FOMC members who have advocated a numerical objective or target have offered varying ranges. Governor Ben Bernanke has said 1% to 2%. Governor Edward Gramlich has suggested 1% to 2.5%. Philadelphia Fed President Anthony Santomero last October proposed 1% to 3%, and St. Louis Fed President William Poole advocates a target of zero, with some allowance for errors in measurement.
Advocates believe a target would enable investors to better predict how the Fed will respond to changing economic circumstances and solidify its commitment to price stability under Mr. Greenspan's successor next year.
But opponents, who include governors Roger Ferguson and Donald Kohn, fret that targets would confer an obligation to change interest rates whenever inflation deviated from the target, even if unemployment or financial stability called for different actions.
An inflation "objective" might be a compromise between an explicit target and no number. Mr. Gramlich said in a speech in 2003 that the Fed could simply state its preferred long-run range for inflation: "The FOMC would not have to defend any deviations from the preferred range."
History suggests Mr. Greenspan would resist even that step. When the FOMC last formally addressed the issue in July 1996, it reached a near consensus that 2% was the right goal. Mr. Greenspan then, according to a transcript, warned his colleagues, "If the 2% inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate."
Write to Greg Ip at greg.ip@wsj.com1
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