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|  | Riccardo Sorrentino, born in 1964, has worked at Il Sole-24 Ore since 1992. In the past years, he has attended several international summits, including the Palermo G-7 of Finance Ministers and Central Bankers in 2001, and the WTO conferences of Cancun (2003) and Hong Kong (2005) and he has covered several G-10 central bank meetings at the BIS and ECB press conferences. As a special correspondent, he has been in The Netherlands; in the US; in Iceland, in Hungary, in Singapore, in Indonesia, in India, in Norway, in Thailand, in Pakistan, in Armenia. In the 2003-2004 winter and in the 2006 summer, he worked at Il Sole 24 Ore's North American bureau in New York. |
| | riccardo.sorrentino@ilsole24ore.com |
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| The Fed unofficial inflation target |
| November 22, 2007 |
It is a crucial issue, speaking about monetary policy. Since Ben Bernanke has been appointed at the Federal Reserve governors' board – his first mandate began in 2002 - inflation targeting regime has been a much-debated question. Many Congressmen don't like this monetary policy framework. They prefer the dual mandate given to the Central Bank by the Federal Reserve Act approved in 1913: price stability and maximum employment or, more precisely, "[the] long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates".
A BIG MISUNDERSTANDING
Policymakers – and many others - believe that adopting the inflation-targeting regime means to prefer always the goal of price stability to that of maximum employment. This is not true, and the Federal Reserve has already chosen: the priority has to be given to the price stability. As far as we know, no monetary policy is possible otherwise (even if some alternative theoretical regimes have been actually proposed).
DEEDS AND WORDS
Central banks, put aside their words, continue to act according what Alan Blinder, a former Fed vice chairman, described in 1996: "A central bank could do its part to achieve low unemployment by pushing the nation's total spending up to the level of capacity, but not further". Why? Because beyond the level of capacity, prices go up, faster and faster. So price stability is, at least, a bounding constraint, chiefly because it so very difficult to forecast what will happen in two years time, when the current monetary policy moves affect
prices.
THE ECB MODEL
At European Central Bank – even if its language is very different, focused on price stability, things are not different. A research by Unicredit, a leading Italian bank, shows that, from the outside, the Ecb seems to give attention only to the economic growth, contrary to its words. Of course, European central bankers are not liar, but in the euro zone prices go up very very quickly when economic growth exceeds its potential level. Differences, between Fed and Ecb, are linked to the different structure of Us and Emu economies, but their monetary policy regimes are very similar: the Fed uses an informal inflation targeting, the Ecb a flexible one.
A COMFORT ZONE…
Something more is needed, in United States, to speak about a full adoption of an inflation targeting, even in his "lite" version: an official inflation target. «The communication of a numerical objective for the optimal long run inflation rate is the defining aspect of inflation targeting», wrote Michael Feroli at JPMorgan. Still many Central bankers revealed the "comfort zone" they chose for the Personal consumption expenditures core deflator, the Fed preferred inflation measure.
…WITH A CENTRAL POINT
Ethan Harris, at Lehman Brothers, drew together all those indications. Ben Bernanke's comfort zone is between 1% and 2%; Janet Yellen, William Poole and Jeffrey Lacker adopted the same corridor but indicated a central point at 1,5%. Sandra Pianalto likes the same central point but with a different range, 0,5-2,5% and Charles Plosser prefers a quit unusual comfort zone between –1% and 1%. «From'96 to 2004, core Pce inflation stayed in the 1-2% range, averaging 1,6%», wrote Harris.
A SECRET TARGET
This is not a surprise. Federal Reserve adopted a secret inflation target in July 1996. The transcript reveals that the 2% target, or more plausibly a ceiling, was proposed by Janet Yellen, during a meeting lead, as usual, by Alan Greenspan who proposed even a baseless reason to lower inflation: «As the inflation rate falls, it becomes increasingly difficult for producers to raise prices. They therefore tend to try to reduce costs in order to maintain margins», he said, adding: «If we are to move toward price stability, is that the process in and of itself induces an acceleration of productivity». Yellen objected: «I have not seen any evidence that convinces me», she said, getting a strange answer. There is, said Greenspan, an «anecdotal evidence».
PRINCIPLED OPPORTUNISM
In that meeting Al Broaddus, from Richmond, argued for a full disclosure of the target. «To get the full benefit, though, I think we would need to make some explicit public reference to these benchmark points and our commitment to them», he said. He criticized the «opportunistic approach»" to keep the target secret. Greenspan replied that it was a «principled opportunism».
A MEAN TO AND END
Like Broaddus, Tom Melzer too spoke like a full inflation targeter. «I think our focus ought to be on prices. In my view, that is the only thing we really influence in the long run, and that is what our policy ought to be aimed at. […]Low and stable inflation or price stability, however you want to say it, enables the economy to reach its maximum potential. That is our ultimate goal». So price stability is a mean to an end, the economic growth, and it is the only one because «that is the only thing we really influence in the long run".
AN INFORMAL AMBIGUOUS CONSENSUS
At the end the Central bankers reached an «informal consensus», and an ambiguous one. What was that "2%"? For Broaddus it was a «ceiling», for Laurence Meyer the fed was establishing «if not a very long-term policy, at least a policy that goes more than from meeting to meeting», and so maybe a «provisional target», for Edward Boehne and Janet Yellen it was a «ultimate target». Greenspan simply spoke of a goal. Deeds are more meaningful that words: from'96 to 2004, core Pce inflation stayed below the 2% ceiling.
AN IMPLICIT TARGET
Something has changed this month with the new communication strategy. There is not an official inflation target, but what else could be an inflation forecast on a third year horizon? Could the Fed admit today that it will fail to get its own objective in three years time? This is why Feroli wrote about a half step toward inflation targeting: «The Fomc forecast will be extended from a two-year horizon to a three-year horizon. In so doing, the committee is able to communicate through its third year inflation forecast the inflation rate that the committee views as desirable- i.e. presuming appropriate policy action toward the implied objective». In the same way, the third year growth and employment rate forecasts could be viewed as the potential growth and natural unemployment rate.
THE PAST DECADE
Harris agrees: «On the surface, Bernanke seems to have postponed his push for a formal inflation target; in reality the new communication process seems to be a way to reveal the target without calling it one. The Fed has arguably been moving toward a target for the past decade».
A NEW TARGET?
An unofficial target allows more flexibility. For instance the objective can be changed without losing credibility. According the Fed projections announced on November 20th 2007, after the communication strategy shift, the inflation forecast, the informal target, for 2010 is not the "old" 2%, even if it is below this ceiling. «The central tendency forecast for 2010 suggests core PCE inflation of 1.6-1.9% matching the forecast for total PCE inflation. This implies a midpoint of 1.75%», wrote Drew Matus at Lehman Brothers.
CORE AND HEADLINE INDEXES
The Federal Reserve is, in that, very close to the Ecb, which «aims at inflation rates of below, but close to, 2% over the medium term». It doesn't matter that Fed focuses on a core index and the Ecb on a headline inflation index; because they tend to converge, on the long term. The new Fed projections indicate also that the US potential growth is at 2,5%-2,6% - in the Euro zone it is a little bit less than 2% – and the natural unemployment rate is at 4,7-4,9%.
THE DIFFERENCE
Ben Bernanke, in some way, validates the view that the Fed took a half-step toward inflation targeting: «At a more technical level, the Federal Reserve differs from most inflation-targeting central banks in that it provides information about the independent projections of Committee members rather than a single collective forecast». Nothing else.
WITHOUT CONTRADICTIONS
Where is the dual mandate in this informal framework? There is no inconsistency, according Bernanke. «The practice of monetary policy in an inflation-targeting regime – he said at the Cato Institute - is not necessarily inconsistent with a dual mandate such as that given to the Federal Reserve; indeed, most if not all inflation-targeting central banks today practice "flexible" inflation targeting, meaning that they take account of other economic goals besides price stability--notably economic growth, employment, and financial stability--when making policy decisions». It is sufficient don't set a zero inflation target. «Were price stability the only objective mandated for the Federal Reserve, the FOMC presumably would strive to achieve zero inflation, properly measured--that is, the optimal measured inflation rate would deviate from zero on average only by the amount of the estimated measurement error in the preferred inflation index. But under the Federal Reserve's dual mandate, the determination of the appropriate long-run inflation rate must take account of factors that may affect the efficient functioning of the economy at very low rates of inflation, such as the risk that the zero lower bound on nominal interest rates might hinder the effectiveness of monetary policy. Thus, the (properly measured) long-run inflation rate that best promotes the dual mandate is likely to be low but not zero». Janet Yellen argued in the same way, on the same issue, during the July 1996 meeting.
AN EXTRA-LITE VERSION
It is possible to conclude that the Federal Reserve adopted, over time, an extra-light version of the inflation-targeting regime, whereas the Ecb adopted a lite version. A purer form of inflation targeting implies something else: more transparency and more accountability. Generally, when the Central bank fails to reach its target a procedure is called by the Parliament or the Government. In some cases, the political body chooses the inflation target, leaving the Central Bank fully independent to decide how to reach that objective. Both the Ecb and the Fed are far away from this.
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