WASHINGTON (Reuters) - The Federal Reserve could take the historic step this week of announcing an explicit target for inflation, a move that would fulfill a multi-year quest of the central bank’s chairman, Ben Bernanke.
An inflation target would be the capstone of Bernanke’s crusade to improve the Fed’s communications, an initiative aimed at making the central bank more effective at controlling growth and inflation. It would, at long last, bring the Fed into line with a policy framework used by most other major central banks.
Bernanke has made clearer communications a hallmark of his leadership, and bit by bit, he has worked to cast light on what for years had been purposefully opaque and secretive deliberations.
He has even given the campaign a personal stamp, contrasting his plainspoken and unaffected persona with that of his predecessor, Alan Greenspan, whose ruminations were notoriously oblique and who was associated with an aloof cadre of policy mandarins.
While Bernanke has touted a numerical inflation goal as a cornerstone of central bank best practices for years, the idea has become timely because it could help quell nagging doubts that the Fed’s unprecedented easy money policies are setting the stage for a nasty bout of inflation.
The U.S. economy strengthened toward the end of last year, with job growth accelerating and the unemployment rate dropping to a near three-year low of 8.5 percent.
But the recovery is not expected to retain the momentum.
By announcing a target, the Fed could smooth the path to another round of bond buying should the recovery falter.
“It’s a good idea whose time has come,” said Marvin Goodfriend, a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh and a former senior Fed policy adviser.
In the eyes of Goodfriend and some policymakers, laying out an agreed inflation goal would squelch the idea that the Fed might allow for a faster pace of price gains as it tries to drive unemployment lower.
It would also put the brakes on any notion that the central bank could resort to quicker inflation to ease debt burdens, as some academic economists have suggested as the needed salve for the painfully slow U.S. recovery.
“One of the reasons to announce a formal inflation objective is to indicate that the Fed does not believe it needs to stimulate inflation in order to stimulate the economy,” Goodfriend said.
Some question whether the change would be little more than an academic exercise, since the central bank already publishes quarterly forecasts that show most officials believe consumer prices should rise between 1.7 percent and 2 percent a year.
This long-term forecast is viewed as an ersatz target, and the Fed seems likely to simply formally enshrine it or a similar formulation.
While food and energy costs drove consumer prices well above the central bank’s desired levels last year, inflation is receding quickly and “core” prices and financial market expectations of future inflation have been largely contained.
The Fed’s preferred core price gauge was up just 1.7 percent in the 12 months through November, while bond markets see inflation of just 2.1 percent 10 years out.
Explicit targeting has eluded U.S. proponents in part because skeptics, particularly among congressional Democrats, worried it would relegate the Fed’s other congressionally set mandate - full employment - to the back burner.
“Discussions of inflation targeting in the American media remind me of the way some Americans deal with the metric system - they don’t really know what it is, but they think of it as foreign, impenetrable, and possibly slightly subversive,” Bernanke said in 2003.
However, the political climate has shifted. The Fed has drawn fire from Republican lawmakers and presidential hopefuls for risking inflation with its efforts to spur stronger job growth.
The central bank cut interest rates to near zero more than three years ago and has vacuumed up $2.3 trillion worth of bonds to pump cash into the financial system and energize growth.
Still, the Fed will need to tread carefully and accompany any inflation target with a description of what it views as constituting full employment.
Officials say that while monetary policy ultimately determines the rate of inflation, labor markets are often affected by structural issues beyond the central bank’s control. Because of that, they are hesitant to put a fixed number on the level of unemployment that can be achieved without generating a self-defeating inflation.
As part of a communications review, officials in December debated a draft statement on their longer-run goals and policy strategy. Policymakers are set to discuss a refined draft at a policy meeting on Tuesday and Wednesday. It is this statement that is widely expected to include an explicit inflation target.
“We are very close to having inflation targeting in the U.S.,” James Bullard, president of the St. Louis Federal Reserve Bank, told Bloomberg Radio in an interview on January 5.
Although there is no guarantee the Fed will announce a target this week, the communications review has already led to another innovation. For the first time ever, the Fed on Wednesday will release forecasts for the path of interest rates.
Officials argue an explicit target would be an improvement on the longer-run inflation forecasts they now provide because it would strengthen the central bank’s commitment to low inflation, even as it casts about for ways to coax the economy into a higher gear.
Also, the long-range forecasts are simply an amalgamation of the individual views of all 17 Fed policymakers. An explicit target would be an agreed-upon common goal that could help bolster the central bank’s already high anti-inflation credibility in financial markets.
It could also help the Fed politically and strategically.
The central bank has taken lumps, mostly from congressional Republicans, who saw its second round of bond buying as an egregious episode of big government overreach.
The concerns of these Republican lawmakers, some of whom have broached the idea of narrowing the Fed’s mandate to only price stability, might be mollified, potentially offering some political cover to an institution that has had few friends in the public arena since the financial crisis and recession of 2007-2009.
A target could also help Bernanke keep a critical mass of support behind his policy decisions within the central bank, where at any given time, three or four of the current roster of policymakers are known to object to the Fed’s ultra-easy stance.
“Having an inflation target is central banking 101,” said Philadelphia Fed President Charles Plosser, one of the Fed’s top inflation hawks. “It’s what most major central banks do.”
Reporting By Mark Felsenthal; Editing by Tim Ahmann and Jan Paschal