January 25, 2012 / 1:07 PM / 7 years ago

Q&A: Fed poised to adopt inflation target

WASHINGTON (Reuters) - The Federal Reserve could announce an official inflation target as early as the end of a two-day policy meeting on Wednesday, part of an ongoing effort to boost transparency.

Most analysts expect the central bank will stick with the target previously pronounced by Fed Chairman Ben Bernanke of 2 percent or a bit lower.

What exactly is an inflation target and what are its purposes? What are the downsides of publicly stating an inflation goal? Here are some questions and answers.

WHY ADOPT AN INFLATION TARGET?

An inflation target is a specific goal agreed upon by the central bank (or, in some places, set by lawmakers). Its purpose is to help prevent future inflation by keeping a lid on inflation expectations, which policymakers see as a precursor to actual inflation.

DO OTHER COUNTRIES HAVE THEM?

Yes, many countries around the world have inflation targets, including euro zone member states, the UK, Brazil, Mexico and New Zealand. The design and level of targets vary, with some allowing more short-term deviation from targets than others.

WHAT ARE THE DOWNSIDES?

Under its previous chairman, Alan Greenspan, the Fed was reluctant to adopt an inflation target because some officials thought it would hinder their flexibility in setting policy. Another potential pitfall is that the Fed might favor the half of its mandate that focuses on stable prices at the expense of promoting maximum sustainable employment.

HOW MUCH OF AN IMPACT WILL IT HAVE?

The Fed already publishes policymakers’ individual forecasts for long-run inflation, which analysts see as the first step toward an official target. But having a singular aim would likely provide a clearer anchor for financial markets.

IS THERE COMPLETE AGREEMENT WITHIN THE FED?

Most if not all Fed officials favor having an inflation target. Bernanke has been a long-standing advocate. However, Fed officials may view the purpose of a target differently. Some of the more hawkish regional Fed bank presidents, like Charles Plosser of Philadelphia and Jeffrey Lacker of Richmond, argue the Fed should not and cannot try to target employment. Focusing on price stability, they say, is the best thing the Fed can do to stimulate optimal growth. However, some of the Fed’s more dovish members, like Chicago’s Charles Evans, see a target as a way of anchoring long-term inflation expectations, effectively giving the central bank further room to ease monetary policy if it sees the need.

POLITICAL OPPOSITION

In the past, when the Fed raised the issue of adopting an inflation target, some Democrats publicly opposed the idea, saying it would lead the central bank to favor stable inflation over full employment. There has been little public debate this time around regarding an inflation target, but the topic could reemerge during a presidential election year. On the other side of the argument, some Republicans have recently called for a change in the Fed’s congressional mandate that would allow it to focus solely on inflation and not full employment.

Reporting By Pedro Nicolaci da Costa; Editing by Neil Stempleman

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