Fed adopts de facto inflation target

Most news headlines, it looks like, have focused on the dissent of views about the launch of QE2 in minutes of the latest FOMC meeting. But what's more revealing is that the Fed discussed whether or not to adopt an inflation targeting, which Chairman Ben Bernanke once promoted but has withdrawn since getting the Fed job.

No decision was made on the adoption of "a numerical inflation objective or a target path for the price level" at this time, but instead the projected longer-run PCE inflation rate in the Summary of Economic Projection is left as a de facto inflation target, saying

participants noted that the longer-run projections contained in the Summary of Economic Projections, which is released once per quarter in conjunction with the minutes of four of the Committee's meetings, convey considerable information about participants' assessments of their statutory objectives.

The Fed implicitly acknowledges that its monetary policy, be it quantitative easing or rate change, is supposed to run for this goal, now 1.6-2.0%, which has just been revised down from 1.7-2.0% in June. PCE inflation rate is currently around 1.4%, a little bit lower from the target.

This de facto inflation target resembles that of the BoJ. Instead of the longer-run PCE inflation rate projection, Japan's central bank has "Understanding of Medium- to Long-Term Price Stability," which was introduced in 2006 to clarify the meaning of price stability in a mid- to long-term as an objective of monetary policy. According to the BoJ,

In today's Monetary Policy Meeting, there was a discussion of the level of inflation rate that each Policy Board member currently understands as price stability from a medium- to long-term viewpoint, in the conduct of monetary policy ("an understanding of medium- to long-term price stability"). While there was a range of views, reflecting the differences in the relative weight attached to factors affecting the understanding of price stability, it was recognized that the level was somewhat lower than that in major overseas economies. It was agreed that, by making use of the rate of year-on-year change in the consumer price index to describe the understanding, an approximate range between zero and two percent was generally consistent with the distribution of each Board member's understanding of medium- to long-term price stability. Most Board members' median figures fell on both sides of one percent. Given that the understanding of medium- to long-term price stability may change gradually reflecting developments such as structural changes in the economy, as a rule, Board members will review it annually.

Currently, the average of most Policy Board members' "understanding" is around 1% in terms of the year-over-year increase rate of CPI. The BoJ hasn't officially declared the adoption of an inflation target mechanism, but a 1% change of CPI is widely believed to be no less than the BoJ's price target. The latest figure is -0.6%, which means Japan is still mired in deflation and hence the central bank will continue the current monetary loosing.

The Fed has, on the other hand, one more target: unemployment rate. The longer-run unemployment rate is projected to be 5.0-6.0%, which has recently been changed from 5.0-5.3% in June, reflecting severe labor markets condition where the current unemployment rate is as much as 9.6%.

As is well known, the Fed has dual mandate: price stability and maximum employment. So, the question may arise as to what if one mandate is fulfilled while the other isn't. Stagflation, recession with rising inflation, is the prime example which could compromise the Fed's mission. As far as the recent minutes go, it seems that the Fed has much more fear of deflation than stagflation.

Lastly, some FOMC members raised concern that "additional expansion of the Federal Reserve's balance sheet could put unwanted downward pressure on the dollar's value in foreign exchange markets." As my previous post shows, Bernanke rebutted a claim that the Fed's quantitative easing has weakened the dollar. But now it's clear that some noticed a positive relation between the monetary easing and a cheap dollar, which would be a cause of later controversy on the Fed's role.