The Fed as Inflation Targeter

January 26, 2012

A post by Kim Schoenholtz

Today, the U.S. Federal Open Market Committee (FOMC) announced a major update of its framework for setting monetary policy. While the FOMC emphasizes its “dual mandate” (regarding inflation and employment), the new framework is fully consistent with an inflation-targeting central bank.

The key change was the announcement of an agreed quantitative longer-run goal for inflation (2.0% as measured by the annual change of the PCE deflator). A public and quantitative target is the sine qua non of inflation targeting. The new target shows up clearly in the January 2012 summary of economic projections by individual FOMC members. Compared to the November 2011 range of projections for “longer run” PCE inflation of 1.5% to 2.0%, the January projections show only 2.0% (i.e. no range).

Inflation targeting does not mean ignoring other indicators. The pace at which an inflation-targeting central bank seeks to reduce deviations from the target depends on policymakers’ preferences with respect to other factors. The new statement of principles from the FOMC addresses this question clearly:

“In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary.  However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.”

In plain English: When inflation deviates from the long-run objective of 2.0%, the FOMC will seek to restore it eventually. If employment simultaneously deviates from what the FOMC estimates as the sustainable maximum, policymakers can alter the pace at which they aim to restore inflation to the 2.0% objective. This amounts to inflation targeting.

How much will this alter FOMC practices going forward? Perhaps only modestly. From a practical perspective, the FOMC has acted for many years as a quasi-inflation targeter. Even if the Fed doesn’t like the label, the “quasi” qualifier no longer seems useful.

Yet, the explicit inflation target could help make policy more effective. First, it should facilitate policy communications. An explicit target provides for accountability and (therefore) credibility. Observers will be able easily to track the FOMC’s success (or lack of it), and policymakers will be compelled to explain why inflation deviations have arisen and the pace at which they expect to correct them. If, over time, the targeting errors prove unbiased (the positives offset the negatives on average), that will help anchor both inflation expectations and price-level expectations. Stable expectations should reduce the risks of deflation or of an outsized inflation. History suggests that stable inflation expectations also will facilitate economic growth. And, other things equal, stable inflation expectations could reduce the volatility of long-term nominal bond yields.

To be sure, today’s favorable reaction in asset markets probably had little to do with the FOMC’s new framework. As press headlines note, the January FOMC statement extended the expected period of “exceptionally low” interest rates to “at least through late 2014″ compared to “at least through mid-2013” (from the December FOMC statement). Investors expect policy rates to stay lower for longer.

That may be true, but the FOMC also provided reasons to be cautious about this conclusion. For the first time, the Committee revealed the policy rates that FOMC members associate with appropriate policy over time. The bottom panel of the newly published Figure 2 (“Overview of FOMC participants’ assessments of appropriate monetary policy”) tells us that the median interest rate projection for the end of 2014 is 0.75% (not zero to 0.25%), so “exceptionally low” does not mean zero interest rates. This news may disappoint some investors.

In addition, headlines regarding the FOMC statement miss how wide the range is of FOMC participants’ projections of the timing for the first FOMC rate hike. According to the figure, six out of 17 FOMC participants expect the first hike by end-2013, while an equal number don’t expect a rate hike before 2015. That wide range imposes a significant qualifier on the FOMC’s conditional interest rate projections. They are not a policy “pre-commitment.”

Interestingly, Figure 2 now also provides information about the FOMC’s views on the long-run real interest rate – the gap between the expected policy rate over the “longer run” and the expected inflation rate (now likely to be quite close to the Fed’s target of 2.0%). The newly published “longer run” projections for the funds rate are clustered in the 4.0%-4.25% range. That’s consistent with an expected real rate of 2.0%-2.25%. Nearly 20 years ago, John Taylor used the value of 2% for the long-run real interest rate in what subsequently became known as the Taylor rule. Policy setting does have regularities, after all.

Posted by Dave Backus for Kim Schoenholtz
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