Financial Targeting Inflation Oxford Analytica, 11.22.05, 6:00 AM ET
On Nov. 17, the Senate Banking Committee approved the nomination of Ben Bernanke as the next chairman of the Federal Reserve. The Federal Reserve acts as an implicit inflation targeter. In contrast to the outgoing chairman, Alan Greenspan, Bernanke is likely to shift the Fed towards more openness in communicating the Fed's long-run desired inflation rate to the markets. He may even introduce an explicit inflation-targeting regime.
The Fed continues to enjoy a high degree of monetary policy credibility. The Federal Open Market Committee decides monetary policy with an unannounced inflation target in mind, typically increasing interest rates in response to inflation threats. Currently, investors do not know the implicit inflation target of the FOMC, despite its importance in shaping monetary policy, inflationary expectations and, thus, long-term forward interest rates:
Benefits: Average growth has been high in the United States over the past decade relative to other industrialized countries, and inflation has not been a problem. This has led opponents of inflation targeting to question the need for an explicit inflation target.
Costs: If the FOMC were to successfully communicate its implicit inflation target to market participants, investors should expect inflation to return to its long-term steady state regardless of the state of the economy. These expectations should be reflected in bond yields, with the forward rate unresponsive to shocks. In a recent paper by Refet Gurkaynak of Bilkent University and his co-authors--"The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models"--the authors test the response of forward rates to economic news. The U.S. long-term forward rates are found to respond significantly and systematically to surprises. However, it is possible that investors could learn about the distribution of future inflation outcomes from data releases and update their beliefs every time there is a surprise development. Evidence of the excess sensitivity associated with implicit targeting will make it easier for Bernanke to argue for clearer guidance from the FOMC on its desired long-run inflation level.
Bernanke is likely to provide more information on the FOMC's long-term desired inflation rate in order to shape expectations and reduce financial-market sensitivity to data. The FOMC will have to reach a consensus decision on whether to establish a numerical inflation target. However, some of the current members are not convinced that the benefits of an explicit target outweigh the potential risks.
Excess sensitivity of bond yields and high volatility in financial markets are clear costs of not having a known inflation target in the United States. Under Bernanke's guidance, the Fed is likely to be more open in communicating its desired long-run inflation rate to the markets in order to anchor long-term inflation expectations. While this may include an explicit inflation target, some members of the Fed are expected to recommend a gradual move toward such a regime, given concerns that monetary policy may become overly constrained.
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