Markets

How Targeting Inflation Could Help the Fed Reinflate the Economy

By Alain Sherter

Updated on: June 27, 2011 / 8:46 AM EDT / MoneyWatch

[Note: This will be my lone post for the week. While I'm away, Dan Bischoff, former European editor for World Business, a multi-national magazine analyzing globalization, has graciously offered (OK, I begged) to guest-write this blog. Dan, who was also art critic for the New Jersey Star-Ledger and before that national affairs editor for The Village Voice, is a terrifically sharp-eyed critic of the economic, political and cultural scene. Enjoy.]

The Federal Reserve's policy of cutting interest rates to near zero and shooting up the U.S. economy with more than $2 trillion has failed to spur growth. What else could it try? One approach that may be gaining favor is "inflation targeting."

That's when a central bank sets an explicit numerical goal for inflation. Although the Fed already aims to produce a certain level of inflation as part of its "dual mandate" to both promote stable prices and a strong labor market, that target isn't binding. Because the Fed can, and does, change it anytime, consumers and businesses may not find it credible. Uncertainty about the direction of prices and wages in turn can crimp spending and investment.

Greasing the skids
Advocates of targeting say the Fed could ease such concerns by formally setting a target inflation rate. And if it modestly increased the rate, pushing it up from the current informal goal of 2 percent to, say, 4 percent, that might spur growth by giving people a reason to spend. Why? Because you're more likely to buy a loaf of bread today if you know the price is going up tomorrow.

Although people understandably fear inflation, this approach could help in other ways. Rising inflation would push down the value of the dollar, making it easier for households and businesses to pay off debt. For the broader economy, a weaker currency also boosts exports.

On the business front, it could drive demand for loans, since borrowers would be more confident that rising inflation will, by pushing up prices, boost revenue. Greater borrowing would stimulate the economy. And since there is a trade-off between controlling inflation and boosting employment, anchoring inflation could give the Fed more room to focus on creating jobs without sowing fear about runaway prices. Raising the inflation target would also be a way for the Fed to state clearly to the financial markets that it has no intention of tightening monetary policy anytime soon, allowing investors to plan accordingly.

Inflation targeting is no panacea. Although devaluing the dollar deflates debt, it hurts purchasing power, which is always a political hot-button. Inflation can also be hard to control, while there is always a lag between a shift in monetary policy and price changes. Even if Bernanke set a specific target, in other words, people may not believe that the Fed is capable of hitting it. That would undermine the goal of keeping inflation expectations in check.

"No imminent" change
As a form of monetary policy, inflation targeting dates back to the 1970s, when Germany's Bundesbank and the Swiss central bank used it to steer their regulation of the money supply. Today, many advanced economies use the approach. Economist Paul Krugman famously urged Japan to try inflation targeting as the nation was sinking into its "lost decade" in the 1990s. Japanese officials demurred, and (for many reasons) the country's economic slump has since stretched into decades.

Within the Fed, there appears to be growing support for inflation targeting. Atlanta Fed president Dennis Lockhart, St. Louis Fed chief James Bullard and other Fed officials have recently backed a move toward targeting. Yet despite also backing the approach in principle, Bernanke remains characteristically cautious. He said this week:

We need to make sure that it is well understood both by the public and by Congress that having a target would not mean that we are abandoning the other leg of the dual mandate. I don't think there's a real barrier to setting a target. However it is very important that first, that we communicate to the public what we are doing.

Translation: Targeting a higher rate of inflation is politically dicey. That's probably true. The right, always eager these days to beat up on the Fed, would charge the bank with debasing the dollar. The left would argue, perhaps correctly, that focusing on inflation would further distance the Fed from its duty to boost employment. Declaring that a shift toward targeting is "not imminent," Bernanke seems content to wait and see where the economy is drifting.

The danger, of course, is that the economy drifts straight into another recession. At that point, caution will no longer be an option.

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