Market Power

Musings by an academic economist on the power of markets and the power over markets.

Friday, January 28, 2005

Inflation Target

People speculate about what the Federal Open Market Committee (FOMC, the primary monetary policy making body, headed by Alan Greenspan, of the US Federal Reserve System) is going to do about interest rates. One may hear "Will the Fed raise interest rates by a quarter percent" as if the FOMC will wave some magic wand and raise all interest rates by a quarter percent. In reality, when the FOMC makes an announcement about altering interest rates, it has made an announcement on the level to which to drive a particular interest rate, the federal funds target rate, which is just that - a target, not a real interest rate. The announcement is merely a public commitment of the level to which the Fed wants to direct the actual Federal Funds Rate.

The Fed is contemplating making public an inflation rate target, but nothing is imminent. See the Wall Street Journal article here.

A snippet:

As Federal Reserve officials prepare to raise interest rates again to keep inflation from rising, they are grappling anew with an old question: Should they aim for a specific inflation number?

On the agenda for next week's two-day meeting of Fed policy makers is a discussion of whether the Fed should set a numerical objective for inflation and, if so, what it should be, according to people familiar with the matter. The Fed ponders such long-term topics twice a year, and no formal decision is likely. Nor is an explicit, public inflation target on the table.

The Fed is required by law to maintain stable prices, but it doesn't quantify that objective as a specific inflation rate. Doing so needn't be the same as setting an explicit target, which implies a duty to adjust interest rates when inflation goes above or below the specified range. Still, if Fed officials can ultimately agree on a number -- a big if -- it would be an important change from its generally successful practice of letting investors infer from its actions what constitutes acceptable inflation.

Many central banks have committed to meeting an explicit target for inflation, believing a target makes them more transparent, credible and accountable. But the Fed is unlikely to join them under Chairman Alan Greenspan, who thinks a target limits his discretion to respond to differing risks as he sees fit.