Managing Inflation

Way back in 1996, I wrote a column titled "Some inflation probably isn't all together a bad thing." This was at one of those many times when the Federal Reserve Board decided there was inflation on the way and raised interest rates to "slow the economy." Well, inflation wasn't very much on the way at all. The average annual Consumer Price Index (CPI) for 1996 increased 2.9% from the previous year and increased just 2.3% the following year.

In the column, however, I noted that the Federal Reserve had put inflation on everyone's mind. Thus, one day that August when the government released a monthly CPI that showed a 3.0% increase over the same month of the year before, the stock market became convinced of impending inflation and fell 58 points, or 1.0%, from the previous day. More significant, the volume of shares traded on the New York Stock Exchange rose 8%.

Seeing moderate gross domestic product (GDP) growth and low inflation over a few years prior to 1996, I concluded: "The question thus becomes, should the U.S. be so concerned about recession and inflation that we stifle economic recovery? Or should some targeted level of inflation be allowed so that stronger growth can be achieved during recoveries?"

I was soundly taken to task in letters from some readers who seemed to think I was trying to rob them of their income.

Economists say an inflation target would probably have some calming effects on equity markets and may help industry in some planning decisions such as capital spending.

The proposal comes after 25 years in which the Federal Reserve has steadily reduced inflation and inflation expectations, without resorting to a specific target. Indeed, for more than a decade, the U.S. has seen the lowest sustained rate of inflation since the country went off the gold standard in 1971. In the years since 1990, the annual CPI increase has been just 2.7%.

So why an inflation target now? Santomero and others believe that establishing a target in a time of low inflation would be less disruptive to the economy than it would be if inflation rates were higher. He told the meeting: "Having achieved price stability, there is still the matter of maintaining it. It is my view that by defining what we mean by our goal of price stability, the Fed would not only better inform market participants of our intentions, but would also strengthen their capacity to monitor our performance."

And, Santomero said, "both economic theory and experience demonstrate that securing a low rate of inflation is the most important contribution a central bank can make to sustaining maximum economic growth."

Specifically, Santomero's proposal calls for a target band of 1 to 3% annual inflation, rather than a single percentage, which is what other countries have implemented. The Bank of England started out with a target band but ultimately moved to a target number of 2.5%. The European Central Bank (ECB) has set 2.0% as its target. Others at the Federal Reserve are in fact arguing for a single target rate.

But no matter whether the target is a single percentage or a band, economists say that what is important is transparency. ECB President Jean-Claude Trichet told the NABE economists, "The final principle that we have adhered to since ECB was established is the importance of open and transparent communication with investors, savers, market participants, and the public at large." He noted that ECB was one of the first central banks to give a real-time detailed analysis and assessment and to organize regular press conferences.

Trichet pointed out that by publishing a definition of price stability--the inflation target--"everybody knows precisely what we are aiming at. This is beneficial for meaningful accountability. The public can judge whether or to what extent we are achieving our goals in comparison with the yardstick we have set ourselves. This is also beneficial for medium- and long-term credibility."

Santomero says communication with the public should help prevent unnecessary inflation or deflation scares when the inflation rate accelerates or decelerates.

There are questions, however, about the effects of a target inflation number or range. In Europe, with its single target, inflation remained low through the 1990s. But inflation also remained low in the U.S., which at present does not have a target. Thus, how much has inflation targeting affected the actual inflation rate? In using a target band, will it be human nature to accept the upper limit of the band--the 3% in the case of Santomero's proposal--as the de facto single target? And what will happen in the case of inflationary shocks to the economy such as the oil embargos of the 1970s?

Whatever the answers, the U.S. seems to be moving toward joining many other countries around the world--so send your letters to the Federal Reserve.