Monday, October 31, 2005

Does inflation forecast targeting make you an inflation dove? 

There is continued carping from some quarters that Fed chairman nominee Ben Bernanke is an inflation dove. But a WSJ article by Greg Ip (subscribers only, but standby for some quotes) does a nice job of adding some nuance to what has been said. Here are the key grafs with my commentary.
In the 1960s and 1970s, many central bankers thought inflation did little harm and that reducing it was unacceptably painful. That breed of dove is now almost extinct. Today's hawks and doves are distinguished not by their philosophy, but by their forecast. Both believe in the wisdom of keeping inflation low. Doves are more confident it will stay there without wrenching increases in interest rates.

Judging by his public comments, Mr. Bernanke is an old-fashioned hawk but a modern dove. He expects inflation to remain low and, if that forecast proves correct, he probably will keep rates down. If that forecast proves wrong, he will raise them as far and as fast as Mr. Greenspan would have, and perhaps further.
As I pointed out last week, inflation targeting is really inflation forecast targeting. The confusion, I think, stems from one of its more famous expressions, in the rule that operates the Reserve Bank of New Zealand, to wit: if the inflation rate over some period is above 2% on an annual basis, the governor of RBNZ is sacked. That is NOT inflation targeting as Bernanke describes it. That is to say, the RBNZ could operate monetary policy using something other than an inflation target, and as long as the inflation rate stayed below 2% nothing would happen. The 2% limit isn't a target, it's a constraint.
Mr. Bernanke long has advocated setting inflation targets as a way of institutionalizing Mr. Volcker's and Mr. Greenspan's conquest of inflation. A target, he has said, would hold the central bank accountable. Over time, it would make the public more willing to believe low inflation will last, and that will make it easier for the Fed to cut rates when the economy softens without fueling inflation in the process.

He also has argued that inflation targets can prevent Japanese-style deflation. Maintaining "price stability," the mantra of modern central bankers, means being both an inflation hawk and deflation hawk, in the old sense of the term.
So, if inflation were to rise in a particular month because, say, a storm wiped out a significant part of the oil refining capacity of the Gulf Coast, and prices rose, the Fed would have to say what it views those events to mean for inflation six to nine months from now, and to act if the forecast was for higher inflation, and NOT to act if it did not. (This will come as no comfort to those who think inflation has not been at all tamed -- I will deal with those later when I answer a reader's question, "why not a zero target?")
As Mr. Bush's economist, Mr. Bernanke has predicted inflation will stay low. However, that is often the refrain of White House officials, who are supposed to sound optimistic. It isn't clear if he will have the same view at the Fed. After all, in recent months even previously dovish Fed officials have ratcheted up their anti-inflation rhetoric. One of them, San Francisco Federal Reserve Bank President Janet Yellen, recently suggested rates have to go higher than she previously believed to reach neutral.
I think that point is vital -- we cannot assume we know Bernanke's forecast for inflation. And, following with the statements about what Supreme Court justices should and shouldn't say in confirmation hearings, here's one vote that Bernanke not offer a forecast for inflation in his confirmation hearings.
In principle, Mr. Bernanke favors pre-emption. "Policy makers achieve better results when they act in advance to forestall developing problems," he said in 2004. Mr. Sack wonders, will Mr. Bernanke "err on the side of restraint, considering that the transition to a new chairman might make the Fed's credibility more fragile?" Both Mr. Greenspan and Mr. Volcker raised rates after taking office.
I would bet that Mr. Bernanke follows suit. If you're still in the market for a loan or mortgage, you might not have much longer to act.