The Fed ver­sus price sta­bil­ity

Financial Mirror (Cyprus) - - FRONT PAGE -

There is a big dif­fer­ence be­tween the Fed­eral Re­serve’s man­date to main­tain “sta­ble prices” – as enun­ci­ated in the Fed­eral Re­serve Act – and the Fed’s self-se­lected tar­get of 2% an­nual in­fla­tion. So how is it that pol­i­cy­mak­ers have man­aged to sub­sti­tute the lat­ter for the for­mer?

The term “sta­ble prices” is self-ex­plana­tory: a bun­dle of goods will cost the same ten, 50, or even 100 years from now. By con­trast, if a coun­try ex­pe­ri­ences 2% in­fla­tion over a tenyear pe­riod, the same items that $100 can buy to­day will cost $122 at the end of the decade. Af­ter 100 years, the price tag will be a whop­ping $724.

In her re­cent Con­gres­sional tes­ti­mony, Fed Chair Janet Yellen re­ferred sev­eral times to the man­date of main­tain­ing “sta­ble prices”; but she men­tioned the Fed’s 2% in­fla­tion ob­jec­tive twice as of­ten. “US in­fla­tion con­tin­ues to run be­low the Com­mit­tee’s 2% ob­jec­tive,” she said, and the cur­rent “high de­gree of pol­icy ac­com­mo­da­tion re­mains ap­pro­pri­ate to foster fur­ther im­prove­ment in la­bor mar­ket con­di­tions and to pro­mote a re­turn of in­fla­tion to­ward 2% over the medium term.”

Does the Fed re­ally want to in­crease an­nual in­fla­tion to 2%, such that the price level of the coun­try will in­crease by more than 700% over the next cen­tury? Is that what Congress had in mind when it tasked the Fed with achiev­ing “sta­ble prices”?

For­mer Fed Chair­man Alan Greenspan knew that it did not. On July 2, 1996, at a meet­ing of the Fed­eral Open Mar­ket Com­mit­tee (FOMC), which was de­voted to ex­ten­sive dis­cus­sion of the ap­pro­pri­ate in­fla­tion tar­get for the Fed, Greenspan posed a sim­ple ques­tion: “Are we talk­ing about price sta­bil­ity or are we talk­ing about zero in­fla­tion?” he asked. “As we all know, those are two sep­a­rate things.”

The dis­cus­sion quickly turned to the dif­fi­culty of mea­sur­ing in­fla­tion ac­cu­rately and the need to build in a “safety cush­ion” to avoid de­fla­tion. Ac­cord­ing to Greenspan, “Price sta­bil­ity is that state in which ex­pected changes in the gen­eral price level do not ef­fec­tively al­ter busi­ness and house­hold de­ci­sions.” Yellen, then a Fed gover­nor, was not sat­is­fied: “Could you please put a num­ber on that?” she asked. Greenspan did: “I would say that num­ber is zero, if in­fla­tion is prop­erly mea­sured,” he replied.

At the time of that FOMC meet­ing, the con­sumer price in­dex was in­creas­ing at about 3% per year. Most of the dis­cus­sion fo­cused on whether the Fed should slow an­nual price growth to 2% or even lower, thereby con­sol­i­dat­ing the gains made in the dif­fi­cult fight against in­fla­tion that pol­i­cy­mak­ers had waged for the pre­vi­ous 15 years. Greenspan sum­ma­rized the con­sen­sus: “...we have now all agreed on 2%...”

Thus, the Fed’s 2% in­fla­tion ob­jec­tive was born. Dur­ing the en­su­ing dis­cus­sion, sev­eral FOMC mem­bers ar­gued that the in­fla­tion rate might be re­duced to less than 2%, but no­body ar­gued that in­fla­tion should be pushed higher if a lower, but still pos­i­tive, rate was achieved.

Fol­low­ing the dis­cus­sion, Greenspan ex­horted the FOMC mem­bers to keep the dis­cus­sion of the in­fla­tion tar­get se­cret. “I will tell you that if the 2% in­fla­tion fig­ure gets out of this room,” he warned, “it is go­ing to cre­ate more prob­lems for us than I think any of you might an­tic­i­pate.” The of­fi­cial min­utes of the meet­ing make no ref­er­ence to the en­tire dis­cus­sion of the in­fla­tion tar­get, which took up sev­eral hours, and the FOMC never for­mally an­nounced its 2% tar­get for an­nual in­fla­tion un­til Chair­man Ben Ber­nanke, Yellen’s pre­de­ces­sor, fi­nally did so in 2012.

The 2% in­fla­tion tar­get now is at the fore­front of FOMC de­ci­sion-mak­ing. For ex­am­ple, while an­nual in­fla­tion stood at 0.8% in De­cem­ber 2014, the min­utes of the Jan­uary 2015 FOMC meet­ing re­fer sev­eral times to the Com­mit­tee’s need to make “progress to­ward its ob­jec­tives of max­i­mum em­ploy­ment and 2% in­fla­tion” by main­tain­ing a highly ac­com­moda­tive pol­icy stance. In­creas­ing the rate of in­fla­tion is now the stated ob­jec­tive of Fed pol­icy.

Congress did not give the Fed a man­date to pur­sue that goal. The Fed­eral Re­serve Act is ex­plicit: the Fed should achieve “price sta­bil­ity” for the US cur­rency, along with mod­er­ate in­ter­est rates and max­i­mum em­ploy­ment. As long as in­fla­tion is some­where be­tween zero and 2%, the Fed should de­clare victory and leave it at that.

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