Having unleashed deflation, Fed mulls how to get inflation back

Deflation Risk Boosts Inflation Target Case

By Krishna Guha
Financial Times, London
Tuesday, November 4, 2008

http://www.ft.com/cms/s/0/2d47d156-aaac-11dd-897c-000077b07658.html

WASHINGTON -- The risk of deflation could lead Ben Bernanke to approach the new administration and Congress next year about adopting an ­inflation target at the Federal Reserve, some experts believe.

The Fed chairman thinks it is unlikely the US will actually experience deflation -- he judges that the starting level of inflation is too high, expectations too well grounded and the policy response to the financial ­crisis too vigorous for that to happen.

Still, he recognises that the deflation risk is not zero and will seek to minimise it, because sustained declines in core prices would greatly magnify all the problems --facing the US economy. Experts say that setting an explicit target for inflation is an obvious deflation-fighting strategy.

Mr Bernanke believes that inflation targets harden --public inflation expectations and make it less likely that near-term shocks -- such as the credit crunch or the ­formerly soaring oil price -- end up pushing the long-term inflation rate either too low or too high.

When Japan faced deflation in the 1990s, Mr Bernanke advised Tokyo to introduce an inflation target -- or its close cousin, a rising ­target for the price index -- as a weapon to counter the possibility.

Some influential Democrats in Congress are wary that an inflation target could lead the Fed -- which operates under a dual mandate to promote both price ­stability and full employment -- to prioritise inflation over growth.

Mr Bernanke set up a ­committee to evaluate the issue soon after becoming Fed chairman, but settled for a compromise in which ­individual Fed officials stated their interim inflation objectives -- in large part because of the political resistance to a formal target.

Nonetheless, he believes that concerns over inflation targets are misplaced, particularly if a target is not tied to a fixed time horizon.

The economic crisis could make the new Congress more receptive to his argument, particularly if there is a full-blown deflation scare next year.

Setting an inflation target would be a way for the US central bank to make a public commitment to do whatever it takes to avoid deflation -- while also committing not to go too far and create too much inflation in the process.

"An explicit numerical objective for inflation would be very beneficial at this critical juncture," Frederic Mishkin, a professor at Columbia university and Fed governor until August, told the Financial Times.

"It would make it less likely that inflation expectations would fall, which would decrease the likelihood that inflation itself would fall below levels consistent with price stability or that deflation would set in."

Mr Mishkin added: "It would also importantly give the Fed more flexibility to pursue expansionary policies, by reducing the risk that this could at some point fuel expectations of high inflation."

If, however, there is still too much political suspicion to push for a formal inflation target, Mr Bernanke will be most likely to opt for a communications strategy that seeks to lock down inflation expectations by mimicking an inflation targeting approach.

"Right now it might be too distracting to try to implement a formal inflation target," said Mark Gertler, a professor at New York university who, like Mr Mishkin, has worked closely with Mr Bernanke.

"Fed officials can communicate that they will effectively act as if they had one, however."

Mr Gertler added Fed officials should give speeches to the effect that they have an implicit target and "will aggressively move to keep inflation in this zone."

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