FOMC Holds Target Rate Near Zero With Explicit Inflation Targeting

On January 28, 2009 the US Federal Open Market Committee (FOMC) announced that it planed to keep the target rate between zero and ¼ %. The announcement comes in the wake of the continuous stream of weak economic news. The low rate is likely to persist well in to 2009 with the committee noting that it anticipated a slow turnaround with considerable downside risks. It appears the FOMC is concerned with the low inflationary environment, noting that inflation remains below the sufficient level for strong economic growth. The Fed is concerned that the US will enter a deflationary environment similar to that of Japan in the 1990’s.

The Fed is officially targeting an inflation range of 1.5-2.0% per the FOMC’s semiannual report to lawmakers. Ben Bernanke is a proponent of inflation targeting having co-authored the book “Inflation Targeting: Lessons from the International Experience.” The book highlights a few key benefits of inflation targeting, (1) countries achieve lower inflation rates and lower inflation expectations, (2) price shocks have a reduced impact on sustained inflation; (3) lower nominal interest rates as a result of lower expectations; (4) better transparency and public understanding of monetary policy; and (5) accountability for policy makers. Interestingly, Bernanke notes in his book that inflation targeting has become a popular tool for central banks as result of economists’ belief that monetary policy is not an effective tool for spurring the economy in the short-run.

The book presents three main reasons for the adoption of inflation targeting in the early 1990’s by a host of industrialized nations including New Zealand, Canada, and the United Kingdom. First, economists are less confident in monetary policies ability to alter short-run changes in the economy. Secondly, low stable inflation is required for sound economic growth and price stability is essential for imposing accountability on central banks. The book further points out a break-down in the trade-off between inflation and unemployment. If inflation inhibits economic growth, moderate-to-high rates of inflation may actual result in higher rather than lower unemployment rates.

Inflation targeting is a relatively new phenomenon, replacing former Fed Chairman Alan Greenspan’s FOMC tool of interest rate targeting informally re-enacted in mid-1980’s (potentially as early as October 1982). Interest rate targeting through the fed funds rate was the result of Greenspan’s assertion there was not a stable relationship between the borrowed reserves and the fund rate. The Fed now believes explicit inflation targeting is the best tool to mitigate the delicate balance between (1) a deflationary (Japan 1990s) economy and (2) an inflationary (US 1970s) economy. The Fed has aptly phrased the paradox as the Two-Headed Dragon.