Fed to Adopt Inflation Targeting, a Few Thoughts

The Federal Reserve is very close to adopting an inflation targeting model to carry-out monetary policy. This will be a significant divergence from the past four years of gut-reaction, ad-hoc policy making, and more or less should be welcoming. There are a few things to consider, however, before accepting this as an effective and praise-worthy change.

Simply put, inflation targeting is where a central bank explicitly states a “target” rate for inflation and then makes changes in interest rates and conducts open market operations to achieve that desired rate of inflation. This differs from the Fed’s current policy because while the Fed implicitly tries to keep inflation around 2% or a little lower, they have risked higher inflation to, in their minds, promote higher employment.

On the surface, it can be viewed as the Fed moving toward a more predictable, transparent, and stable policy making regime which as history shows decreases volatility and contributes greatly to economic growth. If strictly adhered to, it achieves this goal. If not, and the FOMC continues with its monetary experiments, the policy will continue to produce uncertainty in markets.

Some things to consider:

1.) The Fed’s balance sheet

At $2.92 trillion, the Fed’s balance sheet is 20 percent of our nation’s GDP. This is up from just 6 percent as early as September, 2008 when the Fed began binge buying treasuries, mortgages, stocks, and AIG and Bear Stearns.

It has always been Bernanke’s intention to return the balance sheet to a normal and more manageable size, around $1 trillion, however, adopting inflation targeting at this stage in the game means that the $2 trillion in excess balance sheet bloat will not be coming to market soon, and will permanently remain on the Fed’s books. This could prove disastrous should a non-labor driven inflationary spike occur, the beginnings of which are already materializing.

2.) Implications for the agreed upon inflation gauge

In adopting inflation targeting, the Fed will not only need to determine the proper inflation rate, but will also need to decide upon the proper inflation gauge. St. Louis Fed President, James Bullard has said the Fed will use the personal consumption expenditures (PCE) index to determine inflation. The PCE index has been the inflation measure of choice for Bernanke’s communications, and will most likely be the chosen measure confirming Bullard’s statement.

The PCE index tends to underestimate the true inflation that consumers face. The current November reading has PCE inflation at 2.5 percent, while two other measures for inflation, the consumer price index (CPI) and the GDP deflator, reveal a November reading of 3.4 percent and 2.6 percent respectively. Improperly assessing inflation, regardless of the decided upon rate, will call for the wrong policy choices and harm consumers.

3.) Changes to the FOMC

The 2012 Federal Open Market Committee (FOMC) will usher in four new Regional Fed presidents. Kocherlakota, Fisher, Plosser, and Evans (whom we’ve profiled here, here, and here) will all be leaving. Taking their place will be Pianalto, Lacker, Lockhart, and Williams. Of the four that are leaving, three of them have been the only hawkish votes on the entire board. Evans, the most dovish and most outspoken of all members in the entire Federal Reserve System for more easing will thankfully be leaving with them.

Of the four replacements, three are doves and one is mildly hawkish.

For 2012, this leaves only one voting member to keep the printing presses in check, and he, Lacker, is not going to be enough to voice reason upon the board who already look poised to initiate another round of easing.

Despite making an announcement to adopt a strict adherence to inflation targeting, these three considerations could prove to ruin its proper implementation. The balance sheet will remain huge, inflation will remain improperly assessed, and an FOMC that retains the right to enact discretionary monetary policy outside a strict adherence to rule, now has only dovish members making decisions.