Inflation targets in focus, if not in vogue, in US

Alan Greenspan has been, by almost any account, incredibly successful at the helm of the US central bank - a success said to reflect his willingness to throw the old monetary policy rule book out the window.

Instead, the Federal Reserve Board chairman has used an intimate knowledge of economic data, raw instinct and the central banker`s equivalent of the Midas touch to guide the world`s largest economy.

But Ben Bernanke, chosen by President George W. Bush last week to join the chairman at the monetary policy table, has argued the US economy could lock in the gains of the Greenspan era if the Fed had a numerical inflation goal.

"On the principle that it is better to fix the roof when skies are sunny, the Fed should announce its intentions to establish a more open policy framework now, rather than waiting to be confronted by difficult policy choices," Bernanke wrote with two colleagues in a Wall Street Journal opinion piece two years ago. The title? "What Happens When Greenspan is Gone?"

The Princeton University economist has been one of the most visible US proponents of inflation targeting, in which a central bank sets a specific numerical target or range for inflation - and a time frame in which to reach it - to guide decisions on whether to raise or lower interest rates.

A number of foreign central banks employ such a strategy and proponents say their success buttresses a view that the United States would benefit if it followed suit.

"Inflation-targeting central banks have lower inflation rates on average but don`t have noticeably more volatility of the business cycle," said economist Adam Posen of the Institute for International Economics, who has written on the topic with Bernanke.

It`s a subject that has fuelled debate among economists - and Fed officials - for years. And Bernanke`s advent may lead to further discussions around the Fed board table.

Greenspan is against setting explicit inflation targets. "It has been increasingly difficult to pin down the notion of what constitutes a stable general price level," he said last fall. "For all these conceptual uncertainties and measurement problems, a specific numerical inflation target would represent an unhelpful and false precision."

Still, the Fed chief has made clear he believes price stability - which he defines as the point at which inflation is not a factor in business or consumer decisions - is the central bank`s primary goal, the one that makes the Fed`s other congressionally mandated goals of low unemployment and maximum sustainable growth achievable.

Many Fed watchers say Greenspan has pursued what amounts to an inflation-targeting strategy without the targets.

Some officials at the US central bank have echoed Bernanke`s view that a set target would help cement the Fed`s inflation-fighting credibility by institutionalising Greenspan`s price stability commitment.

"The Fed`s long-term commitment to price stability is now largely embodied in our current chairman`s demonstrated commitment to this objective, rather than being institutionally grounded in an explicit objective," Richmond Fed President Alfred Broaddus said last fall.

"It is therefore inherently tenuous, since its continuance will depend on the preference of future chairmen and their susceptibility to political pressure to pursue other goals."

But others argue targets are not the key to credibility. "Real credibility for achieving inflation or other goals must flow ultimately from performance, not from predetermined frameworks," Fed Vice Chairman Roger Ferguson said in January.

To some extent the debate may be purely academic. Officials on both sides say it would be up to Congress to alter the central bank`s policy goals and lawmakers have shown little interest in doing so. "(What) real insiders worry about is that if this is done by some change to... the Fed mandate, it opens up room for Congress to monkey with the Fed," Posen said.

Much of the US inflation targeting debate has revolved around the role the Fed should play in buffering Americans from the downside of the business cycle.

"When the goals conflict and it comes to calling for tough trade-offs, to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target," then-Fed Governor Janet Yellen said in arguing against strict inflation targets at a 1995 Fed policy meeting.

In recommendations he presented one-and-a-half years ago to the inflation-targeting Bank of England, Donald Kohn - a key Greenspan adviser also tapped by Bush last week for a Fed board seat - suggested the flexibility to occasionally deviate from target is important to achieve the best economic outcome.

Proponents say targeting frameworks can be structured so a central bank has leeway to respond to short-term events - even if it means moving away from the target - and that targets free policymakers to respond more aggressively to short-term woes by damping detrimental moves in market interest rates.

For example, if the Fed felt the need to lower short-term rates to deal with economic weakness, it could do so with less worry that long-term market interest rates might rise out of concern the central bank might let inflation take root.

But Ferguson has argued that the more leeway a central bank has in reaching its target, the lower the inflation-fighting credibility - and usefulness - a targeting regime affords.