Why not inflation-targeting?

Larry Kudlow
Posted: Feb 23, 2002 12:00 AM
Wall Street Journal columnist David Wessel raises the right question when he recently asked why the Fed doesn't set a target range for inflation. For years, central banks around the world have been doing it, including the Euroland Fed, Canada, Britain, New Zealand, Australia and others. It is, after all, the people's money. Most everyone has some of it in their purses and wallets. Certainly they have a right to know what the government thinks its future value will be. Yet for years Alan Greenspan has refused inflation target-setting. Before him, so did his predecessors Paul Volcker, William Miller and Arthur Burns. During the '50s and '60s, William McChesney Martin didn't have to set a price target because the dollar was tied to gold, and there was no inflation problem. If history is any guide, the chances of Mr. Greenspan revealing an inflation target when he testifies next week before Congress are slim to none. This is too bad, for inflation is currently rock bottom and expected to stay there, according to real-time financial and commodity market indicators. In particular, the so-called TIPS spread, i.e. the differential between the market rate on 10-year Treasury securities and the inflation-adjusted rate on 10-year notes, is a scant 1.5 percent. This means that markets expect a mere 1.5 percent future inflation rate, as measured by the consumer price index. Such low future inflation would surely restrain the central bank from any credit-tightening policies. And this would calm stock market concerns that economic recovery this year might bring an overly inflation-cautious Fed to raise rates. Actually, inflation is even lower than you think, according to Wall Street Journal report Greg Ip's companion story. The CPI continues to overstate inflation largely because it fails to account for innovative new products in the marketplace, or improved quality of existing goods and services, or the propensity of consumers to substitute lower priced goods for those that are too expensive. Greenspan himself prefers the personal spending deflator (price index for personal consumption expenditures) as a more accurate inflation measure. In recent years the PCE deflator has come in, on average, six-tenths of one percent below the CPI. So the 1.5 percent bond market forecast of future inflation (based on the CPI) is actually predicting slightly less than 1 percent on the more accurate PCE deflator. While the Labor Department experiments with new CPI measures that hopefully will better capture real world transaction prices, there is no reason why the Federal Reserve couldn't publish a zero to two percent inflation target based on the personal spending measure. And since market-based predictions of the inflation outlook (including stable gold, commodities and the dollar) suggests more of the same, there would simply be no need for any Fed rate-hiking measures this year at least, if not longer. Here's a related point: Long-run output growth in the U.S. averages 3.5 percent yearly (since WWII). Adding a 1 percent expected inflation rate implies that risk-free long-term Treasury bonds could yield as low as 4.5 percent. Currently, they range between 5 percent and 5.5 percent. So a stable or even lower bond rate, combined with a recovery-linked rise in corporate profits, leaves plenty of upside potential for stock market prices. Equity markets are currently plagued by more than rising interest rate fears. Like a fogged-in airport, the spillover from Enron accounting fraud hangs densely over stock markets, preventing share prices from taking off. But surely Mr. Greenspan could do his part for both economic and stock market recovery by telling the public that both actual and expected inflation are well inside any reasonable central bank target range.