Stephen Foley: Inflation targets will stay Bernanke's hand


US Outlook: When Ben Bernanke took over as chairman of the Federal Reserve in 2007, it looked like one of his early moves might be to introduce an explicit inflation target for the central bank's interest rate-setting committee.

The idea got parked during the credit crisis, but it is back, and it is easy to see why Mr Bernanke's colleagues are tempted to fall into line behind the plan.

More than $2 trillion of printed money and rocketing commodities prices on the global financial markets have failed to produce a significant uptick in core US inflation, but the Fed is legitimately concerned that a fear of rising prices in the future might start to infect businesses' decision-making. Setting an explicit inflation target could nip in the bud any rise in inflation expectations.

There is also a tempting political argument. The IMF, which cut its growth forecasts for the US economy yesterday, is hardly the first to notice that the recovery here has become more sluggish since the spring. The Fed's monetary policy meeting next week is unlikely to do more than simply note the obvious. Disruptions from the earthquake in Japan and tornadoes here suggest that this slowdown may be only temporary.

But if the economic recovery does run out of steam, and the Fed decides that a third round of quantitative easing (or some variation) is desirable, it can expect even more virulent attacks from the right than it endured when it launched QE2. Setting an inflation target at the same time would provide political cover.

Tempting, but no, this is not a good idea. The Fed has long communicated that it likes to see core inflation at around 2 per cent (it is 1.5 per cent at the moment). By setting a formal target, the Fed is boxing itself into particular actions should price rises get ahead of that. That decisively shifts the central bank in favour of one half of its legal mandate to ensure price stability and full employment, at a moment when price stability is not the problem, unemployment is.

At almost every level of government, the US is pursuing a contractionary fiscal policy. Deficit reduction and spending cuts top the agenda, and tens of thousands of jobs are being lost in the public sector each month at time when more than 9 per cent of Americans are already out of work. The Fed should not do anything that curtails its ability – indeed, its legal obligation – to fight against that tide.

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