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Fed contrives a clamor that it is too tough on inflation

Section: Daily Dispatches

Miskin Fuels Inflation Target Controversy

By Krishna Guha
Financial Times, London
via Yahoo News
Sunday, March 25, 2007

WASHINGTON -- The Federal Reserve would have to think twice before trying to push inflation below 2 percent, governor Frederic Mishkin has warned, in an explosive speech that is likely to unleash a fierce debate as to what the US central bank's inflation objective is and should be.

The speech challenges the market's belief that the Fed sets policy with the intention of returning inflation to a "comfort zone" of 1-2 percent as measured by the core personal consumption expenditure (PCE) deflator.

It raises the possibility that some members of the interest rate-setting Federal Open Market Committee could be willing to settle for bringing core PCE -- which is currently running at an annual rate of 2.25 percent -- down to about 2 percent.

Mr Mishkin suggested it should not be too difficult to get inflation back to that level, given the pull of entrenched inflation expectations.

His remarks -- in a speech to the San Francisco Fed -- could trigger a sharp response from Fed hawks committed to driving inflation below 2 percent.

Financial markets are likely to interpret the speech as further evidence that the Fed is stepping away from a singleminded focus on inflation and opening the door to interest rate cuts, though the message was more complex than this.

Mr Mishkin did not expressly endorse the idea that 2 percent inflation would be acceptable.

What he did say was that it would be much easier to get back to 2 percent than to go much below that.

Further, is it unlikely that his view represents a consensus at the Fed. The FOMC -- made up of the Washington-based Fed governors and presidents of the regional Fed banks -- does not have an agreed inflation objective.

Individual forecasts by members of the FOMC suggest most could live with PCE inflation at or slightly below 2 percent (roughly equivalent to consumer price inflation of 2.5 percent) in the medium term.

However, many members are also publicly committed to the 1-2 percent "comfort zone."

Some regional Fed presidents favour the low end of that range, which -- given measurement error -- might be close to true price stability.

Last year Jeff Lacker, the president of the Richmond Fed, voted against keeping interest rates on hold and in favour of rate increases precisely because he believed inflation expectations had to be hammered lower to achieve a rate of inflation he could be comfortable with.

The confusion over what the Fed is trying to achieve injects uncertainty into the market, which cannot be sure how the US central bank will respond to economic data.

This reinforces the case for an explicit inflation target. Mr Mishkin -- a champion of inflation-targeting -- knows this, and may have deliberately set out to force the debate on this issue forward.

"I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest 12-month reading of 2.25 percent," the Fed governor said.

"I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy."

This, he said, was because people seemed to expect inflation of about 2 percent. This would help the Fed reduce inflation from 2.25 percent to 2 percent, but hinder any effort to go lower.

Mr Mishkin warned that the cost in terms of unemployment and lost output of driving inflation expectations down could be very high, because of inflation no longer responded quickly to changes in unemployment.

This implies that it would only be worth trying to drive inflation from, say, 2 percent to 1.5 percent if there were big additional benefits.

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