Bernanke’s New Inflation Target: What It’s Supposed to Do

With the current Federal Open Market Committee (FOMC) meeting’s conclusion on Wednesday came the announcement of a victory for Chairman Ben Bernanke: the setting of an inflation target. Mr. Bernanke had pushed for this new benchmark for some time. Many world central banks use such a target, but they mostly do not have the Fed’s dual mandate for maximizing price stability and employment.

The adoption of the inflation target marks the first “longer run goals and policy strategy” statement, and goes a long way to make transparent how the secretive FOMC works out its policies. As the economy strengthens toward full employment, the Committee must balance measures to further correct unemployment (i.e. buying bonds), with opposite strategies to prevent unacceptable inflation rates; the inherent problem is that what fixes one ill can make the other one worse. Complicating this dilemma is the need not only to satisfy critics who claim that the Fed is too heavily focusing on one problem to the neglect of the other, but the effects of such suspicions on the markets, and also to stem the possibility of harmful self-fulfilling prophecies.

The fed has set this new benchmark at an inflation rate of 2 percent, predicting that this goal satisfies the dual mandate with the best balance between its two purposes. The rate of 2 percent is the high end of what was traditionally …

an informal and not as widely known target range of 1.7 to 2 percent.

By making this finite benchmark public, the Fed reveals the extent of inflation it will tolerate, which should go a long way to assuage critics’ fears that it would blindly accommodate high price level increases in order to lower unemployment further. Being remiss in such a way could have adverse impacts on markets, not only because of higher prices but also due to the higher interest rates that would accompany them. Further, rapidly accelerating price levels can ignite expected inflation, which is far harder to correct.

Inflation targets, however, also have critics who fear that once the target is met, attempts to correct unemployment will be abandoned at too high a jobless rate. In answer to this inevitable claim, Bernanke said Wednesday that “If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment, then that is something that we would be willing to do.”

So, the target would not be set in stone; if there were a clear need to tolerate an inflation rate above the target — for a short while — in order to bring the jobless rate down, then the Committee would be willing to invoke the target gradually. If this is indeed how the Committee comes to its decisions, probably not many observers would be surprised.

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