The Hindu Business Line : Flexible inflation target favoured

It seems clear that even if the Fed does adopt inflation targets, its approach to determining interest rates will be state of the economy and data-driven. Translation: no big change.

The debate goes on. Should the Federal Open Market Committee (FOMC) of the US Federal Reserve, which decides on US interest rates, go in for inflation targeting?

The new Fed Chairman, Mr Ben Bernanke, in his earlier avatar as a member of the FOMC, was a strong advocate of inflation goals driving monetary policy and interest rates. Although quite a few of his FOMC colleagues espoused that cause, the sheer force of the personality and stature of the (then) US Fed Chairman, Mr Alan Greenspan, ensured that the idea stayed on the back burner.

Will it now get a new lease of life? In his first testimony to Congress after taking over from Mr Greenspan, Mr Bernanke downplayed the notion that the Fed would adopt inflation targets. Nevertheless, speculation refuses to die down. Two members of the FOMC, dissenters of Mr Bernanke, have recently left, paving the way for him to push through his model of interest rate decision-making.

The latest salvo was fired by Ms Janet Yellen, an FOMC member and President of the Federal Reserve Bank of San Francisco. She thinks the Fed ought to have a price objective of one-and-a-half per cent "as measured by the core personal consumption expenditure price index with a comfort zone ... ... between 1 and 2 per cent. Lest this is interpreted as an immediate and rigid target, Ms Yellen goes on to add that: (a) there should be no specific timeframe to achieve the inflation target and (b) policy should take into account the employment situation. Price stability cannot be the sole policy driver.

It is all very well. Lost (or ducked) amidst the arguments on inflation targeting is the knotty issue of asset price inflation. Should that be factored in while formulating policy?

The European Central Bank (ECB) and Bank of England (BoE) certainly seem to think so. The UK housing boom, sparked off, to a considerable extent, a cycle of BoE rate hikes. Lately, the ECB has started worrying about the sharp rise in property prices in various parts of Europe.

On this issue, Mr Greenspan was forthright. He thought an asset price bubble cannot be recognised as one till it collapses. Central banks should then be willing and prepared to perform a mop-up operation, i.e., slash interest rates and boost liquidity. Mr Bernanke seems to share Mr Greenspan's views.

It seems clear that even if the Fed does adopt inflation targets, its approach to determining interest rates will be state of the economy and data-driven. Translation: no big change. Life will go on, Greenspan or no Greenspan, Bernanke or no Bernanke.

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