The US takes to inflation targeting - and how!

Reportage by Robin Harding and Michael Mackenzie in the Financial Times:

The rate-setting Federal Open Market Committee predicted low interest rates until late 2014 and set a formal inflation objective of 2 percent, reflecting Chairman Ben Bernanke’s long-held goal of providing greater transparency.

The FOMC downgraded its estimate of growth in the coming quarters from “moderate” to “modest” and Mr Bernanke indicated that another monetary boost for the economy - most likely another round of quantitative easing, or QE3 - remained an option.

“We are prepared to take further steps in that direction if we see that the recovery is faltering or if inflation is not moving toward target,” Mr Bernanke said.

The Fed also published its first detailed forecasts of future interest rates.

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Adopting the 2 percent objective is a historic move that binds the whole FOMC to a defined goal that will endure after Mr Bernanke leaves. It means the FOMC can easily justify more easing if it wants to because its inflation forecast for 2014, of between 1.6 and 2 per cent, is below target.

The FOMC voted for Wednesday’s decision by 9-1. The only dissenter was Jeffrey Lacker, president of the Richmond Fed, who wanted to leave the late 2014 date out of the policy statement.

The US suffers from legacy legislation, which predatesmodern monetary economics, which places the burden upon the Fed of pursuing both price stability and low unemployment. The evolution of the US Fed has been led by human energy within the Fed. Starting from Paul Volcker, who took charge in August 1979, the US Fed has run a Taylor rule with a nice strong above-1 inflation coefficient.

In a recent column in the Indian Express, Ila Patnaik tells us about Paul Volcker’s story and how it matters to us. In effect, from Volcker’s chairmanship onwards, the behaviour of the US Fed has been that of an inflation targeting central bank. This was the de facto reality. Everyone knew that the US Fed targets inflation at 2 percent. What is new now is that the Fed has put greater credibility behind this, by going closer to _de jure_inflation targeting.A key dharma of good central banking is to say what you will do, and then do what you just said. By saying that there is an inflation target, there is now full alignment between the words and deeds of the US Fed.

The day will come when India will enact high quality legislation which puts monetary policy on a sound institutional foundation. But we should not accept mal-performance by RBI until that day. It is possible for RBI to do much better, when compared with the present, even though the present legislation is really badly written.

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The US Fed is a good example of how technical capabilities within the Fed, and not an external legislative mandate, have driven improvements in the functioning of the Fed. This sort of progression is what RBI can and should aspire to, and this does not require waiting for a high quality RBI Act.