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Monday, April 11, 2005

More Worries From the Fed and Support for Inflation Targeting in a Hard Landing

I have been exploring how the Fed might respond in a hard-landing. A strong hint that the Fed will stick to an inflation target in a hard landing scenario can be found in a speech given by Jack Guynn, President and Chief Executive Officer, Federal Reserve Bank of Atlanta before the Rotary Club of Birmingham on February 23, 2005.

In the speech entitled “The Importance of Price Stability,” President Guynn first expresses considerable concern over current economic conditions:

…But there is more to this picture, and I think we should remind ourselves that there are always risks on the road, and we should drive defensively. As examples, I would like to point out three hazards, each with the potential at some point to threaten our goal of sustainable and non-inflationary growth.

Let’s start with the so-called twin deficits. On the private side, we face a rapidly growing current account deficit, which basically means that the United States is buying more goods and services from abroad than it’s selling to other countries.

Our country has financed this deficit by borrowing more and more from abroad and using much of that debt to finance the purchase of consumer goods. Without belaboring the issue, I’ll say that the accumulation of ever larger amounts of debt entails a level of risk that makes me uncomfortable...

Similar concerns apply on the public side as the nation’s fiscal deficit continues to climb. In testimony to Congress last week, Chairman Greenspan described “the imperative to restore fiscal discipline” in the United States. It’s too early to judge whether we’ll quickly get greater discipline…

…A second hazard I would point out is the price of energy, a now familiar culprit in dampening prior economic expansions...

…A third set of risks has to do with the usual tendency of an economy that’s been expanding for a while to develop bottlenecks and imbalances…

He then talks about the FOMC policy discussions:

These risks and others are taken into account as part of the Fed’s policy-making process. Every six to eight weeks, the 19 members of the Federal Open Market Committee meet in Washington, D.C., with Fed Chairman Alan Greenspan. We talk about what recent data and grassroots insights seem to be telling us, and we talk about the likely path of the economy and the emerging economic issues of the day.

The FOMC’s mandate is to foster stable growth, full employment, and a climate of low inflation. And our experience in this country and in other major economies around the world in recent decades has taught us that price stability—defined as low and stable inflation—should be a central bank’s primary focus because inflation is most directly affected by monetary policy actions…

… I would submit that much of this success was built on the bedrock of low inflation, which I consider to be the state in which expected changes in the general price level do not effectively alter business or household decisions…

…The trick to guarding against an unwelcome run-up of inflation is to prevent the spread of price increases across sectors where they show up in a basket of all prices. And that means preventing the emergence of the expectation of rising inflation, an insidious cycle where people rush to buy before prices rise further. In my view, the policy path we’ve been on has helped to restrain inflationary pressures—at least for now.

As we keep an eye on prices, it’s important to keep in mind that monetary policy acts with a considerable lag, and economic circumstances can and do change quickly. If you wait to see concrete evidence that inflation has taken hold, then it’s already too late to stop it…

… Our opponent is an unwelcome level of inflation, and in that game we don’t want to play catch-up.

As price pressures begin to build, I believe appropriate increases in the fed funds target rate will help to prevent rising inflation and encourage desirable outcomes such as increased saving. The Fed must be willing to make the necessary policy moves, and that’s what the FOMC has been doing since June of last year…

…Low inflation is important for many reasons. For one thing, rising and unstable prices erode business confidence and distort investment decisions. Unwelcome inflation wastes real resources as people expend time and effort to preserve their wealth, and it is an unfair tax. As the Nobel Prize–winning economist Milton Friedman once said, “Inflation is the one form of taxation that can be imposed without legislation.” You can’t find any examples of economies that have enjoyed sustainable growth and prosperity in a climate of steadily rising inflation…

..Let me close by suggesting that we appreciate and enjoy low and stable inflation for what it is: the foundation supporting economic growth. And let’s make sure we do what it takes to ensure price stability for the future.

There is no hint in these remarks of anything but the pursuit of an inflation target even if a hard landing occurs. As he says "These risks and others are taken into account as part of the Fed’s policy-making process." Even so, the call is for strict inflation targeting.

[Update: See the April 11, 2005 statement by Philadelphia Federal Reserve Bank President Anthony Santomero Santomero says Fed must be vigilant on inflation for a more recent statement of the Fed's commitment to price stability in coming months.]

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