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Bernanke messing with success, critics say

BOSTON—During nearly two successful decades as chairman of the Federal Reserve, Alan Greenspan had a simple strategy for defining how much inflation he'd tolerate in the U.S. economy. His only target was inflation so low that average Americans didn't have to worry about it when making long-term financial decisions.

Seven months into the job, his successor, Ben Bernanke, quietly seeks a more formal target. He wants to define an inflation-tolerance zone explicitly, putting numbers on it via a controversial idea called "inflation targeting."

Inflation is the rate of rising prices across the economy. It eats away at the spending power of average Americans, especially those on fixed incomes. Many companies adjust salaries annually to offset inflation, and Social Security adjusts benefits.

Bernanke says explicit inflation targets can signal when the Fed will act to restrain inflation. Financial markets would understand, and thus the practice could reduce market volatility, which hurts everyone from corporations to well-heeled investors to ordinary Americans with 401(k) retirement plans.

But critics warn that the United States has enjoyed a quarter-century of strong economic growth with low inflation and no explicit target from the Fed. They say that Bernanke is messing with success.

Targeting inflation would work like this: The Fed would define an acceptable range for inflation, expected to be an annual rate of 1 percent to 2 percent, and would set a time period for when it hopes inflation will reach that zone. Financial markets could expect that an inflation rate above that range would provoke a hike in interest rates to slow the economy, take the steam out of inflation and push it into the target zone. Alternatively, too-low inflation would require interest-rate cuts.

Supporters of this approach include William Poole, president of the Federal Reserve Bank of St. Louis and a voting member on the Federal Open Market Committee (FOMC), which sets the Fed's benchmark lending rate eight times a year. He likens inflation targeting to placing monetary policy on autopilot and sees its adoption as a matter of time.

"I don't know what the time-horizon should be," he told McClatchy Newspapers earlier this month in Boston. "I think it's obviously on the FOMC's agenda."

Harvey Rosenblum, executive vice president and director of research for the Federal Reserve Bank of Dallas, agreed that inflation targeting is coming.

"Fairly soon, and beyond that I can't say too much," he said from the sidelines of the recent annual conference of the National Association for Business Economics.

The goal of inflation targeting, Poole said, is to reduce guessing about what the Fed will do. When analysts guess wrong, markets tend to swoon, disrupting the economy.

Critics of inflation targeting question why Bernanke would make Fed policy rigid when the two previous Fed chairmen had great success using their discretion. Inflation reached a record 13.5 percent in 1980, but Fed chairmen Paul Volcker and Alan Greenspan reined it back in and held it steady ever since.

"It seems to me that the more discretionary approach that has been used by the last two chairmen has been extremely successful. ... I'm at a loss as to why someone would want to change that history," said Martin Regalia, chief economist of the U.S. Chamber of Commerce and a former Fed staff economist. "We've had five quarters of negative economic growth since 1982. ... Why is he changing what he's inherited?"

One challenge for inflation targeting is that existing inflation measures are imperfect. The consumer price index is believed to understate the importance of housing, while the Fed's favorite measure—the personal consumption expenditure price index—is subject to revision. The latest revision showed that core inflation, which strips out volatile food and energy sectors, might have sharply understated inflation over the past two years.

That's significant because had inflation targets been in place and inflation more accurately measured, it would have created expectations that the Fed would raise interest rates higher than it actually did. That surely would have slowed what has been a strong economy over the past two years. Instead, employing discretion, the Fed followed a measured pace of 17 consecutive quarter-point rate hikes from June 2004 until pausing last month.

Minutes of the FOMC's Aug. 8 meeting show that internal debate on inflation targeting has begun and will resume at the Oct. 24-25 meeting. Over the summer, the Fed created a committee to study communication, a euphemism for inflation targets, since the topic really deals with managing financial-market expectations.

"Although considerable strides had been made in FOMC communications over the past 10 years or so, participants generally thought that further advances were possible," the minutes said, in a veiled reference to inflation targeting.

Many economists expect the Fed to adopt formal inflation targets by the end of 2007, similar to those used by Great Britain, New Zealand and many other countries.

Bernanke, meantime, is stacking the deck in his favor. He quietly pushed for the successful nomination and confirmation of Columbia University economist and ally Frederic Mishkin to the Fed's seven-member board of governors.


(c) 2006, McClatchy-Tribune Information Services.

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