Fed Sets Inflation Target

By The Greek - Economy & Markets:

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Remember the Fed? You know, the group of boring bankers who control the world... What about that Ben fella? You remember; the guy who used to stop traders in their tracks when he spoke; the guy popular media couldn't get enough of back in the day... Remember that guy we all hoped would lead us to the promise land, but at the same time, criticized relentlessly? You know, the Chairman of the Federal Reserve, Ben Bernanke... Well, seems he/they didn't like their new "irrelevant" media status that resulted once the group cut the fed funds rate to zero.

Maybe they thought Ron Paul would finally get his way or something, and the Fed might be dissolved now that it had nothing to do (if you exclude everything they do outside of rate levering). In any event, after returning from the deep woods of Jackson Hole... or was it the hidden high mountain tops of Davos... or was it the catacombs of Rome... well they emerged from introspection anyway, perhaps after a 40-day trial even.

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The Fed returned with fury today, and offered your favorite blogger an opportunity to color up a bunch of boring old scribblings they dropped on your heads like a ton of bricks. We'll take this opportunity to work through Bernanke's speech to the National Press Club in Washington. The Fed also published its FOMC Meeting Minutes from January's two meetings, but I'm only human!

Fed Sets Inflation Target

Oh no he didn't!!! Fed Chairman Bernanke keyed a portion of his speech today to the subject of "transparency." He said that with the release of the FOMC Meeting Minutes, the Fed would formally announce that: "To supplement the current economic projections by governors and Reserve Bank presidents for the next three years, we will also publish their projections of the longer-term values (at a horizon of, for example, five to six years) of output growth, unemployment, and inflation, under the assumptions of appropriate monetary policy and the absence of new shocks to the economy. These longer-term projections will inform the public of the Committee participants' estimates of the rate of growth of output and the unemployment rate that appear to be sustainable in the long run in the United States, taking into account important influences such as the trend growth rates of productivity and the labor force, improvements in worker education and skills, the efficiency of the labor market at matching workers and jobs, government policies affecting technological development or the labor market, and other factors.

The longer-term projections of inflation may be interpreted, in turn, as the rate of inflation that FOMC participants see as most consistent with the dual mandate given to it by the Congress--that is, the rate of inflation that promotes maximum sustainable employment while also delivering reasonable price stability. This further extension of the quarterly projections should provide the public a clearer picture of FOMC participants' policy strategy for promoting maximum employment and price stability over time. Also, increased clarity about the FOMC's views regarding longer-term inflation should help to better stabilize the public's inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low."

Do you see what he did right there? He set an inflation targeting mechanism. We hope and expect it might help to achieve what Bernanke expects it will; that expectation is illustrated there in the last portion of his commentary that we've emboldened. We hope it will, but we're not sure it will.

I couldn't help but wonder if he is trying to expose a few of the, perhaps less savvy or diligent Fed governors and presidents in his midst. Maybe there's a thorn in his side he wants to keep busy working up spreadsheets, versus blabbering views contrary to his own? At the very least, he may be simply keeping his team honest. Or it could be he's just trying to keep them busy so they don't apply for other jobs, like the Treasury Secretary position...

The FOMC Meeting Minutes included the "central tendency" of the Fed team's inflation expectations. It seems this is the target for the next six years. The Fed wrote that inflation should measure as follows:

1.7 to 2.0 percent inflation, as measured by the price index for personal consumption expenditures (PCE).

Lower Than Zero

In his speech today, the Fed chief acknowledged that lowering short-term interest rates to zero percent has proven inadequate medicine for the restoration of the U.S. economy to a healthy state. As a result, Mr. Bernanke has had to innovate, using creative means to ease credit conditions.

From September 2007 through the spring of 2008, the Fed slashed rates 325 basis points, and has since gone to a range of 0 to 0.25% for the fed funds rate. The Fed Chair notes this was helpful in bringing down short-term lending rates, but offsetting factors served to widen some credit spreads among other instruments. Tightened credit standards and the dysfunctional marketplace, resulting from a deteriorating economy and damaged credit markets have worked against the Fed.

As a result, the Fed has had to focus its efforts toward alleviating those factors pressuring credit markets while fighting fires as well. It has both purchased troubled securities and lent money to institutions, with the consequence being an expanded Fed balance sheet. Bernanke addressed this topic, misconceptions, and real risks in his speech today.

Bernanke stated that the Fed's regular efforts for the preservation of financial system stability, specifically by ensuring banks have access to capital, has also gone a long way toward saving the system. The Fed has also acted in concert with foreign central banks to ensure interbank lending across borders. It has kept LIBOR in check as well, and supported many variable rate mortgages that are tied to it as a result.

The Fed noted that commercial paper and asset backed securities markets, two critical markets for the system's fluid operation, needed more specific addressing. So, the Fed buys highly rated commercial paper and provides back-up liquidity for money market mutual funds. The disaster that could have been the money market funds has been averted and confidence restored. Money is flowing back in... The Fed is also about to launch its Term Asset Backed Securities Loan Facility to provide expanded liquidity to many commercial and consumer credit markets.

What I find most appealing, and I mean I dream of it, is the Fed's efforts to buy long-term securities. Since announcing it would buy GSE-sponsored debt and mortgage backed securities guaranteed by government agencies, the 30-year bond has responded. Long-term 30-year fixed mortgage rates are down nearly 100 basis points since. This is something I recommended so long ago I don't know how to even find the article, and it is working. Mortgage activity is responding, and that was illustrated again on Wednesday when the Mortgage Bankers Association reported Purchase Applications.

But what are the risks to all of this effort? Do we run risk of an economic fishtail that could have the Fed raising rates aggressively to contain inflation in the future?

The Fed's Balance Sheet

The Fed's balance sheet has doubled in one year's time, to nearly $2 trillion. However, the Fed sees little near-term inflation risk, as money is sitting in bank reserves on deposit with the Fed for the most part and not making it into broader supply. If there were ever a dangerously academic way of looking at it, gosh golly, I think we have it right there.

Eventually though, things will improve and the Fed acknowledges it will have to shift monetary policy to keep inflation in check as money supply increases. It insists the size of its balance sheet will mostly unwind itself as markets improve and demand for held securities rises. Also, much of the liquidity provision offered is short-term in nature, and will simply be allowed to run off as programs are terminated. Somehow though, we all know that the real world offers unforeseen factors that academia sometimes overlooks. Say a prayer it all works out like the Fed forecasts, and we'll look for Mr. Bernanke's best seller on the shelves in 2010. Hopefully we will not need to burn it for heating or cooking purposes in 2012!


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