June 23, 2004
The Fed's Credibility
By Taggert
Will the Fed raise rates next week? I think everyone agrees they will, the important question becomes by how much?
Expectations of a half-point hike June 30 were massively reduced last week after relatively tame US inflation numbers and hints from Fed officials, including chairman Alan Greenspan, that the rise in US borrowing costs from their current 46-year lows of 1.00 percent will not be aggressive.
The issue is one of credibility. If the Fed has finally earned its anti-inflation credibility, it can afford to be patient when raising rates, in effect it has a bit of credibility to burn. If the Fed is not believable, if the markets think that the Fed will continue to accommodate the large deficits, then they must move now and swiftly. So which is it?
Benanke, in a recent interview with The Region thinks the Fed should adopt an explicit inflation target in order to add that extra bit of credibility.
Bernanke: No, I think we have achieved a substantial degree of credibility based on the record of low inflation and that reduces the inflation bias problem already in itself. However, I think that announcing a target would strengthen our commitment to the price-stability objective and also give more emphasis to long-run considerations in policymaking. Our policy meetings are very often focused on near-term developments. Having a medium- to long-term inflation objective would force us to keep in view where we want the economy to be in the longer run.
We don't have good models for this psychological battle of managing expectations, nor do we understand it as well as we think we do.
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