A specific target might help to prevent high inflation, but it could also allow the Fed to intervene more aggressively

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Last week at a press conference, Bernanke conceded that the Federal Reserve is humoring the idea of adopting a specific inflation target. When inflation hawks heard this, their ears perked up. Finally, the Federal Reserve would be forced to aim for inflation within a certain range -- that would mean an end to their aggressive monetary stimulus efforts, right? Not necessarily. It might not change their policy making and could actually result in even more aggressive intervention.

Here's Andrew Ackerman at Real Time Economics reporting that Sen. Richard Shelby (R-AL) is one such hawk who's pretty excited about the prospect of an explicit inflation target:

Sen. Richard Shelby (R., Ala.) said in an interview that he would urge Fed Chairman Ben Bernanke, a proponent of a formal inflation target, to pursue the matter when the central banker next testifies before his committee in July.

Shelby is likely excited about the sort of situation that the U.S. is in currently. Inflation is at a level that the Fed finds acceptable, which means that it isn't as likely to worry about the full employment side of its dual mandate. For those who don't believe that it should be the Fed's job to smooth economic cycles, this possibility makes an explicit inflation rate target appealing.

A Target Has Two Sides

But they shouldn't get carried away. For starters, hawks need to think about what happens when inflation dips below that explicit target: then, the Fed will be forced to begin pouring money into the financial system to raise inflation. A target isn't meant to insist that inflation stay very low; it would be in place to ensure that inflation gets neither too high nor too low.

For example, even if an inflation target were in place, we would have likely seen November's round of quantitative easing take place. At that time, low inflation was the chief reason that the Fed gave for its intervention. Sure, unemployment was still high, but slowing inflation pushed the central bank into action.

The Mandate Remains the Same

Moreover, if adopted, an explicit inflation target would be long-term in nature. So let's say that unemployment was climbing and the Fed wanted to provide stimulus as result -- but inflation was currently within its target range. In that case, the Fed would likely still act. It would justify inflation floating above the acceptable range in the short-term so that it could adhere to the other half of its mandate.

When I spoke to retired vice chairman of the Fed Board of Governors Donald Kohn recently, he suggested that an inflation target would likely work in exactly this way. The purpose of an explicit target is not to become obsessive over inflation's every uptick; the purpose is to use the target as another tool to manage inflation expectations.

In this sense, an inflation target would actually allow the Fed to intervene more aggressively, not impose restraint. Due to its knowledge of the target, the market would believe that any big stimulus effort would not result in prices rising much in the long-term, since the Fed would adhere to the target after its stimulus effort ends. In this new framework, the Fed could more freely intervene without having to worry quite as much about expectations.

So in a sense, inflation hawks should probably be wary about the prospect of a specific inflation target. It might lead to an even more interventionist Fed. If hawks want the central bank to ignore its full employment mandate, then they should revise the law accordingly -- not foolishly hope an inflation target forces the Fed to look the other way as unemployment climbs.

Image Credit: REUTERS Jim Young

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