Fed Meeting to Pose Question
Of Setting Clear Inflation Rate

Issue of Numerical Objective
Is on Next Week's Agenda,
But Greenspan Is Resistant

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
January 27, 2005

As Federal Reserve officials prepare to raise interest rates again to keep inflation from rising, they are grappling anew with an old question: Should they aim for a specific inflation number?

On the agenda for next week's two-day meeting of Fed policy makers is a discussion of whether the Fed should set a numerical objective for inflation and, if so, what it should be, according to people familiar with the matter. The Fed ponders such long-term topics twice a year, and no formal decision is likely. Nor is an explicit, public inflation target on the table.

The Fed is required by law to maintain stable prices, but it doesn't quantify that objective as a specific inflation rate. Doing so needn't be the same as setting an explicit target, which implies a duty to adjust interest rates when inflation goes above or below the specified range. Still, if Fed officials can ultimately agree on a number -- a big if -- it would be an important change from its generally successful practice of letting investors infer from its actions what constitutes acceptable inflation.

Many central banks have committed to meeting an explicit target for inflation, believing a target makes them more transparent, credible and accountable. But the Fed is unlikely to join them under Chairman Alan Greenspan, who thinks a target limits his discretion to respond to differing risks as he sees fit.

The issue probably won't affect near-term monetary policy. Mr. Greenspan has defined price stability as a zone where inflation no longer materially affects companies' or individuals' decisions. At 1.5% by the Fed's preferred measure, inflation is now "roughly consistent with a working definition of price stability," Federal Reserve Bank of Cleveland President Sandra Pianalto said last week, expressing a view shared by most of her colleagues on the 19-member Federal Open Market Committee, the central bank's policy panel. The Fed wants to keep inflation in that zone, by raising its target for the federal funds rate, now 2.25%, until it no longer stimulates spending and thus poses a long-term risk of inflation.

But the issue may become more pressing if inflation drifts higher this year, and investors start to wonder how much, if at all, the Fed will raises interest rates in response.

Mickey Levy, chief economist at Bank of America, notes that in May 2003, the Fed declared that any further fall in inflation -- then running at a little over 1% -- would be "unwelcome," in effect announcing a floor for inflation. The Fed's fear was that further declines would raise the risk of deflation, or falling prices. "While they have revealed through action and statement their lower bound [for inflation] they have not had the opportunity or been forced to reveal their upper bound."

An informal survey by The Wall Street Journal found some uncertainty over the Fed's tolerance for inflation. Six of eight firms that closely watch the Fed believe it has an implicit inflation target range. Four -- Goldman Sachs, Bank of America, Macroeconomic Advisers and Morgan Stanley -- say it is 1% to 2%, as measured by the price index of personal consumption excluding food and energy. (The Fed believes that index measures the cost of living more accurately than the better-known consumer-price index.) A fifth, ISI group, says it is 1.5% to 2.5%. Merrill Lynch says 1.5% to 2%, and J.P. Morgan Chase and Lehman Brothers say there isn't any implicit target.

FOMC members who have advocated a numerical objective or target have offered varying ranges. Governor Ben Bernanke has said 1% to 2%. Governor Edward Gramlich has suggested 1% to 2.5%. Philadelphia Fed President Anthony Santomero last October proposed 1% to 3%, and St. Louis Fed President William Poole advocates a target of zero, with some allowance for errors in measurement.

Advocates believe a target would enable investors to better predict how the Fed will respond to changing economic circumstances and solidify its commitment to price stability under Mr. Greenspan's successor next year.

But opponents, who include governors Roger Ferguson and Donald Kohn, fret that targets would confer an obligation to change interest rates whenever inflation deviated from the target, even if unemployment or financial stability called for different actions.

An inflation "objective" might be a compromise between an explicit target and no number. Mr. Gramlich said in a speech in 2003 that the Fed could simply state its preferred long-run range for inflation: "The FOMC would not have to defend any deviations from the preferred range."

History suggests Mr. Greenspan would resist even that step. When the FOMC last formally addressed the issue in July 1996, it reached a near consensus that 2% was the right goal. Mr. Greenspan then, according to a transcript, warned his colleagues, "If the 2% inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate."

Write to Greg Ip at greg.ip@wsj.com

Fed, Staying on Course, Lifts Rates

Central Bank Can Continue
'Measured' Pace as Growth,
Inflation Meet Expectations

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
February 3, 2005

The Federal Reserve raised its target for short-term interest rates by a quarter of a percentage point for the sixth time, and signaled no change in its plan to continue raising rates gradually in the months ahead.

The increase brings the target for the federal-funds rate, charged on overnight loans between banks, to 2.5% from 2.25%, and up from 1% in June.

The statement accompanying the rate change was almost identical to that issued after the Fed's meetings in December and November. Economic growth is "moderate," the jobs market is improving "gradually," and inflation is "well-contained." The Fed said that it could continue to raise rates at a "measured" pace, and that risks to both economic growth and price stability were "roughly equal."

"The Fed's on a path to do a quarter-point per meeting until they have a reason to do something different," said Tom Gallagher, policy analyst at ISI Group, an economic-research firm.

All 12 voting members of the 19-member Federal Open Market Committee, the central bank's decision-making body, agreed to the funds-rate increase. The Fed also raised the less-important discount rate, charged on central-bank loans to commercial banks, to 3.5% from 3.25%. Many commercial banks responded by raising their prime rate, a benchmark for many consumer and business loans, to 5.5% from 5.25%.

The Fed's message yesterday, nearly matching its statements since November, reflects two things. One is that economic growth and inflation have behaved as expected recently. While some Fed officials were alarmed at signs of inflation in December, those fears may have been allayed as the dollar has stopped falling, commodity prices stopped rising, and anecdotal reports of businesses raising prices became less widespread.

The second is the importance the Fed has put on being predictable. It has told markets it would raise rates at a "measured" pace. As a result, investors expect the funds rate to rise to 2.75% at the Fed's March 22 meeting, 3% on May 3 and to about 3.5% by year's end.

As long as the Fed is satisfied with those expectations, it may be reluctant to change its message unless compelled to by significant shifts in the economy.

Economist David Greenlaw of Morgan Stanley said in a note to clients that concerns about inflation and speculative activity are probably growing at the Fed, but "are not yet sizable enough to alter the gradual tightening approach."

Like other analysts, he said it's up to Fed Chairman Alan Greenspan to elaborate on these issues when he testifies before Congress on Feb. 16 and 17.

Despite the unchanged Fed statements, some important shifts are under way in how the Fed views the world, though it isn't clear how these moves, taken together, will affect interest rates.

First, the economic expansion is clearly firmly entrenched, and in as little as a year from now, it may have used up the spare capacity left over from the 2001 recession. In an economy operating at full strength, companies will find it easier to raise prices. That prospect would keep the Fed focused on raising rates.

Second, growth in productivity, or output per hour worked, has slowed. That means companies must add more workers than before to boost sales, and may try to pass the added labor cost on through higher prices. Goldman Sachs Group Inc. economist Bill Dudley wrote in a recent report that while such a slowing is normal at this stage of the business cycle, it nonetheless "would likely lead Fed officials to push up the federal-funds rate target by more than expected."

But against those factors, interest rates are no longer abnormally low. At 2.5%, the funds rate is above inflation of 1.5%, according to the Fed's preferred measure (though below the 3.3% rate recorded by the better-known consumer-price index). It's also higher than the official rate of many foreign central banks. "At some point the FOMC will need to alter [its] language to say that policy has become less accommodative or no longer accommodative," said David Rosenberg, Merrill Lynch & Co.'s chief North American economist, in a report yesterday.

Fed officials do believe the funds rate remains below "neutral" -- a level that neither stimulates nor restrains economic activity. But estimates of neutral run from 3% to 5%, and with the funds rate approaching that range, the Fed feels less urgency to raise rates than it did in June.

Write to Greg Ip at greg.ip@wsj.com

Greenspan Expects Trade Gap To Improve After Dollar's Drop

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
February 7, 2005; Page A2

Federal Reserve Chairman Alan Greenspan said the dollar's drop should help to stabilize or narrow the U.S. trade deficit, but he also suggested it could pose an inflation threat.

In a speech in London on Friday, Mr. Greenspan struck an optimistic note on the budget deficit, saying, "The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume."

Mr. Greenspan appeared less concerned about the record U.S. current-account deficit -- the shortfall on all trade and investment income with the rest of the world -- than he did in a speech in Germany last November that helped knock the dollar lower. "Market pressures...appear poised to stabilize and over the longer run possibly to decrease the U.S. current-account deficit and its attendant financing requirements," he said Friday.

The current-account deficit primarily reflects the gap between imports and exports, which topped an estimated $600 billion last year, more than 5% of gross domestic product. The gap widened throughout last year despite the falling dollar. That damped U.S. growth since a growing portion of domestic demand is being met by foreign supply.

Exchange rates normally affect trade with a lag, but the lag seems to be especially long now. Mr. Greenspan suggested a turnaround could be imminent: "Given the dollar's depreciation since 2002, U.S. exporters' profit margins appear to be increasing, which bodes well for future U.S. exports and the adjustment process" of the current account.

But he also strongly hinted that a further dollar decline would boost inflation more than it has so far. The dollar's rise from 1995 to 2002, he said, fattened the profit margins of foreign companies that sell in the U.S. As the dollar subsequently fell, they let those margins shrink again rather than raise prices and lose market share in the U.S.

"We may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins," Mr. Greenspan said. While some companies have limited the impact of the dollar's drop by hedging, those hedges must ultimately expire, he noted.

Mr. Greenspan's comments imply the Fed might choose to raise interest rates more quickly if the dollar's drop resumes. The dollar has been stable since the year began, and Mr. Greenspan's remarks Friday boosted it against the euro.

He said a reduction in the federal budget deficit would help reduce the current-account deficit by lessening the need to borrow from abroad, though his speech text noted Fed research suggests a one-dollar reduction in the budget deficit reduces the current-account deficit by just 20 cents.

Mr. Greenspan's comments Friday suggest he may be upbeat about deficit prospects when he testifies to Congress next week. People in contact with the Bush administration say Mr. Greenspan has been urging it to strive for more spending restraint to balance the impact of tax cuts on the deficit. Mr. Greenspan has long called for a restoration of pre-2002 budget rules that require such balance.

Write to Greg Ip at greg.ip@wsj.com