Federal Reserve to Make History this Week?

The Fed is widely expected to do something that it hasn't done before: be more informative to the people when it comes to inflation...

This week the Federal Reserve might make history and Ben Bernanke's dreams come true. If everything works out right the Fed might announce an "explicit target for inflation." For those of you unfamiliar with inflation targeting, allow me to illuminate...

Inflation targeting is basically an economic policy whereby a central bank publically announces an educated guess as to what it 'targets' the inflation rate to be and THEN that central bank does what it can to guide the actual inflation rate towards that target by changing interest rates and using other monetary tools.

Historically, but not always, interest rates and inflation rates have had an inverse correlation. If actual inflation is higher than the announced target, then the central bank will most likely increase interest rates, thus gradually lowering inflation until it hits the target. Vice versa, if inflation is actually below the stated target, then the central bank might lower interest rates, thus increasing the inflation rate over time.

Establishing this sort of inflation target has been a major attempt as part of Bernanke's purpose to improve the Fed's communications and in order for the central bank to exercise more control over growth and inflation - it is a method that is currently being used by most of the other central banks. I have to admit that these intentions appear to be pretty noble. I mean sure there have been numerous secretive meetings amongst the Fed over the years, but this attempt by Bernanke at "clearer communications" may be just what Americans need to be able to trust the powers that be. In fact this wouldn't be the first time that Bernanke has promoted transparency: the man now holds news conferences four times a year after monetary policy meetings.

The timing couldn't be better too. Bernanke has been trying to establish inflation targeting for years, but now that the U.S. is undergoing...what it is undergoing, this kind of change could be just what the doctor ordered, especially if we want to sustain the momentum that has gathered from recent positive news on job growth and the unemployment rate.

On the other hand, inflation targeting can also operate as a shroud for the Fed because, in essence, what announcing this target also does is give the Fed an excuse to perform further bond buying should the ongoing 'recovery' prove to be short-lived. Despite any viewpoint of a 'sacrifice' on the Fed's part for divulging such information, we have to keep in mind that this sort of targeting would also benefit the Fed both politically and strategically.

Although last year displayed food and energy costs driving consumer prices well above the central bank's desired levels, some say that inflation is actually "receding quickly." If this is true, and you have read Patton Fischer's blog on the relationship between U.S. interest rates and gold, then we may see the Fed lowering interest rates in the near to medium term, which would drive major demand towards the purchase of gold in anticipation of the forthcoming rise in inflation rates. In other words, the Fed's attempts at lowering inflation may have been successful; too successful, and the advent of inflation targeting may actually give gold bugs even more accuracy in their predictions on medium and even short term gold prices. Quite interesting.

A little bit about the 'announcement' itself - last December, officials gathered to review federal communications and debated over a draft statement on policy strategy and long-term goals. It is a refinement of that particular draft that is being discussed this Tuesday and Wednesday and the explicit inflation target is expected to come out as a part of that statement. So there isn't really a guarantee that the Fed will announce a target this week, but at the very least and for the first time in history, the Fed will release forecasts on the 'path' of interest rates.

Of course there are skeptics and, of course, they have a valid concern: that inflation targeting can actually impede the central bank's policymaking flexibility and lead the Fed to focus more on stabilizing prices instead of promoting employment. We won't know for sure yet, but I have to admit that establishing more and clearer communications with its people is definitely a step in the right direction for a government that should truly value keeping its citizens informed.

Over and Out,

- Peter

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