Inflation Targeting by Federal Reserve

November 21, 2007 at 12:13 am | Posted in economy | Leave a comment
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The Federal Reserve partially lifted its veil Tuesday, a weaker economy and higher unemployment than previously expected. In releasing the minutes of the Federal Open Market Committee’s October meeting, the Fed provided a first look at its new economic forecasting system. Inflation is likely to be lower in 2008 than in 2007, and it is expected to fall in subsequent years.
The Fed said the decision last month to cut its benchmark rate to 4.5%–down from 4.75%–was a “close call,” an action taken mainly as insurance against weak economic conditions.

The minutes released Tuesday were highly anticipated by investors because of the new forecasting guidelines put in place by the bank. Predictions for economic growth, unemployment and inflation will now be released four times a year instead of two. And the forecast will also look three years into the future instead of two.

In its forecast, the Fed said real growth in the growth domestic product for 2008 is likely to be 1.8% to 2.5%, down from a June prediction of 2.5% to 2.75%. It also revised its unemployment forecast for the fourth quarter of 2008 to as much as 4.9%, up from a previous prediction of 4.75%.

These benchmarks of the economy suggest the country is in for slowdown, “owing primarily to weakness in housing markets and to the tightening in the availability of credit resulting from recent strains in financial markets,” the Fed said. In recent weeks, many banks, including Merrill Lynch , Citigroup and Bank of America have announced billions of dollars in write-downs due to their exposure to wobbly mortgage-backed securities. They move the bank one step closer to “inflation targeting,” a policy tool practiced by many other central banks (including the European Central Bank) that is meant to give guidance to investors by explicitly stating what is an acceptable level of inflation. Bernanke has long favored an inflation target, but his predecessor, Alan Greenspan, was a foe of the practice, arguing that it doesn’t leave the economy enough wiggle room should an unexpected shock occur.

Some Fed watchers have described the new forecasting guidelines as “inflation-targeting lite” because they essentially reveal the central bank’s thoughts on inflation, allowing it to revise its predictions four times a year.

They have an objective for inflation,” Peter Hooper, chief economist at Deutsche Bank Securities, said of the Fed. “But they’re not strictly inflation-targeting. They’re not going to put the economy into a recession just to make sure inflation comes down next year to the desired level.”

The Fed probably wouldn’t have to take those steps anyway. The bank said that “overall inflation was expected to edge down over the next few years,” due in part to energy prices that fall in line with the predictions of futures markets. According to the Fed, 2007 core inflation projections–which do not include food and energy prices–were revised to about 1.9%, down from 2% to 2.25% in June. For 2008, core inflation could be even lower–1.7% to 1.9%, the bank said. Projections for overall inflation in 2010 ranged from 1.6% to 1.9%. The Fed will lower the fed rate again, I guess

The forecasts opened the Fed’s thinking, but even these central bankers can’t predict the future.

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