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The Fed should stick out its neck on inflation.


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Larry Kudlow

Wall Street Journal columnist David Wessel raised the right question when he recently asked why the Fed doesn’t set a target range for inflation. For years central banks around the world have been doing it, including the Euroland Fed and the banks in Canada, Britain, New Zealand, and Australia. Why not our central bank?

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It is, after all, the people’s money. Most of us carry a little of it in our pockets or wallets. Certainly we have a right to know what the government thinks its future value will be.

But for years Alan Greenspan — like his predecessors Paul Volcker, William Miller, and Arthur Burns — has refused inflation target-setting. And if history is any guide, the chances of Mr. Greenspan revealing an inflation target when he testifies this Wednesday before Congress are slim to none. Under his guidance, this Fed has shown time and again that it refuses to be tied to any policy rules for which it can be held accountable.

And that’s the funny thing in the case of inflation today. You’d think Alan Greenspan would want to put such a positive economic growth story right in the middle of the policy mix.

Inflation is currently rock bottom and is expected to stay there according to real-time financial and commodity-market indicators. And the fact that inflation is virtually nil sets the stage for a stronger-than-expected economic recovery, which has in all likelihood already begun.

In particular, the key “TIPS spread” (the differential between the market rate on 10-year Treasury securities and the inflation-adjusted rate on 10-year notes) is a scant 1.5%. This means that markets expect a mere 1.5% future inflation rate, as measured by the consumer price index.

Actually, the inflation story is even better, according to reporter Greg Ip’s companion story in the Wall Street Journal . The consumer price index (CPI) continues to overstate inflation largely because it fails to account for innovative new products in the marketplace, improved quality of existing goods and services, or the propensity of consumers to substitute lower-priced goods for those that are too expensive.

Alan Greenspan himself prefers the personal-spending deflator (the price index for personal consumption expenditures) as a more accurate inflation measure. In recent years the PCE deflator has come in, on average, six-tenths of one percent below the CPI. So, the 1.5% bond-market forecast of future inflation
(based on the CPI) is actually predicting slightly less than 1% on the more accurate PCE deflator. That’s a nice number.

While the Labor Department experiments with new CPI measures that hopefully will better capture real-world transaction prices, there is no reason why the Federal Reserve couldn’t publish a 0% to 2% inflation target based on the personal spending measure. Indeed, as there is continued worry that economic recovery might make an overly inflation-cautious Fed begin to raise interest rates, this is just the assurance that Wall Street needs to hear.

Remember, the stock markets are currently plagued by more than rising interest-rate fears. Like a fogged-in airport, the spillover from Enron accounting fraud hangs densely over the markets, preventing share prices from taking off. Surely Mr. Greenspan could do his part for both economic and stock-market recovery by telling the public that actual and expected inflation are well inside any reasonable central bank target range.

Constructive accounting and corporate disclosure reforms are on the way. But can we be sure that monetary reform will follow?



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