October 27, 2003, 10:11 a.m.
What the World Needs Now . . .
. . . is a Fed inflation target.

It was refreshing to read in the Wall Street Journal earlier this week that the Federal Reserve is at least talking about establishing a long-overdue inflation target, which will assist it in making monetary and interest-rate policy.

Most of the world central banks have established a stated inflation target, and their currencies are better off for the long term. As I stated in my article "Stick to the Mission, Mr. Greenspan," the Fed's main mission is the creation of price stability. At this point in the U.S. economic cycle — a 1 percent federal funds rate, more than 3 percent growth of real gross domestic product, and a 93.9 percent employment rate — we need a little clarity from the Fed on several fronts:

First, the Fed must state a flexible inflation target "range." Throughout most of U.S. history, inflation has been modest — in the 2 to 3 percent range. An inflation target today wiil "anchor" monetary policy, making it more transparent and easier to anticipate. The lack of such an anchor has long confused businesses (which write capital-spending plans) and investors in capital markets (who are naturally interested in inflation expectations). They've had to guess at the central banker's intended actions.

Since the economy itself is always changing, anchors — in this case an acceptable inflation-rate target that considers labor-force growth and productivity gains among other variables (such as TIPS, the Treasury's inflation-indexed securities) — help relieve the markets of the task of speculating on important policy issues.

An inflation target range — such as 2 to 3 percent or 2 to 4 percent — would also give the Federal Reserve Board more flexibility in setting monetary policy versus the changing economy. It would, in fact, give the markets an anchor.

A less speculative capital market structure is simply a more productive one.

Second, the Fed must raise short-term interests rates to at least 2 percent. With inflation currently running at a 2.3 percent annual rate, the federal funds rate is too low and is out of line with both current inflation and inflation expectations. And in bringing the overnight rate to 2 percent, the Fed won't have to touch it again for awhile.

Third, the Fed must make it clear to investors that the 30-year U.S. Treasury is alive and well and that it is the benchmark for long-dated securities. The 30-year Treasury, currently yielding 5.15 percent, has already acknowledged the current and future inflation rate of approximately 2.5 percent. If inflation expectations are better anchored, the 30-year is the maturity that should bear the full brunt of long-term inflation expectations.

Fourth, the Fed must inform the Bush administration, other politicians, and the many corporate and union leaders that subsidies, tariffs, and embargoes must be eliminated, and that complex U.S. and international tax codes and accounting issues have got to be simplified. This latter change alone would save billions of dollars and create billions more in new global revenues.

Of course, such an occurrence would make a central banker's job a lot easier.

— Patricia A. Small is a partner with KCM Investment Advisors and is Treasurer Emeritus of the University of California. She welcomes your comments at psmall@kcmadvisors.com.