Insight Line—April 2, 2007

Consider the odds: two Federal Reserve Board members, both highly regarded academics prior to joining the Federal Reserve Board of Governors (Board), delivering essentially the same speech on the changing nature of inflation within days of each other.

Was it coincidence? Or was the message so important that two members of the Board had to deliver it? Let’s first consider the message. The speeches practically declared that the Federal Reserve Open Market Committee (FOMC) has reached a consensus on inflation targeting, although the target is not what most investors think.

On March 12, 2007, Federal Reserve Governor Randall S. Kroszner delivered “The Changing Dynamics of Inflation,”¹ and was soon followed by Governor Frederic S. Mishkin’s remarks on March 23, 2007, entitled “Inflation Dynamics.”² Strikingly, the main points of conjecture—the underlying rationale for a now two decade-old moderation in the overall rate of inflation—cited identical and corroborating conclusions from a vast body of academic literature (including the governors’ own) suggesting that the main policy target for central bankers was not inflation itself but inflation expectations.

Inflation expectation theory in itself is not new. Nobel Laureates Milton Freidman and Edmund Phelps introduced the concept as far back as 1967. The main premise is that inflation is related to expectations as well as the level of resource utilization. Thus, if monetary policy is able to influence resource utilization within the economy, then by extension it should also influence inflation expectations.

Needless to say, Friedman and Phelps set off a firestorm of discussion that still echoes in the halls of academia today. Which is more important: resource utilization or inflation expectations? And, as I see it, Governors Kroszner and Mishkin all but proclaimed it to be inflation expectations in their seemingly “coincidental” speeches.

But what are the odds of a coincidence? In my experience, coincidence and FOMC monetary policy are rarely used in the same sentence. The fact that two Board members gave almost identical speeches reaching essentially the same conclusion—inflation expectations matter most when it comes to monetary policy—is historically out of character for the Board. That is, unless some compelling research had a fundamental impact on the mindset of all Board members.

In my analysis, such an occurrence is a rare event but it does happen. The last major example occurred in the mid-1990s as former Chairman Alan Greenspan revealed through his and other Board members’ speeches that the economic measures of productivity were lacking and, as such, the Board recalibrated the measures’ importance in policy deliberations.

Today, for the Bernanke Fed, the issue at hand is one of adopting inflation targeting as the main guide for monetary policy deliberations. However, the sticking point is that no one seems to agree on which inflation measure to target. After all, none of the major measures—the Consumer Price Index, the Producer Price Index, the Gross Domestic Product Deflator or the Personal Consumption Expenditure Index ex-food and energy—come away unscathed when subjected to rigorous statistical analysis. Then perhaps, as Friedman and Phelps first suggested, the Fed’s policy guideline is not targeting inflation per se, but rather targeting inflation expectations.

Inflation expectations are notoriously difficult to gauge, or so it was believed. But the advent of liquid markets for Treasury Inflation Protected Securities (TIPS) ushered in a new metric, providing policymakers with a market-based measure of real and expected inflation. Armed with a new statistical database detailing expectation versus experience, inflation researchers at the Federal Reserve Bank of Philadelphia revisited the Livingston Survey (LS) and the Survey of Professional Forecasters (SPF). The researchers attempted to determine the statistical validity of survey-based forecasts as credible measures of inflation expectations. In a working paper from the economic staff of the Federal Reserve Bank of Philadelphia, visiting scholar Dean Croushore concludes, “The bottom line is: if you want a good measure of inflation expectations you should use the forecasts from SPF or Livingston Surveys.”³ Simply put, inflation expectations are indeed measurable. All of which opens the door, I believe, for the Bernanke Fed to adopt an inflation target that is non-controversial, in that it is long-term, not easily altered and not subject to the volatility of any one data point.

As I see it, the concept is brilliant. Bernanke Fed governors systematically have gone to great lengths to publicly diffuse some of the most widely held beliefs with respect to inflation. High on the list of inflation myth busting was the employment-inflation trade-off. Commodity prices were next and soon followed by twin deficits, currency movements, monetary measures and resource utilization. In essence, the Bernanke Fed showed all of the commonly held truths to be relatively useless, EXCEPT for one. One that is less controversial and little noticed by investors— inflation expectations.

Chairman Bernanke has never kept his preference for inflation targeting a closely guarded secret. Then again, if I’m correct in interpreting the purpose of Governors Kroszner’s and Mishkin’s recent speeches, he’s not willing to let everyone else in on it just yet.

¹ “The Changing Dynamics of Inflation,” remarks by Governor Randall S. Kroszner, National Association for Business Economics 2007 Annual Washington Economic Policy Conference, Arlington, Virginia, March 12, 2007. Available at FRB: Speech, Kroszner--The Changing Dynamics of Inflation--March 12, 2007

² “Inflation Dynamics,” remarks by Governor Frederic S. Mishkin, Annual Macro Conference, Federal Reserve Bank of San Francisco, San Francisco, California, March 23, 2007. Available at FRB: Speech, Mishkin--Inflation Dynamics--March 23, 2007

³ “An Evaluation of Inflation Forecasts Using Real-Time Data,” Dean Croushore, Working Paper 06-19, Federal Reserve Bank of Philadelphia, October 2006, page 19.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.