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It's time for a new approach when it comes to deciphering Fed

Updated: May 3, 2013 12:14PM

Inflation is like air. It's all around us. We take it for granted. Then every once in a while we take notice. More than a whiff of inflation is like more than a whiff of smoke: cause for concern. But how do we measure inflation, and how much is too much? How do we anticipate its emergence, and what actions do we take to prevent the whiff of smoke from becoming a conflagration?

In the 1980s, we watched the money supply. The regular unveiling of the latest figures on the growth of the money supply triggered market reactions and profound commentary. The best way to anticipate Fed reaction to inflation was to study the smoke rings that emanated from Fed Chairman Paul Volcker's omnipresent cigar.

In the Alan Greenspan era, it became more difficult to decipher the Fed's attitude toward inflation and gauge the Fed's strategy to use the money supply to either smother the inflationary fire or to fan the embers to keep the economy from moving into deflation. The pundits were reduced to deciphering Greenspan's obtuse testimony before Congress.

Greenspan came to represent the Fed's power over the economy, steering a course through the 2000 stock market crash, the post-9/11 economic slowdown, and even the housing bubble. How did he do it? As long as he was successful, no one much cared whether he used a divining rod, a Geiger counter or some secret economic calculations.

In fact, a few economists did care that there seemed to be no objective way to target inflation and to understand Fed policy in reaction to the monthly inflation numbers.

In 1999, Ben Bernanke and three other economists wrote a book called Inflation Targeting: Lessons From the International Experience. The purpose of the book was to point out a way to actually "target" an appropriate inflation rate, and then craft a policy that would not lock the Fed into an arbitrary interest rate scenario. They also proposed that the Fed could target inflation rates without impacting its other important responsibility: maintaining employment.

Fast forward to today, and that same Ben Bernanke is now Fed chairman. One of the other authors of that book is now a Fed governor. And so a new era dawns in Fed-watching.

Forget the smoke rings and the mutterings of the oracle. Get ready for inflation targeting. And, more specifically, get ready for OLIR. That's shorthand for Optimal Long-run Inflation Rate. According to well-known economist Edward Yardeni, "The OLIR is the long-run [or steady-state] inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives."

Yardeni, who follows the Fed closely, notes that the concept of inflation targeting was discussed at the Fed's October meeting, and probably will come up again later this month. In fact, he points out, the Fed is already targeting inflation rates, having agreed that the members are "comfortable" with an annual inflation rate of between 1 and 2 percent.

But an actual announcement of "inflation targeting" would put an end to the "personality cult" of Fed management that Bernanke decried in his 1999 book. Says Yardeni: "Bernanke wants the Fed to be independent of personalities; he doesn't have that egotistical need that Greenspan had to run the whole show."

After the Fed meets again in late January, Bernanke will testify before Congress in February. Yardeni suggests that the Fed chairman is unlikely to simply announce a plan to target inflation. Instead he will "float a trial balloon" in his testimony and point out that inflation targeting does not necessarily lock the Fed into a strict interest rate policy.

The Fed governors can, as they have been doing since mid-summer, simply target a federal funds rate that they think is appropriate to bring inflation within the Fed's comfort zone. And, as it has demonstrated over the past six months, the Fed can afford to be patient in waiting for that interest rate to bring inflation down to the targeted levels.

As in every era, Fed watchers will now have to learn some new tricks. Instead of watching the money supply, or wondering when the fed funds rate will change, Wall Street will have to ferret out the components of that OLIR target, and try to predict how long the Fed's patience can be stretched.

It will make the markets interesting, to say the least. And that's The Savage Truth.

Terry Savage is a registered investment adviser whose column appears every Monday in the Sun-Times Business section.

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