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Greenspan Rejects Formal Inflation Target

The Fed chairman doesn't address the current economic condition in a speech in Wyoming.

Updated from 11:15 a.m. EDT

Despite calls for the

Federal Reserve

to adopt a formal inflation target, Fed Chief Alan Greenspan said the central bank would retain its flexibility in shaping monetary policy.

In a speech before the Federal Reserve Bank of Kansas City Friday, Greenspan said the economic outlook is too uncertain for the Fed to consider an official inflation target. He also said a formal rule would likely have no positive effect on economic growth.

"The Federal Reserve should, some conclude, attempt to be more formal in its operations by tying its actions solely to the prescriptions of a formal policy rule," Greenspan said, according to the text of his remarks, which were given in Jackson Hole, Wyo. "That any approach along these lines would lead to an improvement in economic performance, however, is highly doubtful."

Rigidity

Rules tend to be too simplistic and don't always work when significant changes occur in the economy, he said. "They cannot substitute for risk-management paradigms, which are far better suited to policymaking."

During the Russian debt default in the fall of 1998, Greenspan said the Fed cut interest rates even though the economy was expanding at a satisfactory pace. It did this to provide some insurance against a possible adverse outcome. "The product of a low-probability event and a severe outcome, should it occur, was judged a larger threat than" a possible increase in inflation, he said.

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Richard Nash, chief market analyst at Victory Capital Management, said this explains why the Fed has reduced interest rates so much recently in response to the threat of deflation.

"These comments indicate that the Fed will likely keep rates low until they no longer view deflation as even a minor risk to the economy," Nash said. "We continue to believe that the Fed will remain on hold until at least mid 2004 as any risks to the economy from keeping rates low are outweighed by the threat of deflation, though that is viewed as a low probability outcome."

Steve Renko

In his prepared remarks, Greenspan said the Fed's approach is to use its judgment and to "evaluate the risks of different events and the probability that our actions will alter those risks." If policymakers were to rely on formal rules, "we might not know the correct course of action for a considerable time" given the errors in underlying data.

"The prescriptions of formal interest rate rules are best viewed only as helpful adjuncts to policy, as indeed many proponents of policy rules have suggested," he said.

For two decades the Fed has eschewed the idea of establishing a fixed inflation target, with officials arguing that it could limit the central bank's flexibility in times of crisis and that there is little proof it actually makes for a more efficient system.

But over the past year, several Fed officials have begun to embrace the idea. Robert Parry, the president of the Federal Reserve Bank of San Francisco, said last November that "the zero-inflation objective is not desirable," because it could mean that the U.S. falls into a deflationary spiral similar to the one seen in Japan. By setting a target for inflation at say, 2%, some pundits believe the Fed would eliminate the possibility of deflation in the future.

Meanwhile, Richmond Fed President Alfred Broaddus has said he favors an explicit target for inflation, noting that it would allow the public to have a clearer understanding of monetary-policy actions by the Fed. And Fed governor Ben Bernanke has long believed that the central bank should define its goals for inflation, noting this would make "our current procedures more explicit and less mysterious to the public."

Other banks around the globe already use numerical inflation targets to guide monetary policy, including the European Central Bank, Bank of England and Bank of Canada. But some, like Greenspan, and Fed Governor Donald Kohn have expressed doubts, saying there is no real evidence that their system works any better than the U.S. model. Indeed, some argue that the U.S. has achieved price stability without the help of a fixed inflation rate.