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2/20/2020

Is The Fed On Target?

I N S I D E T H E VA U LT | S P R I N G 1 9 9 7
https://www.stlouisfed.org/publications/inside-the-vault/spring-1997/is-the-fed-on-target

Is The Fed On Target?
A Closer Look at our Monetary Policy Objective
When we speak of the Federal Reserve as having responsibility for conducting monetary policy, we are
talking specifically about its role in managing the nation's money supply. To do so, the Federal Reserve
exercises its main monetary policymaking arm—the Federal Open Market Committee or FOMC—which
meets eight times each year. After each meeting, the FOMC issues a directive, which contains instructions for
policy until the next meeting. The Fed implements virtually all monetary policy decisions through the process
of adding or removing reserves from the banking system at the open market desk of the Federal Reserve
Bank of New York.
Ultimately, the goal of any economic policy is to achieve the highest standard of living possible for its citizens.
The question is, how can the Fed most effectively contribute to this goal? The answer to this question has
evolved over the years. The Humphrey-Hawkins legislation of 1978, for example, assigned the Fed multiple
goals, including economic growth in line with the economy's potential to expand, a high level of employment
and stable prices. In recent years, however, legislation has been introduced in Congress that would give the
Fed a single long-run goal of price stability.

Which Target?
With only one policy action—that of directing the open market desk to manage the nation's money supply—
the Federal Reserve is expected to aim at three targets: price stability, economic growth and full employment.
But the Fed's direct influence over the long-term trends in output and employment is negligible. These trends
instead depend largely on population growth, the skill and educational levels of the work force and the
accumulation of capital. The only lasting contribution monetary policy can make to the real output growth
trend is to create an environment conducive to growth, one in which relative prices are clear and markets are
not distorted by high and variable inflation. The Fed's only power in the long-run then, lies in its ability to
manage the money supply, which affects price levels.

Why Price Stability?
In a market system, changes in prices help producers know what and how much to produce. Inflation affects
this process by distorting the signal that prices provide. That's because it's difficult for a producer to discern
whether changes in prices are due to changing supply and demand conditions or to a change in the overall
level of prices. Ultimately, then, inflation distorts decisions about where to use resources, what to produce,
what to consume, where to invest, what to save, what to throw away, even what to study—the fundamental
decisions on which economic well-being depends. Additionally, inflation creates "shoe leather costs" as
consumers and firms expend efforts and resources to attempt to beat inflation—efforts that could haven been
used in a productive capacity. The monetary goal of price stability alleviates the distortions caused by inflation
and contributes to a more efficient economy.
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Is The Fed On Target?

What About Growth?
With current annual inflation rates hovering around 3 percent, the Fed is often encouraged to stop worrying
about inflation and to aim for higher economic growth and lower unemployment. In a recent discussion,
however, Thomas C. Melzer, president of the St. Louis Fed, stressed the value of the single goal of price
stability, contending that the monetary policy that best promotes economic growth is one that prevents
inflation from being a factor in the decision making of businesses and consumers. So should we be shooting
for growth?"We tend to confuse short-term fluctuations in output with long-term growth," he says. This
confusion can be attributed to certain conditions in which a boost in money supply can increase output For
example, if people believe that the underlying inflation trend is 3 percent, but the Federal Reserve begins a
series of monetary policy actions that permit money supply growth consistent with 4 percent inflation, then
output growth may be temporarily stimulated. The reason is that workers and savers are "tricked" into working
at a wage rate or saving at an interest rate that is too low to compensate for the upcoming inflation.
What does all of this imply about the conduction of monetary policy? Melzer explains, "Because under certain
conditions monetary policy has the potential to boost output in the short run, some may be tempted to push
for faster and faster growth by stepping on the monetary accelerator. Output may indeed go up for a time, but
eventually inflation will be the only outcome." Thus, long-term growth is best sustained in an environment of
stable prices.

Bulls-eye!
To hone in on a single objective, we could apply one familiar axiom of economic efficiency—"Do what you do
best." Individuals, firms and nations follow this fundamental rule in order to maximize their incomes and
improve their standard of living. By the same token, monetary policy can be most credible and effective by
following this simple rule and, in the Fed's case focusing on price stability as its target.

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2/20/2020

Q&A

I N S I D E T H E VA U LT | S P R I N G 1 9 9 7
https://www.stlouisfed.org/publications/inside-the-vault/spring-1997/q--a

Q&A
This year the U.S. Treasury began offering inflation-indexed bonds. How do these bonds differ from
conventional bonds?
Conventional, or nominal, bonds repay investors principal plus some stated interest; indexed bonds repay
principal adjusted for inflation and a fixed interest rate applied to the adjusted principal. The Treasury
calculates semi-annual interest payments on its indexed 10-year notes by adjusting the principal for inflation
according to the Consumer Price Index (CPI)
What's the attraction of inflation-indexed bonds?
For investors, the major benefit is the guarantee of a real yield. In contrast, conventional bonds use nominal
interest rates, composed of the real interest rate plus the expected inflation rate. Thus, if an investor
purchases a bond with a 7 percent nominal interest rate and inflation is expected to be 3 percent, the real
yield would be 4 percent. If, however, the actual inflation rate turns out to be 4 percent, the investor's real
yield has fallen to 3 percent. To compensate investors for assuming such risk, an inflation risk premium is built
into nominal bond yields—estimated to be at least 50 basis points, or 1/2 percent, for short-term bonds and
even more for longer-term bonds.
An advantage of inflation-indexed bonds for the issuer is that it does not have to pay the inflation risk premium
since inflation risk has been eliminated.
What are the negative features of indexed bonds?
For investors, the tax treatment and the real rate of return when compared with alternative investments can
be unattractive. The tax consequences are twofold: First, because the U.S. tax code does not distinguish
between increases in real income and increases in nominal income due to inflation, the indexed bondholder's
tax liabilities will increase, lowering the after-tax real yield. Second, investors will pay taxes on the inflationadjusted increase in principal accrued each year (as well as interest received), even though it is not paid out
until maturity. This tax treatment can neutralize the primary incentive of indexed bonds—that of protection
from inflation. The yield on indexed bonds may also be a disincentive for investors. Even after adjusting for
inflation and risk, historic yields over the long term on stocks and many corporate bonds outperforms the
yields on less risky indexed bonds.

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2/20/2020

Economic Snapshot

I N S I D E T H E VA U LT | S P R I N G 1 9 9 7
https://www.stlouisfed.org/publications/inside-the-vault/spring-1997/economic-snapshot

Economic Snapshot
1st Quarter 1997
Q2-96 Q3-96 Q4-96 Q1-97
Growth Rate—Real Gross Domestic Product

4.7%

2.1%

3.8%

NA

Inflation Rate—Consumer Price Index

3.4%

2.7%

3.3%

2.4%

Civilian Unemployment Rate

5.4%

5.3%

5.3%

5.3%

How is the CPI calculated?
Every few years the U.S. Census Bureau conducts a Consumer Expenditure Survey to see what the typical
urban family buys, and compiles a list of goods and services. The CPI is a weighted average—goods such as
salt and toothpicks on which people spend small fractions of their income receive less weight on the average
than goods like housing and energy on which people spend a larger percentage. Then each month the
Bureau of Labor Statistics (BLS) visits thousands of stores to check the prices of approximately 90,000 items.

Rule of 72
To estimate how fast prices will double, apply the Rule of 72 by dividing 72 by the rate of inflation. For
example, if our economy experiences a 6 percent annual inflation rate, prices for cars, houses, and other

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Economic Snapshot

goods and other services you buy would double every 12 years (72÷6). On the other hand, if the inflation rate
is 3 percent, prices would double every 24 years (72÷3).

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