Markets Believe FOMC Has an Implicit Inflation Target: St. Louis Fed Analysis

ST. LOUIS — While the Federal Open Market Committee (FOMC) has not adopted an inflation target, the financial market's reaction to FOMC statements suggests that the markets believe the central bank has an implicit long-run inflation objective.

That's a conclusion reached by economist Daniel L. Thornton in the May/June issue of Review, the Reserve Bank's bimonthly journal of economic and business issues. The publication is also available online at the St. Louis Fed's web site: https://research.stlouisfed.org/publications/review.

Currently, some 21 countries have targets for inflation. Inflation targeting is marked by a numeric objective the central bank attempts to achieve over a reasonably well-specified time range. Among the industrialized nations of the world, the central banks of Japan and the United States stand out in not adopting a formal, numeric inflation target.

While some economists and policymakers have raised a number of objections to establishing an explicit target for inflation for the United States, Fed chairman Ben Bernanke, when he was a Reserve System governor in 2002, suggested the central bank take an "incremental move toward inflation targeting, in the form of the announcement of a long-run inflation objective."

"The adoption of inflation targeting by many of the world's central banks is directly linked to changing views about the central bank's ability to control inflation," said Thornton. "The now conventional wisdom that the Fed and other central banks control long-run or steady-state inflation is the primary reason that central banks have an explicit or implicit long-run inflation objective" (LIO).

Given the markets' belief that the Fed is responsible for the average rate of inflation in the long run and the FOMC's oft-stated commitment to price stability, Thornton suggests that it's reasonable to assume that market participants have a perception of the FOMC's implicit LIO.

"For example," he said, "it is doubtful that anyone believes that the FOMC would be content with long-run inflation of 5 percent or with persistent or protracted deflation. Hence, it seems safe to say that most market analysts believe the FOMC's implicit LIO is somewhere between zero and, say, a maximum of 5 percent."

Thornton noted that the only market-based measure of expectations regarding inflation is the spread between rates on nominal and inflation-adjusted 5- and 10-year government securities. "These market-based measures," he said, "increased by 80 basis points in response to statements made by the FOMC in 1993 that appeared to clarify the lower bound of its LIO."

More recently, Thornton said, statements by the FOMC appear to have "provided more information about the upper bound of the FOMC's implicit long-run inflation objective."

He concludes the FOMC could alleviate the remaining uncertainty by following Bernanke's suggestion and formally announce an LIO. "Until it does," Thornton said, "the market will have to rely on FOMC statements, actions and other information to pin it down more tightly."

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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