Aug. 29 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan rejected using an inflation target such as that used by the European Central Bank to set interest rates, saying it would rob U.S. policy makers of the flexibility they need to respond to developments in the economy. The U.S. economy is too complex to reduce monetary policy to a rule-based model instead of using personal judgment to assess risks, Greenspan told a Kansas City Fed conference in Jackson Hole, Wyoming. A number of Fed officials have recently advocated the Fed adopt a target for price increases, arguing it would make the Fed's intentions clearer and reduce volatility in the markets, like the 1.5 percentage point jump in 10-year note rates since June.
``That any approach along these lines would lead to an improvement in economic performance, however, is highly doubtful,'' Greenspan said. ``Monetary policy based on risk management appears to be the most useful regime by which to conduct policy.'' The Fed chairman, clad in a blue plaid shirt and a blazer, spoke before at least a dozen other central bankers who have successfully managed policy with inflation targets, a numerical goal for inflation to be achieved over a specified period of time. It's used by the Bank of England, the European Central Bank, the Bank of New Zealand, the Bank of Mexico, and at least a half-dozen other central banks around the world. Some Fed policy makers, including Philadelphia Fed Bank President Anthony Santomero and St. Louis Fed Bank President William Poole, have advocated the U.S. central bank adopt an inflation target, arguing it would help the economy by constraining large moves in market interest rates as investors try to anticipate Fed moves. Fed Governor Ben Bernanke also is an advocate of announcing inflation goals.
Investor Criticism
``Some day, somehow, the Federal Reserve may embrace a quantifiable policy rule but as long as Alan Greenspan resides as Fed chairman, no such rule will be adopted in the near or intermediate future,'' said Kenneth Kim, a Fed policy analyst at Stone and McCarthy Research Associates in Princeton, New Jersey. The yield on the benchmark 10-year Treasury note rose as high as 4.66 percent Aug. 14 from 3.07 percent in June as investors offset the risk that by holding the benchmark U.S. interest rate at a 45-year low of 1 percent, the central bank might accelerate inflation, which erodes the return on fixed- income investments. Many investors said the Fed hasn't adequately laid out how far it's willing to go in boosting the economy. An inflation target would give a better idea of when the central bank would raise or lower interest rates. ``Risk management is not in conflict with revealing the Fed's core policy framework,'' said Paul McCulley, managing director of Pacific Investment Management Co. and a critic of the Fed's recent attempts to communicate its policy intentions. ``To the contrary, risk management is more effective if the market knows the Fed's core policy road map.''
Market Rates
Greenspan said there is too much uncertainty about the economy to adopt a target, particularly when inflation is as low as it is now. The personal consumption price index less food and inflation, an inflation measure followed by the Fed, rose just 0.9 percent in the second quarter. ``Rules by their nature are simple, and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking,'' he said. The chairman's speech suggested that ``pragmatic and flexible policy making is incompatible with many inflation targeting regimes,'' said Laurence Meyer, a former Fed governor attending the Jackson meeting. The European Central Bank has been criticized for waiting too long to respond to a slowdown in the 12 nations using the euro. The ECB reduced interest rates four times in 2001, compared with 11 by the Fed, because inflation remained above the central bank's 2 percent target.
``The American is much more pragmatic, doesn't want to be chained to a rigid inflation target as we are,'' Juergen Kromphardt, a member of the five-man panel known as the Wise Men, which advises Chancellor Gerhard Schroeder, said in a telephone interview from Berlin. ``We could take a leaf out of the U.S. book.''
Policy Questions
It's hard to fit a rule to the evolving economy, Greenspan said, noting that innovations in financial markets have decreased the value of using money supply as a policy indicator. Mortgage finance has evolved with the development of secondary markets, allowing homeowners to extract large amounts of equity from their houses, bolstering spending. Because those kinds of changes in the economy are likely to continue, Greenspan asked if the Fed were to set a target how policy makers would know what the proper level of inflation should be in a given economic situation. Should the Fed assume that the current rate is too low, assume it is a new norm and ignore the signal that low prices might be sending about the economy, or assume the current rate can be maintained and set policy to do that? ``Given errors in our underlying data, coupled with normal variance, we might not know the correct course of action for a considerable time,'' Greenspan said. ``Partly for these reasons, 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.''
Matter of Judgment
It is better for policy makers to use their own judgment, taking into account everything they know about the economy. ``By this I mean that policy makers need to consider not only the most likely future path for the economy, but also the distribution of possible outcomes about that path,'' he said. Such a ``risk management'' approach gives the central bank more flexibility than an inflation target would, he said. The Fed chairman cited the experience of the Russian debt default in August 1998. While the economy was expanding at a ``satisfactory pace,'' Greenspan said, the Fed lowered interest rates anyway ``because we were concerned about the low- probability risk that the default might severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy.''
Different policies have different risks, he said. One policy that may work in a given situation might fail if economic developments change, with unfortunate consequences for the economy. Under those circumstances, policy makers must ``reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy,'' he said. That has been true lately as inflation has fallen toward zero. Fed officials have publicly weighed ways they might fight a continuing decline in the general level of prices.
Bubble Defense
``These considerations have inclined Federal Reserve policy makers toward policies that limit the risk of deflation even though the baseline forecasts from most conventional models would not project such an event,'' Greenspan said. During today's session Greenspan also returned to the question of whether the Fed could have or should have used monetary policy to limit the rise of stock prices in the 1990s. The Fed chairman gave a lengthy defense of the central bank's policy actions from 1997 to 2001, when the Standard & Poor's 500 index rose 107 percent, at last year's Jackson Hole conference. ``We at the Fed were obviously aware that markets were beyond what historical trends suggested'' in the late 1990s and early 2000s, Greenspan said.
Yet the Fed's 300 basis point increase in interest rates starting in 1994 had little impact on the rising stock market, he noted. ``This suggested that an appropriate policy would have perhaps been a significant multiple of what we did, Greenspan said. ``We know if we raised rates a thousand basis points we will knock down any bubble. We also know it will knock down the economy,'' Greenspan said. Rather than attack the bubble and possibly produce collateral damage to economic growth, Fed officials ``tried to address its ultimate defusing'' with 13 interest rate cuts, beginning in January 2001, that brought the benchmark overnight bank lending rate down from 6.5 percent. ``Whether that will succeed, we won't know for a while,'' Greenspan said. ``If it does succeed we will only know that it succeeded in this instance. We don't yet know the general principles of this issue'' of asset price bubbles. ``A mild calibration of monetary policy to address asset bubbles does not and cannot work,'' he said. //www.bloomberg.com