Following a speech on Wednesday, Fed Chairman Ben Bernanke had this to say in a Q&A:
"If inflation itself falls too low or inflation expectations fall too low, that would be something we'd have to respond to because we don't want deflation[.]"
At first glance this statement seems reasonable, but upon further reflection there is something troubling about it. It is the monetary policy equivalent of locking the barn door after the horse is already out. Bernanke is saying here the Fed will respond after inflation falls too low. Why not lock the barn door up front by explicitly targeting inflation expectations so that the public's expectations about future spending and price growth are anchored and not likely fall in the first place? If this were the way monetary policy were conducted the Fed would be a little more concerned right now about the now 6-month downward trend in inflation expectations.
If there is one lesson the Fed should have learned from this crisis is that it needs to take a more forward-looking approach to monetary policy. Nowhere is this more clearly seen than in the Fed's September, 2008 FOMC meeting where it decided against further monetary easing because of concerns about rising inflation. Had the Fed been giving more weight to the forward-looking inflation expectations coming from TIPs, it would have noticed that the outlook had been deteriorating since mid-2008. Instead, the Fed was looking in its rear view mirror and saw the realized inflation rates of the past few months that had temporarily gone up because of supply shocks.
Of course, in my ideal world the Fed would go one better and target nominal GDP futures contracts. They don't exist now, but I am hoping that one they do and the Fed explicitly targets them. Not only would such a policy better anchor nominal spending expectations, it would also make the Fed a whole lot more transparent and thus accountable to the public.
Source: Ben Bernanke And The Barn Door