November 2005
Inflation Targeting at Bernanke's Fed?
Panelists at a November 22 AEI conference discussed what inflation targeting might mean for U.S. monetary-policy management and how successful inflation targeting has been in countries that have already adopted it as a monetary-policy guide. The seminar took place shortly after Ben S. Bernanke’s nomination to replace Alan Greenspan as chairman of the Federal Reserve Board of Governors on February 1, 2006. Bernanke is widely expected to advocate that the Fed move away from a discretionary monetary policy toward one based on inflation targeting.
Desmond Lachman
AEI
At last week’s hearing, Mr. Bernanke made it clear that he would like to move towards inflation targeting to enhance the Federal Reserve’s credibility and transparency with a view to better anchoring inflation expectations.
In 1989, New Zealand was the first to introduce inflation targeting. As Mr. Truman suggested in his study, there are now as many as twenty-two nations practicing inflation targeting--although this does not include the big three (the United States, Europe, and Japan).
How might monetary policy differ under inflation targeting from how it was practiced during the Greenspan years? Does the idea of inflation targeting increase the priority of inflation relative to the other goals of monetary policy (i.e. full employment and dealing with asset prices or challenges such as the Asian crisis)?
Edwin M. Truman
Institute for International Economics
Inflation targeting is a framework for the conduct and evaluation of monetary policy. It is not a rules-based system. Rather it is a constrained, discretion-based system, and I am a sympathizer with it, if not a proselytizer.
I believe that the United States would benefit slightly from inflation targeting, while the costs of moving to it would be negligible.
What is inflation targeting and how far are we from it now? Is an inflation-targeting central bank merely one that says it is? I believe that there are four characteristics of an inflation-targeting central bank.
1) It has price stability as the preeminent goal of monetary policy. However, it must be noted that only six banks practicing inflation targeting have this as their sole objective.
2) It has to have a specific target or a number. Most of these targets now do not include zero.
3) It must maintain a rigid commitment to get back to the target if one fails to hit it. Most central banks do not have this.
4) It must have a framework for transparently evaluating one’s relative success in meeting the monetary targets.
The Fed might not have a formal inflation report. However, it has a similar semi-annual report to Congress, and of my four criteria, it already has two (whereas explicitly inflation targeting banks usually have three).
As to the advantages of inflation targeting for the United States, it would provide added transparency and improve communications. Inflation targeting improves the effectiveness of monetary policy by improving the quality of expectations. Inflation targeting achieves higher growth and lower inflation--effectively shifting the Phillips Curve to the right.
Are there disadvantages? It may reduce discretion, by preventing central banks from worrying sufficiently about asset prices. Today’s Financial Times talks about inflation targeting as a “Maginot Line,” which says that sensible central banks should worry about asset prices rather than inflation. But, the specific banks that it cites as “sensible” are all inflation-targeting central banks.
Then there is the traditional argument that you do not know what inflation figure to worry about--but that is already an issue without inflation targeting.
Politically, to the extent that the Congress accepts the Fed’s argument that price stability increases growth, Congress could concentrate on holding the Fed to its inflation target.
A numerical inflation target does not necessarily imply inflation targeting, as we have seen with the case of the European Central Bank.
Bennett T. McCallum
Carnegie-Mellon University
Would inflation targeting be better than current U.S. monetary policy? Originally, it was thought that central banks should focus on inflation at the expense of growth and other objectives. But today all agree that by focusing on the attainment of low inflation as one’s primary objective, one is also contributing to the long-run stabilization of output.
In his book, Ben Bernanke defined inflation targeting as the setting of an explicit numerical target for inflation, communication of that target to the public, and the periodic evaluation of one’s success in meeting that target. Clearly the Fed does not now have an official quantitative inflation target, nor does it acknowledge the primacy of the inflation objective over that of attaining full employment and balanced economic growth.
Should the Fed move to inflation targeting? In terms of economic principles they should, since monetary policy has a beneficial long-run effect on expectations that should be conducive to better output performance. However, in the short run, things are less clear, and so it is dicey to build too much on the belief that inflation targeting would improve matters as they now stand.
Inflation targeting may boost public confidence that the Federal Reserve is truly committed to achieving low inflation. This would make monetary policy more effective, especially in supporting growth.
Explicit targets would require congressional action. I would not expect Congress to make inflation the sole target, although it may be possible to get them to formalize the Greenspan strategy of having the Federal Reserve seek a sufficiently low inflation rate to allow firms to ignore price changes in their decision making. The Fed could create an inflation report in all but name, which could help institutionalize inflation targeting.
Inflation targeting is not a rule. Rather, it represents constrained discretion. This term is a little hard to grasp as it attempts to reach something between a rule and discretion. This idea is fully consistent with the Taylor rule, which has been criticized by Alan Greenspan and Donald Kohn as excessively restrictive. But, this misses the value of a rule--which integrates features to respond to changes in the economy. Rules are not necessarily non-activist.
Andrew Crockett
J.P. Morgan Chase
I am basically in favor of inflation targeting, with the qualifications that Mr. Truman made. However, I do not think that it would lead to a huge improvement for the United States, although it did for other countries that had less success in taming inflation than the United States.
As inflation targeting improves the credibility of a central bank, it improves the transmission of monetary policy. The public endorsement of a target prevents upwardly creeping inflation. In the past, inflation crept up because the benefit of upward creep always exceeded the perceived cost of fighting inflation.
Prior to inflation targeting, monetary targets were a useful part of the public relations battle to suggest to the public the link between monetary policy and inflation. To have a credible policy accepted by the public, an important objective must be to convince the public of the long run employment benefits from price stability.
Flexibility for a central bank is a good thing up to a point. One wants to permit sensible flexibility but not too much, given the basic objective of price stability. Undesirable flexibility should be prevented.
Some form of congressional recognition of inflation targeting would help to strengthen the basis for policy. If asked what long-run inflation it wants, Congress would be sensible. Whereas, if it is asked what interest rate it wants, Congress would always press for lower rates--which would have an adverse effect on price stability.
I see no reason why the Fed should not target its current objective. I favor a slightly longer horizon only because this allows for the paying out of asset price bubbles. If you extend the time horizon for goods price inflation, this allows you to account for the greater asset price inflation.
At the Jackson Hole meeting a few years ago, Stanley Fisher suggested 1 to 3 percent inflation target. Beyond a certain point, inflation impedes rational decision making. Below this, it runs the risk of deflation. The Fed currently has very good credibility with the expectation that the 1 to 2 percent implicit target will continue.
One needs to have a plan for how one adapts the inflation target over time. This is dangerous, as it reduces credibility, but changing circumstances may render it necessary. In the UK, the target band was adjusted down by one half of a percentage point when it was recognized that a lower rate was consistent with the required flexibility.
AEI research assistant Chris Pope prepared this summary.
