FRBSF Economic Letter
98-18; May 29, 1998
U.S. Inflation Targeting: Pro and Con
In recent years, monetary economists and central bankers have expressed
growing interest in inflation targeting as a framework for implementing
monetary policy. Explicit inflation targeting has been adopted by a number
of central banks around the world, including those in Australia, Canada,
Finland, Israel, New Zealand, Spain, Sweden, and the U.K. In the United
States, there has been little public debate over inflation targeting,
although some bills have been introduced in Congress to mandate the use
of explicit targets for inflation.
Issues and questions surrounding inflation targeting formed a major
focus of a recent conference on Central Bank Inflation Targeting jointly
sponsored by the Federal Reserve Bank of San Francisco and the Center
for Economic Policy Research at Stanford University (Rudebusch and Walsh
1998). In this Economic Letter, we set out some of the arguments
for and against adopting inflation targeting in the United States discussed
at the conference. (For further discussion, see Bernanke and Mishkin 1997,
Bernanke, et al., forthcoming, and Keleher 1997.)
What would inflation targeting mean in the
U.S.?
There has been some ambiguity about the precise definition of an inflation
targeting policy regime, in part because certain institutional arrangements
have differed from one inflation targeting country to another--most notably
with regard to how the inflation target is set and how deviations from
the target are tolerated. For our discussion, we define inflation targeting
to be a framework for policy decisions in which the central bank makes
an explicit commitment to conduct policy to meet a publicly announced
numerical inflation target within a particular time frame. For example,
at the start of 1993, Sweden's central bank announced an inflation target
for the consumer price index of between 1 and 3 percent by 1995. Similarly,
if the Federal Reserve wanted to adopt inflation targeting, it would publicly
commit to achieving a particular numerical goal for inflation (a target
point or range) within a set time span of, say, a couple of years. Also,
as part of an ongoing policy framework for targeting inflation, the Fed's
semiannual Humphrey-Hawkins report, which currently provides a near-term
(one-year) outlook for inflation, could be augmented to include a discussion
of whether the medium-term (two- or three-year) inflation forecast is
consistent with the announced medium-term inflation target. Inflation
targeting would not impose a rigid simple rule for the Fed; instead, policy
could employ some discretion to take into account special shocks and situations.
However, the organizing principle and operational indicator for monetary
policy would be focused on inflation and (in light of lags in the effects
of policy) inflation forecasts.
Given some earlier ambiguity, it is important to be clear about how
we interpret the ultimate goals of inflation targeting monetary policy.
In particular, an inflation targeting central bank need not care only
about inflation. Indeed, most inflation targeting central banks continue
to recognize multiple goals for monetary policy with no single primary
one. (In New Zealand--an exception--the start of inflation targeting coincided
with a legislative mandate that the central bank's "primary function"
was price stability, while in Canada--as is more typical--such legislation
was never passed.) Accordingly, an operational policy framework of inflation
targeting would still be consistent with the Fed's current legislated
objectives of low inflation and full employment. An inflation targeting
regime can accommodate a goal of output stabilization by having wide inflation
target bands, long inflation target horizons, and explicit exemptions
for supply shocks. Thus, the adoption of an inflation targeting regime
does not necessarily require that price stability or low inflation be
the preeminent goal of monetary policy. As with monetary targeting, inflation
targeting is an operational framework for monetary policy, not a statement
of ultimate policy goals. (For further discussion, see Rudebusch and Svensson,
1998.)
Arguments pro
By focusing attention on a goal the Fed can achieve, by making monetary
policy more transparent and increasing public understanding of the Fed's
strategy and tactics, by creating institutions that foster good policy,
and by improving accountability, the adoption of inflation targeting would
represent a desirable change in the U.S. monetary policy.
1. The announcement of explicit inflation targets for the Fed would
provide a clear monetary policy framework that would focus attention on
what the Fed actually can achieve. Bad monetary policy often has resulted
from demands that central banks attempt to achieve the unachievable. Most
notably, few macroeconomists believe that monetary policy can be used
to lower the average rate of unemployment permanently, but central banks
often are pressured to achieve just that through expansionary policy;
such policy instead only results in higher average inflation without leading
to a systematically lower average rate of unemployment. In contrast, implementing
explicit inflation targets would help to insulate the Fed from such political
pressure.
2. Transparent inflation targets in the U.S. would help anchor inflation
expectations in the economy. When making real and financial investment
decisions and planning for the future, businesses and individuals must
form expectations about future inflation. Inflation targets would provide
a clear path for the medium-term inflation outlook, reducing the size
of inflation "surprises" and their associated costs. Inflation targets
also likely would boost the Fed's credibility about maintaining low inflation
in the long run, in part, because they mitigate the political pressure
for expansionary policy. Since long-term interest rates fluctuate with
movements in inflation expectations, targeting a low rate of inflation
would lead to more stable and lower long-term rates of interest. Together,
the reduced uncertainty about future medium-term and long-term inflation
would have beneficial effects for financial markets, for price and wage
setting, and for real investment.
3. The establishment of inflation targets in the U.S. would help institutionalize
good monetary policy. Recent U.S. monetary policy has been generally considered
excellent, but earlier in the postwar period, monetary policy clearly
failed by allowing inflation to ratchet up significantly several times.
To some extent, the quality of policy over time has reflected the skills
and attitudes of the people involved in the policy process. Monetary policy
is an area in which it is especially important to implement institutional
structures that will help to avoid bad policies. Inflation targets can
provide this institutional structure and help ensure that monetary policy
is not dependent on always having the good luck to appoint the best people.
4. In the current system, there is some ambiguity about how and why
the Fed operates. For example, although monetary aggregates play a very
modest role in the policy process,they are the only variables that the
Fed is required to set target ranges for and report about to Congress.
As noted above, inflation targets would focus discussion on what the Fed
actually could achieve. Furthermore, an inflation target provides a clear
yardstick by which to measure monetary policy. Given forecasts of future
inflation, it is easy to compare them to the announced inflation target
and hence judge the appropriate tightness or looseness of current monetary
policy. Also, on a retrospective basis, an explicit target allows Fed
performance to be easily monitored. Thus, Congress and the public will
be better able to assess the Fed's performance and hold it accountable
for maintaining low inflation.
Arguments con
Inflation targeting, even without imposing a rigid rule, would unduly
reduce the flexibility of the Fed to respond to new economic developments
in an uncertain world. Furthermore, publicly committing solely to an inflation
target would not enhance overall accountability or transparency given
the multiple objectives of monetary policy.
1. The purpose of inflation targeting is to focus the attention of monetary
policy on inflation. However, concentrating on numerical inflation objectives
(even with caveats or escape clauses) also reduces the flexibility of
monetary policy, especially with respect to other policy goals. That is,
inflation targets place some constraints on the discretionary actions
of central banks. Such constraints can be quite appropriate in countries
where monetary policy has performed poorly, exhibiting sustained unproductive
inflationary tendencies; however, this is not the case in the United States.
U.S. monetary policy has operated quite well for almost two decades, so
limiting the flexibility and discretion of the Fed to respond to new economic
developments would be ill-advised. Why change a system that is working?
Certainly, adept policymakers are one reason for the good performance
of recent monetary policy, but there is also a strong institutional structure--stronger
than existed at the start of the 1970s--that is already in place at the
Fed that fosters good monetary policy.
2. Monetary policy requires the careful balancing of competing goals--financial
stability, low inflation, and full employment--in an uncertain world.
There is uncertainty about the contemporaneous state of the economy, the
impact policy actions will have on future economic activity and inflation,
and the evolving priority to be given to different policy objectives.
However, because monetary policy actions affect inflation with a lag,
inflation targeting means, in practice, that the Fed would need to rely
heavily on forecasts of future inflation. Given the uncertainties the
Fed faces, an inflexible and undue reliance on inflation forecasts can
create policy problems. For example, most forecasts in the mid-1990s of
inflation in the late 1990s over-estimated the inflation we are currently
experiencing. If the Fed had been inflation targeting in the mid-1990s,
it might well have raised the funds rate based on its inflation forecasts.
Yet with today's low inflation and robust economy, it is difficult to
argue that the Fed was too expansionary and that the more contractionary
policy implied by inflation targeting would have produced a better outcome.
As in this instance, it seems unlikely that a mechanical dependence on
inflation forecasts to achieve inflation targets will improve policy.
3. Proponents of inflation targeting argue that it promotes accountability.
However, as is generally agreed, low inflation is only one of the objectives
of monetary policy. While monetary policy may not affect average real
growth or unemployment over time, it does have an important role to play
in helping to stabilize the economy. Even if average inflation is the
one thing the Fed can control in the long run, it does not follow that
the Fed should be held accountable only for its inflation record. Inflation
targeting actually could reduce the Fed's overall accountability by allowing
it to avoid responsibility for damping short-run fluctuations in real
economic activity and unemployment. Making the Fed publicly accountable
for only one policy goal may make it harder for Congress and others to
monitor the Fed's contribution to good overall macroeconomic policy.
4. Similarly, with regard to the transparency and public understanding
of policy, inflation targeting highlights the inflation objective of central
banks but tends to obscure the other goals of policy. Just as uncertainty
about future inflation impedes good economic decision making, so does
uncertainty about the future level of output and employment. Inflation
targeting sweeps the latter concerns under the rug (often by adjusting
the amount of time that deviations are allowed from the inflation target).
Given the multiple legitimate goals of policy, the single public focus
of inflation targeting does not enhance overall transparency.
Summary
The debate about the appropriateness of inflation targets in the U.S.
continues, but it is likely that the actual experiences of inflation targeting
countries will provide the most convincing evidence. The recent record
of inflation targeting countries has been good, but many other countries
also have reduced inflation and maintained low rates of inflation even
without employing a formal targeting framework. The generally benign macroeconomic
environment of the past few years still leaves much unknown about how
best to reconcile sufficient policy flexibility with the maintenance of
low inflation. The oldest inflation targeting regime (New Zealand) is
barely eight years old, and there is still much to learn.
Glenn D. Rudebusch
Research Officer
Carl E. Walsh
Professor of Economics, UC Santa Cruz
and Visiting Scholar, FRBSF
References
Bernanke, B. S., and F. S. Mishkin. 1997. "Inflation Targeting: A New
Framework for Monetary Policy?" Journal of Economic Perspectives
11 (Spring) pp. 97-116.
___, T. Laubach, F. S. Mishkin, and A. Posen. Forthcoming. Inflation
Targeting: Lessons from the International Experience. Princeton,
NJ: Princeton University Press.
Keleher, R.E. 1997. "Establishing
Federal Reserve Inflation Goals." Joint Economic Committee Study (April).
Rudebusch, G. D., and L. E. O. Svensson. 1998. "Policy
Rules for Inflation Targeting." NBER Working Paper No. 6512.
___, and C. E. Walsh. 1998. "Central
Bank Inflation Targeting." FRBSF Economic Letter 98-17 (May
22).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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