What are the costs and benefits of inflation targeting? Should the Fed adopt an inflation targeting monetary policy regime?
Many economists and central bankers today would agree that you ask a great question! Inflation targeting is a hot topic of discussion at many central banks today.
First, what is inflation targeting?
You might be aware that the goals of monetary policy vary across central banks. The Federal Reserve, for example, lists its monetary policy goals as “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. The European Central Bank lists price stability as its primary objective. There are also central banks whose monetary policy centers on exchange rate stability.
A formal adoption of an inflation target is one way (although not the only way) to achieve the goal of price stability. The International Monetary Fund defines inflation targeting in the following way1:
This involves the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets. Additional key features include increased communication with the public and the markets about the plans and objectives of monetary policymakers and increased accountability of the central bank for attaining its inflation objectives. Monetary policy decisions are guided by the deviation of forecasts of future inflation from the announced target, with the inflation forecast acting (implicitly or explicitly) as the intermediate target of monetary policy.
Monetary economists often classify monetary policy as being either “rules” or “discretion.” Rules are monetary policies that require less macroeconomic analysis or judgments from the monetary policy authority (think about the gold standard or the constant-money-growth rule2). Discretionary monetary policies allow policymakers to set monetary policy depending on their assessment of current economic conditions. Both types of policies have advantages and disadvantages that have been studied by researchers and discussed by monetary policymakers (see Meyer 2002).
Inflation targeting is frequently classified as a “rule,” which, if followed very strictly, could open it up to criticism (see the discussion of the costs of inflation targeting that follows). Yet, it is important to realize that not everyone views inflation targeting as a strict rule. Bernanke et. al (1999) argue that “there is no such thing in practice as an absolute rule for monetary policy,” because every rule permits some discretion in practice. Therefore, one might think of inflation targeting as a framework for policy within which “constrained discretion” can be exercised (Bernanke 2003).
So now I understand what inflation targeting is, but what are its costs and benefits?
The fact that not all central banks that state price stability among their goals of monetary policy have chosen an inflation targeting framework is indicative of the fact that it is not clear whether the benefits of inflation targeting exceed its costs. While one obvious benefit of inflation targeting should be lower inflation, inflation has come down worldwide (in inflation targeting countries and other countries alike) in recent decades.
Many benefits of inflation targeting have been proposed. Chief among these are:
- Reduced inflation volatility (see, for example, Svensson 1997)
- Reduced inflationary impact of shocks (see, for example, Mishkin 2004)
- Increased anchoring of inflation expectations (see Kohn 2007, Swanson 2006, Levin et. al 2004)
If inflation targeting were implemented as a very strict policy rule (which many think it should not be) then it could have some serious costs (Bernanke et. al 2003):
- Restricted ability of the central bank to respond to financial crises or unforeseen events;
- Potentially poor outcomes in employment, exchange rate and other macroeconomic variables beside inflation;
- Potential instability in the event of large supply-side shocks;
- Lack of support from the public.
Is inflation targeting easy to implement?
The adoption of a numerical target for inflation poses many operational questions that policymakers must address. In a 2003 speech, Dr. Bernanke, then a member of the Fed’s Board of Governors, articulated his view that adopting an inflation targeting framework entails “two components: 1) a particular framework for making policy choices, and 2) a strategy for communicating the context and rationale of these policy choices to the broader public.”
Let’s address these one at a time.
1) Developing a framework for making policy choices
- Which measure of inflation should be targeted?
In principle, the inflation measure chosen should be broad-based, accurate, timely, and familiar to the general public. The inflation measure chosen should perhaps exclude price changes in sectors that are volatile and where fluctuations are unlikely to affect trend or “core” inflation. Also, it might be important to assure the public that the central bank does not manipulate inflation data (this can be done by choosing data that is compiled by an agency that is independent of the central bank).
- What numerical value should the target have?
Targeting an inflation rate that is too low or too high could create problems. An inflation target that is too low might lead to higher unemployment (Akerlof et. al 1996 suggest that an inflation rate close to zero might increase the long-run level of unemployment), might restrict the central bank’s ability to support a recovery in times of recession due to the zero lower bound on nominal interest rates (Meyer 2001), and might increase the chances or frequency of deflation rather than inflation (to read about costs of deflation, please see my February 2006 answer). Of course, no one wants to have an inflation target that is too high either, as inflation costs can be considerable (to read more about the costs of inflation, please see my answer of March 2006). In practice, inflation targets in developed economies are usually set at 1% to 3% per year (Bernanke et. al 2003).3
- What should the time horizon be to (approximately) hit the target?
Horizons of less than one year or greater than four years are likely to be problematic. Monetary policy has considerable lags, and, therefore, is likely to have difficulty affecting inflation over such a short horizon as one year or less. On the other hand, targets that are as distant as four years into the future might not be viewed by the public as being very credible (Bernanke et. al 2003). Still, there are plenty of time horizon choices within the 1- to 4-year range.
2) A strategy for communicating guidelines of the inflation targeting regime
You’ll see that communication is a major theme in the above discussion of inflation targeting. Increased communication is likely to better anchor inflation expectations if the public trusts that the central bank will achieve its stated price stability goals. The public will then price a more-stable expectation of future inflation into contracts and asset prices (alternatively, imagine if everyone expected inflation to continually rise – and consequently priced this into contracts). In this way, anchored inflation expectations make it easier for the central bank to keep actual inflation stable, and deliver on its price stability promise.
For ways in which the Fed communicates with the public , a description of the benefits of Fed transparency, as well as some of the limits to transparency, see my postings in June 2006 and September 2006.
For further information…
The literature on the mechanics, costs, and benefits of inflation targeting is rich. In addition to the references cited below, try the “Fed in Print”, a search engine that will scour the Fed System for research.
Also, many Federal Reserve officials have spoken publicly about their opinion on whether the Fed should adopt an inflation targeting regime. You can find speeches of Fed governors on the Federal Reserve Board’s website, and you can find speeches of Fed District presidents on each Fed District’s website.
To see which central banks in the world are inflation targeters, see my March 2006 posting about the different goals of central banks around the world.
NOTE: On January 25, 2012, the Federal Open Market Committee issued a "Statement of Longer-Term Goals and Policy Strategy." The document expresses the FOMC's:
- Commitment to the Fed's "statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates."
- Specifies a longer-run goal for the personal consumption expenditure price index of 2 percent.
- Provided an estimate of the longer-run normal rate of unemployment in the 5.2 to 6.0 percent.
1. Read more about the International Monetary Fund’s classification of monetary policy framework and exchange rate arrangements.
3. To give some specific examples, the Bank of England sets inflation target at 2%; European Central Bank aims at inflation rates of below, but close to, 2% over the medium term; The Bank of Canada aims to keep inflation at the 2 per cent target, the midpoint of the 1 to 3 per cent inflation-control target range; Reserve Bank of New Zealand focuses on keeping inflation between 1 and 3 percent on average over the medium term; Reserve Bank of Australia has an inflation target of 2-3 percent over the medium term.