Monday, November 19, 2007

Inflation Targeting Lite

A central bank controls the economy's money supply—the growth of which ultimately determines the growth of the economy's price level (the inflation rate). Many of the world's central banks publicly announce inflation targets. An inflation target is a specific rate (such as 2%) or a range of inflation rates (such as 1%–3%) that the central bank will try to achieve over time. By publicly announcing and consistently hitting an inflation target, these central banks hope to enhance their credibility and anchor people's expectations of future inflation. If people believe a central bank's commitment to low and stable inflation to be credible, they will expect future inflation to be low and stable—feeding a virtuous cycle of low inflation, low inflation expectations, and slow increases in overall prices and nominal wages. Confidence that inflation will remain low reduces the uncertainty surrounding saving and investment decisions, fostering a favorable climate for economic growth.

The Federal Reserve System (the Fed) is a notable holdout on inflation targeting. Most people understand that one of the Fed's policy mandates is price stability, or low and stable inflation, but the Fed has never publicly described exactly what "low and stable inflation" means. Fed chairman Ben Bernanke recently announced a change in Fed practices that will move U.S. monetary policy a bit closer to the inflation targeting ways of the rest of the world. The Fed will now publish three-year economic forecasts four times per year (rather than two). More importantly, the Fed will tell us how it thinks economic output, unemployment, and inflation will take shape over the next few years based on its application of monetary policy. The Fed will essentially say, "Here's what we expect inflation to be if we implement sensible monetary policies over the next three years."

That's not quite the same as explicitly stating a target, but it sounds pretty similar. The American public will now have a better sense of the inflation rate that the Fed seeks to restore in the event of economic disturbances that move the inflation rate away from the Fed's projection. Read this New York Times article or Bernanke's speech to learn more about the Fed's efforts to increase transparency.

Discussion Questions

1. Many central banks face a sole mandate of price stability, whereas the Fed faces a dual mandate of price stability and full employment. Over which part of its dual mandate does the Fed exercise more influence, price stability or full employment?

2. Chairman Bernanke, an advocate of inflation targeting, mentions in his speech that "a superficial drawback of inflation targeting is its very name, which suggests a single-minded focus on inflation to the exclusion of other goals." He goes on to point out that most central banks practice flexible inflation targeting that allows them to focus on other policy goals. The former chairman of the Federal Reserve, Alan Greenspan, was generally opposed to inflation targeting. As the Times article points out, Greenspan felt that "explicit public commitments would hobble the Fed's ability to respond nimbly to unexpected developments." Do you think a publicly announced inflation target would help or hamstring the Fed's dual mandate?

3. Monetary policy has become more transparent over the past couple of decades. The Fed's latest move to publicly offer more frequent and in-depth economic analysis is a continuation of this trend. How will the additional information help households and firms make economic decisions and plan for the future? How can monetary policy become more transparent over time? Should it? For example, would televised meetings of the Federal Open Market Committee (FOMC, the Fed's policymaking arm) help firms and households to make better saving and investment decisions?

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  • At 7:51 PM, November 20, 2007, Blogger realbill said…

    When the Fed issues a new dollar, it gets a dollar's worth of assets in exchange, so assets rise in step with the issue of money, and there is no tendency toward inflation. Furthermore, the issue of money does not change anyone's net worth, so there is no additional spending power created by the new dollar. The Fed does not control inflation be controlling the money supply. It controls inflation by maintaining adequate backing for the money it issues.


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