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FEDERALRESERVE Inflation Targeting BY JENNIFER WANG

The debate over n January of 1995, the Federal Open to institutionalize monetary policy. Market Committee (FOMC) held They believe implementing a formal best-practice Ia debate on inflation targeting. Al inflation target will cement the hard- Broaddus, then-president of the won gains of price stability throughout monetary policy Richmond Fed, presented arguments leadership transitions. On the other in favor of inflation targeting, while hand, opponents of inflation targeting is escalating: Governor (now president deem it unwise to tamper with a discre- of the Bank of San tionary policy that has thus far proven Will it be Francisco) provided the counterargu- so successful. rule-based or ments. The debate ended with Chairman So the question the Fed appears to be Alan Greenspan declaring the asking itself is: Which will better stand discretionary? Committee “as split down the middle the test of time — rules or discretion? as we could possibly get.” A decade later, the issue of infla- The What, How, and Why of tion targeting continues to spark dis- Inflation Targeting cussion within the Federal Reserve What does the term “inflation target- System. The topic remains as contro- ing” mean? Marvin Goodfriend, senior versial as ever, and as Greenspan’s cur- vice president and policy advisor at the rent and final term draws nearer to its Richmond Fed, defines inflation target- February 2006 end date, the topic will ing as “a framework for monetary policy no doubt receive additional attention. characterized by the announcement of Since 1979, the Fed has vigorously an official target for the inflation rate pursued a policy of price stability, first and by an acknowledgement that low under Chairman Paul Volcker, and now inflation is a priority for monetary under Chairman Greenspan. But policy.” uncertainty over Greenspan’s successor To implement an inflation targeting causes some to fear that discretionary framework, the Fed must first declare a power in the wrong hands may reverse specific numerical target (or range) for the work done in the last 25 years. inflation, which is measured by a price The proposed solution? An inflation index such as the CPI or the PCE. The targeting framework for monetary policy. Fed would then pledge to achieve and While inflation levels are stable, maintain inflation within these bounds advocates of an inflation targeting over a stated time horizon. framework want to set a few guidelines Theoretically, through improved Bank of England communication with the markets, and Governor Mervyn King repeated success in attaining target (left) talks with objectives, an inflation targeting U.S. Federal Reserve framework would lead to increased Chairman Alan transparency and credibility for the Greenspan (center) and central bank, fostering an environ- the President of the ment conducive to sustained price , Jean Claude Trichet stability and economic growth. (right), at the Looking briefly at monetary policy 2004 G20 conference in abroad over the past 15 years, it is not Berlin. The Bank of difficult to see why a proposal to put England has adopted an inflation targeting in practice is so inflation targeting compelling. In December of 1989, the framework, while the New Zealand Parliament codified Fed and the ECB inflation targeting as the country’s

remain undecided. WORLD AP/WIDE PHOTOGRAPHY:

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framework for conducting monetary was an early champion of inflation system of rules rather than upon the policy. Since then, 20 other countries targeting. Mishkin articulates the vagaries of individuals, and is less — including industrial, transitional, second advantage: Policymaking would prone to political manipulation or and even developing economies — become less dependent on a chairman’s pressure.” have adopted similar legislation with personal philosophy. “We have as strong some degree of success (see table). a nominal anchor as any country that … Or No? In the United States, during the has announced inflation targeting. On the other side of the fence, skeptics period known as the Volcker disinfla- The problem is that nominal anchor of inflation targeting, including many tion (1979 to ’87), the Fed brought is embodied in Chairman Greenspan.” economists within the Fed, believe down core inflation from 10 percent to Left alone, this strategy could prove there would be a number of disadvan- 4 percent. Subsequently, inflation has dangerous. tages associated with the adoption of remained low and relatively stable. “Putting in an inflation targeting an inflation targeting framework. Pursuing “hawkish” inflation policies regime is, in a sense, trying to provide a The first and most frequently dis- also led the Volcker-Greenspan Fed to succession plan for Greenspan,” cussed issue pertains to the advantage more elusive, unquantifiable accom- Mishkin suggests. “We’d like to clone of having policymaking flexibility with- plishments like the reestablishment of Greenspan. We can’t. But what we in a discretionary framework. Federal central bank credibility and a restored would like to do is imbibe a future pol- Reserve Board Governor Donald Kohn faith in the Fed’s commitment to low icy framework with the basic principles agrees the Fed has conducted policy inflation. [of price stability] in which he has with an eye on long-run price stability, Indeed, Goodfriend and others have operated.” but is not convinced that recent success argued that although the Fed has never Results from countries that practice is due to implicit inflation targeting. explicitly employed inflation target- inflation targeting have been generally Rather, it is derived in large part from ing, it has long done so implicitly. positive. Across the board, average the Fed’s “ability to adapt to changing Goodfriend, a strong supporter of infla- inflation has dropped significantly after conditions — a flexibility that likely tion targeting within the Federal an inflation-targeting policy was has benefited from the absence of an Reserve System, summarizes his case: adopted. In the United Kingdom, for inflation target.” “When one considers the Greenspan example, inflation fluctuated wildly Thomas Schlesinger, executive era as a whole, it would appear that the until the adoption of inflation targeting director of the Financial Markets Greenspan Fed adopted, gradually and in 1992. Since then, inflation has been Center and a vocal critic of inflation implicitly, an approach to monetary pol- brought down to manageable levels for targeting, says that the evidence from icy that can be characterized as infla- the first time in many decades. abroad is not as clear as supporters of tion targeting.” The question becomes: But inflation targeting is certainly inflation targeting might suggest. Should the Fed take the next step and no magic wand, and supporters stress Schlesinger cites a paper by Laurence declare an explicit inflation target? that it should be viewed as a frame- Ball and Niamh Sheridan that con- work or set of guidelines — not a rigid cludes that after factoring in regressions Yes … rule. Mervyn King of the Bank of to the mean, there is “no evidence that Supporters of inflation targeting say it England has been careful to point out inflation targeting improves perform- would generate two significant advan- that inflation targeting is “a way of ance as measured by the behavior of tages over the status quo. Mickey Levy, thinking about policy. It isn’t an auto- inflation, output or interest rates.” chief economist at Bank of America, matic answer to all the difficult policy Schlesinger identifies another reason identifies one of the main benefits: questions.” why an inflation targeting model might more clarity regarding policy decisions. Supporters of inflation targeting prove inadequate: “It ignores obvious “I think a lot of the difficulty or believe a policy change will be easiest and important questions about finan- confusion the Fed has had over its to implement while inflation is already cial stability problems that can occur announcements about monetary policy low, and the public and markets are in a low inflation regime,” he says. would evaporate if the Fed had a familiar with the approach. Even “The evidence indicates … that manag- properly stated monetary policy or Congress is thinking about it. ing the economy in periods of sus- inflation guideline,” Levy says. With Robert Keleher, chief macro- tained low inflation can be just as inflation targeting, “I think the issue of economist of the Joint Economic tricky, if not trickier, than achieving transparency becomes much more Committee of the U.S. Congress, has the goal of price stability. We’ve seen straightforward, which would help the argued that inflation targeting would that asset bubbles and busts can and Fed avoid some of the problems it’s have the effect of “institutionalizing have occurred in periods of sustained run into in the last few years.” and depersonalizing the goal of price low inflation.” Frederic Mishkin, a professor of stability.” This, he says, “will help Finally, skeptics of inflation target- banking and financial institutions at ensure that Federal Reserve perform- ing argue that adopting an inflation tar- Columbia University’s Business School, ance depends more on a transparent get is simply unnecessary. The United

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States has done well without inflation “useful for central banks in transition establishing a time period for an infla- targeting, they say, and it is hard to to price stability. But in the United tion target, and the need to define a justify a policy change when there is States, I don’t know why we would be coping strategy should the inflation little evidence to suggest the economy worse off one way or the other.” rate move toward the ends of a target would profit more under a different The ambiguity inherent in Gertler’s range. regime — particularly since cred- statement echoes the sentiments of Although Hoffman acknowledges ibility could erode if the Fed fails to economists in the banking and finan- that such a change will be difficult to achieve its target range. Moreover, cial services industries who think that implement, he remains hopeful. “I there are less drastic alternatives avail- it is still too early to tell. think the market would benefit from able to increase policy transparency, Stuart Hoffman, chief economist some explicit inflation target frame- such as earlier releases of records and at PNC Financial Services Group, work from the Fed,” he says. “It would forecasts. thinks an explicit inflation targeting be a learning process for the Fed. It framework won’t happen for a while. would be a learning process for the Rules vs. Discretion in a The most basic details have yet to be markets. But I think it would be a good Post-Greenspan Fed worked out — down to which inflation discipline, and I do think it might help Mark Gertler, chairman and professor measure to use, and what the appro- to anchor public and market inflation of the economics department at NYU, priate ranges would be for a target. expectations.” believes that inflation targeting is Hoffman also alludes to the trouble of When asked to speculate about the future look of a post-Greenspan Fed, Bank of America’s Mickey Levy replies Does Inflation Targeting Work? with optimism. “Anything can happen, Average inflation rates have fallen more rapidly in countries with inflation targeting (IT) but the Federal Reserve and the whole regimes, but they have also had more room for improvement. of the financial community recognize the economic benefits of stable low Sample IT Year IT 1980 to 1990 to 1998 to Countries Began 1989 1999 2001 inflation, and so even under a new Fed regime with a new chair, the impetus is Australia 1994 8.4 2.5 2.8 toward continuity, and the policy Canada 1991 6.5 2.2 2.0 thrust toward stable low inflation.” Chile 1991 21.2 11.5 4.0 Ultimately, the decision of imple- Israel 1992 104.7 11.2 3.2 menting inflation targeting can be 1998 8.1 5.7 3.6 thought of as a choice between stabili- New Zealand 1990 11.8 2.1 1.6 ty or flexibility, rules or discretion. Poland 1998 43.0 52.0 8.6 “You don’t want to adopt a policy or not adopt a policy because of cur- Sweden 1993 7.9 3.2 0.9 rent circumstances. You want to adopt United Kingdom 1992 7.4 3.7 2.4 a policy that works under all sorts of Sample Non-IT circumstances — not just in times of Countries economic depression or economic - 2.5 1.2 -0.3 prosperity,” cautions Joel Naroff, chief United States - 5.5 3.0 2.5 economist for Commerce Bank. “My Euro area - 6.6 2.8 1.8 view is that either the policy is correct to be implemented under all sets of SOURCE: Bank for International Settlements circumstances, or it shouldn’t be implemented at all.” RF

R EADINGS Ball, Laurence, and Niamh Sheridan. “Does Inflation Targeting Keleher, Robert. “Lessons from Inflation Targeting Experience.” Matter?” National Bureau of Economic Research Working Paper AReport from the Joint Economic Committee of the U.S. no. 9577, March 2003. Congress, February 1997. Bernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and King, Mervyn. “The Inflation Target Five Years On.” Speech Adam S. Posen. Inflation Targeting: Lessons from the International delivered at the London School of Economics, October 29, 1997. Experience. Princeton: Princeton University Press, 2001. Kohn, Donald L. Remarks at the Federal Reserve Bank of Goodfriend, Marvin. “Inflation Targeting in the United States?” St. Louis’ 28th Annual Policy Conference, “Inflation Targeting: National Bureau of Economic Research Working Paper no. 9981, Prospects and Problems,” October 17, 2003. September 2003. Visit www.rich.frb.org/pubs/regionfocus for links to relevant sites and supplemental information.

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