To Target or Not to Target
Federal Reserve policy makers have recently ramped up both internal and public discussions of the desirability of adopting an explicit inflation target. In fact, several Federal Reserve officials have now come out publicly in support of such a policy, and it is well known that Chairman Bernanke is predisposed in that direction, based upon his writings while a faculty member at Princeton.
Under Chairman Greenspan the topic of inflation targeting was nearly the third rail of any policy discussion. He valued flexibility to respond to economic events as needed and did not want to be tied down by a policy rule or an explicit target for inflation. Additionally, he was also concerned that if there was an explicit inflation target, then congressionally mandated targets for employment and growth would not be far behind, and there is considerable disagreement whether a central bank can affect anything other than inflation in the long run. Hence, Chairman Greenspan did not want to risk being held to objectives that possibly could not be met.
Why the fascination with inflation targeting now? There are two main explanations, one theoretical and one related to current policy.
The theoretical explanation is rooted in the research work by Lars Svensson, Michael Woodford, and other well respected macroeconomists, some of whom were colleagues of Chairman Bernanke at Princeton. They and others have developed simplified economic models that purport to show that, in a world with perfect knowledge and foresight, a publicly announced inflation target helps both to anchor inflation expectations and to achieve the optimal combination of employment, growth, and inflation. Furthermore, simplified models also show that it is sufficient for the central bank to target inflation, which is really the only component that it can affect in the long run, despite other possible mandates.
The second explanation relates to the current policy situation. As the Fed balances the risk that it has overstimulated the economy with its low interest-rate policy against the possibility that a break-out of inflation is just around the corner before it can successfully execute an exit from its quantitative easing policies, there is the need to assure markets that the Fed means business when it comes to inflation. Hence, announcing a move to an inflation-targeting regime is seen by advocates as a means to insure the credibility of FOMC policies and as a critical component of the Fed’s communications policy. Should inflation expectations come unhinged in the present low-rate environment, with the bloated Federal Reserve balance sheet, then excess reserves could quickly be converted into a sharp increase in the money supply, and inflation might break out.
Would the Fed stand to gain at this point from putting forth an explicit inflation target? My view is that it would have nothing to gain, and this would possibly only complicate its conduct of monetary policy rather than simplify it. There are several reasons for this conclusion.
First, one needs to be careful about assuming that simple models can adequately capture the behavior of a dynamically evolving, complex economy like that of the US. Once one adds even small elements of uncertainty or modifies any of the models’ main assumptions, then the policy performance of an inflation-targeting regime deteriorates. For example, work by President John Williams of the Federal Reserve Bank of San Francisco and Athanasios Orphanides, Governor of the Central Bank of Cyprus (http://www.bcentral.cl/estudios/banca-central/pdf/v11/077-123.pdf), shows that the introduction of uncertainty by policy makers, when it comes to knowledge about the natural rate of unemployment or the natural, real interest rate or when imperfections exist in the formation of inflation expectations by market participants, may cause an inflation-targeting regime to perform quite poorly. Put another way, the world is not as simple as the models suggest. Moreover, it is dangerous to become so enamored with the models that policymakers begin to believe that the models are the real world.
Second, the Federal Reserve is already publishing not only its short-run but also its longer-run forecasts for inflation, growth, and unemployment. These forecasts are made under the assumption that policy is carried out appropriately. Particularly important, the forecasts also indicate what the FOMC believes to be the combination of those three key factors that are consistent with its dual mandate to promote stable prices and maximum employment (http://www.federalreserve.gov/faqs/money_12848.htm). These forecasts sure look like targets. It is not logical to assume that the FOMC would publish forecasts of a longer-run steady state for the economy, under the assumption of appropriate policy that would deviate from what its explicit targets are. However, by publishing the forecasts, but not calling them targets, the Fed is relieved from having to be accountable if the forecasts are not realized. At the same time, publishing the forecasts also enhances the Fed’s communications policy. The present regime has most of the benefits of an inflation-targeting regime without the negatives.
Third, it is worthwhile to examine the recent experience of the central banks that have been following inflation-targeting regimes to get a perspective on what the possible negatives of following such a regime might be. About 20 central banks are now doing so, most notable among them the Bank of England and European Central Bank.
Both institutions have only an inflation target and aren’t burdened with the Fed’s so-called dual mandate of inflation and employment. The Bank of England’s target is 2%, but inflation is now running at over 4%. The bank has repeatedly missed its target, for about 45 months now. When the target is missed by more than one percentage point, the BoE must write a letter to the Chancellor of the Exchequer. This is like having to write “I will not talk in class” on the blackboard. The ECB’s target is an inflation rate below, but close to, 2%. Actual inflation has been running above the target for some time now, and as a result the ECB has embarked upon a gradual tightening of rates.
So why did the Bank of England and ECB miss their targets during the recent crisis and not acted sooner? The logical conclusion is that, while having a single mandate, they acted as if they had a dual mandate. They increased liquidity in the market, cut their policy rates, and attempted to stimulate growth and employment. So having a single as opposed to a dual mandate may have little to recommend it when actual performance is evaluated in the policy realm of real economies. Nor does it seem to affect the institution’s behavior significantly when it really counts.
Fourth, the models assume that central bank policies are credible, but credibility depends on effective actions. Moreover, there should be consequences when targets aren’t achieved. Clearly, in the Bank of England’s case, writing a note when targets aren’t achieved is not an optimal way to ensure credibility of its policies or targeting regime. There are no consequences for the ECB in not hitting its targets, as is also the case for most of the other inflation targeting central banks. So establishing a credible inflation targeting regime may not be nearly as straight forward as proponents suggest. A credible regime requires more than just having an explicit target. It also requires a definition of what that target is (a range or a specific number), a specification of the time period over which the target is to be achieved, a precise definition laid out ex ante as to what it means to not hit a target and what steps will be taken if that target isn’t achieved and, most importantly, dogged delivery on those steps and significant consequences for policy makers if they fail.
Without consequences, failure to deliver on an inflation target will quickly destroy credibility and affect how and the extent to which inflation expectations remain well anchored. Furthermore, the crisis period shows the weakness of an inflation-targeting regime when central banks are faced with policies that might deepen a recession in the name of maintaining credibility of the inflation targeting regime. Inflation-targeting central banks act like ones with a dual mandate. All of these issues are presently missing so far in the Fed’s public discussions of moving to an inflation target.
The bottom-line conclusion is that there is little convincing evidence to suggest that a dual-mandate regime is any better or worse than an inflation-targeting regime. Nor is it obvious that it would be in either the Fed’s or the country’s best interest for an inflation-targeting regime to be established. In fact, what the FOMC is currently doing by publishing its forecasts is very close to the kind of “flexible inflation-targeting regime” that Lars Svensson, current Deputy Governor of the Sveriges Riksbank, advocates as best practice. In the end, what matters is experience and reasoned judgment on the part of policy makers, coupled with significant consequences when performance is lacking.
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