Independence and Accountability via Inflation Targeting.

• Author: Ireland, Peter N.

Successful institutional arrangements for monetary policymaking must resolve the tension that can arise between central bank independence and accountability. Because monetary policy actions that appear to promise short-run benefits can often impose even larger long-run costs, outcomes that are preferable to everyone can be achieved by insulating the central bank from day-to-day economic and political pressures. At the same time, however, an independent central bank's objectives should stay aligned with those of society at large.

A streamlined mandate from Congress, instructing the Federal Reserve to focus on stabilizing inflation around its self-declared 2 percent target, would provide the strongest foundation for effective monetary policymaking by satisfying both these requirements. An inflation-targeting mandate would help preserve, de jure, the increased independence won by the Federal Reserve, de facto, only after the United States economy suffered through a damaging phase of high inflation and high unemployment during the 1970s. Without such a mandate, the Fed's independence--already under attack--may erode still further as memories of that historical episode continue to fade.

The same inflation-targeting mandate would make the Federal Reserve more accountable, by specifying a quantitative goal for monetary policy against which the central bank can and should be judged. The new mandate could be reinforced by further legislation, requiring the Fed to make its policy decisions with reference to pre-announced rules, not only for targeting interest rates during normal times but also for conducting large-scale asset purchases during severe deflationary recessions. These rules would help protect the Fed against political pressures to allocate credit and engage in inflationary public finance.

Securing Independence

Article I, Section 8 of the United States Constitution gives to Congress the power to "coin money" and "regulate the value thereof." Modern economic theory provides a rationale for this. In general equilibrium, utility-maximizing households and profit-maximizing Anns care only about relative prices. Thus, market-clearing conditions for goods and services work only to pin down those relative prices. An actor from outside the system is needed to solve the coordination problem that determines the aggregate nominal price level. Consistent with its constitutional powers, Congress gives the Federal Reserve monopoly rights over the issuance of base money (currency plus bank reserves). By exercising its monopoly control over the monetary base, the Federal Reserve regulates on behalf of Congress the value of money or, equivalently, its reciprocal: die nominal price level. Congress retains the right to set the Fed's mandate, specifying the goals it wishes monetary policy to achieve. In this way, Congress ensures that the Fed remains accountable to the American people.

Congress has also put in place a number of institutional features--including 14-year terms for Federal Reserve Board Governors and a decentralized structure consisting of the 12 Federal Reserve Banks in addition to the Board itself--that potentially allow Fed officials to take a longer-run view. Much of post-World War II monetary history, however, suggests that these features, by themselves, have been insufficiently strong. This history points to a lack of independence, rather than an absence of accountability, as the bigger practical obstacle to effective monetary policymaking.

The historical problem is illustrated best by an example presented by Finn Kydland and Edward Prescott (1977) in their article, "Rules Rather than Discretion: The Inconsistency of Optimal Plans." This paper formed an important part of the work for which the two economists were awarded the Nobel Prize in 2004.

In Kydland and Prescott's example, a central banker operating under discretion--making optimal choices period-by-period based on prevailing economic conditions--is always tempted to generate surprise inflation to lower the rate of unemployment. Agents in the private sector, however, correctly anticipate that the central bank will succumb to this temptation, and rationally build their expectations of inflation into price and wage-setting decisions. In equilibrium under discretion, therefore, inflation is suboptimally high, but unemployment is no lower than it would otherwise be.

If, on the other hand, the central banker in Kydland and Prescott's example is insulated from short-run political pressures, and thereby allowed to adopt and adhere to an intermediate-term policy rule that is fixed independentiy of current economic conditions, he or she will successfully eschew the temptation to exploit the expectational Phillips curve and aim to keep inflation low instead. Quite strikingly, by striving to do less, the central bank accomplishes more: it succeeds, at least, in creating and maintaining an environment of stable prices, leaving unemployment to fluctuate, as it would anyway, in response to ever-evolving conditions in the labor markets.

Kydland and Prescott's model is not just an intellectual curiosity, for it successfully explains why, despite die occasional appearance of a statistical Phillips curve relationship between inflation and unemployment in the United States data, the Federal Reserve's efforts to exploit that Phillips curve led, during the 1970s, not to lower unemployment at the cost of higher inflation but instead to the worst of both worlds: higher unemployment and higher inflation (i.e., stagflation). In fact, Barro and Gordon (1983) later used essentially the same model as the foundation for what they called "A Positive Theory of Monetary Policy," meaning a theory that accounts for the historical facts.

Also quite strikingly, both the discretionary and committed central bankers in the Kydland-Prescott model share the same preferences as society as a whole. The model's success at explaining stagflation during die 1970s, therefore, points not to...