The case for inflation targeting.

• Author: Hetzel, Robert L.

Is inflation targeting suitable for the United States? Given that the Federal Reserve has not announced an explicit inflation target, how does one answer that question? If the answer is that inflation targeting is not suitable for the United States, what follows? Does the central bank not control inflation? Alternatively, if the central bank does control inflation, is there no need in a democracy for the central bank to make public its intentions with respect to inflation?

Some members of the Federal Open Market Committee (FOMC) who have opposed an explicit inflation target have also answered the question of whether the central bank controls inflation in the affirmative. So there is something too simplistic about the follow-up question about central bank accountability. Surely, there is something more to the opposition than a desire to avoid accountability. Laurence Meyer (2001: 12), when a Federal Reserve governor, explained the complication as follows:

The most important question that has to be addressed in order to assess the costs and benefits of a move in this direction [announcement of an explicit numerical inflation target] is whether it could be accomplished without reducing the flexibility the Fed now has to pursue a dual mandate. The Fed's Dual Mandate

What is the dual mandate? The Federal Reserve Act instructs the Fed "to promote effectively the goals of maximum employment [and] stable prices." However, the language is vacuous. "Maximum employment" suggests a target of 100 percent labor force participation. Even if one substituted a phrase like "full employment" for "maximum employment," the mandate would still be vacuous because it lacks an assumption about whether a tradeoff exists between the two goals. In fact, Congress has simply delegated responsibility to the Fed for deciding the U.S. monetary standard. The question then arises whether the Fed has a responsibility to articulate the nature of the monetary standard it has constructed.

So far, this line of inquiry has done nothing to elucidate the concerns that have prevented the Fed from adopting an explicit inflation target. It is more fruitful to rephrase the initial questions and to examine what answers FOMC members have given to them. First, does the FOMC control inflation? Second, how does the dual mandate constrain the way that the FOMC implements monetary policy? Answers to these questions depend upon the theoretical assumptions used.

Does the Fed Control Inflation?

A policymaker who believes that inflation is a "nonmonetary phenomenon" is predisposed against an explicit inflation target. By this characterization of inflation, I mean the belief that monetary policy actions are just one influence on trend inflation. The Fed can exercise complete control over inflation, but the social cost in terms of unemployment depends upon whether the nonmonetary factors affecting inflation are virulent or benign. Former FOMC Chairman Arthur Burns (1979) contended that the inflation of the 1970s emerged because the politically acceptable unemployment rate was too low to offset the inflationary impact of powerful nonmonetary forces.

Burns' student, former FOMC Chairman Alan Greenspan, also understood inflation as a nonmonetary phenomenon. He explained the near-price stability at the end of his tenure through the fortuitously felicitous occurrence of benign nonmonetary factors affecting inflation. Greenspan (2004: 33) wrote:

I am increasingly of the view that, at a minimum, monetary policy in the last two decades has been operating in an environment particularly conducive to the pursuit of price stability. The principal features of this environment included (i) increased political support for stable prices ..., (ii) globalization, which unleashed powerful new forces of competition, and (iii) an acceleration of productivity, which at least for a time held down cost pressures. Similarly, Kohn (2005: 340) wrote:

The level and stability of core PCE inflation since 1997 are as much a consequence of unexpected developments as of deliberate policy choices. Importantly, the speedup in productivity growth ... seemed to have greater disinflationary force than anticipated; the broad-based strength of the dollar and the weakness in global commodity prices that...