What type of inflation target?

• Author: White, Lawrence H.

For much of monetary history, inflation targeting was unnecessary. (1) There was no need to worry about constraining the central bank's inflationary proclivities because no central bank existed. The quantity of basic money was constrained by the mints' commitment to full-bodied gold and silver coinage (at least where the mint-owners lacked monopoly status or chose not to exploit that status through debasement). The quantity of bank-issued money was constrained by the commercial banks' commitment to gold- and silver-redeemability for banknotes and deposits. Together these commitments prevented excessive monetary expansion and thereby price inflation. (2) Today (since 1971) the commitments are gone, and a substitute is needed.

Constraining Central-Bank Discretion

Inflation targeting has been much discussed in recent years as a proposal for constraining the Federal Reserve's monetary policy-making. As proposed constaints on central banking go, it is relatively weak. Inflation targeting doesn't abolish the central bank, and--at least in the well-known version recommended by Bernanke et al. (1999)--doesn't even fasten a strict rule on it. In both the Bernanke version and in the versions actually practiced in other developed countries, the central bank authorizes inflation within a range of positive rates, typically 1 to 3 percent. At the midpoint rate of 2 percent, inflation is higher than experienced historically under commodity-standard regimes, and is too high to promote optimal money-holding. As David Laider (2006: 3) has recently pointed out, "A 2 percent inflation rate is a far cry from anyone's (or at least any retiree's) idea of price-level stability: this seemingly low rate in fact reduces the purchasing power of a fixed-money income at a noticeable pace ... over the duration of the current 'low inflation" regime [since 1991 Canada has had an inflation target of "under 2 percent" and an average inflation rate of 2 percent per year] the [Canadian] dollar has lost a quarter of its purchasing power."

But, to emphasize the half-full part of the glass, 2 percent inflation is better than 10 percent inflation, and a predictable 1 to 3 percent is better than an unpredictable 2 to 20 percent. Even if, in Bernanke's language, inflation targeting is a "framework" for "constrained discretion" rather than a rule, it is nonetheless a small step toward a rule for constraining the central bank, and constraining the central bank is a step toward the first-best regime of doing without a central bank. I would characterize Bernanke-style inflation targeting as an overly timid step in the right direction. My fear is not that inflation targeting will "tie the Fed's hands" too tightly, but that it will perpetuate our long-standing failure to tie them tightly enough.

Under the present discretionary regime, we don't know what monetary policy to expect. At his confirmation hearing, Ben Bernanke told the Senate Banking Committee: "With respect to monetary policy, I will make continuity with the policies and policy...