Panel Discussion: Inflation Targeting

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Inflation Targeting

Ben S. Bernanke

Should the Federal Reserve announce a quantitative inflation objective? Those opposed to the idea have noted, correctly, that the Fed has built strong credibility as an inflation-fighter without taking that step and that this credibility has allowed the Fed to be relatively flexible in responding to short-run disturbances to output and employment without destabilizing inflation expectations. So, the opponents argue, why reduce this flexibility unnecessarily by announcing an explicit target for inflation?

It would be foolish to deny that the Fed has been quite successful on the whole over the past two decades. Whether the U.S. central bank would have been even more successful, had it announced an explicit objective for inflation at some point, is impossible to say. We just don't know. We can't rerun history; and although empirical cross-country comparisons can be useful, they are far from being controlled experiments.

However, the relevant question at this point is not the unknowable outcome of the historical counterfactual but whether, given the initial conditions we face today, the adoption of an explicit inflation objective might not improve U.S. monetary policy in the future. The Fed's environment today is different from that of the 1980s and 1990s in at least one important respect: Price stability is no longer just over the horizon, but has been achieved-core inflation rates are currently not much above 1 percent. Thus, in contrast to the experience of the past 35 years or so, in which there could be little doubt about the Fed's desired direction for inflation, today the risks to inflation are more nearly symmetrical; that is, inflation can be too low as well as too high.

A case can be made, I believe, that when the economy is operating in the region of price stability, public expectations and beliefs about the central bank's plans and objectives, always important, become even more so. First, because the public can no longer safely assume that the central bank prefers lower to higher inflation, expectations about future policy actions and future inflation may become highly sensitive to what the public perceives to be the Fed's "just right" level of inflation. Uncertainty about this "just right" level of inflation thus may translate, in turn, into broader economic and financial uncertainty. Second, at very low inflation rates, the zero lower bound on the policy interest rate is more likely to become relevant, which increases the potential importance of effective expectations management by monetary policymakers. For example, when interest rates are very low, the best way to ease policy may be to explain to the public that the current low interest rate will be maintained for a longer period, rather than simply lowering the current rate. It seems to me that the enhanced importance of public beliefs and expectations about monetary policy in the region of price stability argues for greater attention by the central bank to its methods of communication when inflation is low.

On the premise that effective communication is even more crucial near price stability, I will focus today on how an incremental move toward inflation targeting, in the form of the announcement of a longrun inflation objective, might help the Fed communicate better and perhaps improve policy decisions as well, without the costs feared by those concerned about a potential loss of flexibility. As usual, my views are not to be attributed to my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee.

As a preliminary, I need to introduce the idea of the optimal long-run inflation rate, or OLIR for short. (Suggestions for a catchier name are welcome.) The OLIR is the long-run (or steady-state) inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives.

Note that the OLIR is the relevant concept for dual-mandate central banks, like the Federal Reserve. …