Academic journal article Federal Reserve Bank of St. Louis Review

Price Level Uncertainty and Inflation Targeting

Academic journal article Federal Reserve Bank of St. Louis Review

Price Level Uncertainty and Inflation Targeting

Article excerpt

International discussions of monetary policy today often are focused on inflation targeting. At least eight central banks around the world have now adopted explicit targets for inflation. In all of these cases, the central bank has a flexible policy process that focuses on inflation but also cares about other variables, such as employment, output growth, and the behavior of a short-run policy guide such as the federal funds rate or an exchange rate.(1) Even among countries that do not have explicit inflation targets, their policy behavior has been portrayed as if they have inflation targets. Taylor (1993) explains how U.S. monetary policy can be characterized as a rule for targeting inflation. In this rule, the Federal Reserve systematically adjusts the federal funds rate in response to deviations of output from potential and inflation from an implicit target.

One of the perceived advantages of inflation targeting is that a long-run price stability goal may be pursued in combination with other short-run objectives, usually for real output. There is some confusion about this point in the literature. In a chapter titled "The Rationale for Inflation Targeting," Bernanke et al. (1999) argue:

... the increased emphasis on controlling inflation arises not because unemployment and related problems have become less urgent concerns, but because economists and policy-makers are considerably less confident today than they were thirty years ago that monetary policy can be used effectively to moderate short-run fluctuations in the economy, (page 10).

Later in the same chapter, they clearly define inflation targeting to be a framework with multiple short-run objectives:

If inflation targeting were to be treated as a policy rule in the classical sense (which, again, we do not think it should be), it would indeed be open to some serious criticisms. First, the idea that monetary policy literally has no goals other than to control inflation would find little support from the public, from central bankers, or from monetary economists. Second, given that governments and central banks do care about production, employment, exchange rates, and other variables besides inflation, treating inflation targeting as an ironclad policy rule could lead to very poor economic outcomes.

As the two quotes suggest, inflation targeting is appealing to those who think that having a target for inflation focuses policymakers' attention on the inflation objective as well as those who want rule-like policy, but still believe that the central bank can achieve multiple objectives. In this paper we examine inflation-targeting regimes to see how having multiple objectives affects uncertainty about future price levels.

We make two points about commonly proposed rules for inflation targeting. First, we argue that there is a great deal of uncertainty about the price level and inflation inherent in current proposals to target inflation. We show that the degree to which the central bank cares about the real economy can have a large impact on price-level (and inflation) uncertainty. Indeed, we find that [TABULAR DATA FOR TABLE 1 OMITTED] the magnitudes of uncertainty that prevailed across the G-10 countries throughout the last four decades are the expected consequence of commonly proposed inflation-targeting regimes. Second, we show that if central banks want both to stabilize business cycle fluctuations and to achieve price stability, then it may be useful to adopt a long-term objective for the price level. A long-run price-level objective can be implemented in a way that represents a minor change in the way central banks currently implement policies oriented around inflation objectives. Yet, this minor change in the central bank's decision-making process has the potential to deliver price stability.

In this paper, we deliberately chose a model from the inflation-targeting literature that implies a tradeoff between output and inflation variability. …

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