Inflation Targeting in the United States?

Inflation Targeting in the United States? Marvin Goodfriend Federal Reserve Bank of Richmond

Overview • Introduction • The Case for Price Stability--Go/Stop, the Volcker disinflation, the Greenspan era • A Priority for Low Long Run Inflation? • Inflation Targeting in the Short Run • How to Make Inflation Targeting Explicit in the US

Introduction • Can monetary policy as currently practiced by the Fed be characterized as inflation targeting? • What features of inflation targeting should the Fed adopt formally?

Introduction (2) • Explicit inflation targeting is characterized by the announcement of an official target for the inflation rate--- • an acknowledgment that low inflation is a priority for monetary policy • enhanced transparency of procedures and objectives of monetary policy • accountability for attaining objectives

Introduction (3) • The paper argues that much of the improved performance of the US economy in the past two decades is due to inflation targeting procedures that the Fed has adopted gradually and implicitly • The historical record suggests that some form of inflation targeting should remain at the core of Fed monetary policy indefinitely

Origins of the Case for Price Stability • Go/Stop Policy--Fed justified periodic inflation-fighting actions against implicit low unemployment objective • Inflation became a concern only when it clearly moved above previous trend • Pricing decisions already embodied higher inflation expectations • Fed “needed a recession” to fight inflation

Volcker Disinflation: 1979-87 • Breakdown of mutual understanding between the Fed and the public • Unclear inflation, unemployment objectives • Unpredictable inflation expectations • Real interest rates difficult to manage • Opportunity for policy mistakes enlarged • Price stability must be core of mutual understanding

Volcker Disinflation (2) • Loss of flexibility to use interest rate policy to stabilize output relative to potential • When Fed needs an output gap to stabilize inflation and inflation expectations it cannot also use interest rate policy to narrow the output gap • Example: failed disinflation in 1980

Volcker Disinflation (3) • Restoring credibility for low inflation is costly • Fed maintained 9 percent real short-term interest rates during the 1981-82 recession in which unemployment rose to 10 percent • 30-yr bond rate rose 3 percentage points to 14 percent from Jan to Oct 1981, and remained there until the summer of 1982

Volcker Disinflation (4) • The Inflation Scare Problem • Credibility problems show up as sharply rising bond rates reflecting rising long-term inflation expectations • Inflation scares present the Fed with a costly dilemma • Four inflation scares in Volcker years: 1980, 1981, 1983-84, and 1987

Greenspan Era: 1987-Present • Difficulty reversing a minor loss of credibility for low inflation • 1987 inflation scare and policy easing following the Oct market crash--minor loss of credibility for low inflation • PCE inflation up 2 percentage points from 3 percent in 1986 to 5 1/2 percent in 1990 • 30-yr bond rate rose 2 percentage points to 9 percent range March to Oct 1987

Greenspan Era (2) • Fed raised real short rates to around 5 percent from spring of 1988 to 1989 • Gradually cut real funds rate following the 1990-91 Gulf War recession to zero by mid-1992, even as unemployment rate peaked at nearly 8 percent in June 1992 • Bond rate returned to the 7 percent range of 1987 by mid-1992, inflation to 3 percent

Greenspan Era (3) • Preemptive interest rate policy • 1994 preemptive policy actions held line on inflation without creating unemployment • Like Volcker Fed’s 1983-84 preemptive policy actions • Well-timed preemptive interest rate policy actions nothing to be feared • Death of inflation

Greenspan Era (4) • Benefits of full credibility for low inflation • Credibility helped economy operate well beyond levels that might have created inflation and inflation scares in the past • When in 1999 and 2000 the Fed set out to slow the growth of demand to a sustainable rate, it used less real rate restraint than in the past

Greenspan Era (5) • The Fed did not need to restore credibility for low inflation after it had been compromised--it did not need a recession • When the boom turned to bust, the Fed could cut real short rates by nearly 5 percentage points without an inflation scare • Since the Fed did not need a recession in 2001, it had the flexibility to cut real short rates aggressively to try to prevent one

Implicit Inflation Targeting Practiced by the Greenspan Fed • Chairman Greenspan testified in 1989 in favor of a qualitative zero inflation objective for the Fed • Greenspan Fed pursued flexible inflation targeting: restored minor loss of credibility for low inflation gradually between 1987 and 1992, and established virtual price stability by holding the line on inflation in 1994

Implicit Inflation Targeting (2) • Annual core PCE inflation has stayed in the 1 to 2 percent range since the mid-1990s • It is difficult to imagine circumstances that would cause the Greenspan Fed to allow core PCE inflation to move above 2 percent or below 1 percent on a sustained basis • The Greenspan Fed practices inflation targeting in large part as constrained countercyclical stabilization policy

Should Low Long Run Inflation be a Priority? • Main supporting arguments: • Evidence suggests that price stability enhances macroeconomic performance • Ambiguous priority for price stability in conjunction with instrument transparency increases risk of inflation scares

Low Inflation Priority (2) • Counterarguments: • A priority for low long run inflation might make the Fed reluctant to use interest rate policy to stabilize output relative to its potential in the short run • But credible low inflation improves countercyclical stabilization policy

Low Inflation Priority (3) • No need to formalize a priority for low inflation, Fed achieved price stability by “just doing it” • An explicit priority for low long run inflation, legislative or unilateral, would be awkward, inappropriate, and potentially counterproductive • Continue “don’t ask, don’t tell” equilibrium

A Quantitative Target for Low Long Run Inflation • Good candidate measure of inflation: core PCE inflation index • Fed uses a quantitative measure of price stability for internal simulations • Internal quantitative measure of price stability could serve as official target • Explicit lower bound would help act against deflation scares--upper bound for symmetry

Quantitative Long Run Target (2) • A quantitative range as opposed to point target would provide a useful “safe harbor” • A 1 to 2 percent range for core PCE inflation monthly over 12 or 24 months would serve well as a long run inflation target

Inflation Targeting in the Short Run • It is optimal to vary the short run inflation target deliberately in response to shocks in some macromodels • Optimal variation depends sensitively on the details of the macromodel • Difficult to manage departures of inflation from long run target in practice

Short Run (2) • Fed ability to manipulate inflation and inflation expectations in short run is limited--opens door to inflation scares • “Fine tuning” the inflation rate in the short run is likely to be counterproductive • Presumption must be that it is inadvisable for Fed to attempt to vary short run inflation target over time

Short Run (3) • Theory and evidence suggest that it is ordinarily feasible to preclude departures of inflation from the long run target • Low inflation is self-enforcing to a large extent if firms confident that Fed will take actions promptly to conform output to its potential; but Fed must follow through

Short Run (4) • Evidence from the mid-1990s suggests that inflation will remain stable over the business cycle when the Fed makes price stability a priority • Likely to take an exceptional event to destabilize inflation when Fed purposefully pursues price stability • If inflation is destabilized, Fed should return inflation flexibly to the target range

Short Run (5) • Stabilizing output at its potential over the business cycle is consistent with targeting a constant low inflation rate in a benchmark “new neoclassical synthesis” macromodel with sticky prices and effectively flexible wages • From that perspective, even those who care mainly about output and employment can support strict inflation targeting

Short Run (6) • Nominal wages exhibit about the same degree of temporary rigidity as prices • 1 to 2 percent inflation target and 2 percent productivity growth imply trend nominal wage growth of 3 to 4 percent per year--a cushion against downward wage stickiness • Wages flexible ex post in context of long term employment relationships

Making Inflation Targeting Explicit in the US • Low long run inflation is a priority for the Fed: there are no circumstances in which sustained inflation should ever be much higher or lower than it is today • A public acknowledgment by the Fed of this implicit priority would be a useful starting point for making inflation targeting explicit

Making Inflation Targeting Explicit (2) • Since the priority for low long run inflation reflects “best practice” monetary policy, the Fed can and should assert that priority on its own initiative • Acknowledging that priority would open the door for Congress to recognize, accept, and hold the Fed accountable for low long run inflation

Making Inflation Targeting Explicit (3) • It is not feasible to hold the Fed accountable for output or employment objectives because in the long run these are determined independently of monetary policy • This implies a “chicken and egg problem”--

Making Inflation Targeting Explicit (4) • Without a mechanism to assess the Fed’s short run policy reasoning more fully, Congress is reluctant to recognize a priority for low long run inflation • Without an assurance that Congress accepts a priority for low long run inflation, the Fed is reluctant to be more transparent about how it balances the risks to inflation and output in the short run

Making Inflation Targeting Explicit (5) • A proposal: in exchange for the congressional acceptance of a priority for low long run inflation, the Fed could participate in a monetary policy forum in which representatives of the FOMC would subject its current assessment of the economy and thinking about recent policy actions to questions from invited academic and business economists

Making Inflation Targeting Explicit (6) • The discussion would be disciplined by a congressional directive to use monetary policy to stabilize output at its potential subject to inflation remaining in or near its long run target range • The forum could be held twice a year, a couple of weeks before the Fed’s regular monetary policy reports to Congress

Making Inflation Targeting Explicit (7) • The forum proceedings should be televised • The participants should be chosen to reflect the full range of views on whether monetary policy is too easy, just right, or too tight • The forum would enable the Fed to build understanding for its own policy position by addressing comments and questions from a variety of perspectives

Making Inflation Targeting Explicit (8) • The forum would help the Fed to acquire a range of professional advice and council • The forum would improve the transparency of monetary policy, and help inform and educate Congress, the press, markets, and the public about how inflation targeting optimizes the economy’s performance

Inflation Targeting in the United States?