THE FED MUST ADOPT AN INFLATION TARGET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

The Fed must adopt an inflation target


By Frederic Mishkin

Published: October 24 2010 19:35

Ben Bernanke, the Federal Reserve chairman, discussed his institution’s inflation mandate in a recent speech, leading to speculation a numerical inflation target is under consideration inside America’s central bank. And if there ever was a time to establish such a transparent and credible commitment to a specific target, it is now.


The Fed has a dual mandate, to achieve price stability and maximum sustainable employment. But at the moment it is missing both objectives. Inflation is well below 2 per cent. A sluggish economy means unemployment is likely only to decline slowly from its current level of about 10 per cent. This combination of economic slack and low inflation raises the possibility that inflation expectations will drift downwards.


Meanwhile, to stimulate the economy, the Fed has signalled that it is likely to restart its policy of quantitative easing, with a programme of large-scale purchases of long-term US Treasury securities. This signal has already led to concerns in the markets that the Fed may be too soft on inflation in the future, which could see inflation expectations rise.


By establishing an inflation objective at this juncture the Fed can guard against both of these problems. Providing a firm anchor for long-run inflation expectations would make the threat of deflation less likely. But a firm anchor would also give the Fed flexibility to respond to the weakness of the economy – because it would help ensure that any new moves to quantitative easing would not be misinterpreted as signalling a shift in the central bank’s long-run inflation goal, making an upward surge in inflation expectations less likely too.


The Fed can establish a strong nominal anchor through two straightforward steps. First, the federal open market committee could come to a consensus on the specific numerical value that Mr Bernanke referred to as the “mandate-consistent inflation rate” in his recent speech. This should not be too difficult, because the Fed’s longer-run inflation projections indicate FOMC members already think this rate should be about 2 per cent, or a bit below. Second, the FOMC should announce that this rate would only be modified for sound economic reasons, such as improvements in the measurement of inflation or changes in the structure of the economy.


Some commentators have worried that establishing an inflation objective will soon lead to an overemphasis on controlling inflation, and not enough concern about stabilising real economic activity. Agreeing on a mandate-consistent rate is, however, consistent with the Fed’s dual mandate. Indeed the use of the term “mandate consistent” indicates that it should not be misinterpreted as a commitment to control inflation within too tight a range over too short a time horizon. Also, by allowing the rate to be adjusted if sound economic reasoning supports it, the Fed would not be locked in to an inappropriate goal.


A final concern is that these two steps would not provide a sufficient degree of commitment to the target itself. But by stating its intention not to modify the rate without a clear technical rationale, the FOMC would provide a firm nominal anchor that would not differ much in practice from some alternative commitment to a specific numerical inflation objective. When the Supreme Court in the US makes a decision, the reasoning behind it then serves as a precedent that guides all subsequent legal considerations in the same area. The approach that I recommend for monetary policy would operate in a roughly similar way. Because the consensus on the mandate-consistent inflation rate would be transparent, the FOMC would not be inclined to modify that value except for sound economic reasons; hence, this proposal would be sufficient to provide a firm anchor for long-run inflation expectations.


By adopting an explicit numerical inflation objective at this juncture along the lines I have suggested, the Fed would improve economic outcomes by anchoring inflation expectations more firmly while allowing sufficient flexibility to ensure that monetary policy can not only pursue the goal of price stability, but the goal of maximum sustainable employment as well. The Fed and its chairman should move quickly to introduce one.


Frederic S. Mishkin is a professor of finance and economics at Columbia University, a former member (governor) of the Board of Governors of the Federal Reserve System, and the author of the forthcoming book Macroecomics: Policy and Practice


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