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August l , 1996 eCONOMIC COMMeNTORY Federal Reserve Bank of Cleveland Inflation Targets: The Next Step for Monetary Policy by Mark S. Sniderman L September 1995, Senator Connie further encouraging productive capital Mack (R-Fla.) introduced legislation that accumulation. Indeed, this impressive would require the Federal Reserve to inflation performance has been achieved provide a numerical definition of price despite an unemployment rate of 5.5 stability, to set a timetable for achieving percent-lower than current estimates it, and to subordinate other monetary pol- of the rate considered to be consistent icy objectives to it. The merits of these with maintaining stable prices (the non- provisions have been debated at length accelerating inflation rate of unemploy- by economists and policymakers alike. ment, or NAIRU). 1 Is this expansion an Some believe that a monetary policy aberration, or evidence of structural eco- based on price stability must compromise nomic change? It's too soon to know, of economic growth, while others note that course, but it is promising to see a long the differences between a price-level expansion without accelerating inflation objective and an inflation target go way in a low-unemployment environment. beyond semantics. I believe that the nation's economic prosperity will be enhanced by a price-stability approach to monetary policy regardless of how the objective is defined. I believe that the Federal Reserve has materially contributed to the longevity and strength of the expansion by pursuing a monetary policy focused on achieving price stability. If, as a nation, we I would like to preface my remarks on could find a means for institutionalizing this subject with a few comments about this type of policy, I think we would be national economic conditions. The pleased with the effects on our living expansion is entering its sixth year, mak- standards over time. ing it one of the longest upturns in the last half of this century. By almost all Material increases in a nation's standard accounts, this situation will continue for of Ii ving stem from increases in the qual- another year or two. ity and supply of labor, the quantity of capital that it works with, and changes in The expansion has been unusual in a few technology. The primary wealth driver in ways that I regard as being positive for our market economy is the market struc- the long term. Business investment has ture of the economy itself. Poor eco- been very strong, enhancing the prospect nomic policies (of all kinds) lead to that productivity growth will improve in resource rnisallocations and can inhibit the years ahead. Inflation has not accel-. economic growth. Poor monetary policy erated over the course of the expansion, can make resource-allocation decisions - Nations are increasingly turning to specific inflation targets as a way for their monetary authorities to achieve price stability. Although the United States has not yet adopted this approach, such a policy framework would enhance our economic performance. that appear sensible in the short run very price-level target or as an inflation-rate economists (known as "monetarists") costly to undo when accelerating infla- target? What price index should be used, established the feasibility of basing tion is eventually stopped and unwound. and what should be done about biases in monetary policy on the observed move- its measurement? ment of certain monetary aggregates, Sound monetary policy, by providing a only to see the stability of the underly- consistent value for dollar-based trans- These important questions deserve an- ing relationships collapse repeatedly actions, encourages long-range planning swers, but I want to approach the subject during the 1980s and 1990s. and leads to what economists call inter- from a less obvious direction. I think that temporal utility maximization: the high- some historical reflection can provide It is important to recognize that these est sustainable position of economic guidance: How did we get to this legisla- relationships have gone awry before. Breakdowns in historical relationships well-being over time. An environment tive juncture, and why should we believe of low or no inflation can enhance the that a legal mandate to achieve price sta- have sometimes led to changes in the functioning of our economy just as bility will yield desirable outcomes? definitions of particular monetary aggre- surely as would a consumption-based gates -changes that were specifically tax system with a broad base and low It is useful to recall that inflation is a per- designed to restore stability in these rela- marginal rates. sistent increase in the general level of tionships! The limitations of this frame- prices, not an occasional rise in the Con- • Textbook Economics work became apparent only with the sumer Price Index (CPO induced by tran- passage of time and poor results. We do not, however, usually experience sitory factors. The average price level the economic policies prescribed by our could be kept constant by regulating the • textbooks. Why don't we have optimal supply of money to always equal the Monetarism's failure to provide a reli- monetary, fiscal, and regulatory poli- public's demand for it when the economy able policy framework was unfortunate, cies? One reason, of course, is that many is operating at that price level. If we Ii ved if only because the reigning Keynesian policymakers and the general public do in a world where "money" meant only paradigm was also deficient. In the not have a grasp of basic economic prin- "central bank liabilities" and its demand orthodox Keynesian view, inflation is ciples. But this is probably less impor- were perfectly forecastable, price-level caused not by "too much money chas- tant than two other explanations. First, stability would be easy to accomplish, ing too few goods," but rather by "too Keynesian Economics textbook economic assumptions are because the central bank has nearly per- many jobs chasing too few people." rarely, if ever, satisfied in the real world. fect control over its own liabilities. In our Inflation control required aggregate- Second, economists disagree about how actual economy, where money includes demand management. Vintage Keyne- our economy actually works. What is the liabilities of both the central bank and sian policy of the 1960s and 1970s optimal economic policy to one may be private financial institutions, we need hinged on a known potential output' misguided opinion in the eyes of stability in the money multiplier (the re- path and a stable relationship between another. Although abstract economic lationship between central bank money unemployment and inflation (known as theorizing and professional disagree- and circulating, privately issued liabili- the Phillips curve). 2 The government ments are fine in academic debates, poli- ties) and in money demand (the amount decided which unemployment/inflation cymakers have to make decisions in real of money the public wants to hold under combination it wanted, and used both time. Despite being relatively insulated current economic conditions). Alas, we fiscal and monetary policies to control from political influence, central bankers have stability in neither. that no one fully understands. the demand for aggregate output. Monetary policy did its part by tightening still confront a less-than-ideal economy Over the last several decades, it has and easing credit conditions. become apparent that whatever stability • Central Bank Goals we thought existe~ in these relationships We learned two lessons about this framework from the sixties and seven- All of this leads us back to the topic of was the result of the regulations and price-level targeting and the legislation technology that determined the financial ties. First, the Phillips curve is not stable introduced by Senator Mack. A few instruments available to the public. Every in the normal sense of the term. Output obvious considerations confront those time innovation and deregulation swept and inflation do tend to move inversely who must take sides on this sort of issue. through the financial services industry, over short periods, but not predictably Should a central bank be asked to subor- new products became available, the rel- enough over the course of an entire busi- dinate other objectives to price stability? Should price stability be expressed as a ative prices of those products changed, ·and the public altered its holdings of ness cycle, and particularly not from cycle to cycle. This means that the financial assets. As a result, what came Phillips curve is simply not exploitable to be regarded as money changed. Using by policymakers. data from the 1950s and 1960s, some TABLEl INFLATION OBJECTIVES IN SELECTED COUNTRIES Country Price Index Australia Quantitative Objective3 Timespecific? Exemptions and Caveats CPI 2%-3 % average No: mediumterm Mortgage interest payments, government-controlled prices, and energy prices Canada CPI 1%-3% between 1995 and 1998 Yes Indirect taxes, food and energy prices (operational exemption) Finland CPI About2% from 1995 No Housing capital costs, indirect taxes, and government subsidies Israel CPI 8%-11 % for 1995 Yes: updated annually None New Zealand CPI 0%-2% Yes: updated annually Commodity prices, government-controlled prices, interest and credit charges Spain CPI Below 3% by 1997 Yes Mortgage interest payments Sweden CPI 2% ± 1% from 1995 No None United Kingdom RPIXb Lower half of 1%-4% range by spring 1997; 2Y2% or less thereafter No Mortgage interest payments a. For annual inflation. b. Retail Price Index. SOURCE: Andrew G. Haldane, ed., Introduction to Targeting Inflation, London: Bank of England, 1995, p. 8. Reprinted with permission. The output-cost argument against at- The second lesson is that estimates of from wherever it happens to be in equi- potential output, and therefore the "out- librium, the contemporary Keynesian tempts to continue on a disinflationary put gap," are subject to significant perspective stipulates that they will still path begs the following question. If the errors. 3 Moreover, when the actual rate need to create a gap between actual and NAIRU model and these cost estimates of unemployment is considered high in potential output and drive the actual are correct, why would policymakers absolute terms, the output gap tends to unemployment rate above the NAlRU not want to raise the equilibrium infla- value for some period. tion rate from 5 percent to 7 percent? be regarded as large. Judgments of this After all, the neo-Keynesian framework sort seem especially prevalent during election years. Conventional estimates suggest that implies that the public would reap the each percentage-point reduction in infla- benefits of an output surge and bear The Keynesian legacy lives on, but in a tion requires a 2 or 2.5 percentage-point only a trivial cost. And why stop at 7 more sophisticated form. Expectations increase in unemployment for a year. percent? This logic brings us right back now play an important role, as well they For example, when inflation and infla- to the failure of the original Phillips- should. In the long run, the inflation rate tion expectations coincide at 5 percent, curve framework. is independent of the unemployment the output cost of moving to 3 percent rate, and inflation is, once again, would typically be gauged at 4 to 5 per- regarded as a monetary phenomenon.4 centage points of extra unemployment the important benefits of price stability. Today, policymakers are no longer annually-enough to question the effi- The Phillips-curve framework itself thought capable of selecting whatever cacy of initiating such a policy. The ben- offers nothing to tie down the inflation combination of unemployment and efits of lower inflation are commonly trend or anchor inflation expectations.5 It brings to mind an old song: "If you can' t be with the one (inflation rate) you love, ... Jove the one you're with." I believe there are significant benefits to be realized from lowering inflation and making it more predictable. Granted, inflation they want. Any inflation rate regarded as trivial. And yet, in the can be sustained indefinitely, as Jong as United States we have reduced the equi- an equilibrium condition is met: People librium inflation rate along this path dur- must expect that rate to continue. If poli- ing the last decade without, I believe, cymakers want to lower the inflation 'rate incurring exorbitant output costs. The missing link is the. failure to stress these benefits have proven difficult to regarded as a statement that neither It is apparent from examining these var- evaluate, because few periods in the intermediate monetary-aggregate tar- ious inflation-targeting systems that post-gold standard era have been geting, exchange-rate targeting, nor nations are wrestling vyith a perceived marked by inflation sustained in equi- aggregate-demand management poli- trade-off between flexibility and credi- librium and at different rates. However, cies provided a sufficient framework bility. Price-level targets with a narrow logic and historical experience con- for monetary policy. But it meant more tolerance limit and no exceptions for vince me that benefits do exist. Be- than that. It demonstrated that these special factors would be the most con- tween 1953 and 1965, for example, real nations desired a credible nominal straining and arguably would produce economic growth averaged slightly anchor for the purchasing power of the greatest credibility. At the same more than 3 percent per year, while their currencies and were willing to time, the constraints could lead the cen- inflation averaged less than 2 percent. stake their prestige on explicit public tral bank to force the real economy to Remember, it took a while for physi- inflation targets to get it. The goals are adjust so abruptly to an unanticipated cists to find those quarks, but they highly ambitious: With the exception of event that the public would disapprove. turned out to be there, too. Israel, the targets center around 2 per- A very flexible system based on infla- cent per year (see table 1). tion rates and allowing for various disturbances, by contrast, would permit • Inflation Targets It's ironic that America's success in Does inflation targeting represent the greater output smoothing at the cost of reducing inflation from 5 percent to 3 grasp of the obvious or the clutch of less certainty about the price level itself percent may inhibit us from doing better, while the failure of some other the desperate? It is far too early to tell. five to 10 years hence. nations to produce low inflation has ence, and that amounts to just over five New Zealand has had the most experiIt seems that by choosing inflation-rate induced them to take stronger steps to years. I can well imagine that these targets, these nations fear the conse- tie their monetary authorities to the nations recognize the fragility of their quences of returning to a prespecified price stability mast. The countries that situations. After all, they are aware of price level after being forced away by have adopted inflation targets-Aus- the high hopes that previous central unexpected events. However, their tralia, Canada, Finland, Israel, Mexico, bankers had for the various frame- annual inflation-rate targets, generally New Zealand, Spain, Sweden, and the 2 percent or smaller, are so low that United Kingdom-generally did so works that preceded this one. Some of these approaches, like the use of inter- because they had failed to achieve low mediate monetary targets, died a quiet or even moderate inflation through busi- death; others, like the European Com- ness as usual (Australia's target is self- munity's exchange-rate mechanism, irnposed by the central bank, whereas died violently. the others stem from legislation). 6 price-level drift should be minimal over time, particularly after taking priceindex measurement biases into account. 7 It seems clear, however, that these nations wisely do not regard their inflation-targeting systems as a Anticipating potential problems, policy- panacea. They have witnessed other The basic idea of inflation targeting is makers generally build certain flexibili- frameworks crack and collapse under that the monetary authority is precommitted to achieve a specified inflation ties into inflation-targeting regimes. stress. What these countries seem to Many nations adopt a price index that desire above all else is a policy process objective. The central bank bases its not only excludes such volatile compo- based on a goal that their monetary policy actions on predicted deviations nents as energy and food prices, but also authorities can actually deliver over between actual inflation and this pre- eliminates indirect government taxes time-price stability-conducted with as much openness as possible regarding specified target. The public, knowing and mortgage interest payments. In the objective (and in some instances New Zealand, attempts are made to how the central bank will respond to receiving the central bank's inflation evolving economic conditions. forecasts), can anticipate policy actions. eliminate price-level movements due to supply shocks. The rationale is that sup- For some of these nations, inflation tar- out altering the underlying inflation geting came as part of a package be- rate, and the central bank is not to be stowing greater independence on the held responsible for such supply shocks. ply shocks can shift the price level with- central bank from the rest of govern- One also supposes that supply shocks ment. Direct inflation targeting was are expected to be both positive and negative over time, so that the price level itself will not drift away from its intended long-run path as a result of such shocks alone. • Conclusion It may be another 10 years or more before we have enough data to begin scientifically evaluating the performance of these systems. By what standards shall we judge the success of this experiment? Do nations that adopt inflation targets get any interest-rate benefit in the form of a lower inflation or inflation uncertainty premium? Does the • Footnotes 1. See Douglas Staiger, James Stock, and Mark Watson, "How Precise Are Estimates of the Natural Rate of Unemployment?" National Bureau of Economic Research, Working Paper No. 5477, March 1996. The author estimates NAIRU's current value at 6.1 percent. They also acknowledge that due to the difficulty of obtaining precise measurements, the actual figure may lie anywhere between 4.6 and 6.9 percent. NAIRU is also known as the natural rate of unemployment. greater transparency with which monetary policy is conducted enable the real economy to adjust more efficiently to unexpected macroeconomic events and 2. The Phillips curve postulates a trade-off between unemployment and inflation: Lower rates of unemployment are possible only with higher rates of inflation. signals about inflationary pressures? What kinds of shocks will the public allow its central bank to deflect away from the price level, and which others can be absorbed into it? Answers to these questions may differ from country 3. The output gap refers to the difference between actual and potential output. The Keynesian approach contends that a negative gap (where actual output exceeds potential output) would have inflationary consequences. - M ark S. Sniderman is senior vice president and director of research at the Federal Reserve Bank of Cleveland. This Economic Commentary was excerpted from a speech he presented to the Pennsylvania Economics Association in Pittsburgh on May 31, 1996. The views stated herein are those of the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Economic Commentary is now available electronically through the Cleveland Fed's home page on the World Wide Web: http://www.clev.frb.org. to country. I don't know whether the United States ever will be included in studies of inflation targeting. Our most recent monetary policy experiences have been sufficiently promising to prompt many observers 4. In technical language, the long-run Phillips curve is vertical at NAIRU. 5. Remember that under this framework, any inflation rate is sustainable in equilibrium as long as the public expects that rate to continue indefinitely. to say "if it ain't broke, don't fix it." This prescription has some appeal, but it may be a sign of complacency. As 6. For a very readable and useful survey of current practices among these countries, see Andrew G. Haldane, ed. , Targeting Inflation, London: Bank of England, 1995. economists, we know that our current policy framework is inadequate because we have no way of anchoring the purchasing power of the dollar. Inflationtargeting systems are worth our time and attention precisely for that reason. Providing an anchor is a more modest policy objective for a central bank than keeping the economy at full employment, but experience reminds us that it is the more realistic goal. 7. For a more detailed discussion of the upward biases that may occur in measuring price changes (especially in the CPI), see Michael F. Bryan and Jagadeesh Gokhale, "The Consumer Price Index and National Saving," Federal Reserve Bank of Cleveland, Economic Commentary, October 15, 1995. I 1996 Working Papers Now Available Electronically Current Working Papers of the Cleveland Federal Reserve Bank are now available electronically through the Cleveland Fed's home page on the World Wide Web: http://www.clev.frb.org. Single copies of individual papers can be ordered by contacting the Bank's Research Department, P.O. Box 6387, Cleveland, Ohio 44101. If you prefer to fax your order, the number is (216) 579-3050 . • 9601 Dynamic Commitment and Imperfect Policy Rules by Joseph G. Haubrich and Joseph A. Ritter • 9602 Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis by Charles T. Carlstrom and Timothy S. Fuerst Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, OH 44101 Address Correction Requested: Please send corrected mailing label to the above address. Material may be reprinted provided that the source is credited. Please send copies of reprinted materials to the editor. • 9603 Demographic Change, Generational Accounts, and National Saving in the United States by Jagadeesh Gokhale • 9605 Endogenous Money Supply and the Business Cycle by William T. Gavin and Finn E. Kydland • 9604 Bank Deposit Rate Clustering: Theory and Empirical Evidence by Charles Kahn, George Pennacchi, and Ben Sopranzetti BULK RATE U.S. Postage Paid Cleveland, OH Permit No. 385