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August l , 1996

Federal Reserve Bank of Cleveland

Inflation Targets: The Next Step
for Monetary Policy
by Mark S. Sniderman


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

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








Exemptions and Caveats


2%-3 %

No: mediumterm

Mortgage interest payments, government-controlled prices,
and energy prices



1%-3% between
1995 and 1998


Indirect taxes, food and energy prices (operational exemption)



from 1995


Housing capital costs, indirect taxes, and government subsidies



8%-11 %
for 1995

Yes: updated





Yes: updated

Commodity prices, government-controlled prices, interest
and credit charges



Below 3% by 1997


Mortgage interest payments



2% ± 1% from 1995





Lower half of
1%-4% range by
spring 1997; 2Y2%
or less thereafter


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.



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



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


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

Economic Commentary is now available
electronically through the Cleveland Fed's
home page on the World Wide Web:

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.


1996 Working Papers Now Available Electronically
Current Working Papers of the Cleveland Federal Reserve Bank are now available electronically through the Cleveland
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contacting the Bank's Research Department, P.O. Box 6387, Cleveland, Ohio 44101. If you prefer to fax your order, the
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Dynamic Commitment
and Imperfect Policy Rules
by Joseph G. Haubrich and
Joseph A. Ritter
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
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Cleveland, OH 44101
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Demographic Change,
Generational Accounts,
and National Saving in the
United States
by Jagadeesh Gokhale

Endogenous Money Supply
and the Business Cycle
by William T. Gavin and
Finn E. Kydland

Bank Deposit Rate Clustering:
Theory and Empirical Evidence
by Charles Kahn,
George Pennacchi, and
Ben Sopranzetti

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