- The Washington Times - Monday, October 31, 2005

During his years as a Federal Reserve governor, Fed chairman-designate Ben Bernanke’s views were pretty much in agreement with those of Chairman Alan Greenspan. But on one issue they disagreed — whether the Fed should adopt a policy of inflation targeting. Mr. Bernanke favored targeting, Mr. Greenspan did not.

With targeting, the Fed would announce an explicit medium-term goal for inflation, either a single number or a range, such as a 1 to 2 percent annual increase in the core personal consumption expenditure price index, for the next two years. (The target would be set above zero to allow for possible upward bias in the price data and to have a cushion to protect against unexpected deflation.)

Mr. Greenspan has said that such a policy would be constraining, arguing that “a specific numerical inflation target would represent an unhelpful and false precision.”

In 1999, during his professorial years, Mr. Bernanke co-authored a book on inflation targeting. Later that year, in response to a critical review of their book in Foreign Affairs, he and his co-authors took the Fed to task for not adopting inflation targeting, saying that the Fed’s “just trust us approach may work in a period when the chair and the Board of Governors command widespread support and confidence. But the happy state of affairs will not last forever. It is more sensible, and more democratic, to begin to act now to depersonalize monetary policy.”

At the 2002 congressional hearing on his nomination to the Federal Reserve Board, Mr. Bernanke stated that a flexible numerical inflation goal would improve monetary policy and “would not represent a major departure from the current practice of U.S. monetary policy or a change in policy objectives.”

Just how much of a departure would it be, and what are the arguments pro and con?

Proponents of targeting point to the Fed’s increased transparency and openness during Mr. Greenspan’s tenure and argue that a declared quantitative inflation goal is a logical extension of this trend. It would better inform and calm markets, help anchor inflation expectations, promote stable economic growth and low inflation, and make life easier for the Fed. A medium-term numerical target, proponents claim, need not restrict the Fed’s short-run flexibility to adjust the federal funds rate up or down over the course of the business cycle or in response to shocks to the economy. With targeting, it would be possible to improve both inflation and employment outcomes.

Further, proponents argue, explicit targets would increase the Fed’s anti-inflation credibility with the public and Congress, which would ease political pressures for expansionary monetary policies. Accountability would be enhanced. If the Fed missed its target, it would have to explain why. Targeting would also help institutionalize monetary policy and limit the discretion of future Fed appointees who might not be as qualified as current Board members. Moreover, the central banks of many countries, including Canada, the United Kingdom and Australia, use inflation targeting and the evidence thus far is that it has served them well.

Opponents of targeting fear that a fixed rule would tie the Fed’s hands by limiting its flexibility to respond to unexpected events. Knowledgeable policymakers who understand the workings of the economy, they say, don’t need mechanical guidelines. Also, setting an inflation target but not an employment goal would invite criticism that the Fed favors low inflation over job creation, which could lead to congressional action constraining Fed policymaking. Disagreements would be bound to arise in Congress and the executive branch about the best inflation target, thereby confusing the public, destabilizing markets and risking attempts to legislate both inflation and employment targets. Opponents point out that the experience of other countries that use inflation targeting is inconclusive since there’s no way of knowing what would have happened in the absence of targeting.

In reality, the difference between foreign central banks that announce inflation targets and current Fed policy is more shadow than substance. Recent and ongoing improvements in transparency, such as extending its publicized semi-annual economic forecasts, including core inflation, from one to two years, has in effect nudged the Fed into de-facto inflation targeting. Indeed, operationally there is not much difference between the current practice of announcing a numerical range for Fed policymakers’ one- and two-year forecasts of core inflation and Mr. Bernanke’s formal inflation targeting.

In forecasting inflation, the Fed takes into account the estimated effect of its own policy actions on future prices. A discrepancy between the Fed’s inflation forecast and an inflation target would amount to a measure, and an admission, of the Fed’s inability to meet its stated inflation goal. If the Fed at some time in the future decides to adopt formal inflation targeting, in terms of implementation it will only be a baby step forward, not much more than a relabeling of what it already does. However, in a larger context such a policy change risks opening the door to political involvement and encroachment on the Fed’s independence. That would be a bad tradeoff.

Mr. Bernanke has said he will be a team player as Fed chairman. Even when the two current Board vacancies are filled, there is unlikely to be a majority of the Federal Open Market Committee in favor of formal inflation targeting. It might not be a bad idea if Mr. Bernanke’s favorite dish is relegated to the back burner for a while.

Mr. Bernanke is right when he says targeting would not be a major departure from current practice. That reduces its urgency.

Alfred Tella is former Georgetown University research professor of economics.

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