The incoming chairman of the US Federal reserve is likely to use significant resources to study the impact of adopting an inflation target
Ben Bernanke may use modern technology to achieve things even Alan Greenspan could not have. Nominated by president Bush to succeed Greenspan, he has supported the adoption of inflation targets by the Fed. Some of the best work at the frontier of economics research has constructed fancy, hi-tech economic models, and demonstrated that inflation targets can significantly improve the effectiveness of monetary policy.
To understand why inflation targeting may be necessary now, consider how the world has changed. Back in the 1970s, inflation twice rose higher than 10%, and every market participant knew that the Fed wanted inflation to be lower.
Now, core inflation has been quite low for some time, dipping to a year-over-year rate of only 2% in the Labor Department's latest consumer price index report on 14 October.
Market participants must wonder whether the Fed thinks inflation should be lower still, whether it could comfortably be a tad higher, or whether it is just right. This uncertainty is a big deal, and is quite unnecessary.
The Fed could easily tell the world the level of inflation it thinks is ideal. Such an announcement would not necessarily constrain its actions. Even if its target was 2% today, policymakers might still tighten to avoid an increase down the road. But it would allow markets to have a better sense of where the Fed is going.
Would a target matter? One recent study found some significant differences between countries that practice inflation targeting, and those that do not.
For example, private-sector inflation forecasts tend to show more agreement with one another in inflation-targeting countries than in the US. Such disagreement about future inflation is a good measure of the extra risk added to the economy because the Fed is not transparent enough.
How big a difference would the adoption of a target really make? Economists Marc Giannoni and Michael Woodford of Columbia University recently made an ingenious effort to find out. They constructed a fancy economic model and plugged in optimal monetary policy rules, including inflation targets.
They then ran recent economic history through their model. Looking back from 2002, they found the monetary policy that resulted from the optimal inflation-targeting rule looked very much like the monetary policy we had, with a small exception.
Relative to the optimal rule, actual monetary policy was "somewhat too loose in the 1990s" and "consistently too tight in the last nine quarters of our sample". The differences were not huge.
With the benefit of hindsight, many observers agree with the model's findings. Giannoni and Woodford's work suggests the Fed may have known that ahead of time if it had adopted Bernanke's suggestion to target inflation.
Bernanke would not, of course, remove the discretion of policymakers and advocate that some mechanical model replace the terrific system we have. But inflation targets would increase transparency, reduce uncertainties and possibly improve the cyclical performance of the Fed with little downside risk.
My guess is that Bernanke will devote significant staff resources to further study of these issues, and that the advantages of his approach will become overwhelming enough in the next few years that the Fed will adopt an inflation target. When it does, it will be good news.
Kevin Hassett is director of economic policy studies at the American Enterprise Institute
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