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The Case for Inflation Targeting

As this book was going to press,Alan Greenspan’s tenure as Fed chairman was coming to a dose. This Artie, three economists offer his successor some advice. In October 2005, President Bush nominated Greenspan’s successor.Ben Bemanke, the first author of this artice.

What Happens When Greenspan Is Gone

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S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach (that consolidates the gains of the Greenspan years and ensures that those successful policies will continue-even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.

We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary policy framework that commits the central bank to a forward- looking pursuit of low inflation-the source of the current great performance–but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system .

Successful inflation targeting requires that the central bank and elected officials make a public commitment to an explicit numerical target level for inflation (usually around 2%), to be achieved over a specified horizon (usually two years). Equally important, the central bank must agree to provide the markets and the public with enough information to evaluate its performance, and to understand its reasoning when policy and inflation deviate from the long-run goal-as they inevitably will at times .

Adoption of inflation targeting by the Federal Reserve would bring several major advantages over the current, less structured approach. First, it would transform the commitment to price stability-which has served us so well under Mr. Greenspan and his predecessor, Paul Volcker-from a personal preference of the chairman into an official policy. By depersonalizing and institutionalizing the Greenspan policy approach, the Fed would increase the likelihood that future U.S. monetary policy will look like the 1980s and )990s rather than the 1930s or the 1970s.

Second, the transparency of the inflation-targeting approach would encourage politicians and the public to focus on what monetary policy can do (namely. maintain long-run price stability), rather than on what it can’t do (create permanent increases in growth through expansionary policies). In place of politically expedient demands and scapegoating by politicians-a particular danger in election years-public oversight of the Fed would be directed toward discussion of the appropriate level for the inflation target and evaluation of the Fed’s effectiveness in  meeting that target. The Fed would retain the sole authority for specific policy actions-such as setting the federal funds rate-in pursuit of its target. This allocation of responsibility for monetary policy between elected: officials and technocrats would Serve both democratic principles and good policy.

Third, increased transparency would diminish financial and economic uncertainty, More information from the  Fed ‘about its plans and expectations would reduce the perpetual, and wasteful, attempts by financial market participants to guess what the Fed will do next. An infla!ion target would also make it easier for businesses and consumers to plan.

Fourth, inflation targeting is particularly good insurance against the threat of falling prices. Deflation has been associated with deep recessions or even depressions, as in the 19305 and recently in Japan. Targeting an annual inflation a couple of percentage points above zero, as all inflation targets have done, commits tile cerebral bans to maintaining a floor under price level movements (as well as a ceiling over them).

Mr. Greenspan’s reappointment should not make us complacent about the future of feel policy, On the principle that it is better to fix the roof when skies are sunny, the Fed should announce its intentions to establish a more policy framework now, rather than waiting to be confronted by difficult policy decisions. An explicit commitment to inflation targeting would increase the odds that those decisions would be the right ones, and that they would receive public support-whether or not Alan Greenspan is chairman.

This period began with a favorable supply shock. In 1986, OPEC members started arguing over production levels, and their longstanding agreement to restrict supply broke down. Oil prices fell by about half. As the figure shows, this favorable supply shock led to falling inflation and falling unemployment from 1984 to 1986.

Since then, the Fed has been careful to avoid repeating the policy mistakes of the 1960s, when excessive aggregate demand pushed unemployment below the natural rate and raised inflation. When unemployment fell and inflation rose in 1989 and 1990, the Fed raised interest rates and contracted aggregate demand, leading to a small recession in ] 991 and 1992. Unemployment then rose above most estimates of the natural rate, and inflation fell once again.

The rest of the 1990s witnessed a period of economic prosperity, Inflation gradually drifted downward. approaching zero by the end of the decade. Unemployment also drifted downward, leading many observers to believe that the natural rate of. unemployment had fallen, Part of the credit for this good economic performance goes to Alan Greenspan and his colleagues at the Federal Reserve, for low inflation can be achieved only with prudent monetary policy. But as the following case study discusses, good luck in the form of favorable supply shocks is also part of the story.

The economy, however, ran into problems in 2001. as a case study In Chapter 33 described. The end of . the dot-com stock-market bubble, the 9/11 terrorist attacks, and corporate accounting scandals all depressed aggregate demand. Unemployment rose as the economy experienced its first recession in a decade. But a combination of  expansionary monetary and fiscal policies helped end the downturn, and by early 2005, unemployment was close to most estimates of the natural rate.