Mishkin: "In Praise of an Explicit Number for Inflation"

Frederic Mishkin argues that the Fed needs to adopt an explicit inflation target since this would help to insulate against the threat of deflation:

In praise of an explicit number for inflation, by Frederic Mishkin, Commentary, Financial Times: Many central banks throughout the world have adopted an explicit, numerical ... inflation target. The US Federal Reserve is currently not one of them, but it is discussing this possibility. In the current circumstances with the economy in freefall, is ... an increased commitment to stabilising inflation the right thing to do...? My answer is absolutely yes. Adopting an explicit, numerical inflation objective is exactly what is needed right now to help the US economy to recover.

The usual argument for establishing a transparent and credible commitment to a specific numerical inflation objective is that it provides a firm anchor for long-run inflation expectations, thereby directly contributing to the objective of low and stable inflation. ... However, not as well recognised is that an inflation target can help prevent inflation from falling too low. At this critical juncture that benefit can have enormous value. ...

The danger right now is not that inflation expectations will ... become unanchored in the negative direction. Indeed,... if they fall further they could lead to two dangerous consequences.

First, there would be an increased likelihood inflation would become persistently negative: that is deflation. Experiences of deflation in the Great Depression and the “lost decade” in Japan suggest it causes great hardship. Second, with the federal funds rate near zero and therefore unable to go lower, persistent deflation would raise the effective cost of borrowing to households... Despite an interest rate of zero, monetary policy would become highly contractionary.

How would adopting an explicit numerical inflation objective help? First, a commitment ... would provide ... incentives for the Fed ... to stick to its word and ... make monetary policy sufficiently expansionary in the future. Research has shown a lack of such commitment was one reason why unconventional monetary policy actions such as quantitative easing by the Bank of Japan were ineffective...

Second, when the financial system starts to recover, to keep future inflation under control the Federal Reserve will need to drain the massive amounts of liquidity it has pushed into the financial system... A commitment to an explicit numerical inflation objective would ... subject the Fed to public pressure if it was not taking the necessary steps to make this happen.

Critics of inflation targeting fear adoption of an explicit numerical inflation objective might lead to too little focus on stabilising economic activity. ...That is why the term “inflation targeting” is somewhat of a misnomer because it does not mean the central bank should try to hit the target over a fixed horizon.... In addition, an explicit numerical inflation objective by the Federal Reserve would be adopted only if it was consistent with the dual mandate ... of both price stability and stability of economic activity.

Comments

[Gegner]

Wait a minute Slim! The Bush administration spent five trillion over the past eight years and the Fed and the Treasury have spent another ten trillion in just the past eight months.

Before we spend another nickel it seems prudent that we locate the 'black hole' all of this money is disappearing into first, don't you think?

Fifteen trillion dollars in Federal spending, most of it in just the past few months and this guy proposes we start shoveling more out there?

There's something very wrong with this picture and until we figure out what it is, we'd best sit on our hands.

[Shalom P. Hamou]

Inflation targeting works like that: I fix to myself to live till I am 120, and this way I will live till I am 110.

It is wishful thinking and definitively can't work.

But it is like a placebo. If it does not do any good it does not hurt either.

It just show gullible crowd that someone is in charge.

[ctindale]

Mishkin and Bernanke have both refered to inflation targeting as "cheap talk" , this term refers to the Fed talking up inflation and the middle class sheep bleeting to the mantra thats given them.

Stiglitz thinks its rubbish, you simply can manage an economy this way and expect to be successful

The Failure of Inflation Targeting
by Joseph E. Stiglitz

Joseph E. StiglitzNew York – The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.

The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation , the best response is to increase interest rates. One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting in one form or another are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.)

Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?

Inflation in these countries is, for the most part, imported . Raising interest rates won’t have much impact on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, not those in developing countries, should be raised.

So long as developing countries remain integrated into the global economy – and do not take measures to restrain the impact of international prices on domestic prices – domestic prices of rice and other grains are bound to rise markedly when international prices do. For many developing countries, high oil and food prices represent a triple threat: not only do importing countries have to pay more for grain, they have to pay more to bring it to their countries and still more to deliver it to consumers who may live a long distance from ports.

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially non-traded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now – for example, 20% per year – and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign. Former US Federal Reserve Chairman Alan Greenspan, it is now recognized, deserves much blame for America’s current economic mess. He is also sometimes given credit for America’s low inflation during his tenure. But the truth is that America in the Greenspan years benefited from a period of declining commodity prices, and from deflation in China, which helped keep prices of manufactured goods in check.

Second, we must recognize that high prices can cause enormous stress, especially for lower-income individuals. Riots and protests in some developing countries are just the worst manifestation of this.

Advocates of trade liberalization touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. Over a quarter-century ago, I showed that, under plausible conditions, trade liberalization could make everyone worse off. I was not arguing for protectionism, but rather sounding a cautionary note that we must be aware of the downside risks and be prepared to deal with them.

When it comes to agriculture, developed countries, such as the US and European Union members, insulate both consumers and farmers from these risks. But most developing countries do not have the institutional structures, or the resources, to do likewise. Many are imposing emergency measures like export taxes or bans, which help their own citizens, but at the expense of those elsewhere.

If we are to avoid an even stronger backlash against globalization, the West must respond quickly and strongly. Bio-fuel subsidies, which have encouraged the shift of land from producing food into energy, must be repealed. In addition, some of the billions spent to subsidize Western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.

Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.

[bakho]

With rising unemployment how is the Fed supposed to reach its inflation target?
Would it be just a number that is beyond reach?
If it comforts Finance, why not.
What is wrong with employment targeting?

says...

"In addition, an explicit numerical inflation objective by the Federal Reserve would be adopted only if it was consistent with the dual mandate ... of both price stability and stability of economic activity."

The dual mandate is what makes inflation targeting impractical. Monetary creation is far too blunt an instrument to make an effective employment program. It has too many unintended side effects. The rest of the world has rejected the dual mandate system, because it is simply not workable. For inflation targeting to be an effective anchor, the target must be a real target. Not a target that may or may not be followed.

[don]

The problem is to get fed monetary expansion to translate into lending. To do this, borrowers must be convinced prices will not fall. To do this, they must be convinced that monetary authorities won't step in to quash inflation once it starts. That is why positive inflation targeting (a guarantee of positive inflation) is needed. Stiglitz (as quoted above) is talking about negative inflation targeting (limiting inflation).
As Krugman points out, developed countries with responsible central banks are more prone to deflation, because to avoid deflation during a severe downturn requires convincing people that the CB will not step in to reduce inflationary pressures once they appear.
Greenspan has made that harder. A lot of people felt betrayed when he urged them to lend (buy bonds) at low rates, saying he would keep interest rates low for an extended period, only to start raising them as soon as inflationary pressures appeared.

says...

"The problem is to get fed monetary expansion to translate into lending."

I disagree. The problem is to increase the standard of living of the average consumer over time. Mild deflation would serve this goal better. Increasing the purchasing power of the average consumer is a far better long term strategy than continuously increasing loans to people who don't repay. That is a self defeating strategy.

[Too Much Fed]

Mishkin will be as wrong about (price) inflation targeting as he was about Iceland!

[Jeffrey Goodrich]

"Experiences of deflation in the Great Depression and the “lost decade” in Japan suggest it causes great hardship."

Please explain how the average Japanese citizen suffered "great hardship" during the past 18 years. I haven't seen or read any evidence to support this statement. True, nobody appears to have made any money in stocks, real estate or other debt-fueled Japanese investments since 1990. But is that the "great hardship" to which you refer?

As for our own experience with deflation, the 1930's are a useless measure of hardship. We had no unemployment insurance, no social security, no deposit insurance and a large portion of our population were farmers who were devastated by drought and falling commodity prices from which they were entirely unprotected. I believe deflation today would therefore not result in similar hardships, except to debtors and their creditors. The prudent savers --- those whose behavior we should not be encouraging --- would just fine.