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Monday, March 13, 2006

San Francisco Fed President Yellen on Explicit Inflation Targets

Federal Reserve Bank of San Francisco president Janet Yellen  promotes explicit inflation targets:

Enhancing Fed Credibility, by Janet Yellen, San Francisco Fed President: ...There has been a great deal of discussion of whether the Federal Reserve should [announce] a specific, numerical inflation objective. I will spend the remainder of my remarks addressing this question, looking first to the results from theoretical and empirical research on the effects of such communication.

First, what are the benefits of adopting a numerical objective for inflation? In theory, effective central bank communication of a numerical long-run inflation objective ... can simplify the complicated informational problems people face in the economy, and can reduce the uncertainty about the central bank's goals and policies. Indeed, recent research suggests that clear communication of a numerical long-run inflation objective may assist in the anchoring of long-run inflation expectations, relative to a policy that leaves it to the public to infer the objective from experience. The resulting improved alignment of Fed actions and public perceptions would reduce expectations errors that would otherwise add to macroeconomic variability. As a result, the Fed would be better able to achieve both inflation and employment goals. ... Of course, for communication to be effective, policymakers must consistently take appropriate actions that back up the commitment to price stability and full employment.

Another important reason to provide clear guidance to the public regarding the long-run inflation objective is that doing so may help us avoid deflation and reduce the costs of its occurrence. ... An explicit numerical long-run inflation objective may help anchor inflation expectations at a low positive number and avoid a potentially devastating deflationary spiral.

What is the empirical evidence on the value of an explicit numerical inflation objective? So far, it has been hard to find convincing evidence that countries with an announced numerical inflation objective have performed better in terms of inflation and macroeconomic stabilization than those that do not have one. Part of the problem is that there just aren't enough macroeconomic data to get a clear read on this question. But we do have data on inflation expectations that provide evidence about the effect of communication on anchoring expectations, which is the key mechanism that improves macro performance in the theoretical research I've discussed... Researchers using measures of inflation expectations derived from bond market data find that long-run inflation expectations in inflation-targeting countries are remarkably stable and well-anchored, while in the United States long-run inflation expectations have been highly sensitive to economic news. ... Although the evidence from surveys and financial markets is admittedly mixed, taken together these studies suggest that announcing a numerical price stability objective and greater transparency in general could help further anchor long-run inflation expectations.

My personal view is that the steps that we have already taken toward greater transparency have been a good thing, and that we should think seriously about venturing further along this path. ... I support the idea of a quantitative objective for price stability. I believe that it enhances both Fed transparency and accountability and ... it could help to anchor the public's long-term inflation expectations from being pushed too far up or down, and thus help avoid both destabilizing inflation scares and deflations...

A numerical definition of price stability could also help to focus and clarify our own analysis and discussions in the FOMC. ... it is difficult to derive and analyze the appropriate path for policy when one does know what the policy goal is. Similarly, I think the discussion of risks to price stability at the policy table would gain a sharper focus if we had a numerical price stability objective...

The choices of a specific index, objective and range are matters on which judgments may differ. Taking the various factors ... into account, I see an inflation rate of 1-1/2 percent as measured by the core personal consumption expenditures price index, with a comfort zone extending between 1 and 2 percent, as an appropriate price stability objective for the Fed. ...

As with any change in procedure, there are potential drawbacks. One is the ... risk that the Committee's performance with respect to the employment goal could actually be compromised if too short a time-frame is allowed for the attainment of the price-stability objective. To reduce the risk of such an outcome, the announcement of any numerical inflation objective should be made in the context of clear and effective communication of the Fed's multiple goals. Here, I am drawn to some specific language proposed by Chairman Bernanke while he was a Fed Governor: "the FOMC regards this inflation rate as a long-run objective only and sets no fixed time frame for reaching it. In particular, in deciding how quickly to move toward the long-run inflation objective, the FOMC will always take into account the implications for near-term economic and financial stability." ...

In summary, the Fed has made significant progress in building credibility over the past two decades ... I think it makes sense to take this transparency at least one step further by articulating a numerical price stability objective. I recognize that there are potential costs to doing so, but to my mind, they are outweighed by the benefits. Such a step could further enhance the credibility of the Fed and improve the effectiveness of monetary policy not only for controlling inflation but also for stabilizing employment and output.

    Posted by on Monday, March 13, 2006 at 08:00 PM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (1)


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