The Politics of Explicit Inflation Targeting

In this post, I mentioned that some people believe the Fed pays too much attention to its inflation target and not enough to its full employment mandate. This view presumes there is a tradeoff between low inflation and high employment goals and choosing to focus on one goal necessarily causes a loss of focus on the other. Bloomberg's John Berry discusses this topic:

Barney Frank Says No to Narrowing Fed's Mandate, by John M. Berry, Bloomberg: If Federal Reserve officials needed any reminder about how sensitive politically it would be to adopt an explicit numerical inflation target, Massachusetts Rep. Barney Frank gave them one this week.

Asked about that possibility after a speech..., Frank, the incoming chairman of the House Financial Services Committee, said, ''There are people who have been arguing that the Fed should have its mandate changed. That's not going to happen when we are in power.''

Well, it wasn't going to happen even if Republicans hadn't lost control of the House and Senate... Yes, Chairman Ben S. Bernanke and other officials ... are discussing how they might better communicate their intentions to the public, and part of that discussion involves the possible value of having an inflation target.

Nevertheless, none of the officials is asking Congress to change the provision of the Federal Reserve Act that specifies the Fed should seek ''to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.'' ...

Fed officials, including Bernanke ... have long ... [believed] ''The mandated goals of price stability and maximum employment are almost entirely complementary,'' [as] Bernanke said last Feb. 24 in his first speech after becoming chairman.

''Central bankers, economists, and other knowledgeable observers around the world agree that price stability both contributes importantly to the economy's growth and employment prospects in the longer term and moderates the variability of output and employment in the short to medium term,'' Bernanke said.

While such words should reassure someone worried that the Fed might want to ignore unemployment, they don't get around the very real political issue highlighted by Frank's response. To someone now very well versed in economics, simply having a numerical ... inflation goal -- and no similar goal for employment or unemployment -- could easily give the impression that keeping inflation low is seen as more important than keeping employment high. ...

Unless Fed officials can find a way around this serious political problem, they shouldn't adopt an inflation target. ... As for elevating the inflation goal over the employment goal, well, that's certainly not the way the Fed has acted.

For instance, the FOMC chose not to continue increasing its target for the overnight lending rate after it reached 5.25 percent in June precisely because it didn't want to do unnecessary damage to the real economy. Its intention then and now is to bring down inflation very gradually rather than do the job very quickly by crunching the economy.

The degree to which price and output stability are complementary rather than competing goals in modern macroeconomic models is not well understood, something that has been discussed here previously. For example, this is an edited version of one previous post on this topic:

Fed policy can be described fairly well with a Taylor rule. A simplified Taylor rule can be written as:

ff = a + b(y-y*) + c(p-p*)

where ff is the federal funds rate target, y-y* is the deviation of output from target (also called the output gap), and p-p* is the deviation of inflation from its target rate. The political argument is often expressed as Democrats and lower income workers being more concerned with output and unemployment and thus wanting a high value of b, and those concerned with inflation, generally identified as the wealthy and the right, wanting a high value for c. This puts the Fed in the position of appearing to favor one group over another when it chooses a monetary policy rule.

But there is another view of this model of monetary policy that avoids these politics because it does not involve choosing one goal over the other. If we start with a dynamic stochastic general equilibrium model with wage and/or price stickiness, the type of model presented here, and ask what type of policy rule (appropriately linearized) maximizes household welfare, the answer looks a lot like a traditional Taylor rule. And surprisingly, the optimal federal funds rate rule, the one that maximizes welfare (i.e. stabilizes the welfare relevant concept of the output gap), puts a large weight on the deviation of inflation from target relative to the weight on the deviation of output from its target value. That is why the goal of output and employment stability is consistent with a policy rule that places a lot of weight on keeping inflation near its target value.