Barney Frank: Explicit Inflation Target a "Terrible Mistake"

Barney Frank says he won't support an explicit inflation target:

Fed chief warned on inflation target, by Krishna Guha, Financial Times: It would be a “terrible mistake” for the Federal Reserve to adopt any form of inflation target to guide its interest rate decisions, Barney Frank, the Democratic chairman of the House financial services committee, has told the Financial Times.

Mr Frank ... said such a target “would come at the expense of equal consideration of the other main goal, that is employment”. His comments come as Fed policymakers enter the later stages of a far-reaching strategy review that has included detailed debate over the merits of adopting an inflation target.

Ben Bernanke, chairman of the Fed, believes that the bank would be better off with a relatively flexible inflation target – one that would be achieved on average, rather than within a specific time, giving maximum latitude to respond to output shocks.

However, Fed watchers say that, in order to make any such change, Mr Bernanke would need at least the tacit consent of key figures in Congress. Mr Frank’s unequivocal statements suggest this consent will still be difficult to secure...

In an interview, Mr Frank told the FT that Mr Bernanke “has a statutory mandate for stable prices and low unemployment. If you target one of them, and not the other, it seems to me that will inevitably be favoured.” ...

Advocates of an inflation target at the Fed say it is important to distinguish between the relatively rigid form of target used, for instance, by the Bank of England, and the relatively flexible form favoured by Mr Bernanke.

Mr Frank, though, said he would not support even a flexible target “without equal attention to unemployment also”. He agreed that Mr Bernanke and his colleagues probably had an implicit inflation target in mind already, but said it would be dangerous to make it explicit.

“I think when you make it more transparent you enhance its importance,” Mr Frank said. “No question he has something in his head. But when you make it public you lose flexibility.”

Mr Frank said he would listen to the Fed chairman’s arguments, but suggested he was quite firm in his views. “I am always willing to talk to him,” he said. “But he is as likely to change my mind as I am to change his.”

To help with the discussion, let the rule for monetary policy be of the standard modified Taylor rule form:

ff_t = a + bff_t-1 + c(y_t-y_t*) + d(π_t - π_t*) + u_t

where ff is the federal funds rate target, y is output, π is inflation, and u is the uncontrollable part of policy. A * indicates the target value of a variable and a, b, c, and d are choice parameters for the Fed. The parameters c and d determine how forcefully the Fed responds to deviations from its output and inflation targets. (In more general models the deviations might be expected future deviations rather than the deviations today, there are issues about whether to use real-time or revised data, the rule can have additional terms, and there are other issues as well such as what target to adopt when market imperfections are present, but this will suffice.)

Barney Frank says we must pay "equal attention to unemployment.” If he means that the Fed should respond as forcefully to deviations of output from target as it does deviations of inflation from target, that is at odds with current monetary theory which states that the best way to stabilize output and employment - Barney Franks' concern - is to respond more forcefully to inflation deviations than to output deviations. Thus, the value of d is around three times as large as c in standard formulations. If he means the Fed should take account of deviations of output from target (or employment deviations), they already do that.

As to explicit inflation targeting, the issue is whether to announce the value of π_t*, the inflation target. Barney Frank is worried this will elevate the importance of inflation deviations, but nothing I know of suggests that announcing π_t* changes the values of d or c.

Targeting inflation is a means to an end - that of output and employment stability just as Barney Frank wants - and not an end in and of itself. Both theory and evidence tell us that the Fed can stabilize employment and output around their long-run trends, but it cannot change the long-run trends themselves with monetary policy. Thus, the best the Fed can do is to stabilize the economy around these long-run trends and that, we believe, requires stable and low inflation and an aggressive response to deviations of inflation from target.

Barney Frank has his heart in the right place, no doubt at all about that, but he is looking at the economy and at monetary policy through a theoretical lens that is no longer used by macroeconomists. That being the case, it's too bad he has said his mind is all but closed on this matter. I would hope instead that he would devote effort to understanding why an explicit inflation target is on the table and favored by so many people who study monetary policy. There is a need for Congressional oversight, and for Congress to step in if the Fed steps beyond certain bounds, but this is not the time for Congress to interfere, particularly if the interference is based upon a faulty understanding of the purpose of the policy.

I am not 100% convinced that an inflation target is needed, though I lean that way. But I am convinced that people such as Bernanke and Mishkin (and others on the FOMC along with their staffs) know this literature as well as anyone, anywhere, and I trust them to deliberate carefully and come to the best possible decision they can make. But that won't be possible if interference from Congress prevents them from doing what their collective judgment says is best.