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Sunday, January 11, 2009

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.

    Posted by on Sunday, January 11, 2009 at 09:36 PM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (9)

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