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The Fed as Inflation Targeter

By Kim Schoenholtz, Professor of Management Practice and Director of the Center for Global Economy and Business

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Yet, the explicit inflation target could help make policy more effective. First, it should facilitate policy communications. An explicit target provides for accountability and (therefore) credibility.

January 26, 2012

Below is an excerpt from the NYU Stern Economics blog. Read the full post

Today, the U.S. Federal Open Market Committee (FOMC) announced a major update of its framework for setting monetary policy. While the FOMC emphasizes its “dual mandate” (regarding inflation and employment), the new framework is fully consistent with an inflation-targeting central bank.

The key change was the announcement of an agreed quantitative longer-run goal for inflation (2.0% as measured by the annual change of the PCE deflator). A public and quantitative target is the sine qua non of inflation targeting. The new target shows up clearly in the January 2012 summary of economic projections by individual FOMC members. Compared to the November 2011 range of projections for “longer run” PCE inflation of 1.5% to 2.0%, the January projections show only 2.0% (i.e. no range).

Inflation targeting does not mean ignoring other indicators. The pace at which an inflation-targeting central bank seeks to reduce deviations from the target depends on policymakers’ preferences with respect to other factors. The new statement of principles from the FOMC addresses this question clearly:

“In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.”

In plain English: When inflation deviates from the long-run objective of 2.0%, the FOMC will seek to restore it eventually. If employment simultaneously deviates from what the FOMC estimates as the sustainable maximum, policymakers can alter the pace at which they aim to restore inflation to the 2.0% objective. This amounts to inflation targeting.

How much will this alter FOMC practices going forward? Perhaps only modestly. From a practical perspective, the FOMC has acted for many years as a quasi-inflation targeter. Even if the Fed doesn’t like the label, the “quasi” qualifier no longer seems useful.

Yet, the explicit inflation target could help make policy more effective. First, it should facilitate policy communications. An explicit target provides for accountability and (therefore) credibility. Observers will be able easily to track the FOMC’s success (or lack of it), and policymakers will be compelled to explain why inflation deviations have arisen and the pace at which they expect to correct them. If, over time, the targeting errors prove unbiased (the positives offset the negatives on average), that will help anchor both inflation expectations and price-level expectations. Stable expectations should reduce the risks of deflation or of an outsized inflation. History suggests that stable inflation expectations also will facilitate economic growth. And, other things equal, stable inflation expectations could reduce the volatility of long-term nominal bond yields.

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