Inflation targeting (IT) is the “next logical step” for the Federal Reserve’s monetary policy. So said Alan Blinder, a Princeton economics professor and former vice chairman of the Fed’s Board of Governors, at a symposium yesterday in New York. A key reason: the arrival of IT supporter Ben Bernanke as Fed chairman, Blinder explained at a discussion of what comes next in monetary policy at an event sponsored by the New York Association for Business Economics. (It was fitting that the assemblage was held at the Manhattan office of the Canadian Consulate, which represents a country that adopted IT in the early 1990s.)
The Greenspan standard is gone, destined for replacement, Blinder continued. What was the Greenspan standard? The iron law that monetary policy should be exactly what Alan Greenspan wanted it to be, he quipped. “The Fed must get off the Greenspan standard, and IT seems the logical next step.”
Another speaker, Laurence Meyer, an economist with Macroeconomic Advisers and a former Fed governor, also found reason to predict that IT is coming to the world’s most influential central bank. His talk, titled “Coming Soon: An Inflation Target for the FOMC,” expounded on the internal Fed debate that Meyer said is slowly evolving toward a policy favoring IT.
Perhaps, but for all the aura of surgical precision that surrounds the idea of a clear and exact inflation objective, the transition from the Greenspan standard promises to be messy just the same. For starters, the use of the term “inflation target” is so yesterday, and arguably carries some political baggage. For cover, IT advocates increasingly reference their favored brand of monetary policy indirectly. At the February 2005 FOMC meeting, for instance, a debate on IT was labeled a “broad-ranging discussion of the pros and cons of formulating a numerical definition of the price-stability objective of monetary policy,” according to Fed minutes.

If the Fed is gradually transitioning to IT, by whatever name, there is still plenty of debate left in the formulation of monetary policy, Meyer reminded. For example, the debate over whether an inflation target should have a range v. a single number allows for more than a little variation in outcome for real-world results. Consider that if the central bank ultimately opts for the seemingly innocuous decision to go with a target range, the choice opens up a can of worms about when the Fed must act and when it’s free to let things ride.
Let’s assume an IT target range of 1.5% to 2.0%. Assume further that inflation is currently 1.75%. Would Fed monetary policy become more aggressive in fighting inflation if inflation subsequently rose to 1.8%? Or could the Fed wait until inflation touched 1.9% or 2.0% before acting to nip any inflationary pressure in the bud?
The alternative–a single, explicit IT–may be superior, but it raises the concern that the Fed would be handcuffed to a pre-set and restrictive monetary policy at times of financial stress, thereby removing the flexibility that’s come in handy at moments in the past, such as during the immediate aftermath of the October 1987 stock market crash, when the central bank temporarily injected massive amounts of liquidity into the system. Meyer countered that by establishing a long-run IT–an average over, say, two years–would in fact allow for short-term flexibility while preserving the benefits of transparency and accountability that accompany an explicit inflation objective.
Another potentially contentious issue is choosing an index to define inflation for the purposes of an IT policy. Among policy wonks, there’s broad support for using personal consumption expenditures (PCE). But wider public acceptance and knowledge of the consumer price index (CPI) may tip the scale in favor of this popular gauge, which influences various corners of finance, such as adjustments to Social Security payments.
Minds may differ over PCE vs. CPI, but the dismal science generally agrees on using core versions of those inflation measures, which is to say a PCE or CPI that’s stripped of energy and food inputs. That’s at once a benefit and a challenge. A benefit in that running the nation’s monetary policy without the annoying volatility of energy prices makes things easier, especially since energy seems to be in a long-term uptrend. Nonetheless, there’s an argument that the Fed should ignore energy prices for managing the nation’s money supply. Why? Because the energy market is the mother of all exogenous events affecting inflation, and so the Fed has virtually no control over the oil variable, which can flare up at any moment unannounced. “One would like to hold the central bank accountable for something it can do something about,” Blinder argued.
A reasonable view, to be sure. But it also holds open the possibility of headline inflation soaring by way of energy while the Fed congratulates itself on keeping core inflation under control. As a result, success and failure in monetary policy could in theory exist simultaneously in a world that increasingly suffers from energy insecurity.
Scoring an “A” for consistency, Blinder responded to a question about whether the Fed should be concerned about asset inflation, a thinly veiled reference to the current bull market in real estate. But whether it’s stocks, property or any other asset class taking wing, the central bank has no business of trying affect prices other than in a general, macroeconomic sense, he responded. “It’s not the central bank’s job to say stocks or real estate are high relative to money.”
What exactly is the central bank’s job? For the Fed, there is the dual mandate of minimizing inflation and maximizing employment. Sometimes one conflicts with the other, and sometimes achieving success in either realm may seems hopeless, as in the 1970s. Perhaps IT, or whatever it’s called, will help; perhaps not.
In any case, don’t expect someone to ring a bell when the Greenspan standard ends and some form of IT formally begins. Indeed, one could argue that a degree of IT has already begun, if not in name than in process. And that process will continue to evolve. Although it’s hard to figure out where the FOMC stands exactly on the issue, Meyer has helpfully compiled a scorecard of the various opinions that matter by reporting that seven FOMC members have gone on the record of embracing the idea of IT, with suggestions for a target ranging from as low as 50 basis points up to 3.0%. Meanwhile, eight governors have remained mum on the idea, and two have taken a stand against. But nothing ever stays the same in central banking, and in the wake of the anti-IT Ferguson announcing his resignation from the Fed this week, those opposed are effectively down to one, Fed Governor Kohn.
Reading the central banking tea leaves, BusinessWeek opines that the departure of Ferguson makes it easier for Bernanke to dominate the debate on inflation. The Fed’s Loss Is Bernanke’s Gain, runs the headline. If so, will Bernanke’s gain translate into progress for the capital markets as well?