Thursday, October 25, 2007

Walking towards the target 

I realize that to some readers details of monetary policy are arcana. If you feel that way, go to the next topic; I'm going to work through this morning's report on the Federal Reserve's increased transparency proposal.

The discussion about Ben Bernanke since the minute after he was nominated to chair the Fed was whether and when the Fed would switch to an inflation targeting strategy for monetary policy. Today's report says the Fed is deferring that debate to a later time, and some might take from this that the inflation targeting is not in the cards. I read this report to say just the opposite.

The centerpiece of their new communications steps would be the release of economic forecasts of policy makers four times a year, instead of the current two times, with additional detail and background, according to people familiar with the matter. Moreover, the horizon for those forecasts would be extended to three years from two.

The new initiatives have been in the works all year. Earlier this year, the Fed had hoped to finalize them by this month. But the fallout of the market turmoil that erupted in August has complicated the agenda of next week's meeting of the policy-making Federal Open Market Committee and it may defer decisions on its communications policy to a later meeting.

Inflation targeting is really inflation forecast targeting. The central bank issues a report on what it thinks inflation will be over some time horizon. It then establishes a target inflation rate. The two put together inform one what the path of monetary policy would be. But they pretty much have to come in that order: A target without a forecast is a useless signal; a forecast tells you something even if you do not have a specific target in mind. I can think inflation should be higher or lower than the forecast without saying how much, though how much is something we would want to know.

Bernanke has been using forecasts more, elevating them in policy discussions. To have those now made public and more frequent is an important first step necessary for inflation targeting. It's not sufficient, though.

So what has to be discussed? This gets to the very heart of the Federal Reserve Act of 1913, the law that created and controls the behavior of the Fed. The Federal Reserve has a dual mandate to both maintain price stability and provide for high employment. Frederic Mishkin, in an interview just published by the Minneapolis Federal Reserve, discusses this compared to the European Central Bank, which has a mandate for price stability first. He says
The Congress has given us a dual mandate; that is, the Federal Reserve seeks to promote the two equal objectives of maximum employment and price stability, so that's what we have to execute. Even if the Congress hadn't given us such a mandate, the basic structure of the dual mandate is what I would feel is appropriate, and so we should be aiming to pursue such an objective anyway.

A hierarchical mandate says that first we focus on price stability and if we're successful then we'll focus on other concerns, particularly output fluctuations. If you interpret a hierarchical mandate as focusing on price stability in the long run, making sure that long-run inflation expectations are grounded�and we've seen tremendous success not just in the United States but in Europe in terms of grounding inflation expectations�then the dual mandate and the hierarchical mandate are identical.

Some people have said to me that the dual mandate versus hierarchical mandate dichotomy is a red herring. I don't agree, because I think it is an important issue in communications strategy. It's important to make it clear that you care about output fluctuations, but you're going to look at this from a long-run context and never take your eye off the inflation ball. That's the right way to do the dual mandate.

Similarly, with the hierarchical mandate, you should not be an �inflation-nutter,� as Bank of England Governor Mervyn King has expressed it. That is, you shouldn't be focused solely on inflation control. You must also worry about the fact that if you act too quickly to get inflation down to your long-run objective, you might have excessive, unnecessary fluctuations in output. So I think modern monetary theory, in writing down a hierarchical mandate or a dual mandate, will write exactly the same loss function, exactly the same kind of optimization theory for a central bank.
My suspicion is that this statement by Mishkin reflects Bernanke's view as well. (It's very unlikely that in a Fed publication a governor is going to say anything contrary to the view of the Board.) So the Fed may think it can accomplish the inflation target within the context of the dual mandate. But it has a second issue -- does it have complete goal independence to make this statement on its own, or will it need Congress to give some support? I turn to the means by which the Bank of Canada adopted inflation targeting, in which the Bank and the government made a joint statement in 1991. In both cases, the legislature can stop a proposal to create inflation targeting; in the Canadian case, the Bank was able to convince the government of its plan. (I'll point to this paper by Michael King for Canadian central banking history.)

It is interesting then that the Fed continues to refer to these changes as part of its communications strategy. Communicate with whom? I suspect communication is much towards Congress as it is with Wall Street. It needs at least tacit approval from both, in my view, to put inflation targeting on the front burner, and it may need legislation -- something to which both Congress and Wall Street will be loath. It should make for an interesting few years with Bernanke's Fed.

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