Conservatively dressed central bankers may not look like fashion victims, yet they are as prone to the latest craze as anybody else. Remember when monetarism was all the rage? The latest fashion is for inflation targets.
The Fed announces a target for inflation, usually between 1.5 and 2%, and then it adjusts the money supply as it sees fit. It insulates the economy from changes in the velocity of money. It also has the “political advantage” that it is easy to explain to the public.
The politicians and the paternalists counter that an inflation target would give the Fed too little flexibility to stabilize growth and/or employment in the event of an external shock. Today the Fed continues without the strict rules of an explicit target. Greenspan, as well as other former FOMC members such as Alan Blinder, typically agreed with its benefits, but were reluctant to accept the loss of freedom involved; current Chairman Bernanke, however, is a well-known advocate of inflation-targeting.
Should we interpret inflation targeting as a type of precommittment to a policy rule–to simply keep inflation down? Not completely. In all the countries that have adopted inflation-targeting, central banks are left with a fair amount of discretion. Inflation targets are usually set as a range–an inflation rate of 1 to 3 percent, for instance–rather than a particular number. Thus, the central bank can choose where in the range it wants to be: it can stimulate the economy and be near the top of the range, or dampen the economy and be near the bottom. Sometimes central banks allow adjustments to their targets as well–a time inconsistency.
So what is the purpose of inflation targeting if they’re all so flexible? When a central bank is simply told by politicians who don’t understand it to “Do the right thing,” it is difficult to hold anyone accountable. Politicians give the banks some discretionary room, but the banks try to achieve the goals of the politicians, or perhaps worse, a social-welfare ideal.
What about the Federal Reserve? Since Bernanke took office, we might expect a move toward inflation-targeting as the explicit framework for monetary policy, since he is an advocate of inflation targeting. As a commentator from Mises.org said, “We should understand this to mean that Bernanke is a deflation-scared inflationist.”