What's The Fuss Over Inflation Targeting?
The biggest policy difference between Alan Greenspan and Ben S. Bernanke is over something known as inflation targeting. Greenspan is against it, Bernanke is for it. Here's a guide to understanding the debate.
What is inflation targeting?
It's a policy of announcing what you're going to do, and then doing it. Either the central bank or the elected government chooses and publicizes a target goal for the inflation rate -- say, 2% a year. The bank then publicly estimates how high it expects inflation to be in the coming year. It steers monetary policy to try to hit the target inflation rate. If inflation is getting above the target, the bank would ordinarily raise interest rates to cool the economy and bring inflation back down. If inflation gets too low, the bank would lower rates to juice up growth, raising inflation.
Where is this approach in use?
It is the official policy of Britain, Canada, Australia, Sweden, New Zealand, Brazil, and South Korea, among others.
Is it working for those countries?
Apparently so. According to a Goldman, Sachs & Co. (GS ) study in June, countries that implement inflation-targeting policies tend to stabilize their inflation rates while keeping economic growth on an even keel. The study found that the U.S. and Japan, which don't have formal targets, have more volatile stock and bond markets -- perhaps indicating more investor uncertainty about the direction of inflation.
Why does Bernanke favor inflation targeting?
He thinks that a more "transparent" Federal Reserve policy would promote stable, noninflationary economic growth by giving businesses and consumers more certainty about the future course of interest rates and inflation.
Why is Greenspan against it?
He thinks the Fed can control inflation without announcing a target rate. Plus, he worries that an announced rate would make it harder to respond flexibly and intuitively to a financial crisis or changing economic conditions. Greenspan recognized from a variety of subtle indicators in 1997 that rapid productivity growth was likely to curb inflation -- even though most conventional forecasts predicted accelerating inflation. He persuaded fellow Fed policymakers to not raise interest rates, allowing the economy to flourish.
Does Bernanke admit that inflation targeting would decrease the Fed's flexibility?
No. He says that in a crisis the Fed would do whatever it takes to stabilize the economy. Frederic Mishkin, a Columbia University economist and longtime Bernanke collaborator, says that establishing credibility with the financial markets as an inflation hawk gives an inflation-targeting central bank more, not less, flexibility to tackle recessions.
By Peter Coy in New York