The Trap Of Inflation Targeting
By Robert Kuttner
Financial markets and economists across the spectrum breathed a sigh of relief when President George W. Bush named Ben S. Bernanke the new Federal Reserve chairman. Compared with other widely mentioned contenders, Bernanke is no ideologue but a well-respected academic economist with recent experience both on the Fed and the White House Council of Economic Advisers. In fact, he is probably Bush's most mainstream major appointee.
Inflation hawks were especially pleased that Bernanke, to a far greater degree than Alan Greenspan, supports a policy known as inflation targeting. The idea is to fix monetary policy to a supposedly firm star -- the desired rate of inflation. Bernanke has cited a target zone of 1% to 2%. In theory, this tactic becomes a virtuous, self-fulfilling prophecy: Financial markets, reassured that central bankers will act to keep inflation low, will not demand an inflation premium to lend money. These low interest rates, in turn, help damp down inflationary expectations.
UNFORTUNATELY, THERE ARE two big problems with the theory. First, it assumes inflation is controlled by central bankers or is substantially a reflection of expectations. But not all bouts of inflation are created equal. For example, if price increases are the consequence of external shocks such as sudden oil price hikes or currency crises -- and not of macroeconomic "overheating" or market expectations -- and the Fed responds mechanistically by tightening money according to a formula, it could drive a soft economy into full-blown recession.
Second, the Fed's most important short-term mission is to manage crises, such as the market crashes of 1987 and 2000-01. These spasms are seldom well correlated with inflationary trends. In both cases, the Greenspan Fed reacted vigorously by flooding the system with liquidity to keep a financial panic from causing a general depression. If the Fed slavishly kept to a rigid monetary rule based on targeting a set rate of inflation, it would tie its own hands in a crisis. Even Nobel laureate Milton Friedman, an advocate of a "strict monetary rule," doesn't favor that. Indeed, any central banker who failed to pursue a flexible policy in a crisis, as events warranted, would be a disaster.
Greenspan, though a conservative, moved away from strict monetary targeting or the related idea that inflation would be triggered if growth exceeded a "natural rate of unemployment." Why? Because, as a good empiricist, he noticed that a more productive economy could accommodate fuller employment and higher growth without inflation. It would be ironic -- and unfortunate -- if his nonideological successor returned the Fed to a monetary straitjacket.
Thankfully, in his Nov. 15 testimony to the Senate Banking Committee, Bernanke qualified his enthusiasm. Even earlier, while on the Fed from 2002-2005, he spoke of the risks of deflation. This became a handy smoke screen for him to support a loose monetary policy while still preserving his ostensible commitment to inflation targeting. In fact, the real inflation rate during the period stayed in positive territory, often above Bernanke's preferred target range. He also has fudged support for inflation targeting by inventing an oxymoron that he calls "contained discretion," a technical-sounding term for wiggle-room.
We should be grateful for this fudging because, in many ways, Bernanke faces a shakier economy than the one Greenspan inherited in 1987, notwithstanding the October stock market crash that was Greenspan's baptism by fire. Today's economy is menaced by unsustainable budget and trade deficits and escalating dependence on foreign borrowing to finance them. Many smart people, including former Fed Chairman Paul Volcker, believe it is only a matter of time before the dollar crashes, as foreign investors ultimately lose confidence and start selling dollar securities. The U.S. could avert this doomsday trajectory by running a more responsible fiscal policy and negotiating greater openness on the part of trading partners. But that major course correction is not the policy of the present administration and will take years to accomplish.
If a dollar crash did come, prices of imports would rise. Inflation would spike, while purchasing power fell. The Fed would be torn between raising rates to stem the dollar collapse and lowering them to keep the economy from imploding in a credit crunch. In such circumstances, inflation targeting would be useless and self-defeating as a concept or policy.
Robert Kuttner is co-editor of The American Prospect (firstname.lastname@example.org)