Is inflation targeting so good?

I always thought inflation targeting to be one of the best ways to manage inflation. This view developed after reading numerous articles and papers (in particular by Mishkin and Bernanke).

WSJ Blog pointed out a paper (it is an address given to the American Economics Association in 2004) by Benjamin Friedman, a big time critic of inflation targeting framework. He turns the entire perspective on its head and says it isn’t as good as it is made out to be. I just read his perspective which is quite good and he makes it better by using humour.

He says:

1) There is evidence that shows the performance of countries that adopeted inflation targeting improved (papers by Mishkin) and there is evidence that shows nothing really improved (Laurence Ball et al).  Hence , there is no consistency (this is nothing new as everything in eco has two hands 🙂  which according to me makes eco more fun and challenging)

2) The other positive aspect of inflation targeting (which is more important) is that it improves central bank’s communication with the public. Friedman says:

I believe such claims are simply false. The key issue, which comes as no surprise to any student of monetary policy, is multiple goals. Monetary policy has one instrument: typically today some short-term interest rate, but alternatively the quantitative change in the central bank’s liabilities. …….. In this case, instead of inflation why not output? Or employment? Or the economy’s foreign balance? Or any other magnitude of concern to monetary policymakers?

He says inflation targeting is anything but transparent:

Whatever “transparency” the resulting inflation targeting regimes have delivered is strictly one-dimensional. An alternative way of stating the problem, suggested by Faust and Henderson, is to think in terms of the mean inflation rate and the variability of inflation. Excessive variability of inflation is costly, but so is excessive smoothness.

Inflation targeting communicates well about the central bank’s intentions for mean inflation, but not its variability. The failure of most inflation targeting schemes, as implemented by actual central banks, to say anything about how much inflation variability the central bank will tolerate, or why, is likewise a failure to say anything about any goals of monetary policy other than inflation, or about the relationship between those goals and the inflation goal.

Faust and Henderson pointedly refer what they call “one of the most famous principles of spin in the folk wisdom of central banking … that central banks should ‘do what they do, but only talk about inflation’.” They go on to say that inflation targeting “might be viewed as an application of this principle. One should name what one does ‘inflation targeting,’call monetary policy reports ‘inflation reports,’ and only discuss other goals as affecting the horizon over which one intends to hit the inflation target.”

Inflation targeting as a framework captured central banks’ minds when world-wide inflation was a chronic problem. And then going by Milton Friedman-Phelps theories it was understood that inflation expectations is as important as inflation itself. So, Central Banks  used inflation targets to control expectations. Freidman attacks this proposition:

The reverse of this proposition (which, of course, does not necessarily follow from the proposition itself) is that the central bank need not ever do anything. All that matters is that it affect expectations – which is just what inflation targeting, in large part, is intended to do. The operating arm of monetary policy is then not the trading desk but the press office: No matter what the central bank is doing, always write the press release to say that the intended purpose is to keep inflation on the straight and narrow because that is what the public needs to believe for the central bank to enjoy the fruits of “credibility.”

Read this short statement (14 pages) to develop thoughts over performance of inflation targeting. One must always know both sides of the story to develop a better viewpoint. I however, still feel inflation targeting as a framework is pretty neat.

As this address was made in 2004, I am waiting for his new statement he makes to Fed on July 17. Keep watching this space.

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