Policy Debate: Should the Federal Reserve
aim at a zero inflation policy?
Issues and Background
Plausible estimates of the benefits of zero inflation are certainly less than the unemployment costs
of zero inflation.... A low, steady rate of inflation is a reasonable target for the Fed. We cannot say precisely what low rate
of inflation best serves the American people, but we are confident it is not zero.
~ George
A. Akerlof, William T. Dickens, and George L. Perry
If the Federal Reserve commits to an explicit plan for achieving price stability,
the transition costs would be reduced, and any costs that arise will be outweighed by the
benefits. These benefits will be large and permanent, and will far outweigh the costs of getting
there.
~ W.
Lee Hoskins
Virtually all economists agree that high inflation rates are disruptive. Economies
experiencing double-digit inflation rates tend to have lower growth rates than economies experiencing
lower rates of inflation. This is due, in large part, to the increased uncertainty about future
income and prices that accompanies higher inflation rates. Thus, most economists agree that
inflation rates should be relatively low. There is much less consensus about whether an
inflation rate of 0% is better or worse than an inflation rate of 3%.
During the 1950s and 1960s, most U.S. economists would have suggested that a positive inflation rate
was desirable. This is because this period was characterized by a relatively stable inverse
relationship between inflation and unemployment rates. This relationship, known as the
"Phillips' curve," suggested that the opportunity cost of less inflation was higher unemployment.
In this scenario, policymakers could use monetary and fiscal policy to select whatever combination
of inflation and unemployment was perceived as being most desirable.
The economic experience of the 1970s and early 1980s cast serious doubt on this simple Phillips'
curve relationship. Supply shocks, induced in large part by the OPEC oil embargoes, resulted in
higher unemployment and inflation rates at the same time. The double-digit inflation rates
occurring during this period lead to significant changes in the structure of economic relationships.
Many labor contracts initiated during this period contained cost-of-living clauses that caused
labor costs in the current period to rise at least as rapidly as prices did in the previous period.
Inflationary expectations played a major role in the formulation of all types of long-term
contracts.
In response to these economic events, economists began to pay substantially more attention to
the importance of the role of expectations and the process of expectations formation.
The downward sloping Phillips' curve appeared to be, at best, a short-run relationship that
existed only when inflationary expectations were held constant. The long-run Phillips curve, it
is argued, is vertical at the natural rate of unemployment. Thus, in the long run, monetary policy
only affects the inflation rate, but not the level of output.
While many economists believe that a short-run tradeoff exists between unemployment and inflation,
new classical economists argue that only unanticipated monetary changes can affect output and
employment in the short run. In this case, the Fed can reduce unemployment only if they are able
to fool the public by announcing a rate of money growth that is below the actual money growth rate.
If the Fed pursues such a policy repeatedly, however, the public would eventually recognize its
strategy and the Fed's policy announcements would not be credible.
The debate over the conduct of monetary policy often focuses on two major questions:
- Should monetary policy be conducted in a discretionary manner or should it follow a fixed rule?
- If an activist monetary policy is used, what should be the monetary target(s)?
As the articles listed below will demonstrate, there is still a substantial amount of disagreement
over these issues. A growing number of economists, however, appear to be advocating an
inflation rate target. Ben Bernanke, the current Chair of the Federal Reserve Board, has long been
an advocate of an inflation-rate target. Advocates of the adoption of this policy are hoping that
the Fed will move toward an inflation-rate target policy during his tenure as Chair.
Primary Resources and Data
- Rebecca Hellerstein, "The Impact of Inflation"
http://www.bos.frb.org/economic/nerr/rr1997/winter/hell97_1.htm
In this Boston Fed online article, Rebecca Hellerstein provides a good
discussion of the actual and perceived economic costs of inflation. This article summarizes
a large volume of relatively technical recent studies in a very easily
understood manner. Many of the arguments for and against a zero inflation rate target
are summarized in this document.
- Alan S. Blinder, "The Strategy of Monetary Policy"
http://minneapolisfed.org/pubs/region/95-09/reg959a.cfm
In this September 1995 article, Alan S. Blinder, the Vice Chairman of the Federal Reserve Board of Governors,
discusses practical problems in the conduct of monetary policy. Blinder provides a nice summary of the
measurement issues making it difficult to achieve a zero-inflation target and examines the difficulties
of conducting monetary policy in an uncertain environment.
- Bank for International Settlements, "Central Bank Websites"
http://www.bis.org/cbanks.htm
This web site contain links to the websites of virtually all central banks that maintain
an internet presence. These web sites often contain information about the conduct of monetary policy
in these countries.
- New Zealand's Policy Targets Agreement
http://www.rbnz.govt.nz/monpol/pta/index.html
This is the text of the "Policy Targets Agreement" that serves as the basis for New
Zealand's 0-3% inflation monetary policy target.
- Bank of Canada, "Monetary Policy"
http://www.bankofcanada.ca/en/backgrounders/bg-p1.html
The Bank of Canada succinctly summarizes its policy of pursuing an inflation target in this online document.
- Federal Reserve District Banks
http://www.oswego.edu/~economic/fed.htm
This page contains a list of links to the home pages of Federal Reserve District Bank web sites.
These sites contain articles dealing with monetary policy and inflation.
- Consumer Price Indexes
http://www.bls.gov/cpi/
This CPI page, provided by the Bureau of Labor Statistics, contains information about the
construction of the CPI. Problems in dealing with the service sector and capturing the effects of
quality change are discussed at this web site.
- Consumer Price Index Conversion Factors
http://oregonstate.edu/cla/polisci/faculty/sahr/sahr.htm
Robert Sahr provides this table of conversion factors that makes it possible
to convert past, present, and projected future prices into 2005 dollars. Estimated conversion factors are provided for the years
1665 - 2016.
- The Inflation Calculator
http://www.westegg.com/inflation/
This page contains an online calculator that converts prices in any year between 1800 and 2005
into the equivalent price in any of these years.
Different Perspectives in the Debate
- Joint Economic Committee, "Establishing Federal Reserve Inflation Goals"
http://www.house.gov/jec/fed/fed/goals.htm
In this April 1997 study, it is argued that a price stability (or zero inflation) target should
be introduced. Historical and international evidence in support of such a policy is presented in this
document.
- Thomas C. Melzer, "To Conclude: Keep Inflation Low and, in Principle, Eliminate It"
http://research.stlouisfed.org/publications/review/97/11/9711tm.pdf
In these November 1997 article, Thomas C. Melzer, past President of the St. Louis
Fed, argues that maintaining price stability is an important goal of the Fed. He suggests that
there is low inflation will result in a higher rate of economic growth. In this
speech, Melzer argues that a credible Fed policy of price stability (or zero inflation) may be
achieved at no substantial economic cost and provides large long-run benefits.
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this viewer by clicking here.)
- The Region, "Fed Presidents Support Zero-Inflation Proposal"
http://minneapolisfed.org/pubs/region/90-02/reg902b.cfm
In this February 1990 article which appeared in The Region (a publication of the Minneapolis Fed), the
presidents of the New York, Cleveland, San Francisco, and Richmond Feds provide brief summaries of
why they feel that a zero-inflation target is a desirable monetary policy objective.
- William Poole, "Is Inflation Too Low?"
http://www.stls.frb.org/news/speeches/1998/10_22_98.html
In these October 22, 1998 remarks, William Poole, the President of the St. Louis Fed,
provides a series of economic arguments in favor of a zero inflation rate target.
- William Poole, "Inflation Targeting"
http://stlouisfed.org/news/speeches/2006/02_16_06.htm
William Poole, provides additional arguments in favor of a zero inflation rate target in this
February 16, 2006 speech. Since there is some measurement error in price indexes, he supports
an inflation target in the range of 0.5% to 1.5% annual inflation. He argues that the successful
pursuit of such a target would result in lower interest rates in bond markets, encouraging additional
investment. Poole suggests that the use of an explicit inflation target would enhance the Fed's
ability to engage in countercyclical policy.
- Edward M. Gramlich, "The Politics of Inflation Targeting"
http://www.federalreserve.gov/Boarddocs/speeches/2005/20050526/default.htm
Edward M. Gramlich, a member of the Federal reserve Board of Governors, expresses his views
on inflation targeting in this May 26, 2005 speech. He observes that countries that have adopted
inflation targets have been successful in reducing inflation rates and interest rates. Gramlich notes,
though, that the U.S. has been able to effectively achieve these goals without an explicit
inflation-rate target. He observes that the countries that have adopted an inflation-rate target
have parliamentary governments. Gramlich argues that the situation would be more complex under the
U.S. political system in which the Fed would be answerable to the policy objectives of the executive
branch and both houses of Congress. He notes that there has not been much support from Congress for
a switch to an inflation-rate target. Gramlich argues that since the Fed has already been effective in
reducing inflation, the benefits from a switch to an inflation-target would be small while the
potential costs are large.
- Interview with W. Lee Hoskins
http://minneapolisfed.org/pubs/region/91-06/int916.cfm
In this June 1991 interview which appeared in The Region (a publication of the Minneapolis Fed), W. Lee Hoskins, the
President of the Cleveland Fed, discusses his arguments for a zero inflation target. Hoskins
argues that inflation distorts relative prices and results in economic inefficiency.
- W. Lee Hoskins, "Defending Zero Inflation: All for Naught"
http://research.mpls.frb.fed.us/research/qr/qr1522.pdf
In this Spring 1991 article (appearing in Federal Reserve Bank of Minneapolis Quarterly
Review), W. Lee Hoskins provides a detailed discussion of his arguments for a zero inflation
monetary target. He argues that inflation results in:
- higher taxes (since not all taxes are indexed),
- distortions caused by inflation rate uncertainty, and
- higher prices for nonmonetary assets that are used as
a hedge against inflation.
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- Lee Hoskins, Zero Inflation: Goal and Target
http://www.somc.rochester.edu/Dec05/Hoskins.pdf
In these December 5, 2005 remarks to the Shadow Open Market Committee, Lee Hoskins builds a case for
a zero-inflation rate target. He argues that the Fed is unable to effectively use monetary policy
to stabilize the business cycle because of the lag in recognizing the need for a change in policy
and the long and variable lag in the effect of the policy on the economy. Hoskins argues, though, that
the Fed has much more control over the inflation rate. He recommends that the Fed attempt to maintain
an average inflation rate of zero over a three- or five-year period.
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- S. Rao Aiyagari, "Response to a Defense of Zero Inflation"
http://research.mpls.frb.fed.us/research/qr/qr1523.pdf
In this response to W. Lee Hoskins article (above), S. Rao Aiyagari argues that a zero inflation target
is undesirable because:
- the Fed's commitment to a zero inflation target is not likely to be credible,
- it would reduce the tax on capital income (Aiyagari argues that if this is a goal, it should be implemented through changes in the tax code, not through monetary policy), and
- it is argued that there is little evidence suggesting that a zero inflation
target will reduce uncertainty about the variability of inflation.
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- George A. Akerlof, William T. Dickens, and George L. Perry, "Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?"
http://www.brook.edu/printme.wbs?page=/comm/policybriefs/pb04.htm
In this Brookings Institution Policy Brief, Akerlof, Dickens, and Perry argue that there are substantial
permanent costs associated with pursuing a zero inflation target. According to their argument,
these costs exist as a result of firms' reluctance to reduce nominal wages. The results of a simulation
model suggests that reducing the inflation rate below 3% would result in an increase in unemployment that
would persist as long as this inflation target is maintained.
- George A. Akerlof, William T. Dickens, and George L. Perry, "Options for Stabilization Policy: A New
Analysis of Choices Confronting the Fed"
http://www.brook.edu/printme.wbs?page=/comm/policybriefs/pb69.htm
This February 2001 Brookings Institute Policy Brief examines the use of monetary policy targets. Akerlof, Dickens, and Perry
suggest that the effect of expected inflation varies with the level of realized inflation. They suggest that the conventional
theory of the natural rate of inflation is flawed and attempt to construct a model that they believe more correctly
models the process by which expectations are formed. In particular, they suggest that when inflation is low, its effect is
either ignored or assigned a low weight by economic decision makers. This provides a range of sustainable unemployment rates.
Akerlof, Dickens, and Perry argue that such a model better describes the recent experience of the economy with low rates of
both unemployment and inflation. They suggest that there is little or no benefit to a zero-inflation target and substantial costs
since this would limit relative price flexibility (since it is argued that prices are somewhat rigid in a downward direction).
- Remarks by Vice Chair Alice M. Rivlin at the Annual Meeting of the Eastern
Economic Association, Washington, D.C. April 4, 1997
http://www.federalreserve.gov/boarddocs/speeches/19970404.htm
Alice Rivlin, Vice Chair of the Federal Reserve Board of Governors, discusses the objectives
of monetary policy in this address. She argues that a zero inflation target is undesirable due to
problems in measuring inflation and the possibility that the costs would outweigh the benefits. Rivlin
argues that the ultimate goals of monetary policy should be a high (and sustainable) rate of
economic growth and a low unemployment rate.
- John H. Makin, "What Should Central Banks Do?"
http://www.aei.org/publications/pubID.10819/pub_detail.asp
In this October 1999 Economic Outlook article, John Makin discusses the choices facing
monetary policymakers. He argues that central banks were originally formed to maintain stable
financial markets and not to fight inflation. In particular, Makin suggests that the Federal Reserve System was
created in 1913 in reaction to financial panics, particular the financial panic of 1907. He
argues that a low or zero inflation target is just a convenient mechanism for preserving
stable financial markets. Makin observes that central banks have demonstrated an ability to
rein in inflationary pressures, but expresses concern about how they would deal with a period of
deflation. He notes that the Fed is in a difficult position since it needs credibility to maintain
stable financial markets. Since the Fed must follow it's announced policy of a low inflation
target to maintain this credibility, Makin argues that it is unable to effectively deal with other
problems that may occur in financial markets.
- Ben S. Bernanke, "Remarks by Governor Ben S. Bernanke at the 28th Annual
Policy Conference: Inflation Targeting: Prospects and Problems,"
http://www.federalreserve.gov/Boarddocs/Speeches/2003/20031017/default.htm
Ben S. Bernanke provides arguments for the adoption of an inflation-rate target in this October 17,
2003 statement. He argues that the benefits of adopting a low inflation rate target (of approximately 2%)
outweigh the costs. Bernanke is opposed to an inflation rate target that is very close to zero
because of concern over the costs associated with possible deflation.
- Federal Reserve Bank of Minneapolis, "Interview with Ben Bernanke"
http://www.minneapolisfed.org/pubs/region/04-06/bernanke.cfm
In this June 2004 interview, Ben Bernanke discusses his advocacy of an inflation-rate target. He
observes that the Fed has already shifted most of its focus to targeting the inflation rate, since this
is the only outcome that the Fed can control in the long run. Bernanke argues that the adoption
of an explicit low-inflation target would help stabilize inflationary expectations and reduce
macroeconomic instability. (A wide range of other macroeconomic topics are also discussed in this interview.)
- Federal Reserve Bank of Minneapolis, "Interview with James Tobin"
http://woodrow.mpls.frb.fed.us/pubs/region/96-12/tobin.cfm
James Tobin was the 1981 recipient of the Nobel Prize in Economics for his work on money demand.
In this 1996 interview, Tobin states his views on monetary theory (as well as on other policy issues).
He argues that the Fed should consider both unemployment and inflation rate targets in establishing monetary
policy. Tobin also argues that there should be more political control over the Fed.
- Edward M. Gramlich, "The Politics of Inflation Targeting"
http://www.federalreserve.gov/boarddocs/speeches/2005/20050526/default.htm
In this May 26, 2005 speech, Edward M. Gramlich examines the spread of an inflation target. He notes that
the 20 countries that have adopted inflation targeting have experienced declining inflation rates
without experiencing a decline in economic growth. Gramlich notes, though, that this is not conclusive
evidence since other countries (such as the U.S.) also experienced lower inflation without a decline in
growth during the same period. He observes that attempts to introduce a U.S. inflation target in Congress
have not been successful. Gramlich suggests that the best chance of introducing an inflation
target would be through the Fed's introduction of a soft target. This could be used to lobby Congress to move
toward the adoption of an inflation target.
- Stanley Fischer, "Central Banking: The Challenges Ahead"
http://www.worldbank.org/fandd/english/1296/articles/0101296.htm
In this article, Stanley Fischer, the First Deputy Managing Director of the International Monetary Fund, examines
some of the major issues facing central banks. He argues that an inflation target is an appropriate monetary
policy objective, but believes that a positive inflation target is preferable to a zero inflation target.
- John H. Makin, "How Low Should Inflation Go?"
http://www.aei.org/publications/pubID.6952/pub_detail.asp
In this October 1996 article appearing in Economic Outlook, John H. Makin
provides a very nice summary of the problems in establishing an inflation target.
One reason for this is the existence of an inflationary bias in the consumer price index.
This means that a target of zero actual inflation coincides with a positive measured
inflation rate. Makin also provides a concise description of the practical
problems facing the Fed in implementing an inflation target.
- Alan Greenspan, "Problems of Price Measurement"
http://www.federalreserve.gov/boarddocs/speeches/19980103.htm
In this January 3, 1998 speech delivered at the American Economic Association, Alan Greenspan,
the Chairman of the Federal Reserve Board of Governors, presents a detailed
discussion of the problems associated with measuring inflation. This article provides a particularly
good discussion of the difficulties in measuring price changes in
the service sector and for goods that exhibit quality change over time.
- Nicholas Rowe and David Tulk, "A Simple Test of Simple Rules: Can They Improve How Monetary Policy is Implemented with Inflation Targets?"
http://www.bankofcanada.ca/en/res/wp/2003/wp03-31.pdf
Nicholas Rowe and David Tulk examine the possible effect of alternative monetary policy rules in this October 2003 Bank
of Canada Working Paper. They find that a variety of simple rules would not have improved the bank's performance in achieving
inflation targets. (To view this document, the Adobe Acrobat viewer plugin is required. You may download
this viewer by clicking here.)
- Nicholas Apergis, Stephen M. Miller, Alexandros Panethimitakis, and Athanasios Vamvakidis,
"Inflation Targeting and Output Growth: Empirical Evidence for the European Union"
http://www.imf.org/external/pubs/ft/wp/2005/wp0589.pdf
Nicholas Apergis, Stephen M. Miller, Alexandros Panethimitakis, and Athanasios Vamvakidis examine
the effectiveness of an inflation target in this May 2005 IMF working paper. They find that the
use of an inflation-rate target resulted in a higher degree of macroeconomic stability. A low inflation-rate
target, though, resulted in better performance than a zero inflation-rate target.
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