The Inflation Obsession: Flying in the Face of the Facts

Should a central bank address a broad agenda of economic growth, price stability, and full employment? Or should it focus single-mindedly on controlling inflation? Last autumn this debate mounted in Europe, where calls from social democratic governments for lower interest rates grew louder as the continent prepared for the European Central Bank. In the United States, where federal law stipulates full employment as a policy goal, Republican proposals to require that the Federal Reserve focus only on inflation surface regularly in Congress.

Ben S. Bernanke and his colleagues, each a veteran of the Federal Reserve Bank of New York research staff, make the case for inflation targeting in a book that has the intellectual rigidity of a manifesto. But their tone, worried rather than strident, will seem familiar to followers of the recurrent debates over competitiveness, which cater to national vanity in similar terms. In the authors' eyes, the United States is "lagging behind other industrial countries in considering monetary policy frameworks and institutions that might help ensure good economic performance in the long term."

Since the early 1980s, a handful of countries have formally declared that low and stable inflation should be the overriding objective of monetary policy. These countries, which include New Zealand, Canada, Great Britain, and Sweden, are the main focus of the book. After reviewing these cases, Inflation Targeting uses them as examples to argue that inflation targeting would also enhance American "economic performance in the long term." But the authors have a curious interpretation of this phrase. They do not use it to refer to rising living standards, full employment, declining inequality in pay, or similar recent improvements in American material well-being. Rather, they explicitly deny that monetary policy should be praised for these blessings, since the gains of an expansionary monetary policy are inherently temporary and unsustainable. Economists should therefore not count such gifts among the benefits of a sensible long-term monetary policy.

In other words, America's present affair with full employment is sure to end badly, with an acceleration of inflation leading finally to recession and unemployment. In contrast, the right strategy to fight inflation is to keep unemployment high enough all the time at its "natural" rate, or as low as joblessness can go without sparking inflation. A central bank distracted by the pursuit of economic growth and full employment is to be condemned, while a central bank that achieves price stability at the cost of chronic high unemployment -- as in Germany -- has done its duty. The European Central Bank, charter-bound to price stability whatever the cost, represents the pinnacle achievement for this school of thought. Meanwhile, the Federal Reserve -- unmentioned in the U.S. Constitution, obliged to report on unemployment -- must seem emasculated in comparison.

OFF TARGET?

The case for inflation targeting, as Bernanke and his colleagues present it, rests on a theory -- the natural rate of unemployment mentioned above -- that links monetary policy exclusively to inflation control and denies central banks any important role in determining economic growth or employment. As disciples of the natural-rate doctrine, our authors favor inflation targeting not simply as the better strategy, but as the only strategy consistent with sound economics. But are these principles correct?

The authors do not bother to argue their case, but merely tell us that these truths were presented by Milton Friedman in 1967, refined by Robert Lucas in 1976, and consequently were accepted by most economists. Indeed, the theme of consensus crops up time and again. We read that "most macroeconomists agree" the inflation rate is the only variable that monetary policy can affect in the long run; that there is "by now something of a consensus that even moderate rates of inflation are harmful"; and that there "is a growing belief among economists and central bankers" that low inflation is good for both efficiency and growth. For the authors, the case is closed and consensus has settled the issue.

In fact, no such consensus exists or has ever existed. To take just a few examples, Robert Eisner, a former president of the American Economics Association and a renowned macroeconomist, has never accepted the Friedman/Lucas view. Neither has James Tobin, Paul Samuelson, Robert Solow, or the late William Vickrey -- all Nobel laureates. Neither did Ray Fair at Yale, James Medoff at Harvard, or William Dickens at the Brookings Institution. Bernanke and his colleagues maintain the illusion of consensus by ignoring the actual debate, which has grown more intense, not less, in recent years.

There are two basic reasons why this controversy persists. First, although the FriedmanffiLucas doctrine does enjoy some academic dominance, it rests on a peculiar philosophical position that regards the future as a sort of lottery drawing. For example, it would view the Asian financial crisis not as a policy failure but merely an unfortunate, random outcome. Not surprisingly, many thoughtful economists reject this approach. Second, the real world has been openly contradicting the theory for years. Three years ago, every advocate of the natural-rate doctrine firmly held that unemployment below six percent would spark inflation. Unemployment has since fallen, but contrary to theory it not only has remained below the supposed natural rate but has failed to touch off inflation. The Friedman/Lucas arguments have received a clear empirical rebuke.