The Overstretched Superpower
Does America Have More Rivals Than It Can Handle?
James K. Galbraith takes our book, Inflation Targeting: Lessons from the International Experience, as the jumping-off point for a screed against obsession with price stability ("The Inflation Obsession: Flying in the Face of the Facts," January/February 1999). He does Foreign Affairs readers a disservice by misrepresenting our argument and, as a result, leaves them uninformed about perhaps the most important current debate on the conduct of monetary policy.
DEMOLISHING A STRAW MAN
Inflation targeting -- and our "manifesto" in favor of it (to use Galbraith's characterization) -- is not so much about the objectives of monetary policy as about its implementation, particularly the way in which monetary decisions are made and explained. Neither the inflation-targeting regimes adopted by countries such as Australia, Canada, Israel, New Zealand, Spain, Sweden, and the United Kingdom nor the arguments advanced in our book commit inflation targeters to a destructive, single-minded focus on inflation in the short term. To the contrary, the features that accompany such systems -- namely, the added transparency and accountability of central banks that have publicly announced inflation targets -- are the best guarantees against policy mistakes. This is why the European Central Bank and the Federal Reserve Board should adopt these measures.
Galbraith is too concerned with demolishing a straw man to pay much attention to what our book actually says. He asserts, for example, that "the authors of Inflation Targeting do not discuss the Humphrey-Hawkins Act," the U.S. legislation most closely addressing the Fed's mandate and accountability. If Galbraith had glanced at our index, he would have seen that we actually have a three-page discussion of Humphrey-Hawkins in the context of our recommendations for enhancing the transparency of the Fed's operations. A little later, he dismisses our argument that inflation-targeting countries have enjoyed improved economic performance: "A fair evaluation of this claim would require a comparative perspective, which the authors do not provide." Yet our book contains 9 country studies spread over 163 pages, plus a chapter comparing the economic performance of 4 inflation-targeting countries to that of 4 nontargeting countries. What does this provide if not "a comparative perspective," and a fair one at that?
IT'S IN THERE
Galbraith contends that our argument "rests on a theory that links monetary policy exclusively to inflation control and denies central banks any important role in determining economic growth and unemployment." He further implies that if the Fed had followed our advice in its policymaking during the 1990s, it would have raised interest rates unnecessarily because it paid exclusive attention to the "natural rate of unemployment" while ignoring the leading economic indicators. Regarding the first claim, we state quite explicitly in Inflation Targeting that "the idea that monetary policy literally has no goals other than to control inflation would find little support from the public, from central bankers, or from monetary economists," and it finds none from us either, as our argument makes clear. With respect to the allegation that we favor a blinkered Fed, in our book we note that "inflation targeting requires the central bank to use structural and judgmental models of the economy, in conjunction with whatever information it deems relevant. In other words, inflation targeting is very much a 'look at everything' strategy."
On the fundamental issue of monetary policy goals, Galbraith ignores what we wrote in favor of attempted mind-reading, commenting, "One suspects instead that what they really want is to abandon full employment as a formal objective of American monetary policy." If we really wanted that, we would have written that -- but we don't want it so we didn't. In our discussion of Humphrey-Hawkins -- the one that Galbraith claims does not exist -- we explicitly describe the implications of the Fed's adopting our inflation-targeting proposal: "The Humphrey-Hawkins legislation now in effect appears to be sufficiently broad and non-specific to make new legislation unnecessary to implement the framework we have proposed here. Nevertheless, it would be desirable to modify the [law so that it] specifies that price stability is the overriding long-run objective of monetary policy, but also mandates attention to other important economic goals." And as we conclude approvingly from our research on various countries' experiences with inflation targeting, "the notion that monetary policy-makers under inflation targeting are indifferent to the performance of the real economy is simply incorrect. The capacity to deviate from the target if necessary allows the central bank a significant degree of flexibility in trying to stabilize the economy in the short run."
The reality about inflation targeting matters for much more than fairness to our work. The biggest current issues in monetary policy are, in the short run, avoiding deflation in Japan and the new European Central Bank's eurozone, and in the long run, setting the direction for American monetary policy in preparation for Alan Greenspan's inevitable departure as chair of the Fed. Inflation targeting of the type that we advocate is both the most economically beneficial and the most democratically accountable response to both of these challenges.
In a general sense, a short-run inflation target sets a floor above zero, as well as a ceiling, for the rate of price increase for consumer goods. Adherence to the target means that the central bank must loosen monetary policy when the rate of price increase threatens to be too low, just as it must tighten policy when forecasted inflation is too high. Fighting deflationary tendencies becomes easier when inflation targets are publicly announced, for two reasons. First, the target may help to anchor the public's expectations of inflation, preventing an upward inflationary spiral when the central bank pursues expansionary policies to resist deflation. Second, the transparency and accountability of the policy process in inflation-targeting regimes implies that the central bank will be called to account should its policies prove excessively deflationary. The need to insure against deflation is why we strongly advocate greater-than-zero inflation targets in our book, and we state repeatedly that undershooting the inflation target must be opposed every bit as strenuously as overshooting it.
BANKS IN GLASS HOUSES . . .
The greater transparency of policymaking under inflation targeting is also why we recommend this approach for a post-Greenspan Fed. The Fed has performed well during the 1990s, using policies that in many ways -- particularly in their emphasis on keeping inflation low in the long run -- are similar to our proposals. The main difference between current Fed policy and a full-blown inflation-targeting approach is the Fed's relative lack of emphasis on transparency and accountability. The "just trust us" approach may work in a period when the chair and the Board of Governors command widespread support and confidence. But the happy state of affairs will not last forever. It is more sensible, and more democratic, to begin to act now to depersonalize monetary policymaking by increasing Fed transparency and accountability. For example, as was demonstrated by our case studies of the British and Canadian experiences, a formal inflation target would be constructive in channeling debates about monetary policy (in Congress and elsewhere) away from ideological generalities and toward specific issues, such as the appropriateness of the Fed's long-run inflation goal and the Fed's record in achieving its targets. An inflation target would also reduce uncertainty in financial markets about the Fed's prospective policies, since its targets and forecasts would be public information.
The importance of monetary policy arises from its effects on real economic growth. Price stability is not an independent objective but a means to an end. Central banks face the difficult practical problem of keeping inflation and expectations low in the long run (in order to promote growth), while permitting the short-run deviations from price stability that are necessary to keep the macroeconomy on course in the face of unpredictable economic and financial shocks. Our research convinces us that inflation targeting -- because it balances transparency and flexibility -- is the best available framework for managing that difficult task. Our book justifies that view through historical analysis and shows how inflation targeting has been, and should be, implemented in practice.
Ben S. Bernanke is Harrison and Beck Professor of Economics and Public Affairs and Chair of the Department of Economics at Princeton University. Thomas Laubach is an economist at the Federal Reserve Bank of Kansas City. Frederic S. Mishkin is A. Barton Hepburn Professor of Economics at Columbia University's Graduate School of Business. Adam S. Posen is Research Fellow at the Institute for International Economics.