Ben S Bernanke: A perspective on inflation targeting
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the Annual Washington Policy Conference of the National Association of Business
references for the speech can be found on the website of
Economists, Washington, DC, 25 March 2003.The
the Board of Governors of the US Federal Reserve System.
* * *
One of the more interesting developments in central banking in the past dozen years or so has been
inflation
the increasingly widespread adoption of the monetary policy framework known as targeting.
The approach evolved gradually from earlier monetary policy strategies that followed the demise of the
Bretton Woods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's
Bundesbank and the Swiss National Bank during the latter part of the 1970s and the 1980s. For
example, the Bundesbank, though it conducted short-term policy with reference to targets for money
supply growth, derived those targets each year by calculating the rate of money growth estimated to
be consistent with the bank's long-run desired rate of inflation, normally 2 percent per year. Hence, the
Bundesbank indirectly targeted inflation, using money growth as a quantitative indicator to aid in the
calibration of its policy. Notably, the evidence suggests that, when conflicts arose between its money
growth targets and inflation targets, the Bundesbank generally chose to give greater weight to its
inflation targets (Bernanke and Mihov, 1997).1
The inflation-targeting approach became more explicit with the strategies adopted in the early 1990s
by a number of pioneering central banks, among them the Reserve Bank of New Zealand, the Bank of
Canada, the Bank of England, Sweden's Riksbank, and the Reserve Bank of Australia. Over the past
decade, variants of inflation targeting have proliferated, with newly industrialized and emerging-market
economies (Brazil, Chile, Israel, Korea, Mexico, South Africa, the Philippines, and Thailand, among
others) being among the most enthusiastic initiates. Most recently, this policy framework has also
been adopted by several transition economies, notably the Czech Republic, Hungary, and Poland.2
Central banks that have switched to inflation targeting have generally been pleased with the results
they have obtained. The strongest evidence on that score is that, thus far at least, none of the several
dozen adopters of inflation targeting has abandoned the approach.3
As an academic interested in monetary policy, several years ago I became intrigued by inflation
targeting and went on to co-author a book and several other pieces about this approach.4 As I
continue to follow developments in the area, I must say, however, that discussions of inflation targeting
in the American media remind me of the way some Americans deal with the metric system--they don't
really know what it is, but they think of it as foreign, impenetrable, and possibly slightly subversive. So,
in the hope of cutting through some of the fog, today I will offer my own, perhaps somewhat
idiosyncratic, view of inflation targeting and its potential benefits, at least in what I consider to be its
best-practice form.5 I will also try to dispel what I feel are a few misconceptions about inflation
targeting that have gained some currency. Finally, I will end with a few words, and one modest
suggestion, about the implications of the experience with inflation targeting for the practice of
monetary policymaking at the Federal Reserve.6 My main objective today, however, is to clarify, not to
1
The interpretation of the Bundesbank as a proto-inflation targeter is not universally accepted. Certainly, the Bundesbank did
not put the same emphasis on communication and transparency that modern inflation-targeting central banks do.
2
Mishkin and Jonas (forthcoming) describe the experiences of the three transition economies with inflation targets.
3
A few countries that used inflation targeting in the transition to European monetary union are a partial exception. The
European Central Bank itself has an inflation objective (a ceiling of 2 percent) but does not refer to itself as an
inflationtargeting central bank, largely on the grounds that (officially, at least) it also puts some weight on money growth in its policy
decisions. As a newly created central bank presiding over a monetary union, the ECB is unique in more fundamental ways
as well; hence, the lessons from the ECB experience for the Federal Reserve and other established central banks may be
somewhat limited.
4
See in particular Bernanke and Mishkin (1997) and Bernanke, Laubach, Mishkin, and Posen (1999).
5
By focusing on what I call "best practice" inflation targeting, I must necessarily be somewhat subjective; but then my goal
today is largely normative, not descriptive.
6
For a more detailed exposition of the case for inflation targeting in the United States, see Goodfriend (forthcoming).
BIS Review 15/2003
advocate. Of course, my comments today reflect my own views and do not necessarily reflect those of
my colleagues at the Federal Reserve Board or on the Federal Open Market Committee.
Best-Practice Inflation Targeting: One View
Although inflation targeting has a number of distinguishing features--the announcement of a
quantitative target for inflation being the most obvious--capturing the essence of the approach is not
entirely straightforward. The central banks that call themselves inflation targeters, as well as the
economies they represent, are a diverse group indeed, and (not surprisingly) institutional and
operational features differ. Moreover, many central banks that have not formally adopted the
framework of inflation targeting have clearly been influenced by the approach (or, if you prefer, the
same ideas and trends have influenced both inflation-targeters and non-inflation-targeters). For
example, over the past twenty years, the Federal Reserve, though rejecting the inflation-targeting
label, has greatly increased its credibility for maintaining low and stable inflation, has become more
proactive in heading off inflationary pressures, and has worked hard to improve the transparency of its
policymaking process--all hallmarks of the inflation-targeting approach. In short, to draw a bright line
between central banks practicing full-fledged inflation targeting and those firmly outside the
inflationtargeting camp is more difficult than one might first guess--a fact, by the way, that substantially
complicates economists' attempts to assess empirically the effects of this approach.
Nevertheless, for expository purposes, I find it useful to break down the inflation targeting approach
into two components: (1) a particular framework for making policy choices, and (2) a strategy for
communicating the context and rationale of these policy choices to the broader public. Let's call these
two components of inflation targeting the policy framework and the communications strategy, for short.
The policy framework of inflation targeting
By the policy framework I mean the principles by which the policy committee decides how to set its
policy instrument, typically a short-term interest rate. In an earlier speech, I referred to the policy
framework that describes what I consider to be best-practice inflation targeting as constrained
discretion.7 Constrained discretion attempts to strike a balance between the inflexibility of strict policy
rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion.
Under constrained discretion, the central bank is free to do its best to stabilize output and employment
in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of
the economy and of the effects of policy (this is the "discretion" part of constrained discretion).
However, a crucial proviso is that, in conducting stabilization policy, the central bank must also
maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly
under control (the "constrained" part of constrained discretion). Because monetary policy influences
inflation with a lag, keeping inflation under control may require the central bank to anticipate future
movements in inflation and move preemptively. Hence constrained discretion is an inherently
forward-looking policy approach.
Although constrained discretion acknowledges the crucial role that monetary policy plays in stabilizing
the real economy, this policy framework does place heavy weight on the proposition that maintenance
of low and stable inflation is a key element--perhaps I should say the key element--of successful
monetary policy. The rationale for this emphasis goes well beyond the direct benefits of price stability
for economic efficiency and growth, important as these are. The maintenance of price stability--and
equally important, the development by the central bank of a strong reputation for and commitment to
it-also serves to anchor the private sector's expectations of future inflation. Well-anchored inflation
expectations (by which I mean that the public continues to expect low and stable inflation even if
actual inflation temporarily deviates from its expected level) not only make price stability much easier
to achieve in the long term but also increase the central bank's ability to stabilize output and
employment in the short run. Short-run stabilization of output and employment is more effective when
inflation expectations are well anchored because the central bank need not worry that, for example, a
policy easing will lead counterproductively to rising inflation and inflation expectations rather than to
stronger real activity.
In my earlier speech, I gave the Great Inflation of the 1970s in the United States as an example of
not
what can happen when inflation expectations are well anchored. Contrary to the belief in a
long-run tradeoff between inflation and unemployment held by many economists in the 1960s,
unemployment and inflation in the 1970s were both high and unstable. Even today conventional
wisdom ascribes this unexpected outcome to the oil price shocks of the 1970s. Though increases in oil
prices were certainly adverse factors, poor monetary policies in the second half of the 1960s and in
the 1970s both facilitated the rise in oil prices themselves and substantially exacerbated their effects
on the economy.
Monetary policy contributed to the oil price increases in the first place by creating an inflationary
environment in which excess nominal demand existed for a wide range of goods and services. For
example, in an important paper, Barsky and Kilian (2001) noted that the prices of many industrial
commodities and raw materials rose in the 1970s about the same time as oil prices, reflecting
broad-based inflationary pressures. Without these general inflationary pressures, it is unlikely that the
oil producers would have been able to make the large increases in oil prices "stick" for any length of
time.
Besides helping to make the oil price increases possible, the legacy of poor monetary policies also
exacerbated the effects of the oil price increases on output and employment. When the oil price
shocks hit, beginning in 1973, inflation expectations had already become very unstable, after several
years of increased inflationary pressures and a failed program of price controls under President Nixon.
Because inflation expectations were no longer anchored, the widely publicized oil price increases were
rapidly transmitted into expectations of higher general inflation and, hence, into higher wage demands
and other cost pressures. Faced with an unprecedented inflationary surge, the Fed was forced to
tighten policy. As it turned out, the Fed's tightening was not enough to contain the inflationary surge
but was sufficient to generate a severe recession.
The upshot is that the deep 1973-75 recession was caused only in part by increases in oil prices per
se. An equally important source of the recession was several years of overexpansionary monetary
policy that squandered the Fed's credibility regarding inflation, with the ultimate result that the
economic impact of the oil producers' actions was significantly larger than it had to be. Instability in
both prices and the real economy continued for the rest of the decade, until the Fed under Chairman
Paul Volcker re-established the Fed's credibility with the painful disinflationary episode of 1980-82.
This latter episode and its enormous costs should also be chalked up to the failure to keep inflation
and inflation expectations low and stable.
In contrast to the 1970s, fluctuations in oil prices have had far smaller effects on both inflation and
output in the United States and other industrialized countries since the early 1980s. In part this more
moderate effect reflects increased energy efficiency and other structural changes, but I believe the
dominant reason is that the use of constrained discretion in the making of monetary policy has led to
better anchoring of inflation expectations in the great majority of industrial countries. Because inflation
expectations are now more firmly tied down, surges and declines in energy prices do not significantly
affect core inflation and thus do not force a policy response to inflation to the extent they did three
decades ago. Indeed, rather than leading to a tightening of monetary policy, increases in oil prices
today are more likely to promote consideration of increased policy ease--a direct and important benefit
of the improved control of inflation.
The communications strategy of inflation targeting
The second major element of best-practice inflation targeting (in my view) is the communications
strategy, the central bank's regular procedures for communicating with the political authorities, the
financial markets, and the general public. In general, a central bank's communications strategy,
closely linked to the idea of transparency, has many aspects and many motivations.8 Aspects of
communication that have been particularly emphasized by inflation-targeting central banks are the
public announcement of policy objectives (notably, the objective for inflation), open discussion of the
bank's policy framework (including in some cases, but not all, a timeframe for achieving the inflation
objective), and public release of the central bank's forecast or evaluation of the economy (as reported,
Inflation Reports
for example, in the issued by a number of inflation-targeting central banks).9
Why have inflation-targeting central banks emphasized communication, particularly the communication
of policy objectives, policy framework, and economic forecasts? In the 1960s, many economists were
greatly interested in adapting sophisticated mathematical techniques developed by engineers for
controlling missiles and rockets to the problem of controlling the economy. At the time, this adaptation
of so-called stochastic optimal control methods to economic policymaking seemed natural; for like a
ballistic missile, an economy may be viewed as a complicated dynamic system that must be kept on
course, despite continuous buffeting by unpredictable forces.
Unfortunately, macroeconomic policy turned out not to be rocket science! The problem lay in a crucial
difference between a missile and an economy--which is that, unlike the people who make up an
economy, the components of a missile do not try to understand and anticipate the forces being applied
to them. Hence, although a given propulsive force always has the same, predictable effect on a
ballistic missile, a given policy action--say, a 25-basis-point cut in the federal funds rate--can have very
different effects on the economy, depending (for example) on what the private sector infers from that
action about likely future policy actions, about the information that may have induced the policymaker
to act, about the policymaker's objectives in taking the action, and so on. Thus, taking the "right" policy
action--in this case, changing the federal funds rate by the right amount at the right time--is a
necessary but not sufficient condition for getting the desired economic response. Most
inflation-targeting central banks have found that effective communication policies are a useful way, in
effect, to make the private sector a partner in the policymaking process. To the extent that it can
explain its general approach, clarify its plans and objectives, and provide its assessment of the likely
evolution of the economy, the central bank should be able to reduce uncertainty, focus and stabilize
private-sector expectations, and--with intelligence, luck, and persistence--develop public support for its
approach to policymaking.
Of course, as has often been pointed out, actions speak louder than words; and declarations by the
central bank will have modest and diminishing value if they are not clear, coherent, and--most
important--credible, in the sense of being consistently backed up by action. But agreeing that words
must be consistently backed by actions is not the same as saying that words have no value. In the
extreme, I suppose a central bank could run a "Marcel Marceau" monetary policy, allowing its actions
to convey all its intended meaning. But common sense suggests that the best option is to combine
actions with words--to take clear, purposeful, and appropriately timed policy actions that are supported
by coherent explanation and helpful guidance about the future.
One objection that has been raised to the public announcement of policy objectives, economic
forecasts, and (implicit or explicit) policy plans by central banks is that even relatively modest
commitments along these lines may limit their flexibility to choose the best policies in the future. Isn't it
always better to be more rather than less flexible? Shouldn't the considered judgment of experienced
policymakers always trump rules, even relatively flexible ones, for setting policy?
I agree that human judgment should always be the ultimate source of policy decisions and that no
central bank should--or is even able to--commit irrevocably in advance to actions that may turn out to
be highly undesirable. However, the intuition that more flexibility is always better than less flexibility is
quite fallacious, a point understood long ago by Homer, who told of how Ulysses had himself tied to
the mast so as not to fall victim to the songs of the Sirens. More recently, the notion that more
flexibility is always preferable has been pretty well gutted by modern game theory (not to mention
modern monetary economics), which has shown in many contexts that the ability to commit in advance
often yields better outcomes.
For illustration of the potential benefits to policymakers of even modest self-imposed restrictions on
flexibility, consider fiscal policy, which shares with monetary policy some of the same issues that arise
when a group of shifting membership makes a series of policy decisions that have both short-run and
long-run implications. In the short run, fiscal policymakers may have important and legitimate reasons
to depart from budget balance, sometimes even substantially--for example, to appropriate funds to
deal with a national emergency or to provide a stimulus package to assist economic recovery. In the
long run, however, maintaining public confidence requires that fiscal policy be conducted in such a
way that the ratio of national debt to GDP remains stable at a moderate level. Arguably, public
confidence, and hence the ability of policymakers to use fiscal instruments aggressively to address
short-term concerns, is enhanced by whatever legislative rules, guidelines, or procedures exist
that-however gently or firmly--tend to compel the policymakers to bring the budget back toward balance,
and the debt-GDP ratio back toward stability, after the crisis has passed. True, spending caps,
comprehensive budget resolutions, mandatory long-term deficit projections, and similar provisions, to
the extent that they are effective, may reduce at least a bit the flexibility of fiscal policymakers. But if
intentionally yielding a bit of flexibility increases public confidence in the long-run sustainability of the
government's spending and tax plans, fiscal policymakers may find that adopting these rules actually
enhances their ability to act effectively in the short run.
As with fiscal policy, public beliefs about how monetary policy will perform in the long run affect the
effectiveness of monetary policy in the short run. Suppose, for example, that the central bank wants to
stimulate a weak economy by cutting its policy interest rate. The effect on real activity will be strongest
if the public is confident in the central bank's unshakable commitment to price stability, as that
confidence will moderate any tendency of wages, prices, or long-term interest rates to rise today in
anticipation of possible future inflationary pressures generated by the current easing of policy. Now the
central bank's reputation and credibility may be entirely sufficient that no additional framework or
guidelines are needed. Certainly, in general, the greater the inherited credibility of the central bank,
the less restrictive need be the guidelines, targets, or the like that form the central bank's
communication strategy. But credibility is not a permanent characteristic of a central bank; it must be
continuously earned. Moreover, an explicit policy framework has broader advantages, including
among others increased buy-in by politicians and the public, increased accountability, reduced
uncertainty, and greater intellectual clarity. Hence, though a central bank with strong credibility may
wish to adopt a relatively loose and indicative set of guidelines for communication with the public, even
such a bank may benefit from increasing its communication with the public and adding a bit of
structure to its approach to making policy. From the public's perspective, the central bank's
commitment to a policy framework, including a long-run inflation target, imposes the same kind of
discipline and accountability on the central bank that a long-term commitment to fiscal stability places
on the fiscal authorities.
Misconceptions about inflation targeting
I would like to turn now, briefly, to comment on a few key misconceptions about inflation targeting that
have gained some currency in the public debate.
Misconception #1: Inflation targeting involves mechanical, rule-like policymaking. As Rick Mishkin and
I emphasized in our early expository article (Bernanke and Mishkin, 1997), inflation targeting is a
policy framework, not a rule. If it is to be coherent and purposeful, all policy is made within some sort
of conceptual framework; the question is the degree to which the framework is explicit. Inflation
targeting provides one particular coherent framework for thinking about monetary policy choices
which, importantly, lets the public in on the conversation. If this framework succeeds in its goals of
anchoring inflation expectations, it may also make the policymaker's ultimate task easier. But making
monetary policy under inflation targeting requires as much insight and judgment as under any policy
framework; indeed, inflation targeting can be particularly demanding in that it requires policymakers to
give careful, fact-based, and analytical explanations of their actions to the public.
Misconception #2: Inflation targeting focuses exclusively on control of inflation and ignores output and
employment objectives. Several authors have made the distinction between so-called "strict" inflation
targeting, in which the only objective of the central bank is price stability, and "flexible" inflation
targeting, which allows attention to output and employment as well. In the early days of inflation
targeting, this distinction may have been a useful one, as a number of inflation-targeting central banks
talked the language of strict inflation targeting and one or two came close to actually practicing it. For
quite a few years now, however, strict inflation targeting has been without significant practical
relevance. In particular, I am not aware of any real-world central bank (the language of its mandate
notwithstanding) that does not treat the stabilization of employment and output as an important policy
objective. To use the wonderful phrase coined by Mervyn King, the Governor-designate of the
inflation-targeting Bank of England, there are no "inflation nutters" heading major central banks.10
Moreover, virtually all (I am tempted to say "all") recent research on inflation targeting takes for
granted that stabilization of output and employment is an important policy objective of the central bank.
In short, in both theory and practice, today all inflation targeting is of the flexible variety.11
A second, more serious, issue is the relative weight, or ranking, of inflation and unemployment (or,
more precisely, the output gap) among the central bank's objectives. Countries differ in this regard,
both in formal mandate and in actual practice.12 As an extensive academic literature shows, however,
the general approach of inflation targeting is fully consistent with any set of relative social weights on
inflation and unemployment; the approach can be applied equally well by "inflation hawks," "growth
hawks," and anyone in between. What I find particularly appealing about constrained discretion, which
is the heart of the inflation-targeting approach, is the possibility of using it to get better results in terms
of both inflation and employment. Personally, I subscribe unreservedly to the Humphrey-Hawkins dual
mandate, and I would not be interested in the inflation-targeting approach if I didn't think it was the
best available technology for achieving both sets of policy objectives.13
Misconception #3: Inflation targeting is inconsistent with the central bank's obligation to maintain
financial stability. Let me address this point in the context of the United States. The most important
single reason for the founding of the Federal Reserve was the desire of the Congress to increase the
stability of American financial markets, and the Fed continues to regard ensuring financial stability as a
critical responsibility. (By the way, this is a reason to be nervous about the recent trend of separating
central banking and financial supervision; I hope we have the sense not to do that here.) I have always
taken it to be a bedrock principle that when the stability or very functioning of financial markets is
threatened, as during the October 1987 stock market crash or the September 11 terrorist attacks, that
the Federal Reserve would take a leadership role in protecting the integrity of the system. I see no
conflict between that role and inflation targeting (indeed, inflation targeting seems to require the
preservation of financial stability as part of preserving macroeconomic stability), and I have never
heard a proponent of inflation targeting argue otherwise.14
Inflation targeting and the Federal Reserve
As I noted earlier, the Federal Reserve, though rejecting any explicit affiliation with inflation targeting,
has been influenced by many of the same ideas that have influenced self-described inflation targeters.
Increasingly greater transparency and more forward-looking, proactive policy are two examples of
convergence in practice between the Fed and inflation-targeting central banks, and I think most would
agree that both of these developments have been positive and have led to better outcomes. Most
important, however, as I discussed in the earlier speech, under Chairman Volcker and Chairman
Greenspan, the Fed has moved gradually toward a policy framework of constrained discretion.15 In
10
King (1997) appears to be the source of the phrase.
11
Svensson (1999), who I believe coined the phrase "strict inflation targeting", calls this point "uncontroversial." Svensson's
paper and his related work also show in detail the consistency of inflation targeting with a dual mandate.
12
A number of inflation-targeting central banks refer to inflation stabilization as the central bank's "primary long-run objective."
At one level, this statement does not have much content because inflation is the only variable that central banks can control
in the long run. Its real import is to say that the central bank is responsible for long-run price stability, a statement that
should be unobjectionable in any framework.
13
Meyer (2001) draws a distinction between a hierarchical mandate, which subordinates other objectives to the price stability
objective, and a dual mandate, which places price stability and employment objectives on equal footing. Like Meyer, I prefer
the dual mandate formulation and find it to be fully consistent with inflation targeting. Formally, the dual mandate can be
represented by a central bank loss function that includes both inflation and unemployment (or the output gap) symmetrically.
14
Here is part of a verbal reply that I made to a commenter on a paper about inflation targeting and asset prices that Mark
Gertler and I presented at the Fed's Jackson Hole conference in August 1999, as published in the conference volume: "I
want to correct the impression . . . that Mark and I are somehow against lender-of-last-resort activities, which is absolutely
wrong. I have studied the Depression quite a bit in my career, and I think there are two distinguishing mistakes that the
Federal Reserve made. The first was to allow a serious deflation, which an inflation targeting regime would not have
permitted. And the second was to allow the financial system to collapse, and I absolutely agree with, for example, what
happened in October 1987 and other interventions . . . One advantage of the inflation targeting approach as opposed, for
example, to a currency board, is [that] it gives you considerably more scope for lender-of-last-resort activities." (Federal
Reserve Bank of Kansas City, 1999, p. 145)
15
Bernanke (2003). Gramlich (2000) made a similar observation and cited empirical evidence.
BIS Review 15/2003
particular, through two decades of effort the Fed has restored its credibility for maintaining low and
stable inflation, which--as theory suggests--has had the important benefit of increasing the institution's
ability to respond to shocks to the real economy. The acid test occurred in 2001, when the FOMC cut
interest rates by nearly 500 basis points without any apparent adverse effect on inflation expectations.
Given the Fed's strong performance in recent years, would there be any gains in moving further down
the road toward inflation targeting? The most heated debates are said to occur on questions that are
inherently impossible to prove either way, and I am afraid that this question gives rise to one of those
debates, involving as it does counterfactual futures. Personally, though, I believe that U.S. monetary
policy would be better in the long run if the Fed chose to make its policy framework somewhat more
explicit. First, the Fed is currently in a good and historically rare situation, having built a consensus
both inside and outside the Fed for good policies. We would be smart to try to lock in this consensus a
bit more by making our current procedures more explicit and less mysterious to the public. Second,
making the Fed's inflation goals and its medium-term projections for the economy more explicit would
reduce uncertainty and assist planning in financial markets and in the economy more generally.
Finally, any additional anchoring of inflation expectations that we can achieve now will only be helpful
in the future.
To move substantially further in the direction of inflation targeting, should it choose to do so, the Fed
would have to take two principal steps: first, to quantify (numerically, and in terms of a specific price
index) what the Federal Open Market Committee means by "price stability", and second, to publish
Inflation
regular medium-term projections or forecasts of the economic outlook, analogous to the
Reports published by both inflation-targeting central banks.
Particularly now that we are in the general range of price stability, I believe that quantifying what the
FOMC means by price stability would provide useful information to the public and lend additional
clarity to the policymaking process. Let me add a caveat however. Despite the potential long-run
benefits of such a change, FOMC members may be concerned at this juncture that the Congress and
the public would misperceive the quantification of price stability as an elevation of the Fed's price
stability objective above its