Frederic S Mishkin: Central bank commitment and communication
Speech by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Princeton University Center for Economic Policy Studies Dinner,
New York, 3 April 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
One of the things I often tell my 25-year-old son is, "Keep your options open." In effect, this
means that today he should make the best decision possible using the information he has at
hand, and when tomorrow comes he should reconsider all of his options, and again the next
day, and so on. In the terminology of economists, this strategy is usually referred to as
"dynamic optimal policy under discretion." And the idea of complete discretion may sound
like a great idea - after all, why should you restrict your choices? Nevertheless, in the
context of central banking, the modern science of monetary policy indicates that a
discretionary approach can lead to poor economic outcomes.1
Therefore, in my remarks today, I would like to explain how a commitment to keeping
inflation low and stable can help foster the stability of economic activity as well as the stability
of prices. After analyzing the pitfalls of discretion and the benefits of a firm commitment to a
nominal anchor, I will discuss the role of central bank communication in promoting this
commitment. I will then illustrate these conceptual principles by considering the experiences
of other central banks that have adopted explicit numerical inflation objectives.
As usual, these remarks reflect only my own views and are not intended to reflect those of
the Federal Open Market Committee or of anyone else associated with the Federal Reserve
System.2
Pitfalls of discretionary monetary policy
Starting in the 1970s, the economics profession began to recognize that the evolution of
economic activity and inflation - and hence the design of optimal monetary policy - depends
crucially on how households, firms, and financial market investors form their expectations
regarding the future course of policy.3 This recognition of the central role of expectations in
macroeconomic outcomes led to the discovery of the time-inconsistency problem, a concept
that sounds highfalutin but is actually quite intuitive.4
This problem arises whenever the possibility of short-run gains creates a temptation to
renege on an existing plan, even though following that plan would produce a better outcome
over the longer run. In essence, if a good long-run plan will not be followed consistently over
time because the short-run gains of deviating from the plan are too tempting, then that plan is
said to be time-inconsistent. In such a setting, the time-consistent policy is to reoptimize
every period, whereas the preferable alternative would be to establish a firm commitment to
the optimal long-run plan.
To take a common example that illustrates the time-inconsistency problem, someone may
make a New Year's resolution about starting a diet. At some point thereafter, however, it
becomes hard to resist having a little bit of Rocky Road ice cream, and then a bit more, and
pretty soon the weight begins to pile back on.
The time-inconsistency problem arises in the context of monetary policy, because there is a
temptation to give a short-run boost to economic output and employment by pursuing a
course of policy that is more expansionary than firms or workers had initially expected.5
Nevertheless, if the economy is already at full employment, then this boost is merely
transitory: As economic activity rises above its sustainable level, wages and prices begin to
rise, and the private sector's inflation expectations start to pick up. Of course, the central
bank must eventually remove the policy stimulus to avoid a continuous upward spiral of
inflation. At that point, economic activity drops back to a sustainable level. However, inflation
settles in at a permanently higher rate because prospects of future monetary expansions
become embedded in expectations, and hence in wage and price adjustments, and the
higher average inflation rate generates undesirable economic distortions.6 Thus, failing to
address the time-inconsistency problem poses the risk of ending up with a higher average
inflation rate, with detrimental long-run consequences for economic efficiency and the
general standard of living.
As my mother often told me when I was growing up, "The road to hell is paved with good
intentions." Similarly, discretionary monetary policy, even though well intended, can lead to
poor economic outcomes.
Benefits of a firm commitment to a nominal anchor
How can a central bank overcome the time-inconsistency problem? The answer is to
establish a firm commitment to a nominal anchor - that is, to ensure that inflation remains
low and stable over time. In a speech that I gave last week, I highlighted the merits of
specifying an inflation objective in terms of a specific numerical value.7 With an explicit
numerical inflation objective, the central bank's strategy is aimed at keeping economic
activity close to a sustainable growth path and at maintaining a low and stable inflation rate.
Such a commitment ensures that the central bank resists the temptation to pursue short-run
expansionary policies that are inconsistent with the long-run goals of price stability and
maximum sustainable employment.
A strong commitment to an explicit numerical inflation objective has other significant benefits.
First, the long-run inflation expectations of households and firms are a key factor in
determining the actual behavior of inflation.8 In the absence of a firm nominal anchor, these
expectations may wander over time as the private sector revises its assessment of the rate
at which inflation is likely to settle down, and those movements in long-run inflation
expectations can generate pressure on the current inflation rate. Thus, by establishing a
transparent and credible commitment to a specific numerical objective, monetary policy can
provide a firm anchor for long-run inflation expectations, avoiding such pressures and
thereby directly contributing to the objective of low and stable inflation. Moreover, such a
commitment can play an important role in minimizing the risk of "inflation scares" - that is,
episodes in which longer-term inflation expectations jump sharply in response to specific
macroeconomic developments or monetary policy actions.9
Second, as I emphasized in a speech in late February, establishing a firm commitment to a
nominal anchor can help stabilize output and employment.10 Specifically, to counter a
contractionary demand shock, the monetary authorities need to reduce the short-run nominal
interest rate; however, the effectiveness of such a policy action may be hindered if long-run
inflation expectations are not firmly anchored. For example, if the private sector becomes
less certain about the longer-run inflation outlook, then an increase in the inflation risk
premium could boost longer-term interest rates by more than the increase in expected
inflation. The higher inflation risk premium would place upward pressure on the real costs of
long-term financing for households and businesses (whose debt contracts are almost always
expressed in nominal terms) and hence might partially offset the direct monetary stimulus.
Thus, a central bank commitment that firmly anchors long-run inflation expectations can
make an important contribution to the effectiveness of the central bank's actions aimed at
stabilizing economic activity in the face of adverse demand shocks.
Third, a strong commitment to an explicit inflation objective provides the central bank with
greater flexibility to respond decisively to adverse demand shocks. Such a commitment helps
ensure that an aggressive policy easing is not misinterpreted as signaling a shift in the
central bank's inflation objective, and thereby minimizes the possibility that inflation
expectations could move upward and lead to a rise in actual inflation. A strong nominal
anchor can be especially valuable in periods of financial market stress; at such times, prompt
and decisive policy action may be required to prevent the financial market disruption from
causing a severe contraction in economic activity that could further exacerbate uncertainty
and financial market stress, leading to a further deterioration in macroeconomic activity, and
so on.11 Thus, by providing the central bank with greater flexibility in mitigating the risk of
such an adverse feedback loop, the strong commitment to an explicit inflation objective can
play an important role in promoting financial stability as well as the stability of economic
activity and inflation.
Fourth, a strong nominal anchor can help minimize the effects of an adverse cost shock,
such as a persistent rise in the price of energy. Generally speaking, such shocks tend to
result in weaker economic activity as well as higher inflation. However, when longer-term
inflation expectations are firmly anchored, an adverse cost shock is likely to have only
transitory effects on actual inflation; hence, there may be no need to raise interest rates
aggressively to keep inflation from moving upward. Thus, the commitment to a nominal
anchor can help reduce output and employment fluctuations that impose unnecessary
hardship on workers and, more broadly, the economy.
The bottom line is that a transparent and credible commitment to an explicit numerical
inflation objective can provide significant benefits in facilitating the central bank's task of
stabilizing both economic activity and inflation as well as fostering the stability of the financial
system.
The role of central bank communication
Although a strong commitment to a nominal anchor is associated with significant benefits,
establishing and maintaining such a commitment tends to be easier said than done. After all,
my discussion of the time-inconsistency problem indicates that there are always pressures to
renege on that commitment. Here I will argue that central bank communication to increase
transparency and accountability can play a key role in helping central banks maintain a
strong commitment to a nominal anchor.
The public announcement of an explicit numerical inflation objective increases the
accountability of a central bank and therefore promotes the monetary authority's commitment
to delivering low and stable inflation. As put by a former governor of the Bank of Canada,
such objectives give the public a "precise yardstick for measuring how [the central bank] is
doing."12 The credibility of the central bank may rise over time as the public comes to
appreciate its success in delivering inflation outcomes consistent with its stated numerical
objective. Similarly, the temptation to pursue policy actions inconsistent with the objective -
and hence renege on its commitment - may be diminished, because large or persistent
deviations of inflation from the stated goal would be observed by the public and thus would
be more likely to be called into question. As I argued in a speech last week, accountability is
further enhanced if the inflation objective is stated as a numerical value rather than a range
or comfort zone.13
But couldn't a numerical inflation objective be easily changed at the whim of the central bank
or the government? The time-inconsistency problem could then rear its ugly head, because
raising the numerical inflation objective could be used to justify more expansionary monetary
policy to generate higher employment and output in the short run. Although this temptation to
renege on keeping inflation low and stable might be present, the transparency of a public
change in the numerical inflation objective, which will subject it to public scrutiny and debate,
makes it much harder to engage in such opportunistic behavior. Unless an adjustment of the
explicit inflation objective is perceived to be driven by analytical considerations, it will be
viewed as violating the public's trust. The resulting loss of credibility on the part of the central
bank (or the government) could be devastating; hence, there are strong incentives not to
change the inflation objective absent sound technical reasons for doing so. Indeed,
adjustments to the numerical inflation objective or the inflation measure have rarely occurred
in practice, and those adjustments have been consistent with clear scientific reasoning.14
However, two important communication challenges arise in establishing a firm commitment
to an explicit numerical inflation objective. First, a central bank must make clear that this
commitment should not be regarded as implying that the central bank will continuously
maintain inflation at the specified rate or even that the inflation rate will always return to that
rate over a fixed time horizon, in the same way that one might pledge to lose 20 pounds in
12
Dodge (2002).
13
Mishkin (2008c).
14
Two cases are worth noting here. First, the New Zealand government raised the upper bound of the Reserve
Bank of New Zealand's inflation band by 1 percentage point in 1996 (from 2 percent to 3 percent) and raised
the lower bound by 1 percentage point in 2002 (from 0 percent to 1 percent); these changes were consistent
with the science of monetary policy, which had reached a consensus that allowing inflation to remain very
close to zero could have detrimental consequences for the economy (Mishkin, 2008c). Second, the Bank of
England's inflation objective was modified in late 2003, establishing a target of 2 percent for the consumer
price index (CPI) that replaced the previous target of 2-1/2 percent for the retail price index excluding
mortgage interest (RPIX). In that case, as noted by the Governor of the Bank of England, there were
significant conceptual reasons for switching to the RPIX as a measure of U.K. inflation, while the downward
adjustment of 1/2 percentage point in the numerical objective reflected the average magnitude of deviations
between CPI inflation and RPIX inflation over the previous decade or so (King, 2004).
BIS Review 40/2008
the next six or nine months. Given that every economy is constantly buffeted by various
shocks, it is generally neither feasible nor desirable to try to keep inflation constant at some
specific level. Thus, a commitment to keep inflation low and stable should be interpreted in a
probabilistic sense - that is, policy will act in a manner that keeps inflation close to the
inflation objective on average over time, and unusually large shocks may result in more
persistent deviations from this objective.
A second challenge stems from the fact that the optimal monetary policy under commitment
to an inflation objective is oriented toward minimizing variability in the real economy as well
as keeping inflation low and stable.15 As a consequence, when a given shock causes
inflation to deviate significantly from the numerical objective, the central bank must
communicate how its policy strategy will bring inflation back to this rate within a reasonable
timeframe and how this strategy will minimize fluctuations in output and employment over
that horizon.16 For example, it is generally desirable to reduce inflation gradually following an
adverse cost shock in order to alleviate the contractionary effects on the real economy.
These challenges highlight the extent to which central bank projections for economic activity
and inflation play an important role in maintaining a strong commitment to a nominal
anchor.17 The central bank must clarify how the economic outlook shapes its current policy
actions as well as the anticipated path of policy. Moreover, as the economy deviates from
those forecasts, as it inevitably does, the central bank must explain how policy will adapt to
achieve the broad economic goals of price stability and maximum sustainable employment.
Publicly announcing forecasts of inflation has the additional benefit of helping anchor inflation
expectations, thereby enhancing the effectiveness of monetary policy actions to stabilize
economic activity and lowering the economic cost of maintaining low and stable inflation.
Another benefit of publishing such forecasts is that discussion of the forecast can be used to
highlight the analysis and reasoning behind monetary policy decisions, which can help the
public to better understand monetary policy actions and strengthen the central bank's
credibility.
Although communication is a crucial element in establishing and maintaining a strong
commitment to a nominal anchor, with its attendant benefits, there are, of course, other
elements as well. Even if a central bank recognizes that a policy geared solely toward
nearterm economic activity will lead to poor outcomes - high inflation with lower economic growth
- it still may not be able to commit to a strong nominal anchor and avoid the
timeinconsistency problem, because special interests may try to apply pressure on the central
bank to boost employment in the short term through an overly expansionary monetary
policy.18
How can the central bank be insulated from short-run pressures to pursue expansionary
policy at the expense of high inflation? There is a broad international consensus that the
15
Mishkin (2007b).
16
Svensson (1997).
17
Indeed, the Federal Reserve has published quantitative forecasts for several key macroeconomic variables
(output growth, unemployment, and inflation) as part of its semiannual reports to the Congress since 1979.
Several months ago, the Federal Reserve enhanced its communications by publishing these forecasts on a
quarterly basis, lengthening the horizon of the projections, and providing additional quantitative and qualitative
information (Bernanke, 2007; Mishkin, 2007d).
18
Almost two centuries ago, British economist David Ricardo summarized the argument for granting operational
independence to the central bank: "It is said that Government could not be safely entrusted with the power of
issuing paper money; that it would most certainly abuse it....There would, I confess, be great danger of this if
Government - that is to say, the Ministers - were themselves to be entrusted with the power of issuing paper
money" (Ricardo, 1823).
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central bank should have full authority to determine the short-run setting of its policy
instruments, without any external interference.19 In addition, I believe that central bank
communication is crucial in promoting public support for maintaining low and stable inflation.
Indeed, in a democratic society, every government agency is ultimately accountable to the
public, and the establishment of transparent objectives and of a clear policy strategy plays an
essential role in facilitating that accountability.
The old adage correctly states that "Actions speak louder than words," and, clearly, just
announcing an objective for inflation does not mean anything unless the actual policies
pursued by the monetary authorities are consistent with the objective. Words, however, do
matter if those words help ensure that the appropriate policy actions will be taken and
strengthen the public's confidence that the central bank will continue to act in a manner
consistent with its long-run objectives. As I have argued here, the increase in transparency
and accountability, which results from clear communication about inflation objectives and
about how monetary policy will be conducted to achieve these objectives, creates stronger
incentives for central banks to avoid the pursuit of short-run overly expansionary policies.
This approach also helps establish a credible commitment to pursuing policies that keep
inflation under control and economic activity growing on a sustainable path.
The international experience
My discussion so far has been pretty theoretical. But one might reasonably ask whether
communication about inflation objectives and about how monetary policy is conducted to
achieve these objectives actually helps strengthen the commitment to fostering low and
stable inflation, and thereby produces better economic outcomes. More specifically: Does
communication of inflation objectives lead to increased public support for the central bank?
Improved inflation performance? More firmly anchored inflation expectations?
Over the past two decades, most of the major foreign central banks have adopted
frameworks which have the overriding objective of bolstering public confidence that
policymakers will act to keep inflation low and stable. While self-declared "inflation targeters"
are the most prominent in this regard, other central banks also have introduced explicit
inflation objectives of some kind, generally in the form of a preferred inflation point or
range.20 To address the questions that I listed earlier, I will draw lessons from the
international experience with explicit numerical inflation objectives, while deferring further
consideration of the United States until the conclusion of these remarks.
Central bank independence. I have already noted that increased central bank
independence helps support a commitment to a strong nominal anchor and thus should lead
to better inflation performance. Evidence supports the conjecture that macroeconomic
performance is improved when central banks are more independent. For example, when
central banks in industrialized countries are ranked according to the degree of legal
independence of the central bank, those countries with the highest degree of central bank
independence are found to have the best inflation performance.21
I have also argued that adopting an explicit objective can help strengthen the accountability
of monetary policy actions and hence may promote public support for the operational
independence of the central bank. Although there has been a pronounced trend toward
increased central bank independence at the same time that monetary policy frameworks
have adopted explicit inflation objectives, it would be unwarranted to claim that this
correlation implies causation from adoption of explicit inflation objectives to central bank
independence. However, this is where case studies can help us.
One example that illustrates how having an explicit inflation objective encouraged public
support for stabilizing inflation and for the independence of the central bank occurred in
Canada in 1996. At that time, there was an important public debate about whether monetary
policy was excessively contractionary.22 In this case, the existence of an explicit inflation
objective channeled that debate into a substantive discussion over what should be the
appropriate target for inflation, with both the Bank of Canada and its critics obliged to make
explicit their assumptions and estimates of the costs and benefits of different levels of
inflation. Indeed, the debate, as well as the Bank of Canada's record and responsiveness to
that debate, led to increased support for the Bank, with the result that criticism of the Bank
and its conduct of monetary policy became much less of a political issue.
Another interesting example, which I do not have time to discuss in detail here, occurred with
the granting of operational independence to the Bank of England in May 1997 after it had
adopted an explicit numerical inflation objective.23 In explaining the decision to grant
operational independence to the Bank of England, the government specifically pointed to the
Bank's successful performance in providing forecasts and clear explanations of the likely
effects of a range of policy alternatives, thereby increasing accountability and making the
central bank more responsive to political oversight.
Inflation outcomes. The adoption of a monetary policy framework with an explicit inflation
objective has hinged on the belief that such a framework ultimately delivers better inflation
outcomes. Thus, it is legitimate to inquire whether inflation outcomes in the economies that
have adopted such frameworks have been in line with the stated objectives.
Chart 1 displays the inflation objective and the relevant measure of realized inflation in a
sample of industrialized economies. Overall, the economies that adopted explicit inflation
objectives have experienced substantial improvements in their inflation performance; indeed,
in each case the central bank has been largely successful at keeping inflation in line with the
stated objective, sometimes even more than might have been anticipated when establishing
that objective.24 Of course, inflation has occasionally deviated from the objective, as one
would expect from the fact that every economy is continuously buffeted by various sorts of
22
This debate was triggered by a speech given by the president of the Canadian Economic Association. For
further discussion of this episode, see Bernanke and others (1999).
23
Until May 1997, the setting of the monetary policy instrument had been determined by the government, not by
the Bank of England. At that point, the newly appointed Chancellor of the Exchequer, Gordon Brown,
announced that the Bank of England would henceforth have the responsibility for setting both the base interest
rate and short-term exchange-rate interventions. For more discussion of this episode, see Mishkin and Posen
(1997) and Bernanke and others (1999).
24
The following anecdote provides a measure of the extent to which some policymakers were pleasantly
surprised by their central bank's success in keeping inflation in line with its objective. The Governor of the
Bank of England must write an open letter to the Chancellor of the Exchequer when inflation deviates from the
official target by more than 1 percentage point. About a year after the Bank of England was granted
operational independence, the Bank's chief economist wrote that "[even] if inflation shocks were to disappear
entirely, the continued presence of demand shocks would imply that [open letters] would still be triggered
more than 40 percent of the time" (Bean, 1998). A decade later, inflation has remained within 1 percentage
point of the target in all but a single month, or less than 1 percent of the time.
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shocks. Nonetheless, these inflation deviations have been relatively small and transitory by
historical standards. Most important, there is little evidence of a systematic upward bias in
inflation, which would arise if the central bank were attempting to stimulate output beyond
what would be consistent with maintaining low and stable inflation.
I also want to emphasize that this improvement in inflation performance has not been at the
expense of higher employment and output fluctuations; indeed, the variability of output and
employment fluctuations has generally declined in those economies where the central bank
has maintained an explicit inflation objective.25
Inflation expectations. Economies with explicit numerical inflation objectives have
(fortunately) not been alone in enjoying relatively low and stable inflation over the past couple
of decades; indeed, in some cases, inflation was already low and stable prior to the adoption
of the explicit objective. It is thus legitimate to investigate whether the establishment of an
explicit inflation objective has had other measurable effects, particularly with regard to the
anchoring of long-run inflation expectations.26
Chart 2 presents realized inflation along with a survey-based measure of mean inflation
expectations at the two-year-ahead and six-to-ten-year-ahead horizons. The evidence
supports the view that medium- to long-term expectations have become well anchored
around the official objectives. First, survey-based measures of long-term inflation
expectations have converged toward the official inflation objective in all countries. This fact is
consistent with central banks making credible, long-term commitments to pursuing their
objectives, even in countries where the objective must be renewed on a regular basis.
Moreover, surveys of professional forecasters in each of these economies reveal that, on
average, forecasters expect deviations in realized inflation to disappear within two years or
less. In effect, these forecasters anticipate that the central bank will take the policy actions
necessary to ensure that inflation lines up with the explicit objective over a reasonable time
horizon. Econometric analysis of financial market data also indicates that long-run inflation
expectations are firmly anchored in each of the economies in which the central bank has an
explicit numerical inflation objective.27
25
See the empirical analysis and discussion of Fatás, Mihov, and Rose (2007) and Mishkin and Schmidt-Hebbel
(2001, 2007).
26
I will spare the audience a thorough discussion of the methodological issues involved in the measurement of
inflation expectations. Some recent work on the topic was presented at the Conference on Price Measurement
for Monetary Policy, hosted by the Federal Reserve Bank of Dallas on May 24-25, 2007.
27
See Castelnuovo, Altimari, and Rodriguez-Palenzuela (2003); Levin, Natalucci, and Piger (2004); and
Gürkaynak, Levin, and Swanson (2006). There is also some evidence that the dispersion of inflation
expectations may decrease with adoption of explicit inflation objectives. Mankiw, Reis, and Wolfers (2003)
have shown that simple survey statistics, such as the mean or median inflation expectations, can sometimes
hide substantial cross-sectional dispersion in survey responses. If a central bank's credibility in meeting the
inflation objective truly increases over time, one should then observe less disagreement among inflation
forecasters. The international evidence on this aspect is unfortunately scant due to limited data availability.
Beechey, Johannsen, and Levin (2007) recently showed that the cross-sectional dispersion of long-run
inflation expectations in the European Central Bank (ECB) Survey of Professional Forecasters, as measured
by the standard deviation, has more than halved since the ECB, with its explicit inflation objectives, was
launched in 1999. Although this evidence cannot be used directly to measure the impact that the adoption of
an explicit inflation objective has on the dispersion of inflation expectations, it nevertheless suggests that there
are additional benefits to increasing a central bank's credibility.
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Conclusion
In a speech last week, I argued that the science of monetary policy provides a strong
rationale for framing the inflation goal in terms of a specific point objective rather than a
range or comfort zone.28 My remarks today provide further elaboration about how the
establishment of a firm commitment to an explicit numerical inflation objective contributes to
better outcomes for both inflation and economic activity. First, I have explained the pitfalls of
discretionary monetary policy and the benefits of a strong commitment to a nominal anchor.
Second, I have considered how central bank communications promote such a commitment.
Third, I have highlighted some key lessons from the experiences of other major industrial
economies that have adopted explicit inflation objectives.
Finally, you may have noticed that I haven't said much about the United States in this
speech. Nevertheless, the principles emphasized in my remarks today and in last week's
speech have potentially important implications for the ongoing process of refining the Federal
Reserve's policy framework and of enhancing our communications. Indeed, as Chairman
Bernanke has recently indicated, our communication strategy is "a work in progress," and the
Federal Reserve "will continue to look for ways to improve the accountability and public
understanding of U.S. monetary policy making."29 I hope that these remarks will be helpful in
contributing to the continuation of that process.
References
Alesina, Alberto, and Lawrence H. Summers (1993). "Central Bank Independence and
Macroeconomic Performance: Some Comparative Evidence", Journal of Money, Credit and
Banking, vol. 25 (May), pp. 151-62.
Barro, Robert J., and David B. Gordon (1983). "A Positive Theory of Monetary Policy in a
Natural Rate Model", Journal of Political Economy, vol. 91 (August), pp. 589-610.
Beechey, Meredith, Benjamin Johannsen, and Andrew Levin (2007). "Are Long-Run Inflation
Expectations Anchored More Firmly in the Euro Area than in the United States?", Centre for
Economic Policy Research Discussion Paper 6536. London: Centre for Economic Policy
Research Discussion, October.
Bean, Charles (1998). "The New UK Monetary Arrangements: A View from the
Literature", Economic Journal, vol. 108 (November), pp. 1795-809.
Bernanke, Ben S. (2007). "Federal Reserve Communications