Laurence H Meyer: Inflation targets and inflation targeting
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, to the University of California at San Diego Economics Roundtable, San Diego, California, 17
July 2001.
* * *
There is widespread agreement that price stability (in practice, low and stable inflation) should be an
objective of monetary policy. This agreement is reflected both in the mandates set for monetary policy
by governments and in the practice of central banks. Several other important questions about the
objectives for monetary policy are less settled: Should there be other objectives? If there are multiple
objectives, should one of the objectives take priority? And how explicit should the objectives be?
Central banks typically operate under one of two types of mandate. A hierarchical mandate makes
price stability the primary objective for monetary policy and subordinates other potential objectives. A
dual mandate recognizes two objectives - price stability and full employment - and puts them on an
equal footing. Either regime could make the price stability objective more precise by setting an explicit
numerical target for inflation.
Thus we can describe a typical central bank's mandate and objectives in terms of two sets of
alternatives: between a hierarchical or a dual mandate, on the one hand, and an implicit or explicit
inflation objective, on the other hand. During the 1990s, a number of central banks adopted a
framework that is called inflation targeting, combining a hierarchical mandate and an explicit inflation
objective. The United States, in contrast, combines a dual mandate and an implicit inflation objective.
Most of the discussion in the United States on the subject of mandates and objectives has been about
whether to identify inflation as the single or primary objective and whether to move to a formal
inflation-targeting regime.1 The title of my lecture - "Inflation Targets and Inflation Targeting" - is
intended to differentiate between two options for changing the policy mandate for the Federal
Reserve. The first option, which I favor, is setting an explicit numerical target for inflation within the
context of our current dual mandate. The second option, which I do not favor, is moving to an
inflationtargeting regime, that is, also substituting a hierarchical mandate for our current dual mandate. The
purpose of this lecture is therefore to explain the benefits of an explicit inflation target in the context of
the Federal Reserve's dual mandate and to set out the operational steps for implementing such a
target.
Before proceeding, let me note that the views that I am presenting here are my own. I am not
speaking for the Board of Governors or the Federal Open Market Committee (FOMC).
I. The evolution of monetary policy mandates
A good starting point is a survey of mandates around the world. I will begin by discussing the evolution
of the mandate in the United States, including the precise language related to the dual mandate, the
way in which the price stability objective has been interpreted, and proposed legislation that would
have amended the mandate. Then I sketch an inflation-targeting regime and discuss some common
elements and differences among the inflation-targeting regimes of developed economies around the
world.
A. The evolution of policy objectives in the United States
In the United States, it took quite some time for the Congress to establish a precise set of objectives
for monetary policy. In fact, remarkably little about policy objectives was included in the original
Federal Reserve Act in 1913. The only policy objectives of the Fed, as identified in that statute, were
"to furnish an elastic currency [and] to afford means of rediscounting commercial paper." The absence
of any mention of price stability undoubtedly reflected confidence that the gold standard, under which
the United States was operating, would promote price stability. The intent of providing an elastic
currency and of rediscounting commercial paper was to expand the supply of money and credit to
1
See, for example, Bernanke et al. (1999) and Gramlich (2000).
accommodate expansions in production and the accompanying demand for credit. Given that the
immediate impetus of the founding of the Federal Reserve was the Panic of 1907, promoting financial
stability was a clear focus. The framers' intention was that the Federal Reserve would provide banks
with a source of liquidity through rediscounting to meet deposit withdrawals.
On several occasions during the 1920s and 1930s, the Congress debated a price-stability objective for
the Fed. The Fed opposed such a mandate and it was not adopted. Congress did take a step toward a
more explicit treatment of policy objectives in the Employment Act of 1946. This act identified the
objectives for the government in general, but not specifically for the Fed. Still, the act was generally
viewed as applying to the Fed, as a part of government. The objectives identified in the act were "to
promote maximum employment, production, and purchasing power." Although this set of objectives
could be interpreted as including both full employment and price stability, the title of the bill and the
specific language suggests that the priority at the time was more to maintain full employment than to
promote price stability. Such a focus on stabilizing employment and a relative inattention to inflation
was perhaps an understandable reaction to the Great Depression when, for a decade, high
unemployment and falling prices were the major problems facing the U.S. economy.
The specific mandate for the Federal Reserve was first added to the Federal Reserve Act in 1977,
although that same language had been included in a 1975 concurrent resolution of the Congress. The
1977 amendment required the Board of Governors and the FOMC to "maintain the growth of monetary
and credit aggregates commensurate with the economy's long-run potential to increase production, so
as to promote effectively the goals of maximum employment, stable prices, and moderate long-term
interest rates." This language makes the objective of price stability explicit. Because the Fed can
contribute to moderate long-term interest rates principally by achieving low and stable inflation, that
objective is generally not viewed as an independent one. In addition, the goal of maximum
employment is usually interpreted as maximum sustainable employment - meaning the highest level
of employment that can be maintained without upward pressure on inflation. The mandate is therefore
interpreted as a dual mandate: full employment and price stability.
The Federal Reserve has not set an explicit, numerical objective for inflation. Paul Volcker offered the
following definition of price stability in 1983:
A workable definition of reasonable "price stability" would seem to me to be a situation in
which expectations of generally rising (or falling) prices over a considerable period are not a
pervasive influence on economic and financial behavior. Stated more positively, "stability"
would imply that decisionmaking should be able to proceed on the basis that "real" and
"nominal" values are substantially the same over the planning horizon - and that planning
horizons should be suitably long.2
Alan Greenspan has described the price stability objective in a similar way:
We will be at price stability when households and businesses need not factor expectations of
changes in the average level of prices into their decisions.3
These definitions make clear a commitment to low inflation. But they leave open whether, for example,
the inflation rate prevailing today - about 21⁄2 percent for the core consumer price index (CPI) measure
of consumer prices - is consistent with this definition. Is policy going to be set to lower inflation over
time, and if so, by how much? These definitions also leave open the possibility of changing
interpretations as the FOMC membership changes over time.
The Fed often prefers to state its objective without specifically mentioning price stability. This is
perhaps because the emphasis on price stability is taken by some as carrying a hint of restrictive
policy and as an inclination to always be leaning against cyclical increases in demand. The Fed
sometimes prefers to state its objective simply as promoting maximum sustainable growth. Stating its
objective in this way allows the Fed to offer a more positive message and leaves implicit the price
stability objective in two ways. First, if the economy were to grow above a sustainable rate for long
enough, overheating and higher inflation would eventually follow. Second, price stability contributes to
a high and perhaps faster rate of growth in productive capacity, a point I will return to below.
Nevertheless, I prefer to state the Fed's objectives as full employment and price stability. In my view,
the Fed has no growth objective. At full employment, the rate of growth will automatically be the
2
Volcker (1983).
maximum sustainable rate the economy is capable of achieving and a rate largely independent of
monetary policy, except insofar as monetary policy is successful in achieving price stability.
In recent years, bills have been introduced on a few occasions that would have made price stability
the sole or primary objective for monetary policy and required the Fed to set an explicit numerical
inflation target. In 1989, 1991, and 1993, Representative Steve Neal, Chairman of the House Banking
Committee's Subcommittee on Domestic Monetary Policy, introduced resolutions instructing the
Federal Reserve "to adopt and pursue monetary policies leading to, and then maintaining, zero
inflation." In the 1991 and 1993 versions, zero inflation was defined as "when the expected rate of
change of the general level of prices ceases to be a factor in individual and business decisionmaking."
While these resolutions did not pass, the definition of price stability in the 1991 and 1993 resolutions
was, undoubtedly not by accident, nearly identical to the language used by Chairman Greenspan and
to the concept articulated earlier by Chairman Volcker.
A second set of bills was introduced by Senator Connie Mack and Representative Jim Saxton in 1995
and 1997. These bills instructed the Fed to set an explicit numerical definition of price stability and to
"maintain a monetary policy that effectively promotes long-term price stability." Representative Saxton
introduced a significantly revised version of these bills in 1997 and 1999, mandating price stability as
the "primary goal" of the Federal Reserve and requiring the Fed to establish an explicit numerical
definition of inflation. Senator Mack reintroduced his version in 1999.
I interpret these bills as attempts to push the United States toward a full inflation-targeting regime.
Indeed, the Mack versions would establish an inflation-targeting regime among the strictest in the
world, given that it would have established price stability as the sole objective of monetary policy, not
simply a hierarchical set of objectives. The Saxton version is more in line with hierarchical mandates
employed in many inflation-targeting regimes. These bills were, therefore, vigorously opposed by
advocates of the dual mandate. Perhaps because these bills formed the backdrop to the debate in the
United States about the policy mandate, little discussion has taken place on the merits of moving to an
explicit numerical inflation target in the context of the prevailing dual mandate. Of course, another
explanation for the lack of debate is that few are unhappy with macroeconomic performance under the
current regime.
B. Mandates in inflation-targeting regimes
New Zealand in 1990 became the first country to establish a formal inflation-targeting regime. Canada
followed in 1991, the United Kingdom in 1992, and Australia and Sweden in 1993. Subsequently,
Finland and Spain adopted inflation targeting (before becoming members of the European Monetary
Union) and in the last few years several developing countries have adopted this approach. Although
the European Central Bank does not identify itself as an inflation-targeting regime, the Maastricht
Treaty set price stability as the ECB's primary objective and the ECB has set an explicit numerical
target for inflation.
What is an inflation-targeting regime?
Inflation-targeting regimes generally identify price stability as the primary objective, usually in the
context of a hierarchical mandate. They set an explicit numerical target for inflation and set a period
over which any deviation of inflation from its target is to be eliminated, although some regimes provide
escape clauses and other flexibility related to the pace of return to price stability.
The inflation target is sometimes set as a point and sometimes as a range. In most cases, the inflation
objective is set for a measure of overall consumer price inflation, the point or midpoint of the ranges is
generally around 2 percent, and the ranges (where employed) are generally 2 percentage points wide
- typically 1 percent to 3 percent. The time period prescribed for return to the inflation target following
departures is sometimes explicit and sometimes not, generally in the range of eighteen months to two
years.
Examples of inflation-targeting regimes
In New Zealand, the first inflation-targeting regime, the numerical target is set jointly by the Minister of
Finance and the Governor of the central bank and is currently a range of 0 percent to 3 percent, the
widest of any of the ranges in inflation-targeting regimes. New Zealand is quite well-known for
establishing performance contracts for government officials, and this approach is followed in the law
governing the operation of the central bank: The statute allows the governor to be dismissed if inflation
performance is inadequate.
The Bank of Canada operates under the vaguest legal mandate among inflation-targeting central
banks. Its statute requires it to regulate "credit and currency in the best interests of the economic life of
the nation." Despite the absence of a precise legal mandate, the details of the Bank's monetary policy
objectives are reached by agreement between the Bank and the Department of Finance. This
agreement has set price stability as the principal objective for monetary policy. To implement this
objective, the agreement sets the range for inflation as 1 percent to 3 percent and identifies the
midpoint as the explicit target.
The Reserve Bank of Australia has a mandate most closely resembling ours, though it is even broader
and more open-ended. Their legislative mandate is "to [promote] stability of the currency of
Australia;...[maintain] full employment in Australia; and...[foster] economic prosperity and welfare of
the people of Australia." The explicit inflation target, 2 percent to 3 percent, is set by the central bank
and applies to the average inflation rate over a business cycle. Although Australia is counted among
inflation-targeting countries, it has a dual mandate rather than a hierarchical one. Indeed, it is a model
for the combination I prefer: an explicit inflation target within a dual mandate.
The mandate in the United Kingdom is hierarchical. Article 11 of the Bank of England Act sets the
objectives for monetary policy as "to maintain price stability" and "subject to that, to support the
economic policy of Her Majesty's Government, including its objectives for growth and employment."
The explicit target, set by the Chancellor of the Exchequer (the equivalent of the Minister of Finance in
many countries or the Secretary of the Treasury in the United States), is currently 2.5 percent and the
target is for retail prices excluding mortgage interest payments. The Governor of the Bank of England
must write a letter to the Chancellor if inflation deviates by more than 1 percentage point from the
target.
The ECB does not view itself as an inflation-targeting central bank. However, the Maastricht
Treaty - the equivalent of the statute establishing the objectives for a central bank - identifies price
stability as the principal objective in the context of a hierarchical mandate. Article 105 of the Maastricht
Treaty states that "the primary objective of the [European System of Central Banks (ESCB)] shall be to
maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the
general economic policies in the community with a view to contributing to the objectives of the
Community laid down in Article 2." The objectives mentioned in Article 2 include "sustainable and
non-inflationary growth," a "high level of employment," and "raising the standard of living" among
member states. The ECB's Governing Council sets the explicit numerical inflation target. This is
currently set with an explicit ceiling of 2 percent and an implicit lower bound of 0 percent. This is the
case of a range rather than a point, with no preference stated for the midpoint.
The evolution of inflation-targeting regimes
Over their short history, inflation-targeting regimes have evolved to give central banks greater flexibility
in conducting monetary policy. Mervyn King calls regimes which take no account of output gaps
(where the coefficient on the output gap is zero in the loss function) "inflation nutters."4 That language
suggests that entirely ignoring output stabilization is now viewed as an extreme position and not as a
desirable option for central banks. Lars Svensson argues that there has, in fact, been a convergence
toward "flexible inflation targeting" - meaning inflation-targeting regimes that in practice take into
account deviations in both output and inflation from their respective targets.5 Such an evolution has
brought many inflation-targeting regimes closer in practice to a dual mandate regime.
II. The case for a dual mandate
The appropriate goals for monetary policy depend on the structure of the economy and the
preferences of the citizenry. My support for a dual mandate reflects my views about the structure of
the economy and about the public's preferences. These can be summarized as follows:
1. Low and stable inflation ("price stability") is essential to good macroeconomic performance
and hence should be an objective of macroeconomic policy.
4
King (1997).
2. The central bank is uniquely responsible for the inflation rate in the long run.
3. Monetary policy can make some contribution to lowering the variability of output relative to
potential.
4. The public desires both low and stable inflation and a low variability of output relative to
potential.
The first two points, of course, are shared by most central bank mandates. The case for the dual
mandate includes the third and fourth points.
Price stability as a policy objective
As I noted at the outset, it is widely agreed that low and stable inflation is desirable. Several costs of
high and variable inflation have been identified. These costs typically arise from distortions in
economic decisionmaking arising from high or variable inflation rates and result in lower levels of
output than would otherwise be the case. I won't elaborate in detail about these costs here, because I
take as a starting point the agreement that price stability is an important, if not the singular objective
for monetary policy.6 But the key point is that price stability is not an end in itself; it is important
because it contributes to a higher level of output and perhaps faster growth in output.
Monetary policy and inflation
Few economists would disagree that inflation is, as Milton Friedman taught us long ago, always and
everywhere a monetary phenomenon. This was earlier interpreted as a statement about a tight
relationship between money growth (controlled by the central bank) and inflation. Today, it is
recognized that even if the relationship between money growth and inflation has weakened, perhaps
because of financial innovations, central banks can achieve their inflation targets by adjusting their
preferred instrument, typically some short-term interest rate. Hence, monetary policy still determines
the rate of inflation in the long run. While it is also well understood that supply shocks - such as abrupt
changes in the price of energy or food unrelated to the overall balance between aggregate demand
and supply - can result in short-run changes in inflation, such changes in inflation can persist only if
central banks accommodate them. Central banks therefore must accept full responsibility for inflation
in the long run and have the tools to achieve price stability.
The ability to stabilize output
While monetary policy can achieve a long-run inflation target, economic theory suggests that it cannot
affect the level of output or its growth rate in the long run, other than by maintaining low and stable
inflation. Therefore, the objective of price stability should be assigned to monetary policymakers, but
the objective of high and rising living standards should not be. On the other hand, the Congress and
the Administration have many opportunities to affect the level and growth in potential
output - including the size of the structural budget deficit relative to output, the details of the tax code,
and the composition of government spending.
Whether central banks should accept responsibility for stabilizing output relative to potential is more
controversial. Milton Friedman, for example, has always questioned the ability of central banks to
stabilize output relative to potential and worried that attempting to do so could be counterproductive,
given the "long and variable lags" between policy actions and the economic effects. Economists agree
that monetary policy cannot "fine tune" the economy to ensure that the full employment objective is
continuously maintained. However, a considerable amount of research supports the contention that
monetary policy can reduce the variability of output around its full-employment level.7
Preferences
Households and businesses are presumed to prefer low and stable inflation to high and variable
inflation. But they also prefer high and rising real income per capita and output that is consistently
close to the economy's maximum sustainable level of output. This is often expressed in terms of a loss
function where the loss to society is expressed as a weighted average of squared deviations of
inflation from its target and of output from its potential level. The squaring of the deviations ensures
that deviations on either side of the target are treated equivalently as losses.8 The weights, a and 1-a,
indicate the relative intensity of the public's distaste for deviating from their preferred rates of inflation
and output. The loss to society, L, can be expressed as
(1) L = a ( - *)2 + (1-a) (y - y*)2

where is the rate of inflation, * is the target rate of inflation, y is the level of output and y* is the
target level of output or potential output.
Tradeoff between inflation and output variability
Although it is possible in principle to achieve price stability and full employment simultaneously, an
inevitable tradeoff between the variability of output and the variability of inflation exists.9 This tradeoff
is most obvious in the case of a supply shock, for example an abrupt increase in the price of oil. An
adverse supply shock typically raises inflation and lowers aggregate demand (by reducing the
purchasing power of consumers), thereby moving inflation up and output down. This gives rise to a
well-known dilemma for monetary policy: Should monetary policy ease to reduce the decline in output
or tighten to counter the rise in inflation? The structure of the economy is such that the quicker
monetary policy tries to return inflation to its target (to reduce the variability of inflation), the greater the
variability in output.
The choice of a hierarchical versus a dual mandate may be the most important consideration
determining where a country ends up along this tradeoff. That is, countries with hierarchical mandates
are more likely to end up with lower inflation variability at the expense of higher output variability.10 A
dual mandate, therefore, provides flexibility for the central bank to select the point along this tradeoff
that matches the public's preference.
Focusing policymakers on what they can achieve
An argument often made for a hierarchical mandate is that identifying price stability as the sole or
primary objective focuses monetary policy on what it can achieve and, thereby, reduces political
pressure to pursue goals that are not achievable. To be sure, wide agreement exists that central
banks can achieve low and stable inflation and should be held accountable for doing so. There is also
agreement that central banks cannot raise the level or growth of potential output (other than through
achieving their price stability objective) and should therefore not be held accountable for these
dimensions of macroeconomic performance. But the public also cares about the variability of output
relative to potential, and the conduct of monetary policy inevitably will affect output variability.
Therefore, in my view, the importance of keeping monetary policy focused on what it can do supports
the case for a dual mandate that explicitly recognizes both price stability and output stabilization as
objectives for monetary policy.
Is there a single long-run objective?
It is sometimes argued, however, that price stability can be the only objective for monetary policy in
the long run, again placing price stability on a higher plane than full employment. In the long run,
theory holds that the economy gravitates to full employment by self-equilibrating forces, principally
through the effects of price flexibility. That is, if the economy is operating at a level of output below full
employment, the price level will tend to fall, and at least for a given value of the nominal money
supply, this will tend to stimulate aggregate demand. Over time, this process will raise aggregate
demand to a level consistent with full employment. Hence, policymakers do not have to be concerned
with full employment in the long run, leaving price stability as their unique long-run concern.
But this view is misleading in a couple of respects. First, monetary policymakers should be concerned
about two long-run properties of the economy. One is price stability and the other is the variability of
output around full employment. Policy has to be judged by its success in both dimensions. Second,
policy is made in the short run, not the long run. The speed of return of output to its potential level is
influenced by policy decisions and cannot be treated with indifference. It may just take too long and
waste too many resources in the interim to rely on the self-equilibrating forces of the economy.
Policymakers will therefore have to take into account, in practice, both objectives in their policy
actions.
Still, a meaningful difference in the interpretation of the two objectives remains. A central bank can
achieve the inflation target, with considerable precision, in the long run, meaning on average over a
period of years. But it cannot be expected to maintain the economy continuously at full employment.
The full employment objective might therefore be better interpreted as an output stabilization objective.
It instructs the central bank to work to reduce the variability of output around its full employment level.
The need for flexibility
The purpose of a hierarchical mandate is to impose constraints on the operation of monetary policy,
constraints that proponents believe enhance credibility, focus policy on what monetary policy can
achieve, and reduce political pressures for policy to aim at impossible-to-achieve and potentially
destabilizing output goals, such as a level of output above the economy's maximum sustainable rate.
However, those same constraints might interfere with the pursuit of other legitimate objectives of
monetary policy, specifically with policy adjustments to reduce the variability of output around potential
output.
Most inflation-targeting regimes explicitly recognize that returning inflation to its target too rapidly
following some departure could result in excessive variability of output. The solution has been to
encourage a gradual return to the inflation target by explicitly or implicitly setting a policy horizon over
which policymakers commit to return inflation to its target. Setting fixed horizons for the return to the
inflation target, independent of the size or the nature of the shock, clearly reduces the flexibility of
monetary policy. To be fair, many regimes explicitly note that the policy horizons need not be fixed or
include escape clauses that would allow greater flexibility, for example, in response to a supply shock.
But setting a policy horizon is intended to, and does, constrain policy responses. It may therefore
interfere with an appropriate balancing of the full-employment and price-stability goals. This is
especially the case if the mandate is hierarchical, where other objectives can be pursued only if the
inflation objective is achieved.
The Taylor rule and the dual mandate
The Taylor rule is a useful characterization of U.S. monetary policy.11 According to the Taylor rule,
monetary policymakers should adjust the target for the short-term interest rate in response to
deviations of output and inflation from their respective targets and in response to changes in inflation.
It is therefore well aligned with a dual mandate. The Taylor rule can be written as

(2) R = r* + + c [(y/y*)-1] + d ( - *)
where R is the target nominal policy rate, r* is the equilibrium real level of the policy rate (consistent

with price stability and full employment), y is output, y* is the level of potential output, is inflation, *
is the target for inflation, and c and d are the parameters that describe the response of the policy rate
to deviations of output and inflation from their respective targets.
The Taylor rule is consistent with the loss function described in equation 1 because the rule prescribes
an adjustment of the federal funds rate in response to the deviations from target values that are
presumed to give rise to costs to society. The Taylor rule also helps to make the point that
11
Taylor (1993).
policymakers can operate with an output stabilization goal and still ensure that inflation is, on average,
consistent with the inflation target in the long run.12
A strict version of inflation targeting would be one based on a loss function, taking into account only
losses associated with inflation deviating from its target. In terms of equation 1, that would mean that a
= 0 - that is, no costs were associated with deviation of output from its potential level. Based on a
simple model, we could derive an optimal policy response to shocks, based on this loss function and
the more general one where costs are assigned to deviations from both price stability and full
employment. If policy is set assuming a = 0 (as would be the case in a very strict inflation-targeting
regime), it is clear that policy will be suboptimal if the true loss function does assign a cost to deviating
from full employment.13
The more difficult question is: How suboptimal are inflation-targeting regimes that recognize the costs
of excessive output variability, but nevertheless constrain monetary policymakers from responding to
deviations of output from its target, except when the inflation target has already been met or when
policymakers can project that it will be met in a reasonable period? In my view, such regimes are likely
to remain suboptimal, compared with a more flexible dual-mandate regime.
Transparency, accountability, and the dual mandate
As I noted, transparency about monetary policy requires a full and accurate account of the objectives.
But pretending that inflation is the only objective, while taking account of output variability in practice,
only makes for less-transparent policy and ensures that the central bank will have difficulty
communicating the rationale for its policy actions.
I remember the first conference I attended after joining the Board of Governors. Two foreign central
bankers - each from inflation-targeting countries - lectured me about how "good" central bankers
acted in public. They each told me that a disciplined central banker would never admit to having a
stabilization objective and never admit that there was a cost of lowering inflation. Such admissions,
they warned, would only undermine the public's confidence in a central banker's commitment to price
stability. I responded that this lesson in central banking surprised me. I would