Frederic S Mishkin: Comfort zones, shmumfort zones
Speech by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Sandridge Lecture of the Virginia Association of Economists and the
H Parker Willis Lecture of Washington and Lee University, Lexington, Virginia,
27 March 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
It's a genuine pleasure to address the Virginia Association of Economists here at Washington
and Lee University on an important issue in monetary policy. Some of you may be wondering
about the meaning of my speech title - "Comfort Zones, Shmumfort Zones." Well, putting the
"shm" before a word is a way to cast a bit of skepticism on it. Thus, if your friend tells you that
you are "fancy, shmancy," then you might be overdressed for the occasion. And if you
exclaim, "Email, shmemail!" then you've just found your inbox overloaded. Of course, there's
also a significant distinction between the expressions "shlemiel" and "shlimazel," but that's
more-advanced material that I will defer until another speech.
Although this speech has a somewhat humorous title, my remarks will address a serious and
important topic, namely, how central banks promote the stability of prices and economic
activity and how this policy framework is communicated to the public. More specifically, I will
consider whether central banks should describe price stability in terms of a desired range of
inflation outcomes - often referred to as a "comfort zone" for inflation - or in terms of a
specific numerical value at which the inflation rate is expected to settle down over some
reasonable time horizon.
After a brief review of the academic literature regarding the level of inflation that best
promotes longer-run economic growth and employment, I will discuss several conceptual
issues regarding the pitfalls of comfort zones and the benefits of specifying a point objective
for inflation. Finally, I will move from theory to practice and consider the experiences of other
major industrial countries.
As usual, my remarks reflect only my own views and are not intended to reflect those of the
Federal Open Market Committee (FOMC) or of anyone else associated with the Federal
Reserve System.1
What is the optimal level of the inflation rate?
Research in monetary economics usually specifies monetary policy objectives in terms of
stabilizing both inflation and economic activity.2 Those two goals are related: Maintaining
price stability promotes stronger economic activity in the long run.
What do we mean by price stability? A widely cited definition is that the inflation rate is
sufficiently low so that households and businesses do not need to take inflation into account
in making everyday decisions.3 Broadly speaking, I believe this definition of price stability is a
reasonable one, and in practice, central banks around the world have chosen average levels
of inflation between 0 and 3 percent as consistent with this criterion. However, this range can
be narrowed a bit further by considering the implications of economic theory and empirical
evidence about the average inflation rate that produces the best economic outcomes. In
particular, the literature on the optimal inflation rate not only bolsters the case for low inflation
but also highlights the risks of maintaining an excessively low inflation rate.
The case for low inflation
All economists agree that hyperinflations, such as the one in Germany in the 1920s, are
particularly damaging due to the resulting distortion of economic incentives and the waste of
valuable resources. Even rates of inflation far short of hyperinflation appear detrimental to
economic performance, as evidenced by the double-digit inflation rates of the 1970s. And
over the past decade or so, central bankers and academic economists have reached a
remarkable degree of consensus about the desirability of low and stable inflation - and as
you know, arriving at a consensus is quite rare for economists.
The average rate of inflation distorts the efficient allocation of resources through three main
channels. First, because some firms face costs in changing their prices, a rise in the general
price level tends to generate undesirable movements in relative prices, thereby leading to an
inefficient allocation of resources. This relative price dispersion increases with inflation, and
the desirability of minimizing these relative price distortions provides a key rationale for price
stability.4
Second, inflation is an implicit tax on capital. In an imperfectly indexed tax system, inflation
seriously distorts saving and investment because investment income is taxed on the basis of
its nominal rather than inflation-adjusted or real value. In those circumstances, price stability
may considerably improve the efficiency of the economy.5 Third, a higher average inflation
rate tends to generate distortions by raising the cost of holding currency and other
noninterest-bearing assets.6
Can inflation be too low?
While the benefits of low inflation are now widely recognized, somewhat less attention has
been given to the pitfalls of maintaining inflation rates very close to zero, so I will now discuss
3
For example, former Federal Reserve Chairman Alan Greenspan (2002) stated that "price stability is best
thought of as an environment in which inflation is so low and stable over time that it does not materially enter
into the decisions of households and firms."
4
Over the past couple of decades, an extensive literature has analyzed the benefits of low average inflation in a
so-called New Keynesian framework. These studies generally start from a neoclassical model and incorporate
two key features: monopolistic competition and costly price adjustment. Refer, for instance, to Goodfriend and
King (1997) and Woodford (2003).
5
Interestingly, the larger the burden coming from the interaction of inflation and the capital income tax, the more
government tax revenues will fall when inflation is reduced. Feldstein (1997, 1999) provides a quantitative
assessment of the benefits of price stability based on the interaction of inflation and the tax system, showing
that a lower average inflation rate stimulates investment by reducing the effective tax on capital income.
6
Because real money balances bear no interest, the opportunity cost of holding them is the nominal rate of
interest. Higher inflation then leads to higher nominal interest rates, and hence lowers real balances, which
causes a welfare loss because the social cost of producing real balances has remained substantially
unaffected. In the absence of other frictions in the economy, inflation is viewed in this class of models as a tax
on real balances (Bailey, 1956; Friedman 1969). However, the costs from higher holdings of real money
balances has arguably become much less relevant as our economy has become more financially
sophisticated. Households hold only modest amounts of cash, so these "shoe leather" costs are likely to be
fairly trivial.
BIS Review 35/2008
this issue in somewhat greater detail. Specifically, if the average inflation rate is too low, then
the economy faces a greater risk that a given adverse shock could distort labor markets,
induce debt deflation, or cause monetary policy to become constrained by the zero lower
bound on nominal interest rates. These risks imply that undershooting a zero inflation
objective is potentially more costly than overshooting that objective by the same amount, and
that setting the inflation objective at a rate a bit above zero provides some insurance against
these risks.
Downward nominal wage rigidities. Inflation at rates close to zero might create nonnegligible
costs to the economy because firms may be relatively reluctant to cut nominal wages.7 Sticky
nominal wages can prevent labor markets from reaching the optimal equilibrium. However,
empirical evidence from Switzerland and Japan indicates that in an environment of deflation
or very low inflation, downward nominal wage rigidities become less prevalent.8
Debt deflation. Keeping the average inflation rate close to zero increases the likelihood that
the economy will experience occasional episodes of deflation. Deflation can be particularly
dangerous for an advanced economy, in which debt contracts often have long maturities. As
described by Irving Fisher (1933), an episode of deflation can lead to "debt deflation," that is,
a substantial rise in the real indebtedness of households and firms, because the nominal
values of debt obligations are largely predetermined whereas the nominal values of
household income and business revenue are falling together with the general price level.9
Indeed, the deterioration of the balance sheets of households and firms can result in financial
turmoil that contributes to further deflation and greater macroeconomic instability.
The zero lower bound. With a very low average inflation rate, monetary policy is also more
likely to encounter circumstances in which short-term interest rates are constrained by the
so-called zero lower bound on nominal interest rates.10 Specifically, investors will never
choose to lend money at a negative nominal interest rate because they always have the
option of simply holding cash at a zero interest rate; thus, nominal interest rates cannot fall
below zero.
A number of researchers in the Federal Reserve System and elsewhere have analyzed the
implications of the zero lower bound in estimated dynamic rational expectations models.11 If
the economy faces a large contractionary shock, the optimal monetary policy response is to
7
Akerlof, Dickens, and Perry (2000). The main idea can be described as follows: During periods of low
productivity growth and no inflation, firms that need to cut their relative wages can do so only by cutting money
wages. In the presence of downward nominal wage rigidities, firms will keep relative wages too high and
employment too low. Hence, very low rates of inflation might prevent real wages from adjusting downward in
response to declining labor demand in certain industries or regions, thereby leading to increased
unemployment and hindering the re-allocation of labor from declining sectors to expanding sectors. Research
by staff at the Federal Reserve Board has found evidence that downward nominal wage rigidities exist in the
United States (Estevao and Wilson, 1998; Lebow, Saks, and Wilson, 2003). However, the evidence for the
mechanism through which low inflation raises the natural rate of unemployment is not at all clear cut. Inflation
not only can "grease" the labor market and thus allow downward shifts in real wages in response to a decline
in demand along, but it can also put friction in the system ("sand") by increasing the noise in relative real
wages (Groshen and Schweitzer, 1999). The noise reduces the information content of nominal wages and
hence the efficiency of the process by which workers are allocated across occupations and industries.
8
See Kuroda and Yamamoto (2003) for analysis of the Japanese experience, Fehr and Goette (2005) for
analysis of the Swiss experience, and Kim and Ruge-Murcia (2007) for macroeconometric analysis of the
implications of downward nominal wage rigidity for the United States.
9
The fact that the deflation is anticipated does not completely rule out a negative effect on balance sheets: If
the debt is sufficiently long-lived, there still is some redistribution from debtors to creditors.
10
Although these considerations are important for the design of monetary policy, a central bank can make use of
other policy tools if the policy rate does become constrained by the zero lower bound (Bernanke, 2002).
11
See Reifschneider and Williams (2000), Eggertsson and Woodford (2003, 2004), Coenen, Orphanides, and
Wieland (2004), Wolman (2005), and the citations therein.
BIS Review 35/2008
push the short-term nominal interest rate below the level of expected inflation, thereby
reducing real interest rates enough to mitigate the impact of the shock. But if the central bank
has an inflation objective very close to zero, the zero lower bound can prevent the full
implementation of this policy response, and hence the economy will tend to exhibit greater
volatility of economic activity and inflation.
In contrast, given shocks like those seen over the past several decades, an average inflation
rate higher than about 1 percent substantially reduces the frequency with which the economy
hits the zero lower bound. An inflation objective of about 2 percent implies that monetary
policy is rarely constrained by the zero lower bound and thereby minimizes the adverse
consequences for macroeconomic stability.
Why comfort zones?
These considerations provide the foundations for a broad consensus among academic
economists and monetary policymakers around the world that the optimal inflation rate is in
the range of about 1 to 3 percent; that is, an average inflation rate outside this range would
be detrimental to longer-run health of the economy. In light of that consensus, it might seem
natural to specify price stability in terms of a range of acceptable outcomes for inflation.
Indeed, several present and past FOMC participants have used the term "comfort zone" and
specified a 1 to 2 percent range, thereby providing valuable information regarding their views
about what levels of inflation are consistent with the Federal Reserve's dual mandate.12
The analytical case for a point objective
Nevertheless, while a "comfort zone" approach may seem appealing, analytical
considerations reveal some disadvantages of that approach as well as some significant
benefits of specifying and maintaining a point objective for inflation.
The pitfalls of comfort zones
In particular, I would like to highlight three specific pitfalls associated with the "comfort zone"
approach.
Confusion about objectives. First, when the price stability objective is formulated in terms of
an acceptable range of inflation outcomes, the policy implications may be difficult to interpret.
For example, if the comfort zone spans a range from 1 to 2 percent, does that mean that
policymakers are equally comfortable with inflation rates of 1.1 percent and 1.9 percent?
Furthermore, confusion about inflation objectives might make it harder for a committee of
policymakers to decide on the appropriate course of monetary policy. When one member
advocates a more accommodative policy stance than other members, it may not be clear
whether that reflects a more negative outlook for the economy or a greater willingness to
allow inflation to settle in or near the top of the comfort zone. Thus, the comfort zone
approach might lead to greater confusion in policy deliberations and hence produce a less
effective decisionmaking process.
Perverse expectations dynamics. Second, framing price stability in terms of a comfort zone
could lead to perverse expectations dynamics and thereby generate larger fluctuations in
economic activity, especially if policymakers maintain a neutral stance regardless of where
the inflation rate falls within the comfort zone.
For instance, a negative shock to aggregate demand that brought inflation near the bottom
end of the range might cause long-run expected inflation to fall, which would raise the real
interest rate if the nominal interest rate remained unchanged. This rise in the real interest
rate would exert a further drag that could exacerbate the adverse impact of the original
negative shock on the economy. Similarly, a positive shock to aggregate demand that raised
inflation to the upper end of the range might cause a rise in expected inflation and thus a
decline in the real interest rate, which would provide further stimulus to the economy. The
result would then be more pronounced swings in economic activity.
Nonlinearities and macroeconomic
stability. Third, if a central bank places a high degree of
emphasis on the boundaries of the comfort zone, then these threshold effects imply
nonlinearities in the conduct of monetary policy that are likely to produce less desirable
economic outcomes (Orphanides and Wieland, 2000). For example, the stance of policy
would remain roughly neutral in response to a shock that leaves inflation just below the upper
end of the comfort zone, whereas a slightly larger shock that pushes inflation just above that
boundary would cause an abrupt shift to a contractionary policy stance. Such a "stop-start"
approach is likely to cause greater uncertainty in financial markets and would also tend to
generate greater volatility of the macroeconomy.
The benefits of maintaining a point objective
In contrast to the various pitfalls associated with comfort zones, there are a number of
significant benefits to maintaining a point objective for inflation.
Clarity in communication. First, as I have emphasized in several previous speeches,
communication plays a crucial role in the success of monetary policy (Mishkin, 2007b and
2007c). And in this regard, it seems virtually self-evident that communicating about a single
numerical value for the inflation objective is more straightforward than communicating about
an interval or range of numbers. Of course, regardless of whether the central bank has a
point objective or a comfort zone, it is inevitable that the inflation rate will fluctuate in
response to various shocks; that's why it is also crucial for policymakers to communicate
clearly about the outlook for the macroeconomy and about the central bank's strategy for
promoting the stability of prices and economic activity.
Anchoring inflation expectations. An explicit point objective anchors inflation expectations
more effectively than a comfort zone. If the comfort zone is considered to be a zone of
indifference, then the inflation rate might well exhibit highly persistent fluctuations inside the
zone, perhaps even looking like a random walk within that range. In that case, if inflation
drifts up to the top of the comfort zone, then the private sector could take the view that
inflation might remain at that rate for an extended period of time, especially if policymakers
are not taking any action to bring inflation back toward the midpoint of the range. Thus, the
comfort zone might then generate somewhat larger fluctuations in longer-run inflation
expectations, which would in turn tend to contribute to wider fluctuations in actual inflation. In
contrast, with a transparent and credible point objective, longer-run inflation expectations will
be firmly anchored at that rate.
The insurance motive. Even if policymakers are relatively indifferent about the level of
inflation within a comfort zone, research on the optimal design of monetary policy indicates
that they shouldn't be: The central bank should actively seek to bring inflation back to the
midpoint of its comfort zone, thereby minimizing the probability that inflation wanders outside
the boundaries of that zone. In effect, the optimal policy strategy takes into account the
benefits of insurance, and hence the midpoint of the zone becomes the point objective for
inflation (Mishkin and Westelius, 2006).
The empirical case for a point objective
Now let's turn to the international experience.13 As shown in table 1, a number of major
industrial economies have adopted explicit inflation objectives In 1990, the newly
independent Reserve Bank of New Zealand became the first central bank to establish such
an objective. Many governments have followed in New Zealand's footsteps, and the inflation
objectives have been variously expressed in the form of a point, a range with a preferred
midpoint, or a comfort zone (that is, a range of indifference).
In some cases, the inflation objective was adopted in part as a way to lock in the benefits of
recent disinflation and to prevent the return of adverse inflation outcomes. New Zealand,
whose inflation performance in the 1970s and 1980s was the worst among the industrialized
economies, is arguably one such example. In other instances, inflation had already been
kept low and stable for some time, and the adoption of an explicit inflation objective followed
from extensive research and debate on issues such as the benefits of low and stable
inflation, the presence of biases in the measurement of inflation, and the importance of
central bank communications.
Although the mix of reasons and circumstances that led to the adoption of an explicit inflation
objective varies across economies, there is a remarkable degree of similarity in the
characteristics of these policy frameworks, from which three broad conclusions can be
drawn. First, there is a fairly general consensus among central banks throughout the world
that the average inflation rate should be somewhere between about 1 percent and 3 percent.
Second, point objectives have proven more effective than ranges in anchoring inflation
expectations. Third, when the inflation objective is formulated in terms of a range, the implied
degree of nonlinearity in the central bank's policy actions can be alleviated by placing
increased emphasis on the midpoint of the range.
New Zealand
The monetary policy objective of the Reserve Bank of New Zealand is to "keep future CPI
inflation outcomes between 1 and 3 per cent on average over the medium term." The
narrowness of this range may seem surprising, especially given the historical volatility of
inflation in New Zealand. After all, New Zealand is a small open economy with a large
commodity-producing sector, and as a result the economy is particularly subject to external
shocks that can have a relatively large impact on consumer prices. In this context, the use of
a narrow comfort zone would increase the odds that inflation would fall outside the band at
certain times. Some observers have argued that such outcomes may undermine the public's
trust in the central bank's ability to deliver inflation outcomes in line with its stated objective,
and hence that the inflation band should be widened.14 Nevertheless, a wider band would
hinder the anchoring of inflation expectations, which is pivotal to the successful pursuit of an
explicit inflation objective.
As the previous discussion has illustrated, expressing an inflation objective in terms of a
range makes it more difficult for a central bank to anchor inflation expectations, especially in
the absence of any explicit emphasis on the midpoint. A related issue is that the boundaries
of the range may be seen as "hard edges," that is, inflation outcomes inside the range may
be seen as qualitatively different from those outside the range. The nonlinear policy reactions
implied by this approach can lead to greater variations in interest rates, exchange rates, and
output. The international experience indicates that even when inflation bands with hard
edges have been introduced, subsequent changes in the central bank's policy framework
and communications have tended to soften the edges of the inflation band.
The experience of New Zealand is particularly instructive in this regard. The Reserve Bank
Act requires that price stability be defined in a specific and public contract, negotiated
between the Minister of Finance and the Reserve Bank of New Zealand. Under the act, the
Governor of the Reserve Bank is personally accountable for keeping inflation in line with the
stated objective. (Indeed, the Governor could be fired for failing to do so.) Since 1990, price
stability has been defined in terms of a band for the inflation rate. Over the following decade,
the Reserve Bank treated this band as having hard edges, both in its conduct of policy and in
its communications with the public; indeed, the boundaries of the inflation band were
occasionally referred to as "electric fences" (Sherwin, 1999). However, it became
increasingly evident that the Reserve Bank's vigorous attempts to keep inflation within the
band tended to generate destabilizing fluctuations in nominal interest rates and undesirable
outcomes for the broader macroeconomy.
Given the dissatisfaction with that approach, the Reserve Bank's mandate was refined
significantly in 1997, namely, in seeking to keep inflation within the band, the Reserve Bank
should avoid "unnecessary instability" in output, interest rates, and the exchange rate
(Sherwin, 1999). This refinement allowed the Reserve Bank to lengthen the time horizon for
achieving the inflation goal, thereby reducing the need to respond to transitory price
fluctuations and providing greater flexibility in promoting the goal of macroeconomic stability.
And since the edges of the inflation band have been softened, the Reserve Bank has placed
greater emphasis on the policy actions needed to bring inflation toward the midpoint of the
band over the forecast horizon.15
United Kingdom
The desire to anchor inflation expectations more firmly led the United Kingdom to move from
a range to a point objective for inflation. Three weeks after the United Kingdom departed
from the European Exchange Rate Mechanism in the fall of 1992, the Chancellor of the
Exchequer announced an inflation objective of 1 to 4 percent, which was to be achieved by
the middle of 1997. The use of a range for the inflation objective was interpreted by many as
a way of limiting the extent of discretionary policy and of acknowledging the extent of
imperfect control over inflation (Bernanke and others, 1999, p. 154). The initial target range
of 1 to 4 percent was often perceived as a range of indifference, which implied that inflation
just outside the range would be viewed as qualitatively different from inflation just inside the
range. As a consequence, inflation tended to stay near the upper border of the range.
Dissatisfaction with that outcome motivated the subsequent decision in mid-1997 to move to
a framework with an explicit point objective of 2-1/2 percent, with deviations in either
direction treated symmetrically. This modification of the policy framework was well received
by financial markets and the general public, and surveys of households and professional
forecasters indicated that inflation expectations converged fairly quickly to the Bank of
England's point objective.16
The euro area and Canada
The importance of anchoring expectations helps explain why other central banks that initially
adopted an inflation objective stated in terms of a range - even a narrow one - increasingly
emphasized a single value in their communications or have replaced the range with a point
objective. For example, in May 2003 the European Central Bank (ECB) clarified that in
implementing its mandate of price stability, monetary policy would be aimed at maintaining
inflation "below, but close to, 2 percent in the medium term" (European Central Bank, 2003).
That clarification was welcomed by market participants and likely made it easier for the ECB
to anchor inflation expectations.
As a final example, consider the evolution of the monetary policy framework in Canada. In
the late 1990s, this framework was well described as a range with relatively hard edges
because statements by Bank of Canada officials had consistently indicated that the
boundaries of the target zone (which ranged from 1 to 3 percent) were to be taken more
seriously than the midpoint (Bernanke and others, 1999). Over the past decade, however,
the conduct of monetary policy has evolved in the direction of placing greater emphasis on
the midpoint, while the range has been used mainly as a communication device rather than
as an objective in itself.
Conclusion
I have argued today that the science of monetary policy provides a strong rationale for
framing the inflation goal in terms of a specific point objective rather than as a range or
comfort zone.17 First of all, I've argued inflation should be low but not too low. Second, I've
provided a brief review of lessons from economic theory that can inform policymakers in their
choice of inflation objectives. Third, I've outlined what we can learn from the practical
experiences of other industrial economies; indeed, in recent years, a number of foreign
central banks have moved toward emphasizing the midpoint of an inflation range or have
provided a specific point objective for inflation.
Finally, you may have noticed that I haven't said much about the United States in this
speech. Nevertheless, the issues that I've discussed today 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
policymaking" (Bernanke, 2007). And I certainly hope that my remarks will be helpful in
contributing to the continuation of that process.
Table 1: Major industrial economies with explicit inflation objectives
Economy Starting date Current objective
Australia April 1993 2% to 3%
Canada February 1991 2% ± 1%
Euro Area January 1999 Below but close to 2%
New Zealand March 1990 1% to 3%
Norway March 2001 2 1/2%
Sweden January 1993 2% ± 1%
Switzerland January 2000 Above 0 and below 2%
United Kingdom October 1992 2%
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