On the Fed's Cred and Inflation Targeting: Echoes

By Amity Shlaes and Ilan Kolet

Credibility matters. It's hard to gain, and easily lost. As we pointed out earlier this week, Paul Volcker managed to harness inflation (and, perhaps more importantly, inflation expectations) in the 1980s through ruthless adherence to high interest rates. In doing so, he established the Federal Reserve's credibility on price stability.

To maintain that confidence in today's era of low interest rates and quantitative easing, should the Fed adopt an explicit inflation-targeting regime?

Evidence shows that targeting — the process by which a monetary authority adjusts interest rates to achieve an explicit rate of inflation — helps keep inflation "low, stable and predictable," as the governor of the Bank of Canada has put it.

A number of advanced and developing countries have signed up, with measurable success. (See chart.) Many emerging markets that had suffered through economic crises — such as Mexico, Brazil and eastern European countries — have found that an inflation-targeting framework is a better tool for transparently communicating the path of monetary policy to the public and to market participants.

For the Fed, "a formal target might be especially valuable today," a recent note from Macroeconomic Advisers LLC says. And it "could help allay concerns by some that the FOMC will end up being too easy." The authors argue that an inflation target is also a good way to improve the Federal Open Market Committee's "communication, transparency, and accountability."

Volcker looked at monetary aggregates. Central banks today generally look at headline inflation to set monetary policy. Yet these decisions to follow a clear rule have similar effect. That's because uncertainty over what a central bank may do tends to raise expectations of inflation. The very fact that the monetary authority has committed to a rules-based system, rather than a discretionary one, reduces the market's concern about the possible scope of inflation.

Although adopting an explicit inflation target is unlikely until the U.S. economy starts growing more robustly, moving to one sooner rather than later would help solidify the Fed's credibility.

(Amity Shlaes, a Bloomberg View columnist, oversees the Echoes blog. The opinions expressed are her own. Ilan Kolet, who created this graphic, is a data editor for Bloomberg News.)

© Copyright 2011 Bloomberg

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