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Policy Debate: Should the Federal Reserve aim at a zero inflation policy?

Issues and Background

Plausible estimates of the benefits of zero inflation are certainly less than the unemployment costs of zero inflation.... A low, steady rate of inflation is a reasonable target for the Fed. We cannot say precisely what low rate of inflation best serves the American people, but we are confident it is not zero.
~ George A. Akerlof, William T. Dickens, and George L. Perry
If the Federal Reserve commits to an explicit plan for achieving price stability, the transition costs would be reduced, and any costs that arise will be outweighed by the benefits. These benefits will be large and permanent, and will far outweigh the costs of getting there.
~ W. Lee Hoskins

Virtually all economists agree that high inflation rates are disruptive. Economies experiencing double-digit inflation rates tend to have lower growth rates than economies experiencing lower rates of inflation. This is due, in large part, to the increased uncertainty about future income and prices that accompanies higher inflation rates. Thus, most economists agree that inflation rates should be relatively low. There is much less consensus about whether an inflation rate of 0% is better or worse than an inflation rate of 3%.

During the 1950s and 1960s, most U.S. economists would have suggested that a positive inflation rate was desirable. This is because this period was characterized by a relatively stable inverse relationship between inflation and unemployment rates. This relationship, known as the "Phillips' curve," suggested that the opportunity cost of less inflation was higher unemployment. In this scenario, policymakers could use monetary and fiscal policy to select whatever combination of inflation and unemployment was perceived as being most desirable.

The economic experience of the 1970s and early 1980s cast serious doubt on this simple Phillips' curve relationship. Supply shocks, induced in large part by the OPEC oil embargoes, resulted in higher unemployment and inflation rates at the same time. The double-digit inflation rates occurring during this period lead to significant changes in the structure of economic relationships. Many labor contracts initiated during this period contained cost-of-living clauses that caused labor costs in the current period to rise at least as rapidly as prices did in the previous period. Inflationary expectations played a major role in the formulation of all types of long-term contracts.

In response to these economic events, economists began to pay substantially more attention to the importance of the role of expectations and the process of expectations formation. The downward sloping Phillips' curve appeared to be, at best, a short-run relationship that existed only when inflationary expectations were held constant. The long-run Phillips curve, it is argued, is vertical at the natural rate of unemployment. Thus, in the long run, monetary policy only affects the inflation rate, but not the level of output.

While many economists believe that a short-run tradeoff exists between unemployment and inflation, new classical economists argue that only unanticipated monetary changes can affect output and employment in the short run. In this case, the Fed can reduce unemployment only if they are able to fool the public by announcing a rate of money growth that is below the actual money growth rate. If the Fed pursues such a policy repeatedly, however, the public would eventually recognize its strategy and the Fed's policy announcements would not be credible.

The debate over the conduct of monetary policy often focuses on two major questions:

  1. Should monetary policy be conducted in a discretionary manner or should it follow a fixed rule?
  2. If an activist monetary policy is used, what should be the monetary target(s)?
As the articles listed below will demonstrate, there is still a substantial amount of disagreement over these issues. A growing number of economists, however, appear to be advocating an inflation rate target. Ben Bernanke, the current Chair of the Federal Reserve Board, has long been an advocate of an inflation-rate target. Advocates of the adoption of this policy are hoping that the Fed will move toward an inflation-rate target policy during his tenure as Chair.


Primary Resources and Data

  • Rebecca Hellerstein, "The Impact of Inflation"
    In this Boston Fed online article, Rebecca Hellerstein provides a good discussion of the actual and perceived economic costs of inflation. This article summarizes a large volume of relatively technical recent studies in a very easily understood manner. Many of the arguments for and against a zero inflation rate target are summarized in this document.

  • Alan S. Blinder, "The Strategy of Monetary Policy"
    In this September 1995 article, Alan S. Blinder, the Vice Chairman of the Federal Reserve Board of Governors, discusses practical problems in the conduct of monetary policy. Blinder provides a nice summary of the measurement issues making it difficult to achieve a zero-inflation target and examines the difficulties of conducting monetary policy in an uncertain environment.

  • Bank for International Settlements, "Central Bank Websites"
    This web site contain links to the websites of virtually all central banks that maintain an internet presence. These web sites often contain information about the conduct of monetary policy in these countries.

  • New Zealand's Policy Targets Agreement
    This is the text of the "Policy Targets Agreement" that serves as the basis for New Zealand's 0-3% inflation monetary policy target.

  • Bank of Canada, "Monetary Policy"
    The Bank of Canada succinctly summarizes its policy of pursuing an inflation target in this online document.

  • Federal Reserve District Banks
    This page contains a list of links to the home pages of Federal Reserve District Bank web sites. These sites contain articles dealing with monetary policy and inflation.

  • Consumer Price Indexes
    This CPI page, provided by the Bureau of Labor Statistics, contains information about the construction of the CPI. Problems in dealing with the service sector and capturing the effects of quality change are discussed at this web site.

  • Consumer Price Index Conversion Factors
    Robert Sahr provides this table of conversion factors that makes it possible to convert past, present, and projected future prices into 2005 dollars. Estimated conversion factors are provided for the years 1665 - 2016.

  • The Inflation Calculator
    This page contains an online calculator that converts prices in any year between 1800 and 2005 into the equivalent price in any of these years.


Different Perspectives in the Debate

  • Joint Economic Committee, "Establishing Federal Reserve Inflation Goals"
    In this April 1997 study, it is argued that a price stability (or zero inflation) target should be introduced. Historical and international evidence in support of such a policy is presented in this document.

  • Thomas C. Melzer, "To Conclude: Keep Inflation Low and, in Principle, Eliminate It"
    In these November 1997 article, Thomas C. Melzer, past President of the St. Louis Fed, argues that maintaining price stability is an important goal of the Fed. He suggests that there is low inflation will result in a higher rate of economic growth. In this speech, Melzer argues that a credible Fed policy of price stability (or zero inflation) may be achieved at no substantial economic cost and provides large long-run benefits. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

  • The Region, "Fed Presidents Support Zero-Inflation Proposal"
    In this February 1990 article which appeared in The Region (a publication of the Minneapolis Fed), the presidents of the New York, Cleveland, San Francisco, and Richmond Feds provide brief summaries of why they feel that a zero-inflation target is a desirable monetary policy objective.

  • William Poole, "Is Inflation Too Low?"
    In these October 22, 1998 remarks, William Poole, the President of the St. Louis Fed, provides a series of economic arguments in favor of a zero inflation rate target.

  • William Poole, "Inflation Targeting"
    William Poole, provides additional arguments in favor of a zero inflation rate target in this February 16, 2006 speech. Since there is some measurement error in price indexes, he supports an inflation target in the range of 0.5% to 1.5% annual inflation. He argues that the successful pursuit of such a target would result in lower interest rates in bond markets, encouraging additional investment. Poole suggests that the use of an explicit inflation target would enhance the Fed's ability to engage in countercyclical policy.

  • Edward M. Gramlich, "The Politics of Inflation Targeting"
    Edward M. Gramlich, a member of the Federal reserve Board of Governors, expresses his views on inflation targeting in this May 26, 2005 speech. He observes that countries that have adopted inflation targets have been successful in reducing inflation rates and interest rates. Gramlich notes, though, that the U.S. has been able to effectively achieve these goals without an explicit inflation-rate target. He observes that the countries that have adopted an inflation-rate target have parliamentary governments. Gramlich argues that the situation would be more complex under the U.S. political system in which the Fed would be answerable to the policy objectives of the executive branch and both houses of Congress. He notes that there has not been much support from Congress for a switch to an inflation-rate target. Gramlich argues that since the Fed has already been effective in reducing inflation, the benefits from a switch to an inflation-target would be small while the potential costs are large.

  • Interview with W. Lee Hoskins
    In this June 1991 interview which appeared in The Region (a publication of the Minneapolis Fed), W. Lee Hoskins, the President of the Cleveland Fed, discusses his arguments for a zero inflation target. Hoskins argues that inflation distorts relative prices and results in economic inefficiency.

  • W. Lee Hoskins, "Defending Zero Inflation: All for Naught"
    In this Spring 1991 article (appearing in Federal Reserve Bank of Minneapolis Quarterly Review), W. Lee Hoskins provides a detailed discussion of his arguments for a zero inflation monetary target. He argues that inflation results in:
    • higher taxes (since not all taxes are indexed),
    • distortions caused by inflation rate uncertainty, and
    • higher prices for nonmonetary assets that are used as a hedge against inflation.
    (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

  • Lee Hoskins, Zero Inflation: Goal and Target
    In these December 5, 2005 remarks to the Shadow Open Market Committee, Lee Hoskins builds a case for a zero-inflation rate target. He argues that the Fed is unable to effectively use monetary policy to stabilize the business cycle because of the lag in recognizing the need for a change in policy and the long and variable lag in the effect of the policy on the economy. Hoskins argues, though, that the Fed has much more control over the inflation rate. He recommends that the Fed attempt to maintain an average inflation rate of zero over a three- or five-year period. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

  • S. Rao Aiyagari, "Response to a Defense of Zero Inflation"
    In this response to W. Lee Hoskins article (above), S. Rao Aiyagari argues that a zero inflation target is undesirable because:
    • the Fed's commitment to a zero inflation target is not likely to be credible,
    • it would reduce the tax on capital income (Aiyagari argues that if this is a goal, it should be implemented through changes in the tax code, not through monetary policy), and
    • it is argued that there is little evidence suggesting that a zero inflation target will reduce uncertainty about the variability of inflation.
    (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

  • George A. Akerlof, William T. Dickens, and George L. Perry, "Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?"
    In this Brookings Institution Policy Brief, Akerlof, Dickens, and Perry argue that there are substantial permanent costs associated with pursuing a zero inflation target. According to their argument, these costs exist as a result of firms' reluctance to reduce nominal wages. The results of a simulation model suggests that reducing the inflation rate below 3% would result in an increase in unemployment that would persist as long as this inflation target is maintained.

  • George A. Akerlof, William T. Dickens, and George L. Perry, "Options for Stabilization Policy: A New Analysis of Choices Confronting the Fed"
    This February 2001 Brookings Institute Policy Brief examines the use of monetary policy targets. Akerlof, Dickens, and Perry suggest that the effect of expected inflation varies with the level of realized inflation. They suggest that the conventional theory of the natural rate of inflation is flawed and attempt to construct a model that they believe more correctly models the process by which expectations are formed. In particular, they suggest that when inflation is low, its effect is either ignored or assigned a low weight by economic decision makers. This provides a range of sustainable unemployment rates. Akerlof, Dickens, and Perry argue that such a model better describes the recent experience of the economy with low rates of both unemployment and inflation. They suggest that there is little or no benefit to a zero-inflation target and substantial costs since this would limit relative price flexibility (since it is argued that prices are somewhat rigid in a downward direction).

  • Remarks by Vice Chair Alice M. Rivlin at the Annual Meeting of the Eastern Economic Association, Washington, D.C. April 4, 1997
    Alice Rivlin, Vice Chair of the Federal Reserve Board of Governors, discusses the objectives of monetary policy in this address. She argues that a zero inflation target is undesirable due to problems in measuring inflation and the possibility that the costs would outweigh the benefits. Rivlin argues that the ultimate goals of monetary policy should be a high (and sustainable) rate of economic growth and a low unemployment rate.

  • John H. Makin, "What Should Central Banks Do?"
    In this October 1999 Economic Outlook article, John Makin discusses the choices facing monetary policymakers. He argues that central banks were originally formed to maintain stable financial markets and not to fight inflation. In particular, Makin suggests that the Federal Reserve System was created in 1913 in reaction to financial panics, particular the financial panic of 1907. He argues that a low or zero inflation target is just a convenient mechanism for preserving stable financial markets. Makin observes that central banks have demonstrated an ability to rein in inflationary pressures, but expresses concern about how they would deal with a period of deflation. He notes that the Fed is in a difficult position since it needs credibility to maintain stable financial markets. Since the Fed must follow it's announced policy of a low inflation target to maintain this credibility, Makin argues that it is unable to effectively deal with other problems that may occur in financial markets.

  • Ben S. Bernanke, "Remarks by Governor Ben S. Bernanke at the 28th Annual Policy Conference: Inflation Targeting: Prospects and Problems,"
    Ben S. Bernanke provides arguments for the adoption of an inflation-rate target in this October 17, 2003 statement. He argues that the benefits of adopting a low inflation rate target (of approximately 2%) outweigh the costs. Bernanke is opposed to an inflation rate target that is very close to zero because of concern over the costs associated with possible deflation.

  • Federal Reserve Bank of Minneapolis, "Interview with Ben Bernanke"
    In this June 2004 interview, Ben Bernanke discusses his advocacy of an inflation-rate target. He observes that the Fed has already shifted most of its focus to targeting the inflation rate, since this is the only outcome that the Fed can control in the long run. Bernanke argues that the adoption of an explicit low-inflation target would help stabilize inflationary expectations and reduce macroeconomic instability. (A wide range of other macroeconomic topics are also discussed in this interview.)

  • Federal Reserve Bank of Minneapolis, "Interview with James Tobin"
    James Tobin was the 1981 recipient of the Nobel Prize in Economics for his work on money demand. In this 1996 interview, Tobin states his views on monetary theory (as well as on other policy issues). He argues that the Fed should consider both unemployment and inflation rate targets in establishing monetary policy. Tobin also argues that there should be more political control over the Fed.

  • Edward M. Gramlich, "The Politics of Inflation Targeting"
    In this May 26, 2005 speech, Edward M. Gramlich examines the spread of an inflation target. He notes that the 20 countries that have adopted inflation targeting have experienced declining inflation rates without experiencing a decline in economic growth. Gramlich notes, though, that this is not conclusive evidence since other countries (such as the U.S.) also experienced lower inflation without a decline in growth during the same period. He observes that attempts to introduce a U.S. inflation target in Congress have not been successful. Gramlich suggests that the best chance of introducing an inflation target would be through the Fed's introduction of a soft target. This could be used to lobby Congress to move toward the adoption of an inflation target.

  • Stanley Fischer, "Central Banking: The Challenges Ahead"
    In this article, Stanley Fischer, the First Deputy Managing Director of the International Monetary Fund, examines some of the major issues facing central banks. He argues that an inflation target is an appropriate monetary policy objective, but believes that a positive inflation target is preferable to a zero inflation target.

  • John H. Makin, "How Low Should Inflation Go?"
    In this October 1996 article appearing in Economic Outlook, John H. Makin provides a very nice summary of the problems in establishing an inflation target. One reason for this is the existence of an inflationary bias in the consumer price index. This means that a target of zero actual inflation coincides with a positive measured inflation rate. Makin also provides a concise description of the practical problems facing the Fed in implementing an inflation target.

  • Alan Greenspan, "Problems of Price Measurement"
    In this January 3, 1998 speech delivered at the American Economic Association, Alan Greenspan, the Chairman of the Federal Reserve Board of Governors, presents a detailed discussion of the problems associated with measuring inflation. This article provides a particularly good discussion of the difficulties in measuring price changes in the service sector and for goods that exhibit quality change over time.

  • Nicholas Rowe and David Tulk, "A Simple Test of Simple Rules: Can They Improve How Monetary Policy is Implemented with Inflation Targets?"
    Nicholas Rowe and David Tulk examine the possible effect of alternative monetary policy rules in this October 2003 Bank of Canada Working Paper. They find that a variety of simple rules would not have improved the bank's performance in achieving inflation targets. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

  • Nicholas Apergis, Stephen M. Miller, Alexandros Panethimitakis, and Athanasios Vamvakidis, "Inflation Targeting and Output Growth: Empirical Evidence for the European Union"
    Nicholas Apergis, Stephen M. Miller, Alexandros Panethimitakis, and Athanasios Vamvakidis examine the effectiveness of an inflation target in this May 2005 IMF working paper. They find that the use of an inflation-rate target resulted in a higher degree of macroeconomic stability. A low inflation-rate target, though, resulted in better performance than a zero inflation-rate target. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

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