What's in a name?

• Author: Posen, Adam S.
• Position: The Monetary Realist - Public inflation target in central banks

When we sat down twelve years ago at the New York Fed to research the hot new monetary regime of the 1990s, we gave little thought to the resulting book's title. The Reserve Bank of New Zealand, the Bank of Canada, and the Bank of England all called what they were doing "inflation targeting"; so, in the interests of transparency, that is what we called the book. We were more concerned with addressing the threats we perceived than the label: the vulnerability of U.S. monetary policy to a radical change in the Fed's mandate (such as the gold standard a Senator proposed in 1994), and to the excessive personalization of policy through the reputation of a long-serving chairman. We thought a public inflation target (IT) would preempt both dangers.

It turns out we should have paid more attention to marketing. In today's discussions of the future of the Fed, there is a strong presumption in many quarters that "inflation targeting" would be an excessively rigid regime--akin to monetary targeting or a hard exchange rate peg, concentrating only on inflation. If it were such a rules-based regime, as the word "targeting" (and the absence of the word "employment") apparently connotes on Capitol Hill, it would be a very bad idea indeed.

But IT in practice actually enhances a central bank's flexibility in responding to real shocks. If you can anchor inflation expectations through a public commitment, you can cut rates in a recession more aggressively or avoid raising rates after an oil shock, because the central bank's short-term stabilization of the real economy does not raise doubts about its commitment to price stability. The most well-intentioned central bank that cuts rates sharply when unemployment rises, or that fails to raise interest rates soon enough after an oil shock, but does so without such an anchor for inflation expectations as IT provides, ends up with higher inflation rates and then must induce a recession to get them back down. That is what the 1970s taught us.

This use of IT is how the United Kingdom kept its inflation rate low following its devaluation of the pound in September 1992, and how Brazil managed a similar challenge when its currency was hit in the crisis of 1997-98. In both cases, monetary policy still avoided sharp tightening for the sake of employment. Italy and Argentina, whose currencies depreciated at the same times without the IT anchor, got the inflation, as well as less output stabilization. This pattern also shows...