Should the Federal Reserve Adopt an Inflation Target?
Prepared for Members and Committees of Congress
Some economists have long criticized the American model of central banking for featuring
multiple policy goals, discretion on the part of the central bankers as to which goal to emphasize,
freedom in the choice of instruments to achieve the policy goals, and rather vague accountability
for policy failures if, indeed, these can even be identified. Recently, the critics have urged that the
multiple policy goals of the Federal Reserve (Fed) be replaced by a single goal of price stability.
Critics believe that central bankers tend to use their discretionary powers to achieve political as
well as economic objectives, notably to create “good times” through monetary expansion. Since
these “good times” do not last long, such a policy imparts a costly inflationary bias to an
economy and, hence, is not economically optimal over time. Among other virtues, it is argued
that a single goal would provide an explicit anchor for the American monetary system.
The current model has strong support as well. Since an economy faces many unforeseen
contingencies, supporters argue that giving central bankers multiple goals and a high degree of
discretion is optimal. They question whether a price stability goal would be flexible enough to
allow the Fed to remain the lender of last resort to the U.S. financial system and to cope with
short run stabilization problems that beset the country at times. They note that the Fed has
successfully delivered price stability for over two decades under the current multi-goal regime.
Both proponents and opponents of a price stability goal are supported by an array of economic
theories and empirical studies.
To formally replace the current multi-goal mandate of “maximum employment, stable prices, and
moderate long-term interest rates” with a single goal of price stability would require legislation.
Members from both parties have introduced such legislation in past Congresses. But Fed
Chairman Ben Bernanke, a long-time advocate of inflation targeting, has argued that the Fed
could independently adopt an inflation target without changing the multi-goal mandate. A number
of countries have recently made price stability the sole goal of their monetary policy. In practice,
these countries have not focused their monetary policy solely on price stability, but have
responded to changes in output as long as it did not undermine long-term price stability. This
arrangement has been coined “constrained discretion.”
The price stability goal, while simple and straightforward, raises a number of technical questions
about definition, in terms of a goal of inflation or constant prices, whether a point or band target
should be used, and the appropriate price index to measure price stability. The goal may also
place constraints on fiscal, debt management, and exchange rate policies—policies not delegated
to the Fed. Accountability should be greater than under the current regime, but the degree of
accountability depends on how the goal is defined. Since it is infeasible to expect the central bank
to keep inflation right on target at all times, consideration should be given to the exceptions
granted to the goal and the permissible time interval over which the targets must be met. But
these exceptions in turn make accountability more difficult. This report will be updated as events
Backgr ound ..................................................................................................................................... 1
The Case for Refocusing the Federal Reserve.................................................................................3
(1) The Neutrality of Money.....................................................................................................3
(2) Long and Variable Lags.......................................................................................................3
(3) Rational Expectations..........................................................................................................4
(4) Precommitment and Credibility...........................................................................................5
(5) The Natural Rate of Unemployment (the NAIRU).............................................................6
(6) The Desire for Greater Accountability................................................................................7
The Case in Favor of Refocusing Fed Policy—Summary........................................................8
The Case Against a Single Goal for Federal Reserve Policy...........................................................9
(1) Is Money Neutral in the Long Run? Are Expectations Rational?.......................................9
(2) Does NAIRU Exist?..........................................................................................................10
(3) Long and Variable Lags (Again).........................................................................................11
(4) A Little Inflation Can Make Important Adjustments Easier..............................................12
(5) The Importance of Other Goals.........................................................................................12
(6) The Need for Flexibility and Discretion............................................................................13
The Case Against a Single Goal Fed Policy—Summary........................................................14
Technical Problems With Implementing a Price Stability Goal....................................................15
The Definition of Price Stability.............................................................................................15
Choice of Price Index..............................................................................................................16
Should There Be a Fixed Band Around the Target, and If So, How Wide Should It
Be? ....................................................................................................................................... 17
Would Exceptions Be Allowed?..............................................................................................18
How Long Would the Central Bank Have to Achieve Its Goal?.............................................19
If a Target Were Changed or Missed, What Would Be the Optimal Time Over Which
to Return to the Target?........................................................................................................19
What Incentives Are There, or Should There Be, for the Federal Reserve to Achieve
Its Announced Target? Or, What Type of Accountability Should There Be?.......................20
Who Would Set a Target for Price Stability? Does an Inflation Target Require a
How Could the Government Set a Permanent Target?............................................................22
Conclusion ..................................................................................................................................... 22
Figure 1. Phillips Curve, 1961-1969...............................................................................................5
Figure 2. Phillips Curve, 1970-2006...............................................................................................7
Table 1. Average Annual Inflation Rate in the Industrial Countries, 1950-2007.............................1
Author Contact Information..........................................................................................................24
The 1970s stand out in the post-World War II era as the inflation decade. This is evident from the
data in Table 1 for the leading industrial countries. Inflation served to motivate public policy in a
number of countries. A major impetus of these initiatives was to focus central banks on one major
policy goal: the achievement of price stability. In some cases this has taken the form of legislation
specifying this goal to the exclusion of all others. In other cases, the central bank was granted
greater autonomy in the expectation that this would lead to the desired outcome. During recent
years, Canada, the United Kingdom, New Zealand, Sweden, Australia, and Israel, among others
have adopted inflation targeting as the major goal of monetary policy. And since the European
Central Bank’s inception, price stability has been its main objective.
These developments have not gone unnoticed in the United States. The ultimate objectives of
Federal Reserve (Fed) policy are currently specified in the Federal Reserve Reform Act of 1977
as maintaining the “long run growth of monetary and credit aggregates commensurate with the
economy’s long run potential production, so as to promote the goals of maximum employment, 1
stable prices, and moderate long-term interest rates.”
Both Democratic and Republican Members of Congress have introduced legislation that would
replace the current multigoal mandate of “maximum employment, stable prices, and moderate
long-term interest rates” with a single goal to maintain “stable prices.” In some proposals, “stable
prices” is defined as a low inflation rate. In others, the overall price level would remain constant.
An early example of Democratic efforts along these lines was the “Zero Inflation Resolution” th
introduced by Representative Stephen Neal of North Carolina in 1989. In the 109 Congress,
Representative Jim Saxton, Republican of New Jersey, introduced the Price Stability Act of 2005,
H.R. 498, “To mandate price stability as the primary goal of ... monetary policy ....” Two bills th
were introduced in the 110 Congress. The first, the Price Stability and Inflation Targeting Act of
2008, H.R. 6042, was introduced by Representative Jim Saxton, Republican of New Jersey. The
second, H.R. 6053, the Price Stability Act of 2008, was introduced by Representative Paul Ryan,
Republican of Wisconsin. Both would commit the Fed to inflation targeting.
Table 1. Average Annual Inflation Rate in the Industrial Countries, 1950-2007
(data in percentages)
1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 2000-2007
United States 1.8 2.3 7.1 5.6 3.0 2.8
United Kingdom 3.5 3.6 12.6 7.4 3.7 1.6
Austria 6.8 3.3 6.1 4.0 2.4 1.9
Belgium 1.9 2.7 7.1 5.1 2.2 2.0
Denmark 3.8 5.3 9.3 7.1 2.1 2.1
1 For more information, see CRS Report RL30354, Monetary Policy and the Federal Reserve: Current Policy and
Conditions, by Gail E. Makinen and Marc Labonte; and CRS Report RS20949, The Federal Reserve: Recurrent Public
Policy Issues, by Marc Labonte.
1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 2000-2007
France 6.2 3.8 8.9 7.8 1.9 2.0
Germany 1.1 2.4 4.9 2.9 2.3 1.7
Italy 2.9 3.4 12.5 11.8 4.1 2.4
Netherlands 3.8 4.2 7.1 3.1 2.5 2.5
Switzerland 1.1 3.1 5.0 3.3 2.4 1.0
Canada 2.4 2.5 7.4 6.7 2.2 2.2
Japan 3.1 5.4 9.1 2.5 1.2 -0.4
Greece 6.5 2.0 12.3 20.1 11.1 3.4
Ireland 3.9 4.0 12.7 9.9 2.3 3.3
Portugal 0.7 4.0 17.1 18.2 6.0 3.1
Spain 6.2 5.8 14.1 10.6 4.2 3.2
Australia 6.5 2.5 9.8 7.6 2.5 3.0
New Zealand 5.0 3.2 11.4 12.5 2.0 2.7
Mean 3.7 3.5 9.7 8.1 3.2 2.2
Standard Deviation 1.99 1.08 3.28 5.04 2.17 0.96
Source: For 1950-1989: Consumer prices compiled by the International Monetary Fund and reported in Grilli,
Masciandaro, and Tabellini. Political and Monetary Institutions and Public Financial Policies in the Industrial
Countries. Economic Policy. October 1991, p. 344. For 1990-2007 Consumer Prices compiled by International
Monetary Fund. Statistical computations made by CRS.
The Federal Reserve takes no official position on inflation targeting. Governors and Regional
Bank Presidents of the Federal Reserve are perceived to have mixed views on making inflation
the sole goal of monetary policy, with recently retired Chairman Alan Greenspan perceived to be 2
opposed to a congressionally mandated inflation target. His successor, Ben Bernanke, is a long-3
time advocate of inflation targeting. William J. McDonough, former president of the New York
Federal Reserve Bank, said:
It is often said that there is a worldwide community of central bankers. I certainly feel that
way. Central bankers in all countries share a number of concerns. Perhaps the most important
of these is the desire for price stability. While central bankers may differ in the way they
seek price stability—differences grounded in our respective histories, customs, and 4
institutions—the goal we all strive for is no less important.
Although the purpose of this proposal is straightforward, it raises many technical issues that this
report will consider. As a preface to this discussion, the report will begin with pro and con cases
given by economists who either favor or oppose the legislation focusing the Federal Reserve on
an exclusive goal of achieving price stability.
2 Vivien Lou Chen, “Fed’s Debate on Inflation Targets May Shape Post-Greenspan Era,” Bloomberg News, March 22,
3 See, for example, Ben S. Bernanke, “A Perspective on Inflation Targeting,” remarks at the Annual Washington Policy
Conference of the National Association of Business Economists, Washington, DC, March 25, 2003.
4 William McDonough, “A Framework for the Pursuit of Price Stability,” Economic Policy Review, vol. 3, no. 3
(August 1997), p. 1.
The ultimate purpose of refocusing the Federal Reserve on a price stability goal is to increase the
amount of real goods and services available to the nation, not, as the late Professor James Tobin 5
reminded us, because “Price or inflation stability is . . . an ultimate social good.” Thus, it must be
shown that inflation has a pernicious effect on economic growth, the efficiency with which the
economy works, the choices available to Americans to satisfy their needs and wants, or on 6
employment. Such a case can be made. But should price stability be the sole goal of monetary
policy? Proponents make that case based on five powerful strands of economic theory and
empiricism, as well as one political argument.
The basic case made by economists for refocusing the Federal Reserve is built on a very old
economic doctrine known as the “Neutrality of Money.” This is the view that the influence of
money and changes in the money supply are neutral with respect to changes in the real economy
where economic growth, employment, real interest rates, and relative prices are determined.
These depend on such factors as the choices individuals make between leisure and work, the
technical means by which labor and capital are combined, and the saving/investment decisions by
economic agents. Money, on the other hand, influences only money things such as the price level,
money wages, the money value of output, and the nominal or market rate of interest. Since this is
money’s primary economic effect and a changing price level can have harmful effects on an
economy, the doctrine of the neutrality of money can serve as a powerful rationale for focusing 78
monetary policy on achieving price stability.
A second element supporting refocus on price stability is based on the empirical finding that
changes in the money supply can affect the pace of economic activity and prices with a lag that is
both long and of a variable length (i.e., a given change in the rate at which the money supply
grows does not always affect the pace of economic activity and prices within the same length of
time). This may be due to changes in the underlying structure of the economy as well as to
5 Prof. Tobin’s full quote is “As Jacob Marschak gently reminded Henry Wallich in a memorable Yale seminar years
ago, prices are not in anybody’s utility function. Price or inflation stability is not an ultimate social good, but must be
justified as an instrument that will deliver more utility-laden goodies to the society.” See James Tobin, Panel
Discussion in J. C. Fuhrer, ed., Goals, Guidelines, and Constraints Facing Monetary Policymakers, Federal Reserve
Bank of Boston, June 1994, pp. 232-236.
6 The case is made in CRS Report RL30344, Inflation: Causes, Costs, and Current Status, by Marc Labonte and Gail
7 The neutrality of money was viewed by early economists and some of their later followers as a long run proposition.
In the shorter run, variations in the growth rate of the money supply could affect the growth rate of real output and
8 The classic work exploring money’s effect on the economy is Milton Friedman and Anna Schwartz, A Monetary
History of the United States 1867-1960 (Princeton University Press, 1963). See also Christina D. Romer and David H.
Romer, “Does Monetary Policy Matter? A New Test in the Spirit of Friedman and Schwartz,” in O.J. Blanchard and S.
Fischer, eds., NBER Macroeconomic Annual 1989 (Cambridge, MA: MIT Press, 1989), pp. 121-170.
changes in policy regimes, as might be expected to occur when a country moves from a system of
fixed to a system of flexible exchange rates.
Because of the long and variable lag of monetary policy, changes in policy undertaken today can
have their effect on the economy after the underlying cause of the original disturbance may
already have corrected itself. If so, countercyclical monetary policy could be destabilizing. For
that reason, some economists argued against using monetary policy to promote such goals as full
employment. Rather, they argued, it should be geared to producing stable prices, since money’s
lasting effect on the economy is on nominal magnitudes.
Third, there were developments in specifying how economic agents formed their expectations.
Expectations, especially of inflation, are important in many forward looking price-setting
activities in market economies, such as wages, the prices of individual goods and services, and
interest rates. The revolution in this area occurred with the introduction of so-called theory of
Rational expectations is the theory that economic agents make use of all relevant information,
including information about monetary policy, in formulating their expectations about the future.
Wage earners, for example, would strike a wage bargain with an employer only after considering 9
what monetary conditions would likely prevail over the period of the employment contract.
Rational expectations do not mean that individuals are always right. It only means that they do
not make systematic mistakes.
This method of forming expectations has a powerful implication. It implies that systematic
monetary policy, or that expected by economic agents, can have no effect on the real sector of the
economy since it would have been anticipated by economic agents and become a part of their
market behavior. Thus, systematic monetary policy is also neutral in the short run (as well as in
the more general case of long run neutrality). If monetary policy does affect the pace of economic
activity in the short run, it must be because it comes as a surprise—it is unanticipated and
nonsystematic. Its nonneutral effects will last only until economic agents incorporate it into their
wage, price, and interest rate decisions (this leads to the so-called misperceptions theory of
The question might arise why the Federal Reserve would want to spring monetary surprises on
the economy. A major reason given in the literature is that it yields to political pressures to boost
economic activity—create good times—prior to presidential elections. This notion of a political
business cycle enjoys some support among economists. It should also be noted that a surprise
based monetary policy is not an optimal policy since ultimately the cost of avoiding inflation
reduces welfare and output is no higher than it would have been in the absence of the surprise
9 While this may seem to the reader as the natural thing for individuals to do, in empirical approaches to expectation
formation, economists often reasoned that economic agents would merely extrapolate the past in forming notions about
the future. Thus, expectations about the future rate of inflation were taken to be some weighted average of past
inflation. In this formulation, economic agents would neglect some available relevant information about the forces
theory suggested caused inflation (e.g. the rate of growth of the money supply) and, instead, form their notions about
the future by looking only at the past actual rate of inflation. This was regarded as irrational.
inflation. In the jargon-rich language of economists, this is also known as the “time inconsistency
The notion of rational expectations supports focusing Federal Reserve policy on the single goal of
price stability. This is because, according to rational expectations, the only way the Federal
Reserve can alter employment is by engineering a surprise. Surprise changes in monetary policy
can, at best, have only a short run effect on employment. The longer run effect is only on the
inflation rate and inflation has harmful side effects on the economy.
The discussion above stresses the importance of misperceptions by economic agents as a cause of
business cycles. If errors of predictability and errors of understanding are an important part of
misperceptions, then making monetary policy more predictable, consistent, and understandable
should reduce errors and misperceptions. Furthermore, this theory suggests that over time
surprises will become less and less effective at stimulating the economy, until they ultimately
become counterproductive. Conversely, the theory suggests that monetary policy changes, such as
disinflations, could be faster and less costly if credibility were greater. It is thought that under a
credible central bank individuals might change their inflationary expectations more quickly,
making the economy more flexible as a result. Thus, a monetary policy based on precommitment
and credibility should be conducive to economic stability. A single goal such as price stability, it
is argued, can increase the clarity and understandability of monetary policy by “anchoring” 10
expectations and, thus, contribute to this end.
Figure 1. Phillips Curve, 1961-1969
Source: Bureau of Labor Statistics
10 For example, see Ben Bernanke et al., Inflation Targeting (New Jersey: Princeton University Press, 1999), p. 20.
In the 1960s, there was a broad consensus in macroeconomics that a relationship existed between
inflation and unemployment known as the “Phillips Curve.” This theory posited that a rise in 11
inflation would lead to a predictable fall in unemployment, and vice versa. There was, as shown
in Figure 1, considerable empirical support for this notion.
In the late 1960s, two economists, Professors Edmund Phelps of Columbia University and Milton
Friedman of the University of Chicago, independently rejected the Phillips Curve framework and
in its place put forth the notion of the non-accelerating inflation rate of unemployment or NAIRU 1213
as a definition of the unemployment rate consistent with the full employment of labor. This
refers to an unemployment rate consistent with a stable rate of inflation. In the long run, the
economy will return to the NAIRU with any inflation rate, be it zero or any positive number, and
so there is no permanent tradeoff between inflation and unemployment.
Phelps and Friedman suggested that the empirical finding shown in Figure 1 occurred because
individuals during the 1960s had not anticipated the inflation that had occurred because they
based their expectations upon the 1950s when inflation was low. Once they built into their
expectations the inflation that had occurred (both Phelps and Friedman wrote before the rational
expectations revolution), Phelps and Friedman predicted the stability of the Phillips curve would
vanish. The curve would shift up and to the right. The only way monetary policy could then keep
the unemployment rate below the natural rate would be to engineer continual surprises—keep
accelerating the inflation rate.
The contribution of Phelps and Friedman was important and prescient; what these economists
predicted seemed to come to pass. As the data plotted in Figure 2 show, the tradeoff that is
apparent in Figure 1 vanishes after the 1960s. The large amount of dispersion in the data suggests
that there is no stable tradeoff between the two variables. If anything the relationship becomes
positive—as the unemployment rate fell, so did the inflation rate.
The NAIRU cannot be influenced by monetary policy because it is determined in the real sector
of the economy by such things as the work/leisure choices of individuals. Thus, the function of
monetary policy, it is argued, should be to keep aggregate demand growing at a rate consistent 14
with price stability. If aggregate demand grows at a rate consistent with price stability, then the
11 It should be noted that a long run trade-off of unemployment for inflation violates the neutrality of money for it
suggests that inflation (a monetary phenomenon) can have a permanent effect on employment (a phenomenon that
according to the neutrality doctrine is determined exclusively in the real sector of the economy). (Note, the notion of
the NAIRU discussed below is embodied in the concept of the neutrality of money.)
12 See Edmund Phelps, “Phillips Curves, Expectations of Inflation, and Optimal Inflation Over Time,” Economica, NS,
vol. 135 ( 1967), pp. 254-281, and Milton Friedman, “The Role of Monetary Policy,” American Economic Review, vol.
58 (March 1968), pp. 1-17.
13 Economists have always been both uneasy about and somewhat vague in defining what is meant by “full
employment.” Clearly, it has never meant a zero unemployment rate. For some economists who believed in a
permanent trade-off between inflation and unemployment, full employment had, at best, an ambiguous definition.
Other economists were content with accepting an arbitrary rate of 4%, such as embodied in the Humphrey-Hawkins
Act (also known as The Full Employment and Balanced Growth Act of 1978).
14 This, however, does not by itself support a monetary policy geared to producing a zero rate of inflation since the
economy can be at its NAIRU at any constant rate of change of prices. Other factors, such as the losses to an economy
from a positive rate of inflation must be invoked to support a monetary policy committed to price stability.
NAIRU (or full employment) will prevail, making the NAIRU concept consistent with making 15
price stability the sole goal of monetary policy.
Figure 2. Phillips Curve, 1970-2006
Source: Bureau of Labor Statistics
In addition to the economic arguments presented above, there is a closely related political
argument for making price stability the sole goal of monetary policy. There has long been
dissatisfaction voiced with the accountability of the Federal Reserve for the macroeconomic
performance of the economy. The political independence granted to the Fed combined with the
imprecise and oftentimes conflicting goals it is mandated to achieve means that there is little
chance for congressional criticism of its performance to have a concrete effect on future policy 16
15 It should be noted that the NAIRU was not expected to be constant across time. Changing labor market conditions,
changing demographics of the labor force, changes in labor legislation, and changes in institutions governing labor,
among other changes, it was argued, should be expected to change NAIRU. See CRS Report RL32774, Plan
Colombia: A Progress Report, by Connie Veillette.
16 For more information, see CRS Report RL31056, Economics of Federal Reserve Independence, by Marc Labonte.
Twice a year, the Fed reports to Congress on the state of the economy and monetary policy. At
these hearings, the Chairman of the Federal Reserve Board presents a review of the current state
of the economy and projections for the future course the economy is expected to take over the 17
coming 18- to 24-months. This has prompted the Nobel Prize winning economist, James Tobin
to declare: “It is disingenuous for the FOMC [Federal Open Market Committee] to forecast or 18
‘project’ the economy, pretending that they have no control over it.” When the economy
behaves differently from these projections, little effort is exerted in the reports to explain why.
When the effort is made, the explanation frequently attributes it to unexpected events. Federal
Reserve policy is seldom, if ever, the culprit.
Formal accountability is weak in this system. No governor of the Federal Reserve has ever been
removed from office for any reason, although removal is statutorily permissible “for cause.”
Some have not been reappointed, however, and during hearings the Members of Congress have
not been hesitant in voicing displeasure with the performance of the economy, especially during
economic downswings and periods of inflation.
Proponents of a price target argue that it would make the Fed more accountable. The Fed would
no longer be able to justify its decisions by pointing arbitrarily to the achievement of one of its
goals, while disregarding its failure to meet other goals. The target could be crafted in such a way
that a failure to reach it would trigger explicit remedial actions, such as discussed below. Yet a
target would not undermine the Fed’s independence, they argue, because it would not lead to
political interference in the day-to-day decision-making of the Fed.
Proponents of a single price-stability goal base their case on several basic tenets of economic
theory. First, money is “neutral” in the long run, meaning it cannot affect real economic activity.
It can only affect inflation, which in excess is harmful to the efficient market allocation of
resources; this makes price stability the natural goal of monetary policy in their eyes. Second,
unemployment tends to a “natural rate,” which is dictated by labor market conditions and
policies. Since monetary policy cannot affect this natural rate of unemployment, the Federal
Reserve cannot be held responsible for achieving a goal of full employment. Third, people have
rational expectations and cannot be systematically fooled by monetary “surprises.” This implies
that the economy will function most smoothly if monetary policy is given a predictable “anchor”
such as price stability so people can make decisions with some degree of certainty about the
future path of policy. It is claimed that this anchor will make the Fed more accountable for its
actions and will make its decisions more credible, which, in turn, will make policy more
transparent and effective.
For some proponents, a price-stability goal is desirable because they believe discretionary
monetary policy has done more to destabilize than stabilize the business cycle in the past. They
17 The Federal Reserve now prepares and publishes forecasts on a quarterly basis.
18 James Tobin, “Panel Discussion,” in J. C. Fuhrer, ed., Goals, Guidelines, and Constraints Facing Monetary
Policymakers, Federal Reserve Bank of Boston, June 1994, p. 235. Tobin goes on to declare: “I would like to see the
report contain the consensus of the FOMC as to the macroeconomic path they will use their powers to achieve over
coming quarters and years.” Some suggest this would add accountability to the present regime. The Federal Open
Market Committee is the principal policy committee of the Federal Reserve. Its’ voting members consist of the Board
of Governors and five of the presidents of the regional Federal Reserve Banks.
base their case on the temptation for monetary surprises and the long and variable lags in policy
effectiveness that make successful discretionary policy unlikely. Other proponents acknowledge
that the responsible application of monetary policy is helpful in the reduction of economic
instability, but would not see responsible stabilization policy as inimical to a price stability goal in
most cases. They would be likely to agree with Bernanke and Mishkin’s characterization of
monetary policy under a price-stability goal as “constrained discretion” in practice. In this
characterization, central banks would be free to stabilize the business cycle as long as long-run
price stability is not placed at risk in the process.
It is, perhaps, best to begin the case against a single goal for the Federal Reserve with the
proposition that while the current monetary system does not have an explicit anchor such as
would be provided by a fixed exchange rate or a legislated inflation target, it does have an
implicit anchor. The Federal Reserve has been extremely reluctant over the past two decades to
let the U.S. inflation rate rise above 4% without intervention. Rates above 4% seem to bring on
monetary tightening of the type that often leads to a cyclical downturn. Thus, in practice, the
adoption of an inflation target cannot be supported on the grounds that the Fed has neglected to
pursue the goal of price stability. The burden of proof should be on proponents to show that the
Fed’s past performance could have been improved—or there is reason to believe that future
performance could be improved—if a price stability regime had been in place.
The case against an exclusive price stability goal can be subdivided into six parts:19
Most economists believe in the neutrality of money as a long run proposition, some also agree
that for all practical purposes, over any reasonable time horizon, money is not neutral. Changes in
the growth rate of the supply of money can, over such a time horizon, according to this view,
have significant and lasting effects on the growth of real output and employment.
This perspective was well stated by Prof. Richard N. Cooper:
...the strong and sometimes helpful working hypothesis of the economics profession [is] that
in the medium to long run, money supplies affect only price levels, not the real side of
economies, so that central bank action can only influence prices in the long run. This
working hypothesis through repetition and use has come to be accepted as fact, as a
structural characteristic of actual economies. It is a dangerous assumption, largely because it
is rarely questioned. The evidence is ample that it is false in the short run that runs for
several years. The best that can be said about the empirical evidence over longer periods is
that with sufficient imagination by the estimators, the hypothesis cannot be rejected—a very 20
weak test on which to base important policy decisions.
19 As will be explained below, these six parts of the case against a price stability focus are not mutually exclusive. For
example, an opponent of the view that money is neutral could hardly believe in NAIRU.
20 See Richard N. Cooper, “Panel Discussion,” in J. C. Fuhrer, ed., Goals, Guidelines, and Constraints Facing
Those rejecting the neutrality thesis believe that a stable Phillips curve does exist over reasonable
time periods and ought to be exploited, for they argue that the costs to an economy from
unemployment far exceed the costs due to inflation (for the rates of inflation experienced by the 21
United States in the post World War II period). From the above, this can be seen as an assault on
views such as those that business cycles are due to misperceptions of the actual course taken by
inflation and on the concept of the NAIRU.
Other economists question outright the practical significance of rational expectations. They point
out that there is really little evidence that American business cycles are due to misperceptions of
inflation (see “(3) Rational Expectations” section, above) and there is equally little evidence to
support the view that the Federal Reserve somehow yields to political pressure to create booming
economic conditions just before presidential elections (the so-called political business cycle or 22
that the Federal Reserve engages in policies that are “time inconsistent”). Former Presidents
such as Gerald Ford, Jimmy Carter, and George H.W. Bush might agree since they did not have
the best of economic conditions when they faced re-election. There is something quite
fundamental in this criticism that should not be overlooked. The proponents of refocusing the
Federal Reserve on a single goal of price stability do so because of their view that the
continuation of inflation is due largely, if not entirely, to the self-interested short-term focus of
politicians aided and abetted by the discretionary choices made at the Federal Reserve. This
criticism is aimed both at this explanation for inflation and its goal for reform, the conduct of
monetary policy to achieve a single goal.
Some question the entire concept of NAIRU. They point out that the behavior of the U.S.
economy in the late 1990s through 2007 is at variance with the widely held view that for the
United States NAIRU is about 6.0%. If this estimate is correct, the United States should have
experienced a rising rate of inflation since the unemployment rate has been below 6.0% since
August 1994 (except for December 2002 and the period April through October 2003). But the 23
inflation rate followed no trend during those years, fluctuating between 1.6% and 3.4%. These
critics are also likely to claim that monetary (and fiscal) policy may in fact influence the long run
unemployment rate, contrary to the assertions of the neutrality of money and the NAIRU. They
argue that the future employability of people is, in part, determined by their experience with
unemployment. Thus, severe short term downturns may affect the longer term unemployment 24
rates of some countries.
Monetary Policymakers, Federal Reserve Bank of Boston, June 1994, p. 192.
21 For a statement of this view, see James Tobin, “Inflation and Unemployment,” American Economic Review, vol. 62,
no. 1 (March 1972), pp. 1-18. For a more recent exposition, see James Galbraith, “Time to Ditch the NAIRU,” Journal
of Economic Perspectives, vol. 11, no. 1 (Winter 1997), pp. 93-108.
22 See, for example, Alberto Alesina, “Politics and Business Cycles in Industrial Democracies,” Economic Policy, vol.
1 (Spring 1989), pp. 58-98.
23 This is true for the CPI or a stripped down version of the CPI know as the “core” index. The two price indexes from
the GDP accounts fluctuated between 1.2% and 2.3% during that period.
24 As noted above, those who believe in NAIRU recognize that it is subject to shifts over time as conditions in labor
markets change. These shifts, however, are supposed to be independent of changes in monetary policy. There is a major
development in some of the European countries that the critics of NAIRU cite as evidence against the concept.
Supporters of NAIRU estimate that for the countries in the Euro Area, the NAIRU has risen from about 2.5% in the
Nevertheless, those economists who are critical of NAIRU must explain the data patterns
observed in Figure 2. An oil price shock (or supply shock in general) will cause both 25
unemployment and the rate of inflation to rise. Thus, some of the observations can be explained
in this way. Others can be explained by the efforts of the Federal Reserve to reduce the
unemployment caused by the supply shock (which should reduce unemployment while
accelerating the ongoing inflation rate).
As it happens, one of the arguments used in favor of a price stability goal can also be used against
it. The technical difficulties in implementing monetary policy may be as problematic for a price
stability goal as for countercyclical policy.
The Federal Reserve does not directly control the price level. Rather, it controls only the
monetary and credit conditions of the country that influence changes in aggregate demand. And it
is the interaction of changes in demand with changes in supply that affect the price level and the
rate of inflation. To the extent that monetary policy operates with lags that are long and of
variable length, maintaining price stability can be a difficult task. Were a shock to the economy to
move inflation away from the target, policy lags would prevent the Fed from returning inflation to
the target immediately. As explained below, the lack of direct control is not a fatal problem. Much
would depend on how a law would be written, that is, how price stability is defined and the time
horizon over which stability is to be achieved. It may be that the lags pose no fundamental
Another possible way to deal with the difficulties posed by the long and variable lags is to use a
system of intermediate targets such as the monetary aggregates. Intermediate targets can provide
much useful information about the thrust of Federal Reserve policy since they are the link
between Federal Reserve action and the ultimate goals of policy. In the case of the monetary
aggregates, however, the value of the information they provide about Federal Reserve intentions 26
has decreased considerably since the 1980s. Nevertheless, the case for using an intermediate
target and what is required to make it work is well stated by Bernanke and Mishkin:
If credibility building is an important objective of the central bank, and if there exists an
intermediate target variable—such as a monetary aggregate—that is well controlled by the
central bank, observed and understood by the public and the financial markets, and strongly
1950s to perhaps in excess of 8.0% in the 1990s. They do not have an adequate explanation why this has happened, but
some economists hold out the possibility that it may be related in part to the longer run employment consequences of
the monetary and fiscal policies followed in these countries with an excess emphasis on price stability. See C.A.E.
Goodhart, “Central Bank Independence,” The Central Bank and the Financial System (MIT Press, 1995), pp. 60-71.
See also a symposium entitled “The Natural Rate of Unemployment,” in The Journal of Economic Perspectives, vol.
11, no. 1 (Winter 1997), pp. 3-108.
25 Each shock is likely to generate a one-time effect on the price level. Since inflation is customarily defined as a
continuous rise in the price level, there is a dispute as to whether one-time adjustments to the price level are correctly
described as inflationary.
26 For a discussion, see CRS Report RL31416, Monetary Aggregates: Their Use in the Conduct of Monetary Policy, by
Marc Labonte and Gail E. Makinen.
and reliably related to the ultimate goal variable, then targeting the intermediate variable may 27
be the preferred strategy.
Economic systems are subject to a variety of shocks, some of which require changes in real
magnitudes as the system returns to equilibrium. Supply shocks can pose particularly serious
problems. When they involve a reduction in aggregate supply (such as the OPEC cut-off of oil
supplies in 1973), they often require a fall in real wages in order to restore full employment.
Because of the pervasiveness of contractual arrangements in the U.S. market economy, it is
argued that the fall in real wages can be accomplished with less loss of output and increase in
unemployment if the Federal Reserve allows the price level to rise rather than force an increase in
unemployment to bring about a fall in money wages. In this case, a little inflation is thought to 28
ease the return to full employment. For example, Akerlof, Dickenson, and Perry derive a model
based on the assumption of some downward nominal wage rigidity and show with U.S. data that 29
below a certain inflation rate a permanent tradeoff exists with unemployment. In this paper
nominal wage rigidity holds even though expectations are assumed rational. Of course, an
inflation target could avoid this problem if the numerical target were set high enough.
Those who reject changing the ultimate goal of Federal Reserve policy point out that a central
bank has a number of responsibilities that are not necessarily encompassed in a price stability
goal, even if it were to give up its counter-cyclical role. In particular, a central bank is responsible
for the integrity and solvency of the payments system which includes its role as a lender of last
resort to the financial system. An important reason for establishing the Federal Reserve was to 30
deal with financial panics that had periodically gripped the United States. Our central bank was
to serve as a “lender of last resort” to the financial system in time of trouble to avert a serious
destabilization or even collapse. This important role for the Federal Reserve might be precluded
by a narrowly written law mandating a single goal of price stability. Similarly, a literal and
narrow interpretation of a price stability goal could needlessly increase the volatility of output and
27 See Ben S. Bernanke and Federick Mishkin, “Inflation Targeting,” op. cit., p. 112.
28 Interestingly, this case can also be made by those who believe in the neutrality of money, the NAIRU, and rational
expectations. They also realize that supply shocks often imply reductions in real wages and one-time increases in the
price level may be the least cost way to accomplish this even within the confines of their model.
29 The notion of downward nominal wage rigidity is popular among many economists. An early statement of this
proposition and the reasons for it can be found in J.M. Keynes, The General Theory of Employment, Interest, and
Money (Harcourt, Brace and Co. 1936), pp. 12-15. See George Akerlof, William Dickens, and George Perry, “The
Macroeconomics of Low Inflation,” Brookings Papers on Economic Activity, vol. 1, 1996, pp. 1-76. In the first section
of this paper, the authors provide a great deal of evidence for a belief in the downward rigidity of nominal wages.
30 It was the financial panic of 1907 that set in motion the serious effort to reestablish a central bank in the United
States. This was accomplished in 1913. The Federal Reserve failed to adequately handle the financial panic of 1929-
1933 that brought about a collapse of the U.S. banking system. In recent years, Fed watchers have generally applauded
its efforts to deal with the failure of the Continental Illinois Bank in Chicago, the Mexican debt crisis of 1982, and the
terrorist attacks of September 11, 2001, all of which, it was feared, could have had serious destabilizing consequences
for the U.S. financial system and economy. The role of the Federal Reserve in dealing with the collapse of the Bear-
Sterns company in the spring of 2008 may signal a more expanded commitment by it to guaranteeing the solvency of
the financial system. It is not yet clear what the dimensions of this will be. It has not prevented Fed Chairman Bernanke
from continuing to emphasize the Fed’s commitment to containing inflationary pressures.
unemployment. Critics would argue that if this outcome is not desirable, then the goal of full
employment should not be eliminated. They add that most central banks that have made price
stability their sole goal have continued to employ some counter-cyclical policy when they deem it
consistent with long-run price stability. Thus, these foreign central banks do not practice the pure
price stability goal that they are mandated to follow.
Second, monetary policy is not the only policy a nation has. Most governments have fiscal
policies, debt management policies, and even exchange rate policies. In the United States,
responsibility for these policies has not been delegated to the Federal Reserve. There is no doubt
that a goal of price stability for monetary policy can constrain these other policies. It may make it
impossible to achieve certain fiscal positions, to intervene in the foreign exchange market should 31
this prove necessary, or to deal with any attempt by creditors to refuse to renew their holdings of 32
maturing federal debt or to purchase new debt to finance an existing federal budget deficit.
There has been a long and continuing debate in monetary economics over whether monetary
policy should be conducted by rules that limit Fed decision-making or by allowing the Fed to 33
exercise discretion. The debate over the desirability of refocusing the Federal Reserve on a price
stability goal is often cast in the terms of this discussion with the new goal being seen as a rule.
Critics argue that all macroeconomic contingencies cannot be spelled out in advance. Unforeseen
circumstances can arise that cannot be accommodated within the framework of a simple target. 34
For example, would a target have limited the Fed’s reaction to September 11? Since targets
cannot accommodate all contingencies, the judgment of central bankers arguably should prevail
in deciding how to conduct monetary policy. Individuals with this view likely believe that the
judgment of Paul Volcker and Alan Greenspan has produced a better performing economy over
the past two decades than could have been achieved if their hands had been tied by a goal 35
mandating price stability.
Critics would also argue that the empirical evidence has been unable to corroborate the prediction
that more discretionary power leads to poorer economic performance, and has even found the
opposite to be true. Several studies have compared the response of the German economy and the
U.S. economy to shocks. Since the German central bank was presumed to “inspire greater
31 The issue of a permissible range of exchange rate variation becomes less relevant in a system of flexible exchange
rates. Nevertheless, the Federal Reserve could, under its current mandate, intervene in the foreign exchange market
should the dollar come under extreme selling pressure (or should disorderly markets develop). The possibility of this
happening has been heightened over the years as the United States has moved from the position of an international
creditor to international debtor.
32 There have been historical episodes when the Federal Reserve has had to enter financial markets to support the price
of U.S. government securities when customers could not be found for the issues that were offered. A price stability goal
could compromise this type of support by the Federal Reserve should it be required.
See CRS Report RL31050, Formulation of Monetary Policy by the Federal Reserve: Rules vs. Discretion, by Marc
34 The Federal Reserve responded to the terrorist attacks of September 11, 2001, by immediately flooding the financial
markets with liquidity with the goal of averting a possible financial panic.
35 There are those who point out that under the leadership of both Volcker and Greenspan, the Federal Reserve has
pursued a policy of low inflation.
confidence” than the Federal Reserve because of its history of low inflation, Germany should
have experienced a smaller loss in real output relative to the United States in response to a given
reduction in the inflation rate. Yet the evidence seems to suggest that the United States has 36
experienced smaller losses.
In their previous careers as academic economists, Chairman Bernanke and Fed Governor Frederic
Mishkin have argued that in practice the price stability goal does not impose a rigid rule on
central bankers. Rather, the legislation that has been enacted in foreign countries is more
appropriately viewed as a case of “constrained discretion,” in which central banks are given a
goal but have wide latitude in determining how the goal is met. The central bank in this
arrangement is referred to as having “operational independence.” Bernanke and Mishkin argue
that inflation targeting has many of the advantages of rules and discretion, with few of the
drawbacks. If they are correct, a target may not limit the Fed from acting on its best judgment as 37
much as some critics fear. But this, then, raises the question of what purpose a price stability
goal would serve if broad discretion is still allowed to subjugate it to other goals.
Critics of proposals to make price stability the sole goal of monetary policy argue that there are
other important goals that monetary policy can and should accomplish. At the extreme, critics
argue that money is not neutral and can affect unemployment over relevant time horizons, and a
little inflation makes adjustments easier. While few economists may agree with these views today,
there are many who would nevertheless agree that the short-term stabilization of the business
cycle is a meaningful goal of monetary policy that should not be sacrificed in the pursuit of price
stability. They would also argue that the Fed’s lender of last resort function is essential for
maintaining a sound and stable financial system. These critics believe that the economy is too
complex for monetary policy to be committed to one simple goal. It is impossible to foresee every
contingency, so discretion is necessary to allow experts to use their best judgment. They might
agree with certain price stability proponents that “constrained discretion” is the optimal form of
monetary policy, but they would argue that multiple goals are the best way to make certain it is
Having presented both the case for and against the proposal to refocus the ultimate goal of
Federal Reserve policy, this report now explores a number of the technical issues that would
likely be raised should Congress decide to adopt a singular goal of price stability for the Federal
36 See Guy Debelle and Stanley Fischer, “How Independent Should a Central Bank Be?” op. cit., pp. 202-204; and
Adam Posen, “Central Bank Independence and Disinflationary Credibility: A Missing Link?” Federal Reserve Bank of
New York Staff Report, No. 1. May 1995.
37 See Ben S. Bernanke and Frederic S. Mishkin, “Inflation Targeting: A New Framework for Monetary Policy?”
Journal of Economic Perspectives, vol. 11, no. 2 (Spring 1997), pp. 97-116.
Beginning in the late 1980s, a number of countries imposed a goal of price stability on their
central banks. Their experience will be used in the exposition to follow because it demonstrates
that the manner in which the legislation is written in those countries has either compounded or
simplified the technical problems noted below. Mishkin and Schmidt-Hebbel identify 17
countries that currently use a goal of price stability; in addition, the European Central Bank has 39
such a goal.
The former Chairman of the Board of Governors of the Federal Reserve, Alan Greenspan, once
said that “price stability exists when inflation is not considered in household and business
decisions.” Although the utility of this definition for policy formulation can be challenged, it does
raise the question of whether price stability should be defined in general terms or in terms of a
quantified numerical target. Should the former be pursued legislatively, some would suggest
using terms “of reasonable price stability.” Congress might amend the Federal Reserve Reform
Act of 1977 to require the long term growth of monetary and credit aggregates commensurate
with stable prices, thereby dropping goals of potential production, maximum employment and
moderate long term interest rates. However, some would argue that, in practice, the goal of
maintaining stable prices has already dominated Fed policy under Paul Volcker and Alan
Greenspan. If that were the case, making price stability the sole goal of monetary policy would
lead to no changes in policy unless a numerical target was set.
For those preferring numerical targets, discussions about the definition of price stability usually
center on whether the goal should be defined in terms of keeping the value of a price index stable
or keeping an inflation rate stable. The advantage of the former, it is claimed, is that economic
agents would know with certainty the long run value of the price level and it would be an
immense aid in planning a variety of economic activities. The disadvantage is that every
deviation of the price level from its legislated value would have to be corrected and this, it is
conceded, could lead to bouts of deflation and introduce a great deal of volatility into the pace of 40
economic activity and employment.
38 The following discussion draws heavily from C.A.E. Goodhart, and Jose Vinals, “Strategy and Tactics of Monetary
Policy: Monetary Examples from Europe and the Antipodes” in Goals, Guidelines, and Constraints Facing
Policymakers, op. cit, pp. 139-187; Guy Debelle and Stanley Fischer, “How Independent Should a Central Bank Be?,”
ibid, pp. 195-221; and Geoffrey Heenan, Peter Marcel, and Roger Scott, “Implementing Inflation Targeting,”
International Monetary Fund, working paper 06/278, December 2006.
39 The experience of some of these countries is examined in detail in CRS Report RL31702, Price Stability (Inflation
Targeting) as the Sole Goal of Monetary Policy: The International Experience, by Marc Labonte and Gail E. Makinen.
See also Frederic Mishkin and Klaus Schmidt-Hebbel, One Decade of Inflation Targeting in the World: What Do We
Know and What Do We Need to Know? in Norman Loayza and Raimundo Soto, editors, Inflation Targeting: Design,
Performance, Challenge, Central Bank of Chile: Santiago, 2001, pp. 117-219.
40 Although this is typically assumed, it need not be the case. A price level target could be allowed to rise over time, so
that prices did not remain constant, but past deviations from the target would have to be corrected. This would result in
a positive rate of inflation in most years, but years of higher than average inflation would need to be offset by years of
lower than average inflation. However, some of the random price shocks that affect the overall price level would be
Alternatively, Congress could define price stability as a rate of inflation. And the rate could be a
given amount (a so-called point target) or a permissible range, for example, between zero and
2.5%. The advantage claimed for this alternative is that bygones would be bygones in the sense
that rates of inflation that deviated either from the point target or the permissible range would not
have to be corrected in subsequent periods. While this would reduce the volatility of economic
activity and employment over time, it would make uncertain the longer run value of the price 41
index and this may undermine the putative beneficial effects from this legislation.
How price stability is defined would appear to be quite crucial to any legislative effort in this
area. All countries that currently impose a price stability goal on their central banks do so in terms 42
of an inflation range (e.g., Canada 1-3%, New Zealand 0-2%) rather than a price level target.
An ideal index should, at a minimum, be timely, accurate, not subject to revisions, and readily
understood by the public. These characteristics largely exclude the two price indexes that come
from the series on Gross Domestic Product because they are subject to numerous revisions. This
leaves the CPI which is published monthly, widely reported in the news media, understood by the
public, and not subject to revisions. As presently formulated, however, it (as well as many other
prices indexes) is subject to a number of problems or biases which may make it a poor candidate
to accurately measure the true price level or the true rate of inflation. In particular, some
economists believe the CPI overstates inflation, so an inflation target of 0% as measured by the
CPI might result in forcing the Federal Reserve to deflate the economy. Many economists believe
this would be harmful to the goal of maintaining full employment in the presence of sticky 43
Some have argued that the use of a target that included volatile commodities such as food and
energy would make monetary policy destabilizing. They argue that the Fed should instead target a
“core inflation” measure which excludes these commodities. This argument is buttressed by the
fact that energy shocks have often destabilized growth in the past, and making monetary policy
react to their effect on “headline” inflation could compound the destabilization, as discussed
below. Occasionally, the core and headline rates diverge for long periods of time, so a focus on
core could diverge from the price stability goal. For example, headline inflation exceeded core in
five out of six years between 1999 and 2004. Another issue would be whether to use a price index
that includes imported goods or goods and services, the supply of which are more vulnerable to
disruptions and whose price is more sensitive to changes in the exchange rate than goods and
services in general.
likely to cancel each other out over time.
41 Dittmar, Gavin, and Kydland demonstrate that uncertainty about the future path of prices becomes much greater if
the central bank continues to respond to output volatility under an inflation target, a possibility that will be discussed
below. Robert Dittmar, William Gavin, Finn Kydland, “Price-Level Uncertainty and Inflation Targeting,” Federal
Reserve Bank of St. Louis Review, July 1999, pp. 23-33.
42 See Mishkin and Schmidt-Hebbel, op. cit.
43 It would be possible to draft legislation in terms of a price index that would be allowed to trend upward by a given
percent per year or an inflation rate per period fixed in terms of a range whose value would be determined by the upper
bound of the estimated bias. For a discussion of these biases, see Mark Wynne and Frank Sigalla, “A Survey of
Measurement Biases in Price Indexes,” Journal of Economic Surveys, vol. 10, no. 1, 1996, pp. 55-89.
All countries that impose a numerical price stability goal on their central banks use a CPI index.
Most use the full CPI. The remainder use a CPI less a number of items such as food, energy,
excise taxes, and home mortgage costs.
All agree that any target set should be both demanding and credible. Two approaches have been
taken to achieve these ends. One has focused on the selection of a point target (for either a price
level or a rate of inflation). This target is specified in law with the understanding that some
deviations about the point are unavoidable. However, the precise range of these deviations is left
unspecified. A second approach has involved the specification in law of the permissible range or
band in which the price level or rate of inflation may fluctuate, such as 0% to 2% per year. It is
understood that such a law does not impose on the central bank any obligation to keep the rate at
the mid-point of the range. Any point within the range or band is equally good from a policy
perspective. It is possible to view these two approaches in the following way. A point target can
be thought of as the mean value of an unspecified range while a fixed range or band can be
thought of as a specified range without a mean value.
Regardless of what approach is taken, a question arises about the width of the band within which
prices might fluctuate. If it were quite wide, the public might perceive it as not very demanding
and this could undermine credibility. But if it were too narrow, the regime could suffer credibility 44
problems because the band might frequently be inadvertently breached. Achieving the proper
balance could be problematic—estimates of how wide a band would have to be for the central 45
bank to stay within the band 95% of the time range from 3 to 14 percentage points. At the
bottom of this selection is the type of shocks likely to be faced by an economy, the type of price
index that should be used, the lags inherent in monetary policy that hamper control, and the need 46
to maintain credibility. In practice, the widths have been set to about 2 to 3 percentage points.
There is something more substantial in selecting the width of the band that is frequently absent
from the discussion on the desirability of focusing a central bank on a single goal of price
stability. Most economists currently hold the view that the harm inflicted on an economy from
inflation comes not so much from inflation itself as from a variable rate of inflation. If inflation
could be fixed at some moderate but constant percent per year and held there, it might do little
damage. Economic calculations, on the other hand, can be severely handicapped by an inflation
rate that is highly variable. For that reason, the width of the band of permissible variations of the
price level or rate of inflation becomes much more important for it constrains the possible
variations in the price level or rate of inflation and, thus, the damage inflicted on the efficient
operations of the economy.
44 If inflation targeting is interpreted as targeting the forecast of future inflation, it may make more sense to use a point
target than a band. In this case, when the forecast of future inflation exceeded the point target monetary policy would
be tightened and when it was below the target policy would eased.
45 Richard Dennis, “Bandwith, Bandlength, and Inflation Targeting: Some Observations,”Reserve Bank of New Zealand
Bulletin, vol. 60, no. 1, 1997.
46 Svensson argues that a band is necessary if the central bank wishes to pursue any output stabilization and still
achieve its target. Lars Svensson, Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets,
European Economic Review, vol. 41, 1997, pp.111-1146.
It is often said that inflation is a monetary phenomenon caused by too many dollars chasing too
few goods. While this is true in the longer run, in the short run movements in a price index can be
due to more than just movements in the supply of money. Shocks to the turnover rate of money
and the supply of goods and services available to a nation can have an influence on prices and the
rate of inflation. Shocks to supply can come about through changes in such factors as domestic
productivity, unusual weather conditions, and international flows of both trade and capital.
Some of these shocks are random, meaning that their average value over extended periods of time
is zero. The other shocks can be longer lasting in nature and nonrandom in character. Both types
of shocks would bear on the width of a band that would either be specified if a fixed band were
legislated or tolerated if a point target were legislated.
Demand shocks do not pose a serious problem for a single goal regime focused on price stability,
or, for that matter, a multi-goal regime focused on price stability and output stabilization. In a
demand shock, prices and output move together so monetary policy can be used to offset both
problems at once. For example, after a fall in consumer confidence, both output and inflation
would be expected to fall. In this situation, expansionary monetary policy would be consistent
with both maintaining price stability and stabilizing output.
It is the supply type shocks that have been highlighted in the literature as imposing the greatest
difficulty to achieving a price stability objective because output and inflation move in opposite
directions in a supply shock. Supply shocks are of several types. The most commonly mentioned
are the OPEC-type oil price shocks. These are often called terms-of-trade shocks. With a singular
goal of price stability, an OPEC-type shock could force the Federal Reserve to deflate all other
prices in order to keep to the goal. This would lead to a rise in unemployment, especially in the
Terms-of-trade shocks can also occur for other reasons, especially in response to international
movement of capital. When a country is the recipient of a net inflow of foreign capital, its
exchange rate will appreciate and the price of foreign goods will fall relative to domestic goods so
that a trade deficit will occur. If imported goods are in the price index, other things constant, the
index will decline. Under a constant price level target the Federal Reserve could be required to
inflate the value of domestic prices (its policy actions could depend on the time period over which
it was required to meet its goal). It might be required to do the same thing to prevent a negative
rate of inflation (i.e., a deflation), if the target were specified in terms of an inflation band.
Another type of supply shock could occur if the United States decided to add or substitute a
consumption-based tax such as a VAT for the current income-based tax. This is an option for the
fundamental tax reform that the President has proposed. In some of the countries that impose a
numerical price goal on their central bank, such a tax substitution or an increase in the VAT rate is
allowed as an exception to the goal.
The above discussion raises a general issue about exceptions to the goal. If too many events that
cause prices to change were made exceptions to a price stability goal, confidence could be
undermined and the directive to the central bank would be significantly diluted. While some
exceptions might be desirable, too many might make the goal of price stability indistinguishable
from current practice. One way to get around the issue of exceptions is to set a fairly wide range
or band in which prices fluctuations are permitted or tolerated. As the width of the band is
increased, the setting of exceptions becomes less important. However, this is done with the
knowledge that if the band is too wide, credibility in the regime is undermined.
Most countries have chosen not to make a list of formal exceptions. In the other countries,
exceptions are made for shocks originating in terms-of-trade changes, supply disruptions, and
changes in excise taxes and interest rates. That such exceptions are allowed is testimony to the
importance of supply shocks to the general ability of central banks to reach numerical targets.
To answer this question, one should have some appreciation for what is involved. The Federal
Reserve cannot now rely on a direct and stable relationship of a monetary aggregate to aggregate
demand and the price level or rate of inflation. Because of this, it manipulates short term market
interest rates in an effort to shift aggregate demand and, ultimately, the price level and rate of
inflation. Success requires technical expertise, good models of the economy (models that capture
the structure of how monetary variables interact with the real economy), some degree of patience,
and, because policy operates with a lag that is long and of variable length, a long time horizon.
Also hampering the success of the operation is that the relevant interest rates that matter for
aggregate demand are the unobservable real or inflation adjusted rates. Thus, success in meeting
a goal of price stability would likely depend on the time horizon over which the goal would need
to be met. The technical considerations involved seem to support a time horizon longer than one
or two quarters. Among the eight countries specifying a numerical price goal, six specify a time
horizon of at least one year.
Were a numerical target selected that was significantly different from the inflation rate prevailing
at the time, there might also need to be a transition period between the implementation of the new
regime and the realization of the new target. Otherwise, the sharp shift from the prevailing
inflation rate to the targeted rate could temporarily destabilize the economy.
The nature of the lags inherent in monetary policy and the uncontrollable shocks to inflation and
output raise the question of how literally the Fed should pursue its goal under an inflation target.
Because inflation and output do not always move in opposite directions—notably in the case of
oil shocks—a single-minded concentration on stabilizing inflation over short periods of time
could potentially lead to a significant degree of volatility in output and unemployment. Arguably,
countries with inflation targets have interpreted the target as an intermediate goal in practice for
that reason. As a result, they try to minimize short-run fluctuations in output because of its
medium-run effect on inflation, even though this may move inflation further from its target in the
short run. But critics could argue that this behavior begs two questions. First, are the gains in
accountability of an inflation target regime lost if the central bank can always claim to be aiming
for the medium run? And more importantly, what is the purpose of claiming to have a “sole goal”
to monetary policy if, in practice, central banks continue to pursue an unemployment goal in the
If the target were missed, it might have no consequences if the amount of overshooting or
undershooting were small and unlikely to persist. There are other misses, however, that the
monetary authorities could decide required corrective action. If corrective action is required, then
the goal should be a smooth transition back to the target. Sudden and possibly large changes in
monetary variables can have large and disruptive changes to output, employment, interest rates,
and the international exchange value of the dollar. The purpose of a price stability goal should be
to increase the amount of goods and services available to the public, not cause extreme volatility
to real income, employment, and financial markets.
Alternatively, the time period to re-establish the goal should not be so long as to be meaningless.
This would undermine confidence in the new regime. Thus, any legislation refocusing the Federal
Reserve would be expected to pay particular attention to this issue.
The adoption of a single goal of price stability defined with some arithmetic precision would
likely increase accountability compared to the current system, where success is evaluated in
subjective terms. But that raises the question of what appropriate recourse should be taken if the
Fed were to miss its target. Failure to do anything would undermine public confidence in the new
regime. Alternatively, to penalize the governing board for missing a legislative requirement might
be self-defeating if the failure was unavoidable.
The nature of unavoidable shocks to the economy argues for a medium run target, yet
accountability is further weakened if the central bank aims to meet a target only over the medium 47
run. For example, if the Fed is mandated to target inflation one year in the future, it is difficult 48
to evaluate whether or not it is pursuing a policy today that will meet the goal. It can be
punished retroactively for missing the goal today that it set last year, but it can always claim that
it missed its goal for “reasons beyond its control” and “it will do better next year.”
Acknowledging the nature of unavoidable economic shocks, some inflation target proponents
argue that central banks should be able to change inflation targets on a regular basis. This would
reduce accountability further since missed targets could then be revised away in the future.
Formal accountability for meeting price stability targets varies considerably among those
countries that have imposed such a goal on their central bankers. In a few countries, the central
bank is required to write an open letter to the finance minister explaining why the target was
missed and what measure have been taken to rectify the situation. Only New Zealand links the
tenure of the head of its central bank to achieving the inflation target. In most other countries, no
47 A price level target may result in greater accountability than an inflation target because under the former, policy
decisions made today would be strongly influenced by whether the target was missed in the past, information that is
unambiguous and transparent. This is in contrast to an inflation target, where policy decisions are strongly influenced
by forecasts of the future, which are harder for outsiders to evaluate. See Charles Carlstrom and Timothy Fuerst,
“Monetary Policy Rules and Stability: Inflation Targeting versus Price-Level Targeting,” Federal Reserve Bank of
Cleveland Economic Commentary, February 2002.
48 Lars Svensson argues that if the Fed made its forecasting model public, over time outsiders could infer from the
forecasting errors whether departures from the target were unavoidable or due to a shortcoming on the Fed’s behalf.
See Lars Svensson, Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets, National Bureau of
Economic Research, Working Paper 5797, October 1996, p. 12.
explicit sanctions for missing the target are given. Some have proposed that the salaries and,
possibly, bonuses of the governors might be linked to achieving the price stability goal.
In many parliamentary systems of government, this is presented as an important but unsettled
issue. It is important because if the government alone sets the target, it is thought to underscore
the dependent position of the central bank and, it is argued, may undermine central bank
credibility. This may be less important in a country such as the United States where central bank
independence is well established. The joint setting of the goal is thought to enhance credibility for
it would commit the government to the goal and make it more difficult to be critical of the central
bank in achieving the goal. In practice, most countries have set the goal jointly.
In the United States, the Constitution vests monetary policy in Congress. Congress, in turn has
granted the Federal Reserve broad operational independence, but maintained responsibility for
oversight and determining the goals of monetary policy. If Congress chose to set a target for price
stability, it would have two general options. First, it could specify the target in general terms such
as directing the Federal Reserve to achieve reasonable price stability. This would allow the
Federal Reserve discretion in implementing the law (e.g., choosing the specific numerical
inflation target). (Of course, Fed implementation could be done in consultation with relevant
congressional committees as is now the case in the semi-annual monetary policy hearings).
Second, Congress could set the target range and direct the Federal Reserve to achieve the goal.
But could an inflation target be adopted without Congressional action? Inflation targeting and a
sole goal of price stability have typically been seen as going hand in hand by proponents and
opponents alike, as this report has stressed. Price stability is seen as the goal of monetary policy
and inflation targeting is seen as the means for achieving that goal. Indeed, it is fair to say that the
underlying motivation of most inflation targeting proponents was to move monetary policy away
from the goal of maximum employment. This is not the view of Chairman Bernanke, however.
He has argued that inflation targeting is consistent with the current multi-goal mandate because 49
low inflation promotes economic efficiency. While this distinction may seem semantic, it turns
out to be highly important in the current debate because Chairman Bernanke has argued that if an
inflation target does not require a change in the mandate, then the Fed can adopt one 50
independently without Congressional action. Since Congress gives the Fed broad discretion to
formulate policy as it sees fit, if it wished to prevent the Fed from adopting an inflation target, it
would probably need to do so explicitly through legislative action.
49 See speech by Ben Bernanke at the Center for Economic Policy Studies, Princeton University, February 24, 2006.
Most economists would agree with his view, but it does not address the main issue—that there is sometimes a tradeoff
between lower unemployment and lower inflation, and most inflation targeting proponents argue that the tradeoff
should mostly or always be made in favor of low inflation.
50 The Nomination of Ben S. Bernanke, of New Jersey, to be a Member and Chairman of the Federal Reserve Board of
Governors, Hearings Before the Senate Comm. on Banking, Housing, and Urban Affairs, 109th Cong. (2005)
(statement of Ben S. Bernanke).
This question bears on the credibility of a monetary policy focused on a single price stability
goal. Many writers on this subject have expressed the concern that if the government could
override any prior decision on the target, it would undermine the confidence of economic agents
that price stability would remain the central goal of monetary policy. For example, there could be
opportunistic changes in the numerical target in order to “pump up” the economy to meet short-
term political objectives.
Although it is clear that credibility would be enhanced if it could be ensured that changes to prior
legislation would not take place, this is not possible in the American political system. The
possibility of change is always present. That government has the power to change laws is, of
course, the essence of democracy. It may also be the essence of good economic policy.
The American model of central banking has distinctive attributes. The U.S. Congress delegates to
a central bank its power to “coin money and regulate the value thereof.” In doing so, it specifies a
variety of goals that monetary policy should achieve that can be viewed as mutually inconsistent.
This lack of goal independence is, however, arguably superficial since the Federal Reserve has
long been allowed to pick and choose the one or ones on which it will place the greatest emphasis
during any given time period. The Federal Reserve has also been given complete instrument
independence in the sense that no constraints are placed on the monetary powers available to it to
achieve its ends. The exercise of monetary policy is completely at the discretion of the Federal
A growing number of economists argue that a more desirable regime would be one in which the
central bank is directed to achieve a single goal, price stability. While this regime would restrict
the goal independence of the Federal Reserve, instrument independence would continue as it is
Most economists would agree that monetary policy has been highly successful in the past 25
years. Proponents of a single price stability goal for monetary policy must contend with the time-
honored adage “if it ain’t broke, don’t fix it.” While proponents are likely to agree that monetary
policy has been a success in the last two and a half decades, they would attribute that success to
the Fed’s decision to focus single-mindedly on price stability. Making price stability the sole goal
of monetary policy would institutionalize this success, preventing any potential departure from
this philosophy under future Fed chairmen and insulating current policy from political pressure.
With the current regime of broad discretion, there is always the potential for the Fed to spring
opportunistic monetary surprises which would lead to an inflationary bias that would create long-
term harm for short-term gain. Furthermore, they would argue that the Fed pays lip service to
goals that are contradictory and unattainable—thereby avoiding criticism—while focusing on
only one goal. This, they argue further, is a potential threat to the credibility, transparency, and
accountability of monetary policy. In proponents’ eyes, a price stability goal would lead to an
improvement on all three of these fronts, whereas the current multi-goal regime leads to
uncertainty, opacity, and subjectivity. Some proponents are motivated by a desire to end
discretionary policy, while others view a price stability goal as “constrained discretion.” The latter
believe that monetary policy can play a useful role in reducing the volatility of the business cycle,
as long as constraints are present in the form of a price stability goal to prevent high inflation and
Critics would contend that price stability proponents underestimate the complexity of monetary
policy and the broad and varied effects it has on the economy. While most would acknowledge
the salutary effects the Fed’s pursuit of price stability has produced, they would disagree that this
is the only policy goal the Fed can and should pursue. Instead, they would argue that the Fed has
proven in the last two decades that price stability can go hand-in-hand with a monetary policy that
minimizes the excesses of the business cycle and maintains the soundness of the financial sector.
If a price stability goal is interpreted as precluding the Fed from pursuing these other two goals,
then they would argue that the economy would suffer as a result. For example, a price stability
goal could have limited the Fed’s ability to ease policy in response to recent oil shocks and the
attacks of September 11. It remains to be seen if the recent expansion in Federal Reserve
activities related to the financial aftermath of Bear-Stearns crisis will compromise its ability to
maintain an inflation goal for the United States. Alternatively, if the price stability goal is
interpreted as a regime of “constrained discretion” which still allows for the stabilization of
output, then critics would view the current multi-goal mandate as more appropriate. Furthermore,
they would argue that the complexity of the economy means that policy must rely on expert
judgment, and the Fed has proven in the past two decades that discretion can be pursued
In conclusion, the price stability goal, while simple, is deceptively so. The long and variable lags
in policy effectiveness and unpredictable nature of shocks to the economy mean that the Fed’s
control over inflation is imprecise and delayed. For that reason, the Fed could not reasonably be
expected to keep inflation on a point target at all times, should a price stability goal be adopted.
This implies accountability would not be as straightforward as proponents might hope.
Legislation can address this problem explicitly. Possible remedies for the problem include
allowing inflation to stay within a range, targeting core rather than headline inflation, permitting
exceptions when inflation would be allowed to miss its target under pre-determined
circumstances, and targeting forecasted rather than contemporaneous inflation. But critics would
argue that none of these solutions really solves the inherent complications that makes the price
stability goal impractical.
To date, Congress has taken no legislative action on the issue of inflation targeting or changing
the current mandate, but its hand may be forced in the near future. Fed Chairman Ben Bernanke, a
longtime advocate of inflation targeting, has argued that the Fed could independently adopt one
without any change to the current mandate. This is a departure from the views of most proponents
and opponents who see inflation targeting and changing the mandate to a sole goal of price
stability as going hand in hand. If the Fed decides to unilaterally adopt an inflation target,
Congress can either prevent it through legislative action or accept it, actively through legislation
or passively through inaction.
Marc Labonte Gail E. Makinen
Specialist in Macroeconomic Policy Consultant in Economic Policy