Thursday, July 13, 2006

Taylor on Inflation Targeting

Ben Bernanke has long advocated inflation targeting--the policy of a central bank announcing a numerical target for the inflation rate. In today's Wall Street Journal, John Taylor disagrees with him:

Some have argued that the lesson learned from this recent volatility experience is that the Fed should set a specific numerical target for inflation. I disagree; recent experience indicates setting such a target could increase volatility again. First, we do not know what inflation rate to target. If we choose one, we might have to change it later. Second, an explicit focus on the inflation rate may actually take emphasis away from price stability. Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise in the price level. In recent research, Yuriy Gorodnichenko and Matthew Shapiro of the University of Michigan found that Mr. Greenspan placed relatively greater weight on the price level than on the inflation rate in speeches: He was twice as likely to mention the price level as inflation; Mr. Bernanke was half as likely to mention the price level as inflation.

In sum, powerful lessons can be learned from Mr. Bernanke's start. Keep to the proven principles. Talk about the economy, not about the future of the federal funds rate. Commit to price stability without adding uncertainty about the meaning of a new inflation target.

Taylor seems to suggest that he would prefer a target path for the price level, rather than the inflation rate. The difference between price-level targeting and inflation-targeting is that price-level targeting requires making up for past mistakes. That is, under price-level targeting, if inflation comes in above target during one period, the central bank would need to produce inflation below target in some future period in order to get the price level back on its target path.

References: The Gorodnichenko-Shapiro paper that Taylor mentions can be found at the NBER. Here is my paper (published version) on the topic of price-level vs inflation targeting.