What do you think of the idea that the Federal Reserve should manage the nation’s money supply so as to reach a certain level of inflation, say 2.5 percent?
Many people might respond negatively. After all, isn’t the job of the Fed to manage interest rates and to stimulate the economy when it slows down?
The suggestion that the Fed set an explicit target for inflation is not an idle one, however. The International Monetary Fund suggested it just this past week in its semi-annual world economic outlook.
In a press briefing, IMF Chief Economist Kenneth Rogoff said the time has come for the European Central Bank, the Bank of Japan and the Fed to be “more transparent” about their inflation objectives. “More transparency on inflation would risk little while greatly enhancing central banks’ capacity to fend off deflation, which is already present in Japan and at least an outside risk in Europe and the United States,” Rogoff said.
To understand this issue, it’s useful to remember that the key function of central banks is simply to manage a nation’s money supply. Everything else is secondary.
Central banks can create new money and lend it to commercial banks. Or they can create new money and use it to purchase bonds or the currency of other nations. We call the first method “discount window lending” and the second “open market operations.”
To constrict or decrease the money supply, the actions are reversed: Discount loans are decreased and bonds or foreign currency is sold, and the money that results disappears.
Central banks can also vary the money supply by changing the proportion of checking, savings and other deposits that commercial banks have to keep in reserve. But in developed countries, this method is largely a historical artifact.
Increasing or decreasing the money supply is the only important thing that central banks do.
They don’t control interest rates, exchange rates, output, inflation or unemployment. Changing the money supply may influence all of these variables. But it will only influence — not control — them. Other forces in the economy inevitably play a role.
Central banks thus face the perennial question of whether to expand or contract. It is hard to look at the money supply itself at any point in time and say “This is right” or “This is too big or too small.” Central bankers need to look at other indicators.
For decades, they looked at or “targeted” interest rates. If interest rates got too high, they increased the money supply. If too low, they decreased the money supply. This method brought many industrialized countries the great peacetime inflations of the 1970s.
Some economists argued that central banks should target a low, fairly constant growth rate for some specific measure of the money supply.
In some countries, it is a common practice to target the exchange rate. In Japan, if the yen gets too strong, hurting businesses and employment, the Bank of Japan creates yen to sell for dollars or Euros. If the Brazilian real gets too weak, the Banco Central in Brasilia may constrict the money supply to make the real more expensive.
Increasingly, some economists argue that central banks should target a rate of change of the price level, or inflation. It might be a limit to acceptable inflation, say 3 percent, or it might be a range, from 2.5 percent deflation to 2.5 percent inflation.
Regardless of whether the Fed, or any other central bank, sets an explicit target for inflation, central bankers always consider how their actions may affect inflation. So the IMF is not suggesting anything new in what Fed decision-makers think about. It is rather saying that the Fed should explicitly tell the public what its goals for inflation are.
Not every economist agrees with this, and it is likely that Fed Chairman Alan Greenspan is among those who do not. So why do advocates of transparency think it is important?
First, it would make clear to the public that there is a strong link between what the Fed does to the money supply and what happens to the price level.
Second, it would reassure the public that the Fed can and will act to prevent deflation as well as inflation. Deflation has stalked Japan for nearly a decade and its effects can be even more insidious than inflation. The U.S. is coming off a stock-market bubble just as Japan did in the early 1990s, and an explicit inflation target would tell the public that the Fed is prepared to crank out enough money to keep prices from falling.
Third, it would move the public away from its ongoing fixation with interest rates. People think the Fed “sets” interest rates because that’s the frame of reference in which the Fed announces changes in money-supply policy.
So the IMF is right that there are some good arguments for the Fed setting explicit, transparent targets for inflation. What inflation targeting cannot do is break the public from the erroneous belief that every economic ill can be solved by correct monetary policy.
Central banks influence a narrow range of economic variables. They cannot cure every recession immediately, and they cannot keep unemployment low or income growth high.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.