In my judgment, the only way for financial institutions to insure stability in the event of nonquantifiable shocks is for them to maintain a substantial extra capital cushion above that deemed necessary by analysis of quantifiable risks.

In addition, at few key junctures in the past five years, the Federal Reserve exercised a more flexible monetary policy than inflation targeting probably would have suggested or allowed. The first occurred in reaction to the "seizing up" of financial markets that followed the Russian debt default in the late summer of 1998. Although forecasts were marked down at this time, the easing was faster and larger than would have been suggested by Taylor-type rules based on our past pattern of behavior and incorporating an implicit inflation target. In effect, to protect against the potential for a really bad outcome for markets and economic activity, the policymakers raised the most likely outcome for inflation--or at least skewed the risks toward the possibility that inflation would pick up. Similarly, in 2001, easing was unusually aggressive, even before September 11, as the extent of the demand shock gradually revealed itself. To be sure, when one looks back, the outcomes in both instances in terms of stable inflation were not any different than inflation targeting would have sought. At issue, however, is whether the FOMC would have responded so aggressively to these shocks if it had been constrained by an inflation target. It is a matter of how the central bank is likely to weigh the risks and rewards of various courses of action--where it takes its chances. My sense is that, given the stress on hitting inflation objectives, the pressures of an inflation target would have constrained flexibility that in the end turned out to be useful.

There is nothing inherent in our objective for price stability and what we are trying to do about the purchasing power of money that says that when we have a favorable supply shock we should raise our money growth objectives. There’s no more reason to do that than to cut the money growth targets if we had an adverse supply shock.  We wouldn’t do that. I’m sure that back in the 1970s or the 1980s we didn’t argue for lowering our targets. What we want to do is to view the transitory effects of the acceleration in productivity growth in a lower reported rate of inflation or transitory decline in the price level as an increase in the purchasing power of money. It would be a one-time decline in the price level--I don’t want to use that “D” word. And then when the supply shock goes away, we would return toward the sort of balanced equilibrium that we would have been in.