One percent appears to be a good target for actual inflation...An inflation rate a bit above zero gives us a bit more leeway to lower real interest rates to prevent inflation from falling below target. 

If inflation moved outside the range we would feel compelled, I believe, to acknowledge that fact and to state how inflation will be brought back within the range. A range rather than a point target would give the Fed a reasonable “safe harbor” within which we would not be pressed to explain fluctuations in inflation. The narrowness of a 1-percentage-point range, however, would discipline us to explain any substantial deviations of inflation from the target.

Ambiguity about the Fed’s long-run inflation intentions has outlived its usefulness.

Some nations, along with the European Central Bank, have chosen to set explicit numerical inflation-rate objectives for their central banks. Others, like the United States, have been fairly successful without them.

I think having a long-run inflation objective that is defined first of all not as price stability per se, but rather as the long-run inflation rate that best achieves our dual mandate, would be a major step forward.  And if we were to take that step—that is, if we were to establish a true north on the compass, so to speak, for long-run monetary policy—I would not push for any further steps in the direction of a short-term inflation targeting regime.

[T]he term "rule" suggests a rigid and mechanistic policy prescription that leaves no room for discretion or judgment. However, the argument that monetary policy should adhere mechanically to a strict rule, made by some economists in the past, has fallen out of favor in recent years. Today most monetary economists use the term "rule" more loosely to describe a general policy strategy, one that may include substantial scope for policymaker discretion and judgment. Here I will use the term "policy" instead of "rule" to avoid the connotations of the latter.

The economic stimulus provided by monetary policy depends mostly on longer-term interest rates, which in turn are largely determined by the expectations of financial market participants about the future course of monetary policy. As a general matter, the more guidance the central bank can provide the public about how policy is likely to evolve (or about the principles on which policy decisions will be based), the greater the chance that market participants will make appropriate inferences--and thus the greater the probability that long-term interest rates will move in a manner consistent with the outlook and objectives of the monetary policy committee.

Under the forecast-based approach, in contrast, the public will generally find inferring the likely course of policy to be a great deal more difficult. In that regime, policy plans depend in a complex way on policymakers' outlooks, risk assessments, and objectives, which the public is unlikely to deduce accurately without guidance. Clear communication thus appears to be especially important for central banks that employ a forecast-based approach to policy--a category that includes most contemporary central banks, including the Federal Reserve.

The practice of the European Central Bank differs somewhat from that of the “inflation targeters.”  The ECB offers a degree of transparency with respect to its monetary policy objective—the ECB has an announced goal of keeping the inflation rate close to but below two percent per annum “in the medium run.”  However, the ECB has never announced an explicit definition of the “medium run.” 

A small step towards a more explicit statement of the FOMC’s inflation objective was taken in 2003 when, at the May FOMC meeting, the Committee indicated that “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.”  This statement gives a hint about the view of committee members of the lower end of a tolerance range of measured inflation.  At that time inflation, as measured by the Committee’s preferred “core” personal consumption price index, was approximately 1 percent.  To date, the Committee has not addressed the question as to what inflation rate would mark the limit such that a substantial rise in inflation above that rate would be unwelcome.

To reassure those worried about possible loss of short-run flexibility, my proposal is that the FOMC announce its value for the OLIR {Optimal Long-run Inflation Rate} to the public with the following provisos (not necessarily in these exact words):

(i) The FOMC believes that the stated inflation rate is the one that best promotes its output, employment, and price stability goals in the long run. Hence, in the long run, the FOMC will try to guide the inflation rate toward the stated value and maintain it near that value on average over the business cycle.

(ii) However, the FOMC regards this inflation rate as a long-run objective only and sets no fixed time frame for reaching it. In particular, in deciding how quickly to move toward the long-run inflation objective, the FOMC will always take into account the implications for near-term economic and financial stability.

As you can see, stating the OLIR with these provisos places no unwanted constraints on short-run monetary policy, leaving the Committee free to deal with current financial and cyclical conditions as the Committee sees fit. In this respect, the proposal is very similar to one recently advanced by Governor Gramlich (2003).

As a preliminary, I need to introduce the idea of the optimal long-run inflation rate, or OLIR for short. (Suggestions for a catchier name are welcome.) The OLIR is the long-run (or steady-state) inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives.

Note that the OLIR is the relevant concept for dual-mandate central banks, like the Federal Reserve. Thus it is not necessarily equivalent to literal price stability, or zero inflation adjusted for the usual measurement error bias. Rather, under a dual mandate, a strong case can be made that, below a certain inflation rate, the benefits of reduced microeconomic distortions gained from price stability are outweighed by the costs of toofrequent encounters of the funds rate with the zero-lower-bound on nominal interest rates. (This argument underlies the common view that there should be a “buffer zone” against deflation.)  Hence, in general, the OLIR will be greater than zero inflation, correctly measured. Note also that the OLIR is an average long-run rate; variation of actual inflation around the OLIR over the business cycle would be expected and acceptable (Meyer, 2003).

A few industrial countries--the United States, Japan, and Switzerland--have resisted pressures to adopt formal inflation-targeting regimes. Debates continue in these countries about the desirability of adopting more formal inflation-targeting procedures. The inflation targeters point to the advantages of transparency, commitment, and accountability; non-targeters point to the loss of flexibility and the reduction in the ability to meet alternative goals such as high employment and financial stability. Rudebusch and Walsh (1998) give a good summary of this debate.

The first question is whether the U.S. central bank should adopt a more formal inflation-targeting regime. I personally would not go that far. My reading of the empirical evidence is that the key ingredient in keeping inflation low and stable is that the central bank be firmly determined to achieve and maintain stable prices in the long run. I believe the Fed is already so determined, with every member of the Federal Open Market Committee (FOMC) since I have been here repeating this mantra often. To me, there does not seem to be huge value in further tying down the committee through a formal inflation-targeting regime, and there could be some costs.

On the other hand, it may be possible to get some of the transparency and accountability advantages of inflation targeting, and to lock in the gains from having reduced inflation, by going to an intermediate approach. The FOMC might simply announce its preferred long-run range for inflation. This range should be understood as a preferred range that would not bind the committee or override other important objectives of monetary policy. It should clearly be understood as a long-term objective, not a short-term objective. The FOMC would not have to defend any deviations from the preferred range. Perhaps such a step would increase transparency without limiting central bank flexibility to any appreciable degree.

If we were to adopt a preferred range, what should it be? In light of the strategic considerations mentioned above, along with quantifiable measurement error, I would personally set the bottom of the range at slightly above 1 percent per year for the core PCE deflator, the Fed's preferred inflation measure. Because of audience polls, and at least until they are replaced by more rigorous information, I would set the top of the range at about 2.5 percent per year. The midpoint of this range is then slightly less than 2 percent per year, which turns out to be about what U.S. core PCE inflation has averaged over the past eight years. But I would stress the range more than the point estimate.

Over the past decade or so, a number of central banks around the world have, to good effect, adopted inflation targeting as a means of achieving both price stability and credibility as inflation fighters. The monetary authorities of more than 20 countries, including New Zealand, the United Kingdom, and Canada have adopted explicit inflation targets.

...Our neighbors to the north speak well of explicit inflation targeting. In Canada, the economic boom at the end of the 1980s, together with an oil price shock and the introduction of their goods and services tax, led to fears that inflation would escalate. Against this backdrop, the Canadian government and the Bank of Canada agreed on explicit targets for inflation reduction in 1991.

The first formal targets aimed to bring inflation down to 2 percent by December 1995. Inflation declined more quickly than anticipated and was already closing in on its target by January 1992 — almost four years ahead of schedule. Since then, with year-over-year inflation almost always in the 1 to 3 percent target range, the policy has been widely regarded as a success.