It is time for the Fed to explicitly adopt the flexible inflation targeting framework and in doing so take three steps to strengthen its approach to policymaking. First, clarify and make explicit that our long-run inflation objective is 2 percent year-over-year PCE inflation. Second, publish information about the individual FOMC participants’ assessments of the appropriate monetary policy that underlie their economic projections in the FOMC’s Summary of Economic Projections. Third, provide information on the FOMC’s reaction function. That is, communicate policy decisions in terms of changes in the economic conditions that the FOMC is using to formulate policy.

But I do not think that a temporary period of inflation above 2% is something to regard with horror. I do not see our 2% goal as a cap on inflation. Rather, it is a goal for the average rate of inflation over some period of time. To average 2%, inflation could be above 2% in some periods and below 2% in others. If a 2% goal was meant to be a cap on inflation, then policy would result in inflation averaging below 2% over time. I do not think this would be a good implementation of a 2% goal.

Setting a formal inflation target would be appropriate to address concern over rising prices, Lacker said. While he has advocated an inflation target of 1.5 percent, he said he would back a Fed consensus that set the goal at 2 percent.

“I think now -- this point in the business cycle -- would be a relative good time” and “relatively useful to clarify what we mean by price stability,” Lacker said at a conference on manufacturing in the Southeast U.S. hosted by Virginia Governor Bob McDonnell.

Let me offer a few general thoughts about what would make for an effective inflation target.

First, it would be stated in terms of some measure of overall, or headline, inflation.

Second, the target must be achievable over a realistic timeframe. That time horizon should be short enough to serve the real interests of the public and short enough to serve as a verifiable check on central bank performance.

But since monetary policy actions do not have an impact on the economy instantaneously, the time horizon should be long enough for the objective to be realized at an acceptable cost. I also accept that there will be times we must allow short-run deviations from the targeted rate of headline inflation, and the stated objective should be constructed with this in mind.

I do not think the establishment of an inflation target would produce much change in how the Federal Reserve conducts policy. We have been pursuing policies with an eye toward 2 percent or slightly less headline inflation at least since we began publicly reporting our longer-term inflation forecasts.

At 1.7 percent to 2.0 percent, the mandate-consistent rate of inflation is greater than zero for a number of reasons. Perhaps most important, attempting to maintain inflation at zero would increase the risks of experiencing an extended bout of deflation or falling wages and prices, which in turn could lead employment to fall below its maximum sustainable level for a protracted period.

Hence, the goal of literally zero inflation is not consistent with the Federal Reserve's dual mandate. Indeed, most central banks around the world aim to set inflation above zero, usually at about 2 percent.

The price index for personal consumption expenditures has risen 1.3 percent over the last 12 months, which is very close to my own long-run objective of 1½ percent.

The Federal Reserve has a statutory mandate to foster maximum employment and price stability, and explaining how we are working toward those goals plays a crucial role in our monetary policy strategy. It is evident that neither of our dual objectives can be taken in isolation...

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate. The longer-run sustainable rate of unemployment is the rate of unemployment that the economy can maintain without generating upward or downward pressure on inflation...  Similarly, the mandate-consistent inflation rate--the inflation rate that best promotes our dual objectives in the long run--is not necessarily zero; indeed, Committee participants have generally judged that a modestly positive inflation rate over the longer run is most consistent with the dual mandate. (The view that policy should aim for an inflation rate modestly above zero is shared by virtually all central banks around the world.)...  Several rationales can be provided for this judgment, including upward biases in the measurement of inflation. A rationale that is particularly relevant today is that maintaining an "inflation buffer" (that is, an average inflation rate greater than zero) allows for a somewhat higher average level of nominal interest rates, which in turn gives the Federal Reserve greater latitude to reduce the target federal funds rate when needed to stimulate increased economic activity and employment.

[I]nflation is now on target, as far as I'm concerned. Over the last 12 months the price index for personal consumption expenditure has risen 1.5 percent, which is exactly what I've been recommending for the last six years. We also track a core price index that omits volatile food and energy prices, and it is sending the same message, having risen by 1.4 percent over the last 12 months. I believe that the Fed's best contribution to our nation's economic prosperity over time would be to keep inflation stable near the current 1.5 percent rate. But inflation has been lower this year, with overall inflation increasing at only a 0.7 percent annual rate, which is too low for me. I would point out that these inflation numbers often run hot or cold for several months at a time, which is why economists focus on the 12-month number I cited a moment ago. I am not yet convinced that inflation is likely to remain undesirably low. Moreover, the public's expectation of future inflation is not at such a low level; indeed, the latest survey from the University of Michigan puts the public's short-run inflation expectation at 2.2 percent. So I do not see a material risk of deflation — that is, an outright decline in the price level.

For all these reasons, my strong preference would be to use regulation and supervision to strengthen the financial system and lean against developing problems. Given our current state of knowledge, monetary policy would be used only if imbalances were building and regulatory policies were either unavailable or had been shown to be ineffective. But, of course, we should all be working to improve our state of knowledge, so as to better understand economic and financial behavior and to further expand the range of policy tools that can be employed to enhance macroeconomic performance.

Given the heavy costs that have resulted from the financial crisis, the question naturally arises as to whether the circumstances that caused the crisis could have been avoided. Among other crucial policy issues, we now need to reexamine, with open minds, whether conventional monetary policy should be used in the future to address developing financial imbalances as well as the traditional medium-term macroeconomic goals of full employment and price stability. .. Obviously preventing situations like the current one would be very beneficial. But against this important objective we need to balance the potential costs and uncertainties associated with using monetary policy for that purpose, especially in light of the difficulty in judging the appropriateness of asset valuations.

One type of cost arises because monetary policy is a blunt instrument. Increases in interest rates damp activity across a wide variety of sectors, many of which may not be experiencing speculative activity... In the current situation, with output expected to be well below its potential for some time and inflation likely to be under the 2 percent level that many FOMC participants see as desirable over the long run, tightening policy to head off a perceived threat of asset price misalignment could be expensive in terms of medium-term economic stability.

Furthermore, small policy adjustments may not be very effective in reining in speculative excesses. Our experience in 1999 and 2005 was that even substantial increases in interest rates did not seem to have an effect on dot.com stock speculation in the first instance, and housing price increases in the second. And larger adjustments would incur greater incremental costs...

“I don’t get it,” Volcker said, leading to a lively back and forth between the two central-bank heavyweights.

By setting 2% as an inflation objective, the Fed is “telling people in a generation they’re going to be losing half their purchasing power,” Volcker said. And if 2% is the best inflation rate, and the economic recovery lags, does that mean that 3% becomes the ideal rate, he asked.

Kohn responded that by aiming at 2%, “you have a little more room in nominal interest rates … to react to an adverse shock to the economy.”

“Your problem is two [percent] becomes three becomes four,” Kohn told Volcker. But other central banks with a roughly 2% target haven’t had that problem, Kohn said.

Fed officials, Kohn added, “need to be clear about why we’re choosing the number we’re choosing.” He also said that while he doesn’t think deflation is much of a risk, “I can’t say the risk is zero” and the Fed must be mindful of the possibility that inflation expectations fall to the point that real interest rates rise.

...

Kohn and Volcker fought to a rhetorical draw, with each conceding that he wasn’t going to persuade the other.

As reported by Wall Street Journal's Real Time Economics Blog.

Currently, significant excess capacity in the economy risks lowering inflation and inflation expectations.  Since short-term interest rates are effectively zero, reductions in inflation expectations imply a higher real interest rate – and, effectively, tighter monetary policy.  So the additional clarity on the long-run intentions of monetary policy (as reflected in the longer-range forecasts) might keep inflation expectations well anchored[Footnote 4] and real interest rates low enough to help get the economy moving again. 

An important consideration involves what the long-run goal for inflation should be, given recent experience.  Twice this decade, short-term interest rates have approached zero, and the probability of possible deflation has risen significantly.  In light of this experience, some might conclude that the implicit inflation target has been too low.  A fruitful area for future research would be to re-consider the likelihood and the cost of hitting the zero lower bound, and what that cost implies for setting inflation targets.[Footnote 5]

What do we mean by price stability?  A widely cited definition is that the inflation rate is sufficiently low so that households and businesses do not need to take inflation into account in making everyday decisions.³  Broadly speaking, I believe this definition of price stability is a reasonable one, and in practice, central banks around the world have chosen average levels of inflation between 0 and 3 percent as consistent with this criterion. However, this range can be narrowed a bit further by considering the implications of economic theory and empirical evidence about the average inflation rate that produces the best economic outcomes...

In contrast, given shocks like those seen over the past several decades, an average inflation rate higher than about 1 percent substantially reduces the frequency with which the economy hits the zero lower bound. An inflation objective of about 2 percent implies that monetary policy is rarely constrained by the zero lower bound and thereby minimizes the adverse consequences for macroeconomic stability.

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).