Question

Federal Reserve Vice Chairman Donald Kohn's question-and-answer session at a conference here was going as countless others have in his years as a top policy maker. Until Paul Volcker raised his hand. Then, the former Fed chairman grilled Mr. Kohn over the Fed's effort to convey that it considers a 2% inflation rate to be appropriate for the U.S. economy in the long term. Mr. Volcker, who led the Fed in conquering double-digit inflation in the 1980s, questioned how the Fed can talk about both 2% inflation and price stability. "I don't get it," Mr. Volcker said, leading to a lively back-and-forth between the two central-bank heavyweights at a conference on Saturday at Vanderbilt University. 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," Mr. Volcker said. Mr. Kohn, who worked as a staffer to Mr. Volcker in the 1980s, replied that aiming at 2% inflation gives the Fed "a little more room...to react to an adverse shock to the economy" because it is easier to get its key short-term interest rate below the inflation rate, the usual remedy for recession. "Your problem is [2%] becomes three becomes four," Mr. Kohn told Mr. Volcker. But other central banks with a roughly 2% target haven't had that problem, he said.Fed officials, Mr. 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. Messrs. Kohn and Volcker fought to a rhetorical draw, each conceding that he wasn't going to persuade the other. The two men spoke at a conference honoring former Fed Governor J. Dewey Daane. Fed Chairman Ben Bernanke, in a speech earlier this month, noted that "most members" of the Fed's policy committee "have indicated that they would like to see an annual inflation rate of about 2% in the longer term." "Right now," Mr. Bernanke said, "because of weakness in economic conditions...inflation has been running less than that, and our best forecast is that inflation will remain quite low for some time." By being explicit about its inflation target, the Fed hopes to assure consumers, businesses and investors that it will prevent both deflation,or falling prices, and rising inflation.”

a) Explain what inflation targeting is.

b) Mention the case of other central banks that have adopted inflation targeting.

c) Which advantages and disadvantages would you expect the Fed might gain from adoption of inflation targeting?

Answer 1

Ans a= This is a monetary strategy in which a country’s central bank sets an explicit target rate of inflation for the medium-run & publicises it. The presumption is that the best that monetary strategy can do to assist long-run economic growth is to sustain price stability.

Ans b=The Czech National Bank (since 2010) utilizes 2 % with a '+ or -' 1pp range as the inflation target. It gives a lot of importance to transparency / communication

ans c=

Advantages-Monetary strategy can ‘concentrate on various domestic concerns/ to react to shocks in the domestic economy’, which isn’t doable under a fixed exchange rate set up.

Transparency is an additional advantage.

Investor uncertainty is lessened & thus investors may more simply factor in probable ROI fluctuations into their investment decisions.

Disadvantages-Supporters of 'market monetarism' claim that in the US, the Fed 's mandate is to stabilize level of output as well as the level of prices, & that accordingly a nominal income target is better suited to the Federal bank’s mandate