Federal Open Market Committee - Interest Rate Targeting: Criticism and Alternatives

Interest Rate Targeting: Criticism and Alternatives

The committee's practice of interest rate targeting has been criticized by some commentators who argue that it may risk an inflationary bias. Possible alternative rules that enjoy some support among economists include the traditional monetarist formula of targeting stable growth in an appropriately-chosen monetary aggregate, and inflation targeting, now practiced by many Central Banks. Under inflationary pressure in 1979, the Fed temporarily abandoned interest rate targeting in favor of targeting non-borrowed reserves. It concluded, however, that this approach led to increased volatility in interest rates and monetary growth, and reversed itself in 1982.

Current Fed Chairman Ben Bernanke spoke sympathetically as a Governor in 2003 of the inflation targeting approach. He explained that even a Central Bank like the Fed, which does not orient its monetary policies around an explicit, published inflation target, nonetheless takes account of its goal of low and stable inflation in formulating its interest rate targets. Bernanke summed up his overall assessment of inflation targeting as follows:

Inflation targeting, at least in its best-practice form, consists of two parts: a policy framework of constrained discretion and a communication strategy that attempts to focus expectations and explain the policy framework to the public. Together, these two elements promote both price stability and well-anchored inflation expectations; the latter in turn facilitates more effective stabilization of output and employment. Thus, a well-conceived and well-executed strategy of inflation targeting can deliver good results with respect to output and employment as well as inflation.

Although communication plays several important roles in inflation targeting, perhaps the most important is focusing and anchoring expectations. Clearly there are limits to what talk can achieve; ultimately, talk must be backed up by action, in the form of successful policies. Likewise, for a successful and credible central bank like the Federal Reserve, the immediate benefits of adopting a more explicit communication strategy may be modest. Nevertheless, making the investment now in greater transparency about the central bank's objectives, plans, and assessments of the economy could pay increasing dividends in the future.

In keeping with his 2003 speech as Governor, Bernanke as Chairman has attempted to promote greater transparency in Fed communications. The Fed now indicates publicly the range within which it would like to see future inflation.