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What Does Inflation Targeting Mean?

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Tags The FedCapital and Interest Theory

10/26/2005Roger W. Garrison

Although Ben Bernanke has pledged to ensure a continuity between the Greenspan policies and his own, he differs in several important respects, including his endorsement of "inflation targeting." Greenspan has always been against it.

But Bernanke's idea of "inflation targeting" is in need of some deconstruction.

First and foremost, it means that he actually wants some positive rate of inflation, a rate that is expected to persist and therefore gets factored into nominal interest rates. He wants nominal rates kept high enough to give the Fed some elbow room. That is, if the nominal fed-funds rate is, say, 5%, then the Fed has some scope for lowering that rate — in the event that it believes the economy is due for a monetary infusion.

Bernanke was most vocal about this view a year or so ago, when the fed-funds rate was 1% and Fed watchers began to worry about Greenspan "having no more arrows in his quiver." (That was the metaphor of the day.)

Bernanke believes that it is critical that the Fed always has the monetary-infusion option because he considers it essential to avoid deflation at all costs. This judgment derives from the so-called debt-deflation theory of the Great Depression, a theory that was first articulated by Irving Fisher and more recently has been popularized by Bernanke himself in his Essays on the Great Depression (Princeton University Press, 2000).

The debt-deflation theory is no more than the recognition that if an economy suffers a dramatic decline in prices and wages at a time when debt levels are high, the resulting increase in real indebtedness can be debilitating. (This was actually Irving Fisher's own circumstance: He had borrowed lots of money from his sister-in-law and lost it in the stock market crash.)

What Bernanke has in mind is a little two-by-two payoff table. The cells are labeled "Probability of Inflation"; "Costs of Inflation" and "Probability of Deflation"; "Costs of Deflation." His policy strategy is driven by what he perceives as a very high cost of deflation. Further, though inflation may have some costs of its own, it also has the benefit of giving the Fed some elbow room, as explained above. This whole framework, of course, translates into a strong bias toward inflation.

But can Bernanke actually pursue a policy of inflation targeting in the literal sense? In other words, can he increase the money supply whenever, say, the CPI begins to indicate an inflation rate below the target rate and decrease the money supply whenever the CPI begins to indicate an inflation rate above the target rate? I don't think so.

The lag between changes in the money supply and corresponding changes in the CPI is somewhere between 18 and 30 months. This is the "long and variable lag" identified long ago by the monetarists. One of the lessons in Monetary Economics 101 is that a viable target must be one that yields timely feedback to the targeter.

Bernanke is an advocate of inflation targeting. We should understand this to mean that Bernanke is a deflation-scared inflationist.



Contact Roger W. Garrison

Roger W. Garrison received his doctorate degree from the University of Virginia in 1981. He is now Emeritus Professor of Economics at Auburn University in Alabama, where he taught Macroeconomics and History of Economic Thought (among other courses) from 1978 to 2012. He was a Post Doc Fellow at New York University in 1981. He was winner of the Smith Prize in Austrian Economics in 2001 for his book Time and Money: The Macroeconomics of Capital Structure. In 2003 he was named First Hayek Visiting Scholar at the London School of Economics, where he delivered LSE’s First Memorial Hayek Lecture. He served as President of the Society for the Development of Austrian Economics in 2004. His Austrian-oriented writings have appeared in Economic Inquiry, Journal of Macroeconomics, History of Political Economy, Journal of Economic Education, Independent Review, Cato Journal, Journal of Austrian Economics, and in a number of conference volumes and reference volumes. Most recently, his invited chapter titled “Friedman and the Austrians” appears in Robert A. Cord and J. Daniel Hammond, eds., Milton Friedman: Contributions to Economics and Public Policy, Oxford University Press, 2016. 

Roger Garrison is professor emeritus of economics at Auburn University and Associated Scholar of the Mises Institute.

See his web page. Send him mail.

Recent Publications (2012–2016)

Earlier Publications (1979–2012) can be accessed through www.auburn.edu/~garriro.

Garrison, Roger W., “Friedman and the Austrians,” in Robert A. Cord and J, Daniel Hammond, eds., Milton Friedman: Contributions to Economics and Public Policy, Oxford University Press, 2016 (forthcoming).

Garrison, Roger W., “Cycles and Slumps in an Overly Aggregated Theoretical Framework,” in Steven Kates, ed., What’s Wrong with Keynesian Economics, Edward Elgar, Cheltenham, UK, 2016 (forthcoming).

Garrison, Roger W., Review of Randall G. Holcombe, “Advanced Introduction to the Austrian School of Economics, Journal of Economic Literature, 2015 (vol. 53, no. 1): 119-–21.

Garrison, Roger W. and Norman Barry, eds. 2014), Elgar Companion to Hayekian Economics, Edward Elgar, Cheltenham, UK (2014).

Garrison, Roger W., Review Essay: “Alchemy Leveraged: The Federal Reserve and Modern Finance,” Kevin Dowd and Martin Hutchinson’s Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, The Independent Review, 2012 (vol. 16, no. 3): 435–51.

Garrison, Roger W., “Natural Rates of Interest and Sustainable Growth,” The Cato Journal, 2012 (vol. 32, no. 2): 423–37.

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