WASHINGTON (MNI) – The following is the fourth and final section
of the text of Federal Reserve Vice Chairman Donald Kohn’s remarks late
Wednesday prepared for Davidson College in Davidson, North Carolina:

Recently, some prominent economists have called for central banks
to raise their inflation targets to about 4 percent. Shifting inflation
targets up would tend to raise the average level of nominal interest
rates and thus give central banks more room to lower interest rates in
response to a bad shock to the economy before running against the zero
bound. Although I agree that hitting the zero bound presents challenges
to monetary policy, I do not believe central banks should raise their
inflation targets. Central banks around the world have been working for
30 years to get inflation down to levels where it can largely be ignored
by businesses and households when making decisions about the future.
Moreover, inflation expectations are well anchored at those low levels.

Increasing our inflation targets could result in more-variable
inflation and worse economic outcomes over time. First of all, inflation
expectations would necessarily have to become unanchored as inflation
moved up. I doubt households and businesses would immediately adjust
their expectations up to the new targets and that expectations would
then be well anchored at the new higher levels. Instead, I fear there
could be a long learning process, just as there was as inflation trended
down over recent decades. Second, 4 percent inflation may be higher than
can be ignored, and businesses and households may take inflation more
into account when writing contracts and making investments, increasing
the odds that otherwise transitory inflation would become more
persistent.

For both these reasons, raising the longer-term objective for
inflation could make expectations more sensitive to recent realized
inflation, to central bank actions, and to other economic conditions.
That greater sensitivity would reduce the ability of central banks to
buffer the economy from bad shocks. It could also lead to more-volatile
inflation over the longer run and therefore higher inflation risk
premiums in nominal interest rates. It is notable that while the
economic arguments for raising inflation targets are well understood, no
major central bank has raised its target in response to the recent
financial crisis.

Another approach to this problem is for central banks to target a
gradually rising price level rather than a constant inflation rate.
Imagine a plot of the consumer price index (CPI) from today onward
increasing 2 percent each year. Central banks would commit to adjusting
policy to keep the CPI near that line.

The advantage of this approach, in theory at least, is that when a
negative shock drives prices below the target level, people will
automatically expect the central bank to increase inflation for a while
to get back to trend. In principle, that expectation would lower real
interest rates without the central bank changing its inflation
commitment, even if nominal interest rates were pinned at zero. It could
also make it easier for people to make long-term economic decisions
because they could anticipate that inflation misses would be reversed
over time, reducing uncertainty about the future price level.

While I appreciate the elegance of this price-level-targeting idea,
I have serious doubts that it would work in practice. Central to the
idea is that the Federal Reserve would be committing to hit a price
level that was growing at a constant rate from a fixed point in the
past. The specific inflation rate that could be expected in the future
would change over time, depending on the inflation that had been
realized up to that point. You could know what inflation rate to expect
only if you knew both the current consumer price index and the Feds
target for the index in the future. In addition, the inflation rate that
you could expect would be different for different horizons. Moreover,
central banks are able to control inflation only with a considerable lag
and even then only imprecisely, so the process of hitting a target would
likely involve frequent overshooting and correction and consequently
frequently shifting inflation objectives.

Contrast this approach with the communications required of central
banks when targeting a specific inflation rate. For example, central
banks targeting a 2 percent inflation rate typically put that target
prominently on their webpage. If those banks were instead targeting a
price level growing at 2 percent, their webpages would have to provide a
table of inflation rate targets for a variety of horizons, and the
targets would change each month. I fear that rather than anchoring
people’s expectations about prices, it could leave them perplexed. As
you can tell, I see compelling reasons why central banks should stick to
their current inflation objectives. Those reasons relate most
importantly to the effect of a central bank’s communications and
behavior on its credibility and on the publics expectations. More study
leading to a better understanding of the linkage between central bank
actions and expectation formation should improve the ability of central
banks to achieve society’s inflation and output objectives more
effectively under a variety of circumstances, including in a severe
negative shock of the type we recently experienced.

Conclusion

Many central bankers and economists, myself included, were a little
complacent coming into the crisis. We thought we knew enough about the
basic structure of the markets and the economy to achieve economic and
price stability with relatively minor perturbations. And we thought we
had the tools necessary to deal with liquidity shortages and
maldistributions. The reality is that we didn’t understand the economy
as well as we thought we did. Central bankers, along with other
policymakers, professional economists and the private sector failed to
foresee or prevent a financial crisis that resulted in very serious
unemployment and loss of wealth around the world. We must learn from our
experience. The questions Ive posed are tough, but addressing these
issues successfully should enable central banks to reduce the odds of
future crises and respond more effectively to any bouts of instability
that still might arise.

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** Market News International Washington Bureau: 202-371-2121 **

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