The Fed Needs a Credible Commitment to Price Stability

Introduction

In the decades since the Fed under Paul Volcker ended the Great Inflation in the early 1980s, central banks around the world have come to understand that sound monetary policy requires a credible commitment to price stability, which in practice has come to mean committing to an inflation target. In January 2012, the Federal Reserve finally followed the global trend when the Federal Open Market Committee [FOMC] adopted a 2 percent inflation target in its "Statement of Longer-Run Goals and Monetary Policy Strategy."

The "Statement" as currently written is a good first start; but the statement stops short of committing the Fed fully to an inflation target, and in some ways it actually undermines the target's credibility. Below, I will recommend improvements in the "Statement" to lock down the public's belief and confidence in the inflation target. Before doing so, however, I discuss three specific ways in which the Fed's weak commitment to its inflation target creates policy risks for the economy and I explain how the Fed and the economy would benefit from a greater commitment to price stability as embodied in the inflation target.

By failing to secure the credibility of its inflation target, the Fed:

• increases risk inherent in using the federal funds rate to influence longerterm interest rates, and thereby degrades the capacity of monetary policy to stabilize employment and inflation over the business cycle.
• invites a re-emergence of cyclical "inflation-fighting" risk premia in longer-term interest rates with potentially adverse effects on employment and inflation.
• forces households to guard against inflation risk, and thereby greatly increases household financial insecurity over a working lifetime and in retirement.

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