The Fed's enhanced communication strategy: stealth inflation targeting?

Michael Woodford 08 January 2008



Perhaps the most interesting development of the past year in central-bank communications policy has been at the Federal Reserve. Along with the minutes of its October 30-31 meeting, the FOMC released a summary of the members’ forecasts for several economic variables, the first example of a type of information that is now to be released four times a year, following the 1st, 3d, 4th and 7th FOMC meetings of each year. The change in communication policy, announced in a press release by the FOMC on November 14, and explained in further detail in a speech by Chairman Bernanke to the Cato Institute’s Annual Monetary Conference the same day,1 represented the outcome of a year-long process of deliberation within the FOMC about ways in which the transparency of Fed policymaking might be improved.

Is it ‘forecast targeting’?

An obvious question about the new policy is the extent to which it represents an attempt to implement for the U.S. the kind of “forecast targeting” that has been used by a number of central banks with official inflation targets, such as the Bank of England and Sweden’s Riksbank, for the past 15 years. Both Chairman Bernanke and Governor Frederic Mishkin were well-known as leading American fans of inflation targeting before taking their current positions at the Fed,2 and many have wondered whether the Bernanke Fed might adopt some form of inflation targeting. Regular publication of quantitative projections of the future evolution of inflation and other variables --- in the Inflation Reports of the Bank of England, that appear 4 times per year, or the Monetary Policy Reports of the Riksbank, published 3 times per year --- is a characteristic feature of those banks’ approach to monetary policy. To what extent does the Fed’s new “enhanced communication strategy” achieve a similar end? Should it be viewed as inflation targeting in everything but the name?

It is useful first to recall the point of the publication of forecasts by the other central banks. “Forecast targeting” is a particular kind of decision procedure for monetary policy, under which the policy committee seeks, each time that it meets, to determine the level of its policy rate consistent with a projected evolution of the economy that would satisfy a quantitative target criterion. For example, the Bank of England often explains its policy as aiming to ensure that the projected rate of CPI inflation at a horizon 8 quarters in the future should equal 2.0 percent. Given a criterion of this kind, that refers to the future conditions that policy is intended to bring about, the bank’s internal forecasts play a crucial role in policy deliberations.

The regular publication of the bank’s forecasts also plays a central role in these banks’ communication policies. The point of publishing the forecasts is to make the nature of the banks’ policy commitments evident to the public, and to increase the credibility of these commitments, by allowing the public to observe how policy decisions are actually shaped by the banks’ efforts to ensure the fulfillment of the target criterion. The Inflation Reports or Monetary Policy Reports include not only forecasts and discussion of the reasoning behind them, but also, crucially, an explanation of how the bank’s most recent policy decisions are justified by the projections presented in the report. The argument presented, essentially, is that (i) projections are displayed conditional on a particular assumption about policy; (ii) the projections can be seen to have the desired properties; hence (iii) it may be verified that the assumed policy is an appropriate one.

The commitment to justify policy to the public in this way increases public understanding of the policy, and so should improve the public’s ability to correctly anticipate the future conduct of policy, increasing the effectiveness of policy.3 It also serves the goal of making the central bank more accountable, which provides democratic legitimacy for the central bank’s grant of operational independence.4 And finally, it can improve policy itself, by providing a check on possible temptations to base policy purely on short-run considerations, losing sight of whether policy remains consistent with the bank’s medium-run objectives.5

Flexible inflation targeting

Does the Fed’s commitment to release additional projections, and additional discussion of those projections, serve a similar function? Both Chairman Bernanke’s speech, and a speech soon after by Governor Mishkin,6 make it clear that at least for these two members of the FOMC, the point of the new policy is to better communicate the nature of the FOMC’s policy commitments --- essentially, revealing that the Fed conducts policy in the way advocated by proponents of “flexible inflation targeting,” albeit without any official announcement of targets for policy.

How Mishkin views it

Governor Mishkin’s speech is clearest about the way in which the “Summary of Economic Projections” in the minutes is intended to reveal the goals of Fed policy. First of all, the new projections, unlike those previously summarized in the semi-annual Monetary Policy Report to Congress, extend three years into the future, rather than only two. In addition to providing projections more similar to those of the forecast-targeting central banks, this means that the projections extend far enough into the future that one might usually expect the economy to converge over that horizon to something like the long-run (or “steady state”) values of inflation and unemployment associated with the contemplated approach to policy. Hence, it is suggested, the public should be able to tell from the projections for three years in the future the place that policy is trying to reach, relatively independently of where it may currently be.

To be specific, according to Mishkin, the three-year projections for inflation “provide information about each FOMC participant’s assessment of the inflation rate that best promotes [the Fed’s dual stabilization] objectives --- a rate that I will refer to as the ‘mandate-consistent inflation rate’.” This is essentially the inflation target in a quadratic objective function for the individual FOMC member, though Mishkin is careful to describe the target as an assessment --- a matter of fact, rather than a value judgment --- of the inflation rate required to achieved the goals assigned to the Fed by Congress, rather than a goal chosen by the FOMC itself. Here the inclusion of a projection for headline PCE inflation, and not just the core PCE inflation projection previously emphasized in the Monetary Policy Report, also seems to be intended to help communicate the FOMC’s inflation target (or rather, the members’ collection of individual targets). While the FOMC has in the past paid greater attention to projections of core PCE inflation in making short-run policy decisions, as it is believed to be a more reliable indicator of risks to price stability over short periods of time, they would clearly prefer to express their medium-run inflation target in terms of a broader index, which better conforms to the public’s concerns.

Forecasts and the Fed’s dual mandate

Mishkin similarly argues that the three-year unemployment projection indicates the participants’ views of the “sustainable unemployment rate” or natural rate of unemployment. He emphasizes even more strongly in this case that the long-run forecast represents a judgment about an economic fact rather than a goal chosen by the members of the FOMC, as “the Federal Reserve most emphatically cannot choose the level of maximum sustainable economic activity.” Nonetheless, it is clear that in his view, this “sustainable unemployment rate” plays the role of an unemployment target in the FOMC member’s loss function, in the sense that policy should aim (other things being equal) to minimize departures of the actual unemployment rate from the sustainable rate. Thus target values for two variables, representing the twin stabilization objectives of the Fed’s “dual mandate,” can both be discerned from the projections. Mishkin suggests that the relative weight placed on the two goals can also be discerned, not from the three-year projections alone, but from the relative rates of convergence of the inflation and unemployment projections to their eventual values.

There are certainly some advantages to communicating the Fed’s stabilization goals in this way, rather than through an explicit announcement of policy targets. One is that it allows the Fed to maintain a degree of symmetry in the way that it treats the two stabilization objectives --- projections are presented for both (in fact, there are projections for two inflation measures and for two measures of real activity), and one can make similar inferences about medium-run objectives for both variables --- unlike the inflation-targeting central banks, which have an official target for the inflation rate but no equally explicit target for any measures of real activity.7 This circumvents one of the most important objections raised to proposals that the Fed adopt an inflation target, which is that an apparent focus on inflation alone might be found to violate the Fed’s legislative mandate. At the same time, the fact that the members of the FOMC present only their forecasts, and not targets or objective functions, avoids the delicate problem of having to justify an unemployment “target” higher than what some politicians might feel that society should set itself as a goal.

Publishing forecasts is not a commitment to policy targets

Nonetheless, while the approach taken treads a careful path through a political minefield, it is far from providing a full substitute for an explicit announcement of policy targets. The fact that members of the FOMC all currently forecast that PCE inflation should eventually decline to a rate between 1.5 and 2.0 percent per year does not convey the same thing as a commitment to aim to return it to that level. On the hypothesis that each member of the FOMC is a covert inflation-targeter, then their forecasts (of how inflation would involve under an “appropriate” path for policy) for a long enough horizon should reveal their inflation targets; but the fact that their current forecasts happen to converge to some inflation rate hardly proves that their objective function involves an inflation target at all. The important thing that is achieved by an official inflation target is that medium-run inflation expectations should remain firmly anchored even in the face of disturbances that cause inflation to temporarily depart from the target rate. But the knowledge that members of the FOMC currently expect PCE inflation to fall below two percent gives one no reason to suppose that they will continue to expect that (or aim at it) in the event of a disturbance that makes disinflation more difficult than had previously been expected.

Over time, of course, one can expect to learn whether the three-year forecasts of inflation remain constant or not. But even if they do, and this eventually creates confidence in the existence of fixed inflation targets, requiring people to learn in this way is a slower and more uncertain process than would be possible with a public commitment from the start, with likely consequences for the stability of inflation expectations in the meantime. Even after several years of relatively constant three-year forecasts, there might remain considerable uncertainty about the FOMC’s intentions regarding inflation in the event of a relatively unusual disturbance that had not been experienced in the previous five years. Moreover, the absence of an explicit statement of the targets makes it less likely that even those members who privately think in terms of inflation targets will feel a need to stick to the same target when circumstances change. An assessment of the mandate-consistent inflation rate, treated as a judgment of fact about the economy, can reasonably change as the perceived facts change; hence no member need be embarrassed if his or her assessment is observed to shift over time. If instead one believes that stability of inflation expectations is more important than the particular inflation rate that is expected, then a commitment to a particular target, that one should have little ground to subsequently revise, has much to recommend it.

More generally, the Fed’s “Summary of Projections” is far from a complete substitute for the Monetary Policy Report of a forecast-targeting central bank, because the projections are not used to justify a policy decision. In the absence of an explanation of how the projections are supposed to relate to the decision that has been taken, publication of the additional information, while arguably an increase in transparency of one sort, does not do much to clarify the nature of FOMC decisionmaking, and hence to make future policy more predictable.

The summary of projections is presented separately from the summary of the discussion leading to the interest-rate decision, and contains no comments on any implications of the projections for policy. Nor do the minutes of the discussion at the meeting contain many references to the projections supplied by the FOMC members. There is considerably more discussion (at least in the minutes of the October 2007 meeting) of the forecast prepared by the staff of the Board of Governors for the meeting; but no information about this forecast is currently released except with a considerable delay.

Two elements short of forecast targeting

Moreover, even if the members’ projections are the relevant ones for understanding the policy deliberations, the information provided in the “Summary of Projections” lacks two key elements required for a justification of policy under a forecast-targeting procedure. On the one hand, banks like the Bank of England and the Riksbank explain the assumptions about future policy reflected in their projections; and on the other hand, they explain what acceptable projections must look like. It is then possible to judge that the projections under a particular policy should be acceptable, and to know what policy it is that has thereby been shown to be appropriate. In the case of the Fed, instead, there is no explicit target criterion, apart from what may be inferred from looking at the projections themselves; and while each member’s projections are supposed to be based on his or her “assessment of appropriate monetary policy,” no information is supplied about what policy is being assumed by any of the members. One therefore has no way of saying whether the decision actually taken at the meeting has any similarity to the policies assumed in the projections or not.

It’s not inflation targeting but it matters

So the Fed has not yet taken too great a step toward implementation of inflation targeting in the U.S. (This is likely to come both as a relief to some and as a disappointment to others.) Does the new policy matter at all?

I think that it will make a difference, but not primarily to the degree to which outsiders are better able to understand or predict Fed policy, in the first instance. Rather, the most important consequence of the new strategy, in the short run, will be for the Fed’s own deliberations. Requiring the members of the FOMC to consciously consider the way in which the economy is likely to evolve over the next several years, and the nature of appropriate policy not just in the short run, but also over the next several years, is likely to increase the extent to which policy decisions are considered as part of a coherent strategy rather than as a sequence of unrelated decisions. Encouraging them to discuss with one another the extent to which their forecasts differ and why will facilitate the development of a shared understanding of what a sensible strategy would be like. And pressing them to consider the reasons for the changes in their forecasts from one release to the next should ultimately favour the maintenance of consistency over time in the way that policy is approached.

Changes of these sorts in the way that policy decisions are approached are highly desirable, given the extent to which the anticipation of policy, and hence its intelligibility, matters to its effectiveness. Once policy decisions are made to a greater extent on the basis of a consistent strategy, it should be possible for the Fed to explain more about that strategy to the public. In this respect, the new strategy does represent a step toward an eventual improvement in public understanding of Fed policy.

Editors’ note: This is the first of 2 columns based on Woodford’s comments at the American Economic Association meeting last weekend in New Orleans.




1 Ben S. Bernanke, “Federal Reserve Communications,” a speech at the Cato Institute 25th Annual Monetary Conference, Washington, D.C., November 14, 2007.
2 See, for example, Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen, Inflation Targeting: Lessons from the International Experience, Princeton: Princeton University Press, 1999, which includes a chapter arguing that inflation targeting would be desirable for the U.S.
3 For evidence that the Inflation Reports of forecast-targeting central banks do actually increase the predictability of policy, see Andrea Fracasso, Hans Genberg, and Charles Wyplosz, 'How Do Central Banks Write? An Evaluation of Inflation Targeting Central Banks', Geneva Reports on the World Economy Special Report 2, London: Centre for Economic Policy Research, 2003.
4 It is no accident that the Bank of England was finally granted the authority to set interest rates independently in 1997, after several years of experience with a forecast-targeting regime.
5 For further discussion, see Michael Woodford, “The Case for Forecast Targeting as a Monetary Policy Strategy,” Journal of Economic Perspectives, Fall 2007, pp. 3-24.
6 Frederic S. Mishkin, “The Federal Reserve’s Enhanced Communication Strategy and the Science of Monetary Policy,” a speech to the Undergraduate Economics Association, M.I.T., Cambridge, Mass., November 29, 2007.
7 A partial exception is Norway, where the official target criterion requires that the projections maintain “a reasonable balance” between the gap between actual and target inflation on the one hand and the rate of “capacity utilization” on the other. However, even in this case, greater prominence is given to the requirement that the inflation rate be projected to converge to the target rate. See the box “Criteria for an appropriate interest-rate path,” Norges Bank Monetary Policy Report 2007/3, p. 9.





Topics:  Monetary policy

Tags:  US, inflation targeting, inflation criterion, Federal Reserve

John Bates Clark Professor of Political Economy, Columbia University and CEPR Research Fellow