LegiStorm

Summary:

Some economists have long criticized the American model of central banking for featuring multiple policy goals, discretion on the part of the central bankers as to which goal to emphasize, freedom in the choice of instruments to achieve the policy goals, and rather vague accountability for policy failures if, indeed, these can even be identified. Recently, the critics have urged that the multiple policy goals of the Federal Reserve (Fed) be replaced by a single goal of price stability. Critics believe that central bankers tend to use their discretionary powers to achieve political as well as economic objectives, notably to create "good times" through monetary expansion. Since these "good times" do not last long, such a policy imparts a costly inflationary bias to an economy and, hence, is not economically optimal over time. Among other virtues, it is argued that a single goal would provide an explicit anchor for the American monetary system. The current model has strong support as well. Since an economy faces many unforeseen contingencies, supporters argue that giving central bankers multiple goals and a high degree of discretion is optimal. They question whether a price stability goal would be flexible enough to allow the Fed to remain the lender of last resort to the U.S. financial system and to cope with short run stabilization problems that beset the country at times such as the financial turmoil that began in the summer of 2007. They note that the Fed has successfully delivered price stability for over two decades under the current multi-goal regime. Both proponents and opponents of a price stability goal are supported by an array of economic theories and empirical studies. To formally replace the current multi-goal mandate of "maximum employment, stable prices, and moderate long-term interest rates" with a single goal of price stability would require legislation. Members from both parties have introduced such legislation in past Congresses. But Fed Chairman Ben Bernanke, a long-time advocate of inflation targeting, has argued that the Fed could independently adopt an inflation target without changing the multi-goal mandate. A number of countries have made price stability the sole goal of their monetary policy. In practice, these countries have not focused their monetary policy solely on price stability, but have responded to changes in output and to the recent turmoil in financial markets. Thus far, these policy shifts seem not to have undermine their long-term price stability goals. This arrangement has been coined "constrained discretion." The price stability goal, while simple and straightforward, raises a number of technical questions about definition, in terms of a goal of inflation or constant prices, whether a point or band target should be used, and the appropriate price index to measure price stability. The goal may also place constraints on fiscal, debt management, and exchange rate policies—policies not delegated to the Fed. Accountability should be greater than under the current regime, but the degree of accountability depends on how the goal is defined. Since it is infeasible to expect the central bank to keep inflation right on target at all times, consideration should be given to the exceptions granted to the goal and the permissible time interval over which the targets must be met. But these exceptions in turn make accountability more difficult. This report will be updated as events warrant.