The Federal Reserve and the Inflation Problem

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Table of Contents

Introduction
Lessons for Monetary Policy
The macroeconomic effects of inflation targeting
Inflation Targeting and Optimal Monetary Policy
Forecasting Inflation and Growth
Conclusion
Works Cited

Introduction

In a review conducted by the Federal Reserve Bank of St. Louis in 2005, it was noted that the economic hero of the inflationary decades was the then chairman of the Fed, Paul Volcker. In the review, Allan Meltzer recognizes some mistakes and policy errors. Both political and economic factors that led to the Great Inflation are identified and scrutinized. It was found out that policy errors were based on the limited independence of the Federal Reserve. Misinterpretation of the apparently flawed economic theories resulted to fruitless policy deliberations and had an impact on the increased inflation rates. It was through Volcker’s new policy of inflation targeting that the inflation was controlled and sustained.

The FOMC (Federal Open Market Committee) were slow in their response to the great inflation. This allowed the growth of inflation rates until it was out of control. Reasons for the 1979 monetary policy reform and how it was implemented have been analyzed in the review (Meltzer 18). The success of the reform is apparent over the past two decades characterized with higher degrees of price stability. The main principle behind the monetary policy reform was the control of the U.S money supply. Lindsey’s article splits the reform into five sections: how it happened, why it happened, challenges facing the FOMC, analysis of the then chairman Paul Volcker and finally the conclusion. Lindsey presented the historical description of the reform, reasons for the adoption, mechanisms of handling various challenges and tries to describe the economist Paul Volcker (Lindsey et al. 6).

Lessons for Monetary Policy

Several lessons have been learnt from the great inflation era. Personnel who have benefited from such lessons include policy makers, politicians and the public in general. The main lesson learnt from the high-inflation era is that low and stable inflation has considerable more economic benefits than high inflation. In the past two decades, substantial economic improvements have been recorded as a result of low inflation. Improvements such as a fall in economic volatility, economic growth and increased productivity have been recognized (Bernanke et al. 11). Bullard provides the following three lessons for monetary policy from the panic of 2008: lender of last resort on a grand scale, the several faces of monetary policy and the asset price bubbles. The Federal Reserve acts as the lender of last resort. Its ability to act in such a way was very innovative. It has proved to be more powerful and flexible than was previously held and has regained the confidence and support of the public. Apart from interest rate adjustment, monetary policy can also be sustained by other dimensions. Policy makers have learned better and sophisticated ways of responding to asset bubbles. Challenges were met in the recent crisis but an opportunity arose for evaluation of responses and the impacts of such responses.

The macroeconomic effects of inflation targeting

Over the past two decades, there is little or no evidence of the effects of inflation targeting on macroeconomics. A study by Bernanke et al. showed no significant short run gains in countries which had adopted inflation targeting (12). Macroeconomic elements include: balance of trade, the Gross Domestic Product (GDP) and the levels of employment. In general, there are two models of macroeconomics: the Classical model and the Keynesian model. The former is concerned with wage rates while the latter concentrates on both long term and short term interest rates.

Inflation Targeting and Optimal Monetary Policy

Features of inflation targeting include: a public announcement, a target which should strictly be adhered to and transparency. Inflation targeting has become very popular in emerging economies. Inflation targeting helps the central bank meet the objectives of monetary policy as well as promoting public understanding of the monetary policy. The theory of optimal monetary policy suggests that inflation is best at low and stable levels. A forecast of future inflation is relevant to the implementation of the optimal policy. Forecasts are done in decision cycles normally on a quarterly basis. Woodford argues for the history dependent target criterion as opposed to the common forward-looking criterion. He points out that targets based on past events handle the zero lower bound more effectively than the forward looking alternative.

He gives the example of the problem facing the Bank of Japan, which depends purely on the forward looking method. Currently, inflation targeting represents one of the greatest innovative achievements as shown by practices in banks such as the bank of Canada and the Bank of England. This has protected many central banks from the discretionary trap and improved the effectiveness of the policy (Woodford 27). As much as evidence for forward-looking is overwhelming, a backward-looking trend should not be ignored. According to Woodford, Policy makers should incorporate both backward-looking and forward-looking elements. The FOMC has explicitly indicated the level of inflation target; they intend to keep it close to zero for a long period.

Forecasting Inflation and Growth

Such forecasts have been under attacks from economics who do not agree with the policy. William Poole, the president of the Federal Reserve Bank of St. Louis is such an economist who tries to challenge the validity and reliability of the forecasts. He favors concentrating on the impacts of forecast surprises over the implementation of economic forecasts. A study conducted on the accuracy of these economic forecasts established that the accuracy declines as the forecasting horizon is extended. The inaccuracy of the forecasts (forecast error) was observed in the 2000 blue chip consensus, which missed the 2001 recession. On average, all forecasts predicted inflation rates which were higher than the actual inflation. Since 1994, the FOMC consensus has been better than the Blue Chip consensus in forecasting. In the 90s, inflation rates have been lower than what was forecasted. Forecast errors exist and pose a great financial risk. Therefore, policy makers should make informed decisions and should be ready for forecast changes (Poole 4).

Conclusion

To the majority, the Federal Reserve made the right move against the inflation problem. The policy change made in 1979 was the right choice. Some even consider the Federal Reserve as the Central Bank to the world. Though the Fed has been successful in many occurrences, they have a duty to provide for consultations and exhibit transparency. It is crucial that the Fed should never allow or encourage such inflation bursts in the future. In my view of point, I believe inflation targeting works and I support IT as a framework for the management of monetary policy in the United States. I have great confidence that IT will prevent a replay of the Great Recession.

Works Cited

Bernanke, Ben. Blinder Alan and McCallum Bennett. What Have We Learned Since October 1979? St. Louis Federal Reserve Bank Review, 2005. Print.

Lindsey, David, Athanasios Orphanides, and Robert Rasche. The Reform of October 1979: How It Happened and Why. Federal Reserve Bank of St. Louis Review, 2005. Print.

Meltzer, Allan. Origins of the Great Inflation. Federal Reserve Bank of St. Louis Review, 2005. Print.

Poole, William. “Best Guesses and Surprises,” Review Federal Reserve Bank of St. Louis, 2004. Print.

Woodford, Michael. “Inflation Targeting and Optimal Monetary Policy”, Review, Federal Reserve Bank of St. Louis, 2004. Print.

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