Volcker openly criticizes his Fed successors over inflation targeting. He is correct yet he did not go far enough.

False Precision

Paul Volcker wrote an op-ed for Bloomberg accusing the Fed of “false precision”. On that score, as well as inflation targeting, his criticisms are accurate.

Please consider What’s Wrong With the 2 Percent Inflation Target by Paul Volcker.

In 1996, Federal Reserve Chairman Alan Greenspan had an exchange with Janet Yellen, then a member of the Fed’s Board of Governors, that presaged a major — and, I think, ill-advised — change in the central bank’s approach to managing the economy.

Yellen asked Greenspan: “How do you define price stability?” He gave what I see as the only sensible answer: “That state in which expected changes in the general price level do not effectively alter business or household decisions.” Yellen persisted: “Could you please put a number on that?”

Since then, under the chairmanship of Ben Bernanke and then under Yellen [the answer] has been translated into a number: 2 percent.

I puzzle about the rationale. A 2 percent target, or limit, was not in my textbooks years ago. I know of no theoretical justification. It’s difficult to be both a target and a limit at the same time. And a 2 percent inflation rate, successfully maintained, would mean the price level doubles in little more than a generation.

I do know some practical facts. No price index can capture, down to a tenth or a quarter of a percent, the real change in consumer prices. The variety of goods and services, the shifts in demand, the subtle changes in pricing and quality are too complex to calculate precisely from month to month or year to year.

It is also true, and herein lies the danger, that such seeming numerical precision suggests it is possible to fine-tune policy with more flexible targeting as conditions change. Perhaps an increase to 3 percent to provide a slight stimulus if the economy seems too sluggish? And, if 3 percent isn’t enough, why not 4 percent?

I’m not making this up. I read such ideas voiced occasionally by Fed officials or economists at the International Monetary Fund, and more frequently from economics professors. In Japan, it seems to be the new gospel. I have yet to hear, in the midst of a strong economy, that maybe the inflation target should be reduced!

The fact is, even if it would be desirable, the tools of monetary and fiscal policy simply don’t permit that degree of precision.