Monday, June 30, 2008

Inflation Targeting

Well, I assume Paul Krugman got tired of spreading misinformation, and decided to get back to something in which he is actually quite great at: straight forward analysis.

There is significance in what Krugman wrote because when Ben Bernanke became chairman of the Fed, many, including myself, understood that Bernanke is a fan of inflation targeting, and would most likely become a “hawk” when it came to inflation in the U.S.

So, it is significant to consider that Krugman cites Bernanke’s ability to put off inflation targeting in order to keep economic activity high. Here are some qualifications:

Krugman’s main point is that this is not the 1970’s, and that stagflation may not exactly be on the horizon just yet. The circumstances between the 1970s and today are different.

Also, since Bernanke is such an inflation hawk, and continues to be mindful of it in his testimony to Congress, I feel it safe to assume that if and when inflation were to become the most important target of the Fed in relation to our economy, Bernanke would do what is necessary. Who knows, maybe we should be thanking that Bernanke is the chairman of the Fed at this time.

But the idea of inflation targeting is an interesting one to posit. I remember when Alan Greenspan was coming out with his book; he did an interview on The Daily Show with Jon Stewart. There, Jon Stewart asked what was so “free market” about an economy that has a “Fed” meddling with it? Much to Greenspan’s credit, he admitted that it really was not a true free market.

Greg Mankiw and Ricardo Reis discuss inflation targeting here in a way that not many of us think about. The question is, by what measures do we target inflation? Mankiw and Reis explain in their abstract that: tentative conclusion is that a central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages.

This is a nice tie in to what monetary policy fights with all the time, as well as any economy: the balance between employment and inflation. Examining nominal wages for inflation target purposes shows that targeting inflation will also be relevant to employment in the sense that our wages are tied to employment.

In the end, Ben Bernanke has the responsibility of making decisions regarding where our economy is in balancing employment and inflation, or making the final decisions on where to take that balance. Even though the Fed is not how every economist envisioned a “free market” economy, I trust that Bernanke will do his best. If only that trust was some guarantee to making the right decision every time.

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