Inflation Indicators and Inflation Policy

In recent years, policymakers throughout the world have advocated that monetary policy shift toward inflation targeting. Recent actions in the United States serve to highlight the desire of the Federal Reserve to keep inflation both low and stable, while downplaying the likely output and employment consequences. But control of inflation requires both that one be able to forecast its future path, and that one have estimates of what impact policy changes have on that path. Unfortunately, inflation is very difficult to forecast even at very near horizons. This is true because the relationship of candidate inflation indicators to inflation is neither very strong nor very stable. Beyond this, the relationship between monetary policy instruments, such as the federal funds rate, and inflation also varies substantially over time and cannot be estimated precisely. Construction of policy rules must take these difficulties into account. Several rules are examined, and they have the following interesting properties. First, since prices take time to respond to all types of impulses, the federal funds rate should be raised immediately following a shock. One should not wait for prices to rise before acting. Finally, comparison of the results of price-level targeting with nominal-income targeting suggest that the difficulties inherent in forecasting and controlling the former provide an argument for focusing on the latter.