This Selected Issues paper on the United States examines the effect of the structure of the mortgage market on real housing activity and housing prices. The market-based financial structure has reduced the volatility of mortgage lending. Changes in the structure of the mortgage market have coincided with lower volatility of real housing activity. Regional income growth and unemployment rates have statistically significant and correct signed effects on housing prices. Tests of the relative importance of mortgage market structure and macroeconomic variables suggest an important effect from the financial structure.

Abstract

This Selected Issues paper on the United States examines the effect of the structure of the mortgage market on real housing activity and housing prices. The market-based financial structure has reduced the volatility of mortgage lending. Changes in the structure of the mortgage market have coincided with lower volatility of real housing activity. Regional income growth and unemployment rates have statistically significant and correct signed effects on housing prices. Tests of the relative importance of mortgage market structure and macroeconomic variables suggest an important effect from the financial structure.

PART III: POLICY ISSUES

VI. Should the Fed Adopt an Explicit Inflation Objective?47

A. Introduction and Summary

1. This paper considers whether the Federal Reserve should adopt an explicit inflation objective and, if so, what this might involve. The Fed has established a highly successful record in maintaining price stability and has steadily enhanced the transparency of monetary policy in recent years. At the same time, it is one of the few remaining central banks among industrial countries that do not have a quantitative price objective.

2. The potential benefits of a numerical price-stability objective are a recurrent issue of debate by the Fed and private researchers. The Federal Open Market Committee (FOMC) has discussed the application of inflation targets in the United States—most recently in February 2005—and Fed Governors have also raised the subject in their speeches. Most academic research has come out in favor of an explicit inflation objective.48

3. This paper takes the view that the adoption of an explicit inflation objective could enhance the effectiveness of monetary policy. An explicit inflation objective would help anchor long-term inflation expectations by reducing uncertainty regarding the Fed’s longer-term policy objective while further enhancing the transparency of its near-term policy stance. At the same time, the international experience does not suggest that this would significantly impair the Fed’s flexibility with respect to its other policy objectives.

B. The Fed’s Monetary Policy Framework

Legal mandate and accountability

4. According to the 1977 Federal Reserve Act, the objectives of the Fed are to promote maximum employment, stable prices, and moderate long-term interest rates. The last objective is widely interpreted as intended to support the first two goals, giving the Federal Reserve a “dual mandate” of maximum employment and stable prices (Ferguson, 2005). However, over the past decade Fed officials have often explained that reaching the employment objective is only possible if price stability is maintained, in effect elevating price stability as the principal policy priority. In addition, the Fed, like other central banks, sometimes takes financial stability considerations into account when circumstances warrant.

5. Accountability for the Fed is informal in the context of a high degree of independence. The Chairman is mandated to testify on Capitol Hill twice a year. However, the Fed enjoys substantial latitude both in how it interprets its mandate, and in its accountability to the public, partly because the latter is more difficult to formalize in the United States than in many other countries. An important difference between the Fed and central banks operating in parliamentary systems is that the checks and balances of the U.S. system mean that the Fed does not deal with a party in control that speaks with one voice (Kohn, 2003a).

Communication

6. Press statements and FOMC minutes are the Fed’s main short-term communication channels. A statement is issued immediately following each of the eight FOMC meetings per year. Recently, the statement has included a short explanation of any decisions that were taken, a view on inflation, a succinct assessment of the balance of risks, and a view regarding the likely direction of future FOMC actions. In addition, a fairly detailed minute of each meeting (around 3,500 words) is released with a three-week lag, which also attracts considerable market attention.

7. The twice-yearly Monetary Policy Report (MPR) to Congress reviews economic and monetary policy developments. The MPR includes a detailed discussion of the rationale for and reaction to the policy decisions made at the most recent FOMC meetings. It also includes the range and “central tendency” of FOMC members’ two-year forecasts of nominal and real GDP, the personal consumption expenditure deflator excluding food and energy (core PCE), and the unemployment rate.

8. Communication is further enhanced through speeches and testimonies by FOMC members. These speeches—that occur frequently compared with most other central banks—convey a diversity of views on both monetary policy and other issues, such as demographic challenges, fiscal developments, or financial market issues.49 They provide a flavor of the Fed’s internal discussions on a broad range of topics, and serve as a useful basis for the analysis of monetary policy decisions.

9. The Fed has increased policy transparency in recent years(Table 1). Explanations of policy views and intentions have become more regular and frequent, more information is conveyed on the views of FOMC members, and publication lags for FOMC minutes have been shortened.

Table 1:

Recent Changes in FOMC Transparency

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Sources: Swanson (2004); and Board of Governers of Federal Reserve website.
Comparisons with other industrial countries

10. All but one industrial country central banks have either an explicit or implicit price stability anchor. Counting the ECB as the central bank for the euro area, the monetary regimes of the 12 industrial country central banks are as follows:

  • Central banks in Australia, Canada, Iceland, New Zealand, Norway, Sweden, and the United Kingdom practice full-fledged inflation targeting (FFIT), defined as an institutionalized commitment to a quantitative inflation target, accompanied by a high degree of transparency and often formal accountability (Bernanke and others, 1999; Truman, 2003).50

  • Price stability frameworks in the Euro area, Japan, Switzerland, and the United States are less explicitly defined than in FFIT countries (Carare and Stone, forthcoming). The ECB and the Swiss National Bank operate under explicit inflation objectives, but do not have the formal commitment modalities of FFIT countries. Japan, a special case, currently has an anti-deflation objective. All of these countries have what can be termed an “implicit” price stability anchor.51

  • Finally, Denmark has an exchange rate peg.

11. In many respects, the Fed is highly transparent(Table 2). However, as the United States is one of the few industrial countries that does not quantify its inflation objective, the forward-looking policy discussion is less detailed than in other countries, almost all of which publish an inflation report (Wyplosz and others, 2003). The Fed also has fewer formal institutional elements in support of monetary policy accountability compared with other industrial countries (Table 3).

Table 2.

Transparency Practices of Industrial Country Central Banks

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Table 3.

Industrial Countries, Accountability Aspects of Monetary Framework

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Source: Tuladhar, 2003.

C. Adopting an Explicit Inflation Objective: The Pros and Cons

12. Given the Fed’s successful track record, there are relatively few imperatives for changing its monetary policy framework. For example, Greenspan (2004) has argued that a rules-based policy such as a strict inflation target would be an imperfect substitute for the risk-management paradigm the Fed has followed in recent years. In his view, some FFIT regimes have not yet had to balance risks to inflation and growth of a sufficient magnitude in order to constitute a real “test.” Kohn (2003a) believes that even flexible inflation targeting is “ill-adapted” to the Fed’s risk management paradigm. While he acknowledges that a flexible inflation targeting framework leaves room for deviations from the inflation target, he is skeptical that deviations can occur in practice.

13. However, others have argued that an explicit inflation objective should be seen as a refinement of the existing framework, aimed at enhancing transparency. Academic research suggests that improvements in transparency on the part of the Fed has made monetary policy more predictable (Swanson, 2004; Lange and others, forthcoming), improving economic decision-making and thus benefiting the real economy. Building on these results, a number of commentators argue that clarifying the Fed’s inflation objectives would further enhance transparency.

Anchoring inflation expectations

14. Despite the Fed’s clear commitment to price stability, Fed officials have offered different interpretations of what this means. Chairman Greenspan has said that “price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms” (Greenspan, 2001). Other FOMC members have provided their own definitions of price stability: for example, Lacker (2005) argues in favor of a 2 percent CPI target with a 2 percent band; Santomero (2004) proposes a 1 to 3 percent inflation rate target for the 12-month moving average of the core PCE; and Bernanke (2003b) does not explicitly specify a target, but he argues that research suggests it is likely to be around 2 percent.

15. A clearer price objective may be especially important at low levels of inflation. Bernanke (2003b) argues that in a high-inflation environment, the Fed would clearly prefer to reduce inflation, and expectations would be for monetary policy to tighten. However, in a low-inflation environment the public could not be sure that the Fed would not change its view of the level of long-term price stability consistent with full employment. Defining price stability could therefore reduce economic and financial uncertainty, potentially shifting long-term interest rates to a lower level. Indeed, with the advent of deflation fears during 2003, it was argued by a number of analysts that an explicit inflation objective could have helped the Fed reassure the public and financial markets that it stood ready to take measures to maintain a positive rate of inflation.

16. An explicit inflation objective would reduce these uncertainties. The stabilizing impact of a long-term definition of price stability could also be enhanced by prospective uncertainties regarding the monetary policy setting. For example, Goodfriend (2003) and Stone (2003) take the view that an inflation target could help resolve uncertainty regarding the prospective change in chairmanship at the Fed.

17. An explicit inflation objective may also reduce the volatility of inflation expectations in the United States—which appears higher than in FFIT countries. As discussed in Box 3 of the accompanying Staff Report, the volatility of inflation forecasts in the United States—measured by the standard deviation of CPI inflation forecasts surveyed by Consensus Forecasts—has dropped over the past 15 years. However, the decline has been smaller than in Canada and the United Kingdom, the two G-7 countries that have adopted FFIT. Similarly, volatility measures for benchmark government bond yields and inflation-indexed bond yields are higher for the United States than the two other countries.52

Inflation measures

18. Concerns have been raised about tying a central bank to a particular definition of the inflation index (Ferguson, 2004). The most relevant inflation index is typically influenced by technological and other advances, as illustrated by the Fed’s shift in focus from a fixed weight CPI to a chain-weighted core PCE deflator. The concern would be that—once the inflation objective was defined explicitly—a change in the index would adversely affect credibility. However, the experience in other countries (e.g., Canada) suggests that redefinitions of indices do not present major problems.

Flexibility

19. Some FOMC members argue that an explicit inflation objective could hinder the Fed in pursuing its other policy objectives (Ferguson 2003, 2004; Kohn 2003a, 2004). Compared with price stability, the Fed’s other objectives—maintaining full employment and moderate long-term interest rates—may be harder to quantify or define. For this reason, it is sometimes argued that an explicit inflation objective would cause the Fed to place an undue emphasis on price stability versus its other objectives.

20. However, there is no clear evidence that a formal inflation target has reduced flexibility for other countries. In particular, FFIT central banks also pay close attention to output and employment stabilization. Indeed, industrial FFIT countries miss their inflation range a surprisingly high 35 percent of the time, and no FFIT country has so far dropped its regime, notwithstanding some episodes of large and prolonged misses (Roger and Stone, 2005). Corbo and others (2001), de Simone (2002), and Hu (2003) found that even FFIT does not seem to entail much cost in terms of output volatility. As Bernanke (2003a) argues, “the general approach of inflation targeting is fully consistent with any set of relative societal weights on inflation and unemployment; the approach can be applied equally well by inflation ‘hawks,’ ‘growth hawks,’ and anyone in between.” Moreover, a credible explicit inflation objective could actually enhance flexibility with respect to other targets because, for example, the impact on inflation expectations and price stability of policy changes aimed at output stability could be weaker (Yellen, 2005).

Accountability

21. A clearer policy objective should enhance accountability, making it more difficult for monetary policy to deviate from a target-consistent path. Santomero (2004) has argued that an explicit inflation objective would make it easier for the public to monitor the Fed’s performance, increasing incentives for monetary policy to adhere to the objective. An explicit objective could also improve accountability by focusing congressional testimony of the Chairman on monetary policy and price stability, and less on tangential issues (Gramlich, 2005). Announcement of an explicit inflation objective could increase “democratic accountability” by requiring the Fed to be clearer and more open about its decision-making process (Blinder and others, 2001).

22. By contrast, Ferguson (2003) argues that a flexible inflation target policy could lead to a loss in accountability and ultimately credibility. The central bank could adopt only the language of a more formal inflation target without any of the constraints and, in doing so, would become less transparent and accountable.

Central bank independence

23. Some FOMC members have warned that adopting an explicit inflation objective could compromise the Fed’s independence. Kohn (2003a) argues that Congress could involve itself in either defining policy objectives or determining accountability arrangements in ways that might undermine Fed independence. Similarly, Gramlich (2005) warns that, while the Fed’s dual legal mandate is well entrenched, introducing an explicit price objective could possibly trigger a Congressional debate on the formalization of the employment objective.

Communication policy

24. The Fed’s reliance on the precise wording of policy statements to convey its forward-looking views has the potential for confusing financial markets. For example, the statement of the May 2003 FOMC meeting cautioned that inflation could fall below 1 percent, surprising markets and leading to a sharp fall in long-term interest rates (Lacker, 2005). Bernanke (2003b) argues that announcing a numerical objective “would help to reduce the reliance of the Fed on complex and easily misinterpreted qualitative language in its communications with the public.”

25. The experience of FFIT countries indicates that an explicit inflation objective could reduce the potential for miscommunication. FFIT central banks disclose in detail their policy framework, and publish their forecasts and detailed assessments of the economic outlook and the implications for policy looking ahead. Under this approach, there is less weight on the precise wording of the text of policy statements.

26. However, some argue that an explicit inflation objective could reduce transparency Friedman (2004) suggests that an explicit inflation objective would obscure the weights accorded by the Fed to output and financial stability. Similarly, Kohn (2003a) argues that FFIT is less transparent than the current Fed policy, because it emphasizes the observable inflation objective, downplaying other “messy stuff that does not fit into the IT framework well.” He suggests that other goals—such as economic and financial stability—are not sufficiently covered in FFIT central bank communications although they are in fact factored into policy decisions. Ferguson (2003) says that a flexible version of inflation targeting may lead to greater uncertainty about policy: should a deviation from the target occur, there could be uncertainty about how quickly the central bank would want to take inflation back to the target path.

D. Implementing an Explicit Inflation Objective

27. The technical details of the target would need to be specified. The Fed would need to decide on: (i) what long-term average rate of change in prices to aim for; (ii) whether to specify the target in terms of a point, a range, or a point and a range, and (iii) how wide to set the range. International experience suggests that, for practical purposes, inflation targets anywhere in the range of 1-3 percent are uncontroversial. Although international practices vary on the issue of point versus range targets, no clear-cut advantages have emerged for one or the other (Roger and Stone, 2005).

28. The Fed would also have to choose a price index on which to base its objective. All FFIT and implicit price stability anchor countries have opted to define the inflation target in terms of the CPI or the CPI excluding particular items such as fresh food and fuel. This reflects the assessment that the CPI is the most widely known measure of inflation and, therefore, plays a central role in forming expectations. At the same time, all inflation targeters routinely discuss a variety of analytical measures of “core” inflation, as well as wages and costs, tradable and non-tradable prices, etc., in their inflation reports.

29. The central bank may well choose to focus on a different inflation measure internally. Typically, a central bank would closely track a measure of inflation more reliably related to the evolution of the output gap than the CPI, but still linked to the CPI over time. The Fed has already undertaken considerable work on measurement issues in the headline and core CPI and PCE indices and would continue to have considerable scope for taking a range of other price and cost factors into account.

30. Policy formulation and decision-making would also be affected by announcing an explicit inflation objective. The need to communicate policy with reference to the inflation target tends to establish the achievement of the inflation target as the benchmark for internal forecasting and policy judgments. The inflation target therefore provides a systematic starting point for policy discussions.

31. Policy communication would need to be adjusted slightly to explain monetary policy actions in terms of the inflation objective. FOMC policy discussions would likely be conducted in an even more forward-looking way, which should be reflected in press statements and transcripts.

32. Inflation reports published by FFIT countries offer some insights into how the Fed’s Monetary Policy Report could change (Schmidt-Hebbel and Tapia, 2002; Wyplosz and others, 2003; Leeper, 2003).53 These reports provide detailed backward-looking accounts of recent economic and financial developments and their effects on the behavior of inflation relative to the target. Inflation reports also contain a forward-looking discussion of inflation trends over the policy horizon, as well as a discussion of the attendant risks and uncertainties. All but one industrial country publish an inflation report on a quarterly basis, reflecting the quarterly publication of national accounts data, which serves as the starting point for forecast updates (Laxton and Scott, 2001; Table 4).

Table 4.

Inflation Reports

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Source: Roger and Stone, 2005.

33. The Fed might also report key assumptions underlying its inflation forecast. All inflation-targeting central banks publish an inflation forecast, either in a more limited form (using a fan chart), or based on unchanged interest rate assumptions or on market interest rate forecasts (Table 4). Very few central banks (Colombia, Czech Republic, and New Zealand) publish forecasts that include endogenous policy settings. Mishkin (2004) argues that this may be going too far on the grounds that markets might not understand the fact that these forecasts are highly conditional on the assumptions made—and therefore subject to frequent revision. On the other hand, endogenous policy forecasts can be extremely effective in explaining the central bank’s perception of trade-offs between rapid action and more gradual responses to various kinds of shocks.

E. Conclusion

34. On balance, the case for an explicit inflation objective appears to outweigh the possible drawbacks. An explicit inflation objective would almost certainly attaining price stability, and less volatile interest rates arising from greater transparency and accountability could foster higher employment. In addition to the axiom “if it ain’t broke, why fix it?” counterarguments include the potential loss of policy flexibility and independence, but the strong record of other inflation targeting countries and the degree of credibility that the Fed enjoys suggest that the potential downside may be limited.

35. Adopting an explicit inflation objective would not necessitate significant changes to monetary operations or the monetary framework(Bernanke 2003a,b; Gramlich, 2000). Unlike inflation-targeting central banks, the Fed need not be required to meet its objective within a given time horizon. Operating procedures for policy implementation would also remain largely unchanged, and most of the monitoring and analysis of economic and financial developments would not be altered. On the other hand, choices would have to be made regarding the objective itself and what inflation index to employ, and some changes in internal practices might be required.

36. The Fed’s communication policy would also need to be adjusted to the new policy environment. This could affect the frequency of publication of the MPR, and the presentation of the forecast of the FOMC. Moreover, external statements would likely need to become more forward-looking and focus on the Fed’s policy in the context of attaining the price stability objective.

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47

Prepared by Turgut Kisinbay, Scott Roger, and Mark Stone (all MFD).

49

During the first five months of 2005, FOMC members gave about 70 speeches according to websites of the Federal Reserve System.

50

FFIT countries all publish detailed inflation reports. Most of them are formally accountable through requirements to publicly explain breaches of the inflation target, formal relations of the decision-making body with the government, and in some cases the possibility of a government override (Roger and Stone, 2005).

51

Implicit price stability anchor countries tend to be larger and have more developed financial systems compared to FFIT countries, and they have a history of lower and more stable inflation (Stone, 2003). The Fund’s detailed Monetary and Financial Policy Transparency Code assessments give implicit price stability anchors relatively high scores for transparency, but less than for FFIT countries (Roger and Stone, 2005).

52

The box calculated the 12-month moving average of the monthly standard deviation of daily 10-year government bond yields.

53

Two of the central banks with implicit price stability objectives publish reports that resemble the inflation reports of FFIT countries. The Swiss National Bank discusses inflation, including a forecast, in its Quarterly Bulletin but coverage is less complete than in FFIT countries (Wyplosz and others, 2003). The ECB extensively discusses inflation developments in its Monthly Bulletin.