When you get right down to it, we really know very little about how people form their inflation expectations.  To what extent are expectations based on past inflation experience versus looking into the future? Do people scour all of the available data to predict inflation, or do they just consider the information most readily available to them? And, perhaps most important, how do people act on the inflation expectations that we measure through the household surveys?

There is much at stake in the answers to these questions. We might discover important differences between household survey information and financial market data. We may also find an answer to one of the great questions - and obstacles - in the monetary policy process. Namely, are inflation expectations responsible for the long time it takes for monetary policy actions to show up in the inflation data?

Understanding what lies behind our measures of inflation expectations could greatly enhance the design and conduct of monetary policy. For example, it could help us understand what types of institutional arrangements and communication policies help the central bank retain credibility for meeting its price stability objective, even when large and persistent relative price changes ripple through the inflation data.

To that end, unlocking some of the mysteries about inflation expectations may help central banks decide whether, and how, to incorporate a numerical inflation objective into the monetary policy process.  Some central banks have used these numerical objectives as a tool to help anchor inflation expectations. Economists refer to a numerical inflation objective as a "commitment device," that is, a means for holding a central bank's feet to the fire. That may be so. But whether or not there is an explicit numerical objective, anchoring inflation expectations requires a central bank to keep inflation low and stable, to reinforce its commitment to price stability, and to clearly communicate its policies in pursuit of that commitment

I have often noted that my own personal preference is to define “price stability” as a condition in which the rate of inflation, properly measured, is on average zero. I insert the qualifier “properly measured” to point out that actual price indexes may have statistical problems such that zero measured inflation on a particular price index might not in fact reflect a true state of zero inflation. Although my own preference is for zero inflation properly measured, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important than the exact number chosen. Thus, I find that recent discussion of a “comfort zone” of 1-2 percent inflation measured by the price index for personal consumption expenditures, excluding the volatile food and energy components, is perfectly consistent with my own thinking.

And I expect the Fed will keep trying new and different ways to communicate important views and actions, including perhaps establishing targets for acceptable levels of inflation.

Suppose a central bank successfully adopted a formal inflation guideline that respects a dual mandate by flexibly adjusting the time horizons for achieving both its guidelines. Would this policy look any different from current Fed policy? Some academics who study inflation- targeting central banks say no. They say that, effectively, the Federal Reserve does engage in flexible inflation targeting. This is a bit puzzling since there are no announced explicit guidelines. Still, financial markets and the public do not seem to be overly bothered by the lack of an explicit number for future inflationary expectations, and at the present time, inflationary expectations are well anchored. Our actual policy appears to have successfully obtained one of the most important benefits ascribed to a regime based on formal guidelines.

Such models provide insight into how to conduct monetary policy that will successfully sustain a low and stable inflation environment: the monetary authorities must clearly communicate their inflation policy objectives. The communication must be symmetric: private agents must understand what rates of inflation are unacceptably high and what are unacceptably low to the central bank. Central banks that announce explicit numeric inflation objectives go a long way towards satisfying this communication objective.

The most important indicator of the success of a central bank is the performance of inflation itself; for that variable, a central bank must, over the long term, be held accountable.

The Federal Reserve has a three-part mandate: price stability, low/moderate long-term interest rates and maximum employment.  Clearly, keeping inflation low and stable addresses directly the first two of those, in particular, since long-term interest rates can only be low if investors expect inflation to remain low.  I would argue that there's very strong evidence that low and stable inflation and well-anchored inflation expectations also contributes mightily to the third objective which is strong and stable employment growth.

I remain in favor of [inflation targeting]. It's something that the FOMC is going to be taking up. It's not on the agenda as far as I know right now in the sense of, you know, I don't have a meeting agenda that says that it's there. In fact, I don't have the agenda for the next meeting... I don't believe that an inflation target has any particular bearing on the current monetary policy. I think it has a much longer-run bearing on the Fed and its communication with the market.

I think that there are some differences in the FOMC as to what the desirable target ought to be. I don't think those differences are large but I think they are there. I think we ought to come to an agreement on a common approach because there can only be one target at the end of the day for the central bank...The differences we have across the FOMC I think are pretty minor but we ought to dispose of that issue.

So far, it has been hard to find convincing evidence that countries with an announced numerical inflation objective have performed better in terms of inflation and macroeconomic stabilization than those that do not have one.

Researchers using measures of inflation expectations derived from bond market data find that long-run inflation expectations in inflation-targeting countries are remarkably stable and well-anchored, while in the United States long-run inflation expectations have been highly sensitive to economic news.

I support the idea of a quantitative objective for price stability. I believe that it enhances both Fed transparency and accountability and that it offers important benefits, as I have discussed. In particular, it could help to anchor the public's long-term inflation expectations from being pushed too far up or down, and thus help avoid both destabilizing inflation scares and deflations; a credible inflation objective could thereby enhance the flexibility of monetary policy to respond to the real effects of adverse shocks.

In my view, the choice of a specific inflation objective should depend, in part, on an evaluation of the costs and benefits of very low inflation. The inflation objective should contain a buffer sufficient to make sure that the lower bound on the nominal interest rate does not interfere with the ability of monetary policy to stabilize the economy and that downward nominal wage rigidity does not interfere with overall labor market performance.

I see an inflation rate of 1-1/2% as measured by the core personal consumption expenditures price index, with a comfort zone extending between 1 and 2%, as an appropriate price stability objective for the Fed. In terms of setting a long-run goal, I think it makes sense to focus our public communication on one specific price index. Doing so is simpler and more transparent than giving out multiple, potentially contradictory, objectives for different price indices.

Allowing as best we can for measurement bias, which might be in the neighborhood of half a percent per year for broad measures of consumer prices, I favor literally zero inflation. Given measurement bias in price indexes, I might state my goal as inflation between 0.5 and 1.5 percent as measured by the price index for personal consumption expenditures (the PCE price index).