By Jennifer Wang
A thornier aspect of implementing an inflation targeting framework is the issue of monetary policy response to an unanticipated shock to the economy. The most obvious example: the terrorist attacks of Sept. 11, 2001.
In the aftermath of 9/11, the Fed cut interest rates aggressively, in an effort to provide adequate liquidity and ward off an economic downturn. Most economists agree that this was a wise course of action, possibly demonstrating an advantage of adaptive policymaking over a rigid targeting regime. Fed Governor Donald Kohn, for example, wonders "whether the FOMC would have responded so aggressively to these shocks if it had been constrained by an inflation target."
Kohn raises an interesting question. Would policy reactions after 9/11 been different under an inflation targeting regime?
According to Mickey Levy, chief economist at Bank of America, "any reasonable target or guideline would have flexibilities built into it that would allow the Federal Reserve to conduct a policy as needed around a significant shock."
Stuart Hoffman of PNC Financial Services Group adds that the financial markets would be tolerant of the Fed temporarily abandoning its inflation – as long as it had credibility as an inflation fighter. "A credible Fed would still have the latitude to say, ‘This is a unique situation, but we’re not giving up on our inflation target.’"
Thomas Schlesinger of the Financial Markets Center, however, hesitates over the thought of exceptions. "September 11 was the mother of all shocks. I can’t conjure up an instance in which a rule wouldn’t get bent or suspended to patch things together."
But what about a less extreme example such as the 1997 Asian financial crisis? Should the Fed be able to deviate from the target in a case like that? And if not, why not? In short, it’s not clear how you draw the line. "Either you have discretion or you don’t," says Schlesinger.