Introduction

This chapter provides a perspective on the evolution to inflation targeting based on economic theory and the US experience. The Federal Reserve is not formally inflation targeting. Nevertheless, it is commonly believed to be an implicit inflation targeter. While the analysis presented here is based largely on the US experience, I believe that it applies broadly to all central banks.

The economics profession has made considerable progress towards understanding the role of central banks in controlling inflation in the forty-five years since I took my first economics course. Until at least the early 1970s the majority of the economics profession believed that central banks could do little to control inflation. Conventional wisdom had it that monetary policy was relatively ineffective for controlling inflation or for economic stabilisation. Fiscal policy, not monetary policy, was the principal way that governments could stabilise the economy and keep inflation low, by filling the gap between private demand and potential output. I review the evolution of economic thought from ‘there is little central banks can do to control inflation’ to ‘inflation targeting’.

My thesis is that policymakers' belief in the efficacy of monetary policy for inflation control changed dramatically in spite of the fact that there was no fundamental refutation of what I call the monetary policy ineffectiveness proposition (MPIP).