Can the Fed Target Inflation? Toward an Institutionalist Approach

Milton Friedman famously argued, "inflation is everywhere and always a monetary phenomenon." In debates with orthodox Keynesians regarding the appropriate method of modeling the transmission of monetary policy, Friedman preferred analysis via the quantity theory of money and reduced-form models rather than detailing within structural models the links between monetary policy and inflation. Of course, in addition to the money supply, the natural rates of unemployment and inflation expectations also were key in Friedman's understanding of the transmission of monetary policy to inflation. Central banks in the real world target interest rates, not monetary aggregates, while neither economists nor central bankers have uncovered a particular rate of unemployment or a methodology for doing so in real time that was reliably linked to the inflation rate. AB the only part of Friedman's transmission mechanism that remains, inflation expectations are front and center within the current "New Consensus" framework for analyzing monetary policy.l In the New Keynesian Phillips curve standard in the "New Consensus" literature inflation is determined by expected inflation and the current output gap. In a core "New Consensus" paper, Clarida, Gall, and Gertler (1999) argue that inflation expectations are set by current and expected future paths of the output gap, while the output gap depends on current and expected future paths of monetary policy. AB Michael Woodford put it, "not only