In the current issue of Newsweek, Stephen S. Roach of Morgan Stanley offers a critique of inflation targeting. He gets off to a weak start by attacking a straw man, the view that under inflation targeting “Presto – the economy is cured of any and all ailments.” Actually, the objective of CPI inflation targeting is much more modest: to cure the economy of one ailment, a CPI inflation rate higher than desired.

Does it work? Cross-country evidence indicates that inflation fell by more percentage points in the 1990s in the countries that targeted inflation. But (as Ball and Sheridan found) since those were the countries that began with higher inflation, it isn’t clear what caused what: the desire to bring about a larger drop in inflation may have caused the adoption of inflation targeting, rather than inflation targeting causing a larger drop in inflation.

Roach suggests that Greenspan’s inflation targeting was responsible for asset-bubble problems in the US economy. This is odd because (1) Greenspan had no explicit inflation target, and (2), as Roach recognizes, “Central banks, who have ultimate control over the flow from the liquidity spigot, are responsible for this dangerous state of affairs.” Under Greenspan, the Fed “slashed the federal funds rate to 1 percent and spurred the mother of all liquidity cycles.” In so doing, Greenspan was exercising his discretion, not following a rule. So it’s hard to see how any asset-bubble problems on Greenspan’s watch can be attributed to his (implicit) rule-following rather than to his discretion.

Roach does make a valid point: “A CPI-type price rule could compound the negligence of bubble-prone central banks.” Hayek and Robbins made a similar argument about Fed policy in the 1920s: despite CPI stability, credit expansion pumped up the asset price bubble that burst in 1929.

The remedy for this problem isn’t discretion; it’s a better rule (assuming we're stuck with having a central bank). In particular, a better rule would incorporate asset prices, directly or indirectly, rather than only consumer prices. An example of "directly" would be a gold standard, or a rule targeting an Alchian-Klein-type index, or a rule targeting an index of input prices. An example of “indirectly” would be a rule targeting a broad measure of per capita nominal expenditure (MV), as proposed by George Selgin, rather than only the CPI price level (P).