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cially. But it has heretofore behaved as if it

and does not distort economic decisionmak-

has an inflation target, and markets believed

ing. In a market economy, the key decisions

that to be so. The Fed is widely believed to

involve allocating resources to their most

valuable use.4 Market prices play a critical role

want inflation to remain under 2 percent--

low but not zero.10

in that process by signaling to everyone the

relative scarcity of goods and urgency of ends.

CPI inflation has remained above the Fed's

Friedrich A. Hayek characterized the price

notional target for some time. In February

system as a communications mechanism for

2008, the consumer price index for all urban

transmitting information about economic val-

consumers (CPI-U) was 4 percent higher than

ues.5 By communicating that valuable infor-

in February 2007. To put that figure in histor-

mation, the price system helps coordinate eco-

ical context, President Richard M. Nixon

nomic activities. As with any communication

decided to impose comprehensive price and

system, it is desirable to filter out "noise," extra-

wage controls on August 15, 1971, because the

neous signals that interfere with communica-

CPI seemed stuck at 4 percent inflation or

tion. Money is indispensable to price forma-

higher all that year (having actually hit a 5 per-

tion, but money can generate noise along with

cent annual rate the prior year).

information. The ideal monetary policy is one

Certainly Nixon chose the wrong remedy,

An ideal

in which there is no noise, only valid price sig-

but his intuition that 4 percent inflation was

monetary policy

nals. The best possible monetary policy would

unacceptably high was on target. Yet why are

maximize the signal-to-noise ratio.6

most policymakers--as opposed to the pub-

is one that

Monetary noise comes about when policy

lic--now comfortable with that inflation

facilitates and

changes the value of money. In economies on

rate? What has changed?

does not distort

gold or silver standards, the discovery of new

Actually nothing has changed for those

sources of the precious metal could set in

who earn, spend, and save dollars. What has

economic

motion forces leading to an expansion of the

changed is that Fed officials prefer an infla-

decisionmaking.

money supply and the depreciation in the

tion measure excluding food and energy ("core

inflation").11 They have persuaded most pub-

value of money. In modern times money is

lic officials, but not the public, of the wisdom

created by printing it or through expansion

of that approach. It is an increasingly unper-

of the liabilities of banks. In nearly all devel-

suasive line of argument.

oped countries, the rate of that expansion is

(or can be) controlled by central banks.7

The Fed originally decided to exclude ener-

Changes in the value of money create mon-

gy prices because it felt it was unreasonable to

etary noise because investors and ordinary

offset OPEC-induced supply shocks. The Fed

individuals mistake changes in money prices

wanted an inflation measure that focused on

for changes in relative prices. For instance,

persistent movements. It did not want to be

during inflation prices rise just to reflect the

forced to offset one-time changes in the price

increase in money and not as the result of any

level, focusing instead on inflation targeting.

shift in preferences for goods.8

By similar logic, the Fed thought it wise to

The best possible monetary policy would

exclude food prices so as not to take on the

seem to be one in which no change occurred

responsibility of offsetting one-time changes

in the value of the appropriate price index.

in food prices due to weather shocks.

The theory supporting a policy of zero or low

Whatever the original merits of the Fed's

price inflation is conventionally termed

approach, the globalization of food trade mit-

"monetarist" and its modern origins go back

igates the effects of localized weather events

to Milton Friedman.9

on food prices. And rising energy prices are

A number of central banks, such as the

systematically demand-driven outcomes. Core

Bank of England and the European Central

inflation has become a misleading statistic,

Bank have adopted inflation targeting as

which disconnects policymakers from the

official policy. The Fed has not done so offi-

experience of the public.

3