Inflation Targeting: A New Framework for Monetary Policy?

This 1997 Journal of Economic Perspectives essay by Ben Bernanke and Frederic Mishkin is a survey and policy assessment, not an empirical study: it draws on comparative experience across the eight economies that had formally adopted inflation targeting by 1997 (Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United Kingdom), on Germany and Switzerland as “hybrid” cases that pursue inflation goals through money-growth targets, and on existing empirical work, to assess inflation targeting (IT) as a framework for monetary policy. All eight direct targeters use CPI-based series (often “core” or “underlying” measures excluding food, energy, indirect taxes, or mortgage costs), set target levels at 4 percent or below, mostly as ranges rather than points, over horizons of one to four years, and retain short-run flexibility through supply-shock exclusions, target ranges, adjustable near-term targets, or explicit escape clauses. The paper’s central argument is that IT is best understood as “constrained discretion” — a third category distinct from both a mechanical policy rule and pure discretion, since it fixes the medium-term goal while leaving short-run tactics to the central bank’s judgment — and that it serves two functions: providing a nominal anchor that reduces uncertainty about future inflation, and creating transparency and accountability that can discipline policymakers against inflationary bias. The authors argue against treating IT as an exclusive single-goal rule, note that there is not yet evidence that IT countries have disinflated at lower sacrifice ratios than others or that announcing targets by itself moves private expectations, favor a positive target of roughly 2 percent over a zero target (citing CPI measurement bias of an estimated 0.5 to 2 percentage points per year, downward nominal-wage rigidity, and insurance against deflation), and express a mild preference for inflation targeting over nominal GDP targeting on grounds of data timeliness, the practical similarity in short-run flexibility, and public understandability, while arguing the pre-1997 Volcker-Greenspan Federal Reserve’s policymaking framework was already “de facto very similar to inflation targeting.”

Symposium on the Monetary Transmission Mechanism

This 1995 Journal of Economic Perspectives paper by Frederic Mishkin is the introduction to a JEP symposium on the monetary transmission mechanism, and it contains no original data or estimation of its own; instead it lays out an organizing taxonomy of the channels through which monetary policy affects real activity, against which the symposium’s other papers (Taylor 1995, Bernanke and Gertler 1995, Obstfeld and Rogoff 1995, and Meltzer 1995) are meant to be read. Mishkin groups the transmission channels into four broad categories. The traditional Keynesian interest-rate channel runs from a monetary contraction to higher real interest rates (via sticky prices and rational expectations) to a higher cost of capital to lower business fixed investment, residential investment, consumer durables spending, and inventory investment; Mishkin notes this channel is contested within the symposium, since Taylor argues for a strong interest-rate effect while Bernanke and Gertler counter that “empirical studies have had great difficulty in identifying quantitatively important effects of interest rates through the cost of capital,” a difficulty that itself motivated the search for credit-channel alternatives. The exchange-rate channel extends the interest-rate logic to an open economy: higher domestic real rates make domestic-currency deposits relatively more attractive, appreciating the currency and reducing net exports and output. A third category, other asset-price effects, covers Tobin’s q (a monetary contraction lowers equity prices, reducing the market value of firms relative to the replacement cost of capital and so discouraging investment financed by new equity issuance) and Modigliani life-cycle wealth effects (a fall in equity and other asset values lowers households’ lifetime resources and hence consumption), with Meltzer’s symposium contribution extending this logic to land and property values via the Japanese experience of the 1980s-1990s. The fourth category, the credit channel, is the paper’s most detailed, comprising a bank lending channel (a monetary contraction drains bank reserves and deposits, cutting the supply of loans to bank-dependent borrowers such as small firms facing asymmetric-information constraints in public capital markets, though Mishkin notes doubts about this channel’s continued quantitative importance given financial innovation’s erosion of banks’ relative role since the 1950s-1970s); a balance-sheet channel operating through equity prices and net worth (lower net worth raises adverse selection and moral hazard in both business lending and consumer credit for durables and housing); a balance-sheet channel operating through cash flow (higher interest rates directly reduce firm cash flow and so weaken balance sheets independent of equity-price movements); an unanticipated-price-level or debt-deflation channel (an unexpected price decline raises the real value of nominally fixed debt, a rationalization of Fisher’s 1933 debt-deflation account of the Great Depression); and a liquidity effects channel operating through consumers’ own willingness to spend rather than lenders’ willingness to lend (a decline in financial asset values raises the perceived likelihood of financial distress, and because consumer durables and housing are illiquid assets subject to an Akerlof-style “lemons” discount in a distress sale, consumers shift toward more liquid financial assets and cut durables and housing spending). No empirical magnitudes are presented in Mishkin’s own text — the paper’s magnitudes and evidence come from the symposium papers it introduces (Taylor 1995, Bernanke and Gertler 1995, and others) — and Mishkin’s meta-argument, developed in the introduction and concluding remarks, is that monetary policy operates through several of these channels simultaneously, so that focusing solely on the textbook interest-rate channel risks missing quantitatively important transmission routes running through credit markets and asset prices.

Frederic S. Mishkin | Macro Paper Warehouse

Inflation Targeting: A New Framework for Monetary Policy?

Symposium on the Monetary Transmission Mechanism