Inflation Targeting: A New Framework for Monetary Policy?

As of 1997, eight economies — Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United Kingdom — had adopted inflation targeting, all announcing an explicit numerical target (usually a range) for a CPI-based price index, at levels of 4 percent or below, over horizons of one to four years, most often open-ended or long-horizon rather than fixed to a single date. All of these central banks target “core” or “underlying” CPI variants that exclude volatile components such as food, energy, indirect taxes, or mortgage interest costs. Critically, none of them treat the target as an unconditional commitment: every targeter preserves short-run flexibility through some combination of (a) supply-shock exclusions from the targeted index, (b) target ranges rather than point targets, (c) adjustable short-term targets, and (d) explicit escape clauses. As the authors put it, “in practice no central bank has of yet completely forsworn the use of monetary policy for short-run stabilization” (p. 100).

Germany and Switzerland have pursued inflation-focused policy since the mid-1970s but express it through money-growth targets rather than a direct inflation target; the authors argue this distinction is “overstated” (p. 102) because “the Bundesbank’s money growth targets are derived, using the quantity equation, to be consistent with an annual inflation target” that “has remained at 2 percent — the level deemed consistent by the Bundesbank with price stability — since 1986,” and has shown willingness to miss its money targets when they conflict with the inflation goal. The paper attributes the difference in framework choice to institutional circumstance rather than differing objectives: Germany’s relatively stable money velocity and slowly evolving financial institutions made a monetary intermediate target workable, whereas the United Kingdom’s history of unstable velocity made money growth a poor guide to policy, pushing it toward direct inflation targeting instead (p. 103). More broadly, the authors identify velocity instability as the general reason countries moved away from monetary intermediate targeting: “the relation between intermediate targets, such as money growth, and the central bank’s goal variables has proven to be relatively unreliable — the so-called ‘velocity instability’ problem” (p. 101).

The authors’ central claim is that inflation targeting is best described as “constrained discretion”: not a rule in the traditional sense, because it “does not provide simple and mechanical operational instructions to the monetary policymaker,” but also not pure discretion, because it “constrains monetary policy in the medium term” by fixing the ultimate goal (p. 104). They describe the standard rules-versus-discretion framing as “misleading” (pp. 103-104) precisely because it omits this third category: a framework that binds policy over the medium and long term to a numerical inflation objective while leaving the central bank free to use judgment in responding to short-run shocks.

The authors identify two functions: first, communication and transparency — IT provides a nominal anchor for policy and for private-sector inflation expectations by explicitly stating the central bank’s long-run objective, which is meant to reduce uncertainty about future inflation; second, discipline and accountability — because central bank governors “dislike admitting publicly that they are off track with respect to their long-run inflation targets, the existence of this framework would provide an additional incentive for the central bank to limit its short-run opportunism” (p. 106). They add a political-economy nuance: in democracies it is typically the executive and legislative branches that have the greater incentive toward inflationary behavior (“often because of approaching elections”), while central bankers “tend to view themselves as defenders of the currency” (p. 106) — implying the inflation target may function as much to insulate the central bank from political pressure as to discipline the central bank itself.

The authors marshal several pieces of evidence against a strict single-goal reading of IT: the view that monetary policy has essentially no legitimate goals besides inflation “would find little support among central bankers, the public and most monetary economists” (p. 105); an exclusive inflation focus could, like a money-growth-rate rule, “lead to a highly unstable real economy should there be significant supply shocks” (p. 105, citing Friedman and Kuttner 1996); and, empirically, while inflation-targeting countries have generally achieved and maintained low inflation, “little evidence supports the view that these reduced rates of inflation have been obtained at a lower sacrifice of output and employment than disinflations pursued under alternative regimes” (p. 105, citing Debelle and Fischer 1994 and Posen 1995). They further note there is no evidence that the introduction of inflation targets “materially affects private-sector expectations of inflation, as revealed either by surveys or by the level of long-term nominal interest rates” (p. 105, citing Posen and Laubach 1996) — that is, announcing a target does not appear to move expectations independent of delivering on it.

The authors conclude an inflation target of zero or near zero “is not desirable” (p. 110), and give three reasons. First, CPI measurement bias: “official CPI inflation rates tend to overstate the true rate of inflation, due to various problems such as substitution bias in the fixed-weight index and failure to account adequately for quality change,” an overstatement “studies for the United States have estimated… to be in the range of 0.5 to 2.0 percentage points per year” (p. 110, citing the Boskin Commission report) — so a measured-zero target would imply actual deflation. Second, downward nominal-wage rigidity: drawing on Akerlof, Dickens, and Perry’s (1996) simulations that “inflation rates near zero would permanently increase the natural rate of unemployment” through binding downward wage rigidity (p. 110). Third, deflation risk: setting the target too low raises “a greater chance that the economy will be tipped into deflation, with the true price level actually falling,” which “can create serious problems for the financial system” (p. 110), citing Japan’s 1990s recession and the Great Depression (Bernanke and James 1991; Mishkin 1991) — while noting Sweden’s 1930s price-stabilization norm let it avoid the deflation other countries suffered. The authors are explicit that the exact positive level is a judgment call, not a precisely derived number.

No: the authors argue, following Svensson (1997a), that the central bank’s own forecast of the goal variable (inflation) is itself the optimal intermediate target, and that any other single variable — including the money stock — cannot dominate it, because if that other variable contains information about future inflation, the bank should simply incorporate that information directly into its inflation forecast rather than target the intermediate variable and discard the rest of the available information (p. 112). Given that money velocity has been unstable (a claim made repeatedly earlier in the paper, p. 101), it is highly unlikely that money growth alone captures all information relevant to future inflation, so on this logic inflation-forecast targeting dominates money-growth targeting. (Note: this record paraphrases rather than directly quotes the Svensson passage, since the source wiki page itself flags the exact wording on p. 112 as unverified.)

The authors acknowledge that NGDP targeting (Hall and Mankiw 1994; Taylor 1985) has an attractive automatic-stabilization property — a fall in output growth mechanically permits higher inflation within the same NGDP path — but state a mild preference for inflation targeting over NGDP targeting for three practical reasons (p. 113): first, data timeliness, since “information on prices is more timely and frequently received than data on nominal GDP (and could be made even more so)”; second, that “given the various escape clauses and provisions for short-run flexibility built into the inflation-targeting approach, we doubt that there is much practical difference in the degree to which inflation targeting and nominal GDP targeting would allow accommodation of short-run stabilization objectives”; and third, public understandability, since “it seems likely that the concept of inflation is better understood by the public than is the concept of nominal GDP, which could easily be confused with real GDP.”

Addressing the objection (citing Friedman and Kuttner 1996) that the US had performed well without a formal IT framework, the authors argue that “a major reason for the success of the Volcker-Greenspan Fed is that it has employed a policymaking philosophy, or framework, which is de facto very similar to inflation targeting,” noting that “the Fed has expressed a strong policy preference for low, steady inflation, and debates about short-run stabilization policies have prominently featured consideration of the long-term inflation implications of current Fed actions” (pp. 113) — i.e., the US was already a de facto inflation targeter in substance. They nonetheless argue formal adoption would add several things: greater transparency, an institutional commitment less dependent on any single individual’s philosophy, and, as a matter of timing, that “inflation targeting will be easiest to implement in a situation, like the current one, in which inflation is already low and the basic approach has been made familiar to the public and the markets” (pp. 113-114). The authors close by explicitly hedging on the overall verdict: “it is too early to offer a final judgment on whether inflation targeting will prove to be a fad or a trend” (p. 114), and they note throughout that the empirical record on IT rests on a small number of countries over a short (post-1990) period.