What is inflation targeting?

Stephen Cecchetti, 1 July 2006




Last week's announcement that Frederic Mishkin will join the Federal Reserve Board chaired by Ben Bernanke marks a turning point in US monetary policy. We can expect to see improvements in both the internal decision-making and external communication of the Federal Open Market Committee. The result will, I believe, be increased clarity and improved performance.

Together, Messrs. Bernanke and Mishkin have provided much of the intellectual foundation for a monetary policy framework called "inflation targeting". Begun in New Zealand nearly 20 years ago, and now used in two dozen countries, including Australia and Mexico, this bypasses intermediate targets and focuses directly on the objective of low inflation.
Experience with inflation targeting is universally positive. No country that has adopted the framework has turned back. It has weathered the test of financial sector shocks, commodity price shocks, big exchange rate movements and more. Importantly, different types of disturbances require different responses and inflation targeting has shown it can accommodate this.

Inflation targeting does not ignore fluctuations in such things as growth, employment and long-term interest rates. As Mervyn King, governor of the Bank of England and one of the earliest proponents of inflation targeting, said some years ago, any successful monetary policy framework must combine an inflation objective with a response to shock. The question is: following a disturbance to the economy, how fast should policymakers bring inflation back to its long-term objective? The faster they go, the more aggressive the interest rate reactions, the larger the fluctuations in growth and employment. The rate of response depends on both societal preferences for inflation versus output stability and the type of disturbance. Importantly, because the economic landscape is constantly changing, inflation targeting does not lead to a hard-and-fast rule for interest-rate setting - a substantial element of judgment is involved.

Inflation targeting enhances long-term economic performance for a host of reasons. First, an agreed and publicly announced objective focuses the monetary policy committee's internal debate. It is clearly easier to make a decision when everyone agrees on the objective. Second, by providing a natural language to explain monetary policy actions, inflation targeting enhances communication with politicians, financial market participants and the public at large. Third, and most importantly, it creates an environment in which everyone believes policymakers will keep inflation low, anchoring long-term inflation expectations. This means wage increases remain contained and a vicious cycle from higher prices to higher wages to yet higher prices cannot get started.

My guess is that Mr. Bernanke sits in his office thinking that if only he had an explicit inflation objective, there would be much less concern over his inflation-fighting credentials. Alan Greenspan, his predecessor, was successful with only a clear but implicit commitment. But the transition to a new Fed chairman, coinciding with energy price increases and dollar depreciation, has created unnecessary uncertainty. The touchstone of an explicit medium-term inflation target would give Mr. Bernanke and his FOMC colleagues a natural vocabulary for communicating their actions. They could make clear, for example, their belief that inflation is likely to return to their objective in the next year or two, thereby avoiding tightening policy just to appear credible.

An explicit objective combined with statements about economic analysis would, as Mr King noted in a speech last month, make guidance about the near-term path of the policy-controlled interest rate less necessary. While central bankers need a sense of what policy is "neutral", and an estimate of how long it will take to get there, their month-to-month decisions are driven by data as they arrive. By contrast, the decisions of individuals and companies rely not on the exact short-term interest-rate path but on the expectation that policymakers will meet their long-term inflation objective.

Inflation targeting is best practice in 21st-century monetary policymaking. It is my hope that chairman Bernanke, governor-designate Mishkin and their Federal Reserve colleagues can convince Congress that low and stable inflation provides the foundation for maximum sustainable growth and employment, and in doing so join the growing ranks of inflation-targeting central banks.

This article first appeared in the Financial Times, http://www.ft.com/home/uk


Topics: Monetary policy
Tags: inflation, inflation targeting

Stephen Cecchetti

Economic Adviser and the Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland