INFLATION TARGETING

Inflation Targeting

Inflation Targeting

Since the early 1990s, an increasing number of countries have adopted explicit inflation targets as the defining principle that should guide the conduct of monetary policy. This development is often credited with having brought about substantial reductions in both the level and variability of inflation in the inflation-targeting countries, and is sometimes argued to have improved the stability of the real economy as well.1 Inflation-forecast targeting, as a systematic decision procedure for the conduct of monetary policy, was developed at central banks like the Reserve Bank of New Zealand, the Bank of Canada, the Bank of England, and the Bank of Sweden on a trial-and-error basis, with little guidance from the academic literature on monetary policy rules. But the growing popularity of inflation targeting has more recently led to an active literature that seeks to assess the desirability of such an approach from the standpoint of theoretical monetary economics. This literature finds that an optimal policy regime — one that could have been designed on a priori grounds to achieve the highest possible degree of social welfare — might well be implemented through procedures that share important features of the inflation-forecast targeting that is currently practiced at central banks like those just mentioned. At the same time, the normative literature finds that one ought, in principle, to be able to do better through appropriate refinement of the practices developed at these banks.

One important advantage of commitment to an appropriately chosen policy rule is that it facilitates public understanding of policy. It is important for the public to understand the central bank's actions, to the greatest extent possible, not only for reasons of democratic legitimacy—though this is an excellent reason itself, given that central bankers are granted substantial autonomy in the execution of their task — but also in order for monetary policy to be most effective. For not only do expectations about policy matter, but, at least under current conditions, very little else matters. Few central banks of major industrial nations still make much use of credit controls or other attempts to directly regulate the flow of funds through financial markets and institutions. Increases in the sophistication of the financial system have made it more difficult for such controls to be effective, and in any event the goal of improvement of the efficiency of the sectoral allocation of resources stressed above would hardly be served by such controls, which (if successful) inevitably create inefficient distortions in the relative cost of funds to different parts of the economy. Inflation targeting is a recent monetary policy strategy that encompasses five main elements:

1) the public announcement of medium-term numerical targets for inflation; 2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated; 3) an information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments; 4) increased transparency of the monetary policy strategy through communication with ...