Inflation Targeting Has Been A Successful Monetary Policy Strategy

Inflation targeting appears to have been successful in increasing the transparency of monetary policymaking and in lowering significantly the rate of inflation in these countries, without any negative consequences for output.

The key issue facing central banks as we approach the end of the twentieth century is what strategy they should pursue in the conduct of monetary policy. One choice of monetary strategy that has become increasingly popular in recent years is inflation targeting, which involves the public announcement of medium-term numerical targets for inflation with a commitment by the monetary authorities to achieve these targets. How well has inflation targeting worked in countries that have adopted it?

In Inflation Targeting: Lessons from Four Countries (NBER Working Paper No. 6126) , Research Associate Frederic Mishkin and coauthor Adam Posen examine this question by analyzing the experience in the first three countries that have adopted inflation targeting -- New Zealand, Canada, and the United Kingdom -- as well as in Germany which adopted many elements of inflation targeting even earlier. Inflation targeting appears to have been successful in increasing the transparency of monetary policymaking and in lowering significantly the rate of inflation in these countries, without any negative consequences for output.

Mishkin and Posen show that Germany is best thought of as a "hybrid" inflation targeter, in that it has an explicit numerical inflation goal and has more elements in common with the features of an inflation targeting regime than with a rigid application of a monetary targeting rule. Key elements of a successful targeting regime -- flexibility and transparency -- have been present in Germany and are also essential elements in inflation targeting regimes in other countries.

New Zealand was the first country to implement inflation targeting formally starting in 1990 and it has been highly successful: this country, which was prone to high and volatile inflation before the inflation-targeting regime was adopted, has emerged from this experience as a low-inflation country with high rates of economic growth. However, the New Zealand experience indicates that strict adherence to a narrow inflation target range can lead to movements in policy instruments that may be greater than the central bank would like and can create unnecessary instances in which credibility can be damaged even when the underlying trend inflation is contained.

The Canadian experience with inflation targeting (adopted in 1991) suggests that an inflation-targeting framework with a less rigid institutional structure can also be highly successful. Inflation targeting has worked to keep inflation low and stable in Canada even though accountability is to the general public rather than specifically to the government through specified contracts. As in Germany and New Zealand, a key component of Canada's success with inflation targeting has been a strong and increasing commitment to transparency and the communication of monetary policy strategy to the public. As part of this strategy, the Bank of Canada has emphasized that inflation targeting can help dampen business cycle fluctuations because the floor of the target range is taken as seriously as the ceiling.

The United Kingdom adopted inflation targets in 1992 in the aftermath of a foreign exchange crisis in order to restore a nominal anchor and to lock in past disinflationary gains. Until May 1997, inflation targeting was conducted under severe political constraints -- that is, under a system in which the government, not the central bank, set the monetary policy instruments. Despite this handicap, British inflation targeting helped produce lower and more stable inflation rates. The success of inflation targeting in the United Kingdom can be attributed to the Bank of England's focus on transparency. The Bank of England led the way in producing innovative ways of communicating with the public, especially through its Inflation Report. Indeed, the Bank of England's achievements in communication have been emulated by many other central banks pursuing inflation targeting.

Mishkin and Posen conclude that the design choices of the inflation targeting countries have tended to converge over time, suggesting that a consensus is emerging on best practice in the operation of an inflation-targeting regime. Transparency and flexibility, properly balanced in operational design, appear to create a sound foundation for a monetary strategy in pursuit of price stability. Inflation targeting has been successful in enabling countries to maintain low inflation rates, something that they have not always been able to do in the past. Furthermore, inflation targeting has not required the central banks to abandon their concerns about other economic outcomes such as the level of the exchange rate or the rate of economic growth. Indeed, there is no evidence that inflation targeting has produced undesirable effects on the real economy in the long run; instead it has likely had the effect of improving the climate for economic growth. However, Mishkin and Posen caution that inflation targeting is no panacea: it does not enable countries to eliminate inflation from their systems without cost, and anti-inflation credibility is not achieved immediately upon the adoption of an inflation target. Indeed the evidence suggests that the only way for the central bank to gain credibility is the hard way: they have to earn it.