A perspective on inflation targeting: why it seems to work

Business Economics, July, 2003 by Ben S. Bernanke

Inflation targeting--whose major feature is announcement of a quantitative goal for inflation--is becoming more widely used as a principal policy instrument of central banks. Moreover, none of the dozens of banks that have adopted it have abandoned it. The policy framework of inflation targeting may be characterized as "constrained discretion," albeit with inflation as the primary focus. Maintaining this focus, as well as effectively communicating it, is essential in containing inflationary expectations on the part of the private sector. Although this reduces flexibility of monetary policy, less flexibility has some advantages of its own. The paper addresses misconceptions about inflation targeting and notes that while the Federal Reserve Board has not explicitly accepted inflation targeting, its recent actions have been consistent with an inflation-targeting approach. It also notes the further steps that would be necessary for the Fed to move further toward inflation targeting.

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One of the more interesting developments in central banking in the past dozen years or so has been the increasingly widespread adoption of the monetary policy framework known as inflation targeting. The approach evolved gradually from earlier monetary policy strategies that followed the demise of the Bretton Woods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's Bundesbank and the Swiss National Bank during the latter part of the 1970s and the 1980s. For example, the Bundesbank, though it conducted short-term policy with reference to targets for money supply growth, derived those targets each year by calculating the rate of money growth estimated to be consistent with the bank's long-run desired rate of inflation, normally two percent per year. Hence, the Bundesbank indirectly targeted inflation, using money growth as a quantitative indicator to aid in the calibration of its policy. Notably, the evidence suggests that, when conflicts arose between its money growth targets and inflation targets, the Bundesbank generally chose to give greater weight to its inflation targets (Bernanke and Mihov, 1997). (1)

The inflation-targeting approach became more explicit with the strategies adopted in the early 1990s by a number of pioneering central banks, among them the Reserve Bank of New Zealand, the Bank of Canada, the Bank of England, Sweden's Riksbank, and the Reserve Bank of Australia. Over the past decade, variants of inflation targeting have proliferated, with newly industrialized and emerging-market economies (Brazil, Chile, Israel, Korea, Mexico, South Africa, the Philippines, and Thailand, among others) being among the most enthusiastic initiates. Most recently, this policy framework has also been adopted by several transition economies, notably the Czech Republic, Hungary, and Poland. (2) Central banks that have switched to inflation targeting have generally been pleased with the results they have obtained. The strongest evidence on that score is that, thus far at least, none of the several dozen adopters of inflation targeting has abandoned the approach. (3)

As an academic interested in monetary policy, several years ago I became intrigued by inflation targeting and went on to co-author a book and several other pieces about this approach. (4) As I continue to follow developments in the area, however, I must say that discussions of inflation targeting in the American media remind me of the way some Americans deal with the metric system--they don't really know what it is, but they think of it as foreign, impenetrable, and possibly slightly subversive. So, in the hope of cutting through some of the fog, I offer my own, perhaps somewhat idiosyncratic, view of inflation targeting and its potential benefits, at least in what I consider to be its best-practice form. (5) I also try to dispel what I feel are a few misconceptions about inflation targeting that have gained some currency. Finally, I end with a few words--and one modest suggestion--about the implications of the experience with inflation targeting for the practice of monetary policymaking at the Federal Reserve. (6) My main objective, however, is to clarify, not to advocate. Of course, my comments reflect my own views and do not necessarily reflect those of my colleagues at the Federal Reserve Board or on the Federal Open Market Committee.

Best-Practice Inflation Targeting: One View

Although inflation targeting has a number of distinguishing features--the announcement of a quantitative target for inflation being the most obvious--capturing the essence of the approach is not entirely straightforward. The central banks that call themselves inflation targeters, as well as the economies they represent, are a diverse group indeed, and (not surprisingly) institutional and operational features differ.

Moreover, many central banks that have not formally adopted the framework of inflation targeting have clearly been influenced by the approach (or, if you prefer, the same ideas and trends have influenced both inflation-targeters and non-inflation-targeters). For example, over the past twenty years, the Federal Reserve, though rejecting the inflation-targeting label, has greatly increased its credibility for maintaining low and stable inflation, has become more proactive in heading off inflationary pressures, and has worked hard to improve the transparency of its policymaking process--all hallmarks of the inflation-targeting approach. In short, to draw a bright line between central banks practicing full-fledged inflation targeting and those firmly outside the inflation-targeting camp is more difficult than one might first guess--a fact, by the way, that substantially complicates economists' attempts to assess empirically the effects of this approach.