Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Should Central Banks Reduce Inflation?-Conceptual Issues

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Should Central Banks Reduce Inflation?-Conceptual Issues

Article excerpt

It is tempting to give a very short answer to the title of the session-raise interest rates and reduce monetary growth. But when and by how much? That raises two questions which are central to the design of monetary policy. First, starting from an inflationary episode, how quickly should inflation be reduced to its desired level? Second, should monetary policy react to shocks to output as well as to inflation? The two questions are closely related and are the subject of this paper.

Both questions were faced by the United Kingdom following departure from the exchange rate mechanism (ERM) in September 1992. At that time, the latest published inflation rate (retail price inflation excluding mortgage interest payments) was 4.2 percent, but that was following a recession during which output fell, relative to trend, by almost 10 percent, and the sterling effective exchange rate had just depreciated by 13 percent. The policy challenge was to prevent the depreciation having second-round effects on wages and prices, and to keep inflation falling during a recovery in output that had already started.

The exchange rate link was replaced by a domestic monetary framework defined in terms of an inflation target. The objective was to achieve "price stability" in the long run, defined by the then Chancellor, as a measured inflation rate of 0 to 2 percent a year. But the aim was not to bring inflation down to below 2 percent by the next month, or even the next year. It was to approach price stability gradually. In October 1992 a wide band of 1 to 4 percent for the target range of inflation was announced, with the additional objective of reaching a level below 2.5 percent by the end of the Parliament, a date then some four to five years ahead. The implicit assumption was that it would take approximately five years to make the transition to price stability. In the event, inflation fell below 2.5 percent in March 1994, remained below that level for ten months, but then rose again to just over 3 percent. In August 1996 inflation was 2.8 percent.

In 1995 the target was modified. Monetary policy would aim consistently to achieve an inflation rate of 2.5 percent or less some two years ahead. Shocks would mean that inflation would sometimes be above and sometimes below that figure. But in the long run, if policy were successful in achieving the target, inflation would average 2.5 percent or less. The stated objective of monetary policy was permanently low inflation. There was no mention of output as an explicit consideration in setting monetary policy.

Other countries have shown an equal reluctance to move quickly to price stability. Table 1 shows those countries which have in recent years adopted an explicit inflation target. Except for Australia, in all cases target inflation was below the existing rate of inflation. And in most cases, there was planned to be a gradual transition to price stability. A good example is that of Canada, which planned to bring inflation down from over 6 percent to a range of I to 3 percent over four years. New Zealand is a contrast in which the aim was to move quickly from an inflation rate of 7 percent to a range of 0 to 2 percent.

Table 2 shows average inflation rates in each decade since 1950 for the G-3 countries and the seven industrialized countries which adopted inflation targets. From a peak in the 1970s and 1980s, inflation declined steadily. But only in Germany, Japan, and New Zealand was there anything other than a slow adjustment to low inflation. Chart 1 compares the path of the inflation rate since 1950 for the G-3 countries and the inflation target countries as a group. Not surprisingly, on average the countries which subsequently adopted an inflation target experienced higher inflation than the G-3 over most of the period. It is interesting that following an inflation shock there were rather different speeds of adjustment. Japan, in particular, appears to have brought inflation down more quickly than either the United States or the inflation target countries over the past 20 years. …

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