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

Conducting Monetary Policy with Inflation Targets

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

Conducting Monetary Policy with Inflation Targets

Article excerpt

Since the early 1990s, a number of central banks have adopted numerical inflation targets as a guide for monetary policy. The targets are intended to help central banks achieve and maintain price stability by specifying an explicit goal for monetary policy based on a given time path for a particular measure of inflation. In some cases the targets are expressed as a range for inflation over time, while in other cases they are expressed as a path for the inflation rate itself. The measure of inflation that is targeted varies but is typically a broad measure of prices, such as a consumer or retail price index.

At a conceptual level, adopting inflation targets mav necessitate fundamental changes in the way monetary policy responds to economic conditions. For example, inflation targeting requires a highly forward looking monetary policy. Given lags in the effects of monetary policy on inflation, central banks seeking to achieve a target for inflation need to forecast inflation and adjust policy in response to projected deviations of inflation from target. But central banks without an explicit inflation target may also be forward looking and equally focused on a longrun goal of price stability. Thus, at a practical level, adopting inflation targets may only formalize a strategy for policy that was already more or less in place. If so, targets might improve the transparency, accountability, and credibility of monetary policy but have little or no impact on the way policy instruments are adjusted to incoming information about the economy.

This article examines how central banks have changed their policy procedures after adopting explicit inflation targets. The first section summarizes the key features that characterize and motivate most inflation targeting regimes. The second section documents the procedural changes that a number of central banks have taken to implement inflation targeting. The third section examines empirical evidence to see if and how inflation targets have changed the way monetary policy reacts to economic information. The article concludes that, while inflation targets have perhaps improved the transparency, accountability, and credibility of monetary policy, it is difficult to discern any significant and systematic changes in the way policymakers adjust policy instruments to incoming information after adopting inflation targets.

I. RATIONALE FOR AND KEY FEATURES OF INFLATION TARGETING

Central banks have adopted inflation targets as a strategy for achieving, and then maintaining, price stability. Inflation targeting regimes share several common features. This section describes the conceptual rationale for most inflation targeting regimes, as well as their common features.'

Rationale

Inflation targets can be set by the government, jointly agreed upon by the central bank and the government, or set by the central bank itself. The ultimate rationale for targets is to help the central bank achieve a desired long-run level of inflation, usually a measured rate of inflation consistent with "price stability." The inflation rate deemed consistent with price stability varies from country to country but generally falls within a range of 0 to 3 percent annually as measured by a broad index of consumer prices.2 Inflation targets are designed to help the central bank achieve longrun price stability in three principal ways: by providing a nominal anchor for monetary policy, by improving the transparency and accountability of monetary policy, and by enhancing the central bank's inflation-fighting credibility.

Providing a nominal anchor. One rationale for inflation targets is that they supply a nominal anchor for monetary policy. Without such an anchor, policy actions can drift under the influence of short-run economic disturbances and, in the process, become inconsistent with longrun goals. With a nominal anchor, policy is bound to a long-run goal-such as price stability-that ties down inflation expectations but retains the slack needed to respond to short-run disturbances. …

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