FRBSF Economic Letter
97-04; February 7, 1997
Inflation targeting
Beginning in the early 1990s, price stability became an increasingly
important goal of the monetary authorities in many countries. But some
central banks found the traditional approaches--namely, influencing inflation
and economic activity by controlling intermediate variables like monetary
aggregates or an exchange rate--not very successful. As a result, these
central banks faced the serious possibility of losing credibility.
To address this problem, several industrialized countries--New Zealand
(1990), Canada (1991), the United Kingdom (1992), and Sweden (1993)--adopted
monetary policy regimes that target inflation directly. These regimes
are said to be "transparent," and therefore more credible to
the public, because the central bank makes an explicit commitment to conduct
monetary policy to meet a specified numerical inflation rate target within
a specified time frame. The explicit target provides an anchor for monetary
authorities, and it also serves as an anchor for private market expectations.
This Letter discusses the rationale for inflation targeting
(IT) and examines how it has been implemented, with special emphasis on
the U.K. In addition, it shows that while these countries have had low
and stable inflation since adopting IT, indicators of long-term inflation
expectations also reveal that there still remain doubts in the market
about whether the recent performance will be extended well into the future.
Why inflation targeting?
Many central banks historically have targeted an intermediate variable,
such as a monetary aggregate or an exchange rate, to achieve their ultimate
goals of low inflation and sustainable growth. This procedure assumes
both that the intermediate target variable is controllable and that there
is a reliable relationship between the intermediate target variable and
the ultimate goals.
Unfortunately, this approach has not been uniformly successful; for
example, many of the economies of the G-7 countries have had recurring
booms and busts and flare-ups of inflation over the past several decades.
There are a number of reasons why the approach has not always worked so
well. For one thing, at times the central bank cannot pursue both goals--high
output and low inflation--simultaneously. Second, this conflict in the
goals leads to uncertainty among the public about which goal has top priority;
such uncertainty undermines the credibility and hence the efficacy of
anti-inflation policy, typically at a time when the public's confidence
in the policy is most crucial for it to work. Finally, the way in which
intermediate variables affect output and inflation has varied over time.
Inflation targeting could help alleviate these problems. By explicitly
stating that maintaining low inflation is the main goal, monetary authorities
reduce uncertainty about the priority of alternative policy goals. Also,
the question of the stability of the relationship between intermediate
targets and the objective of price stability becomes irrelevant, since
price stability is being targeted directly; rather, money aggregates and
exchange rates are taken simply as indicators of market conditions.
Before adopting IT, both the U.K. and Sweden had followed fixed exchange
rate regimes. For brevity, this section will focus on the U.K. experience
only. During most of the 1970s, the U.K. had high inflation and high government
budget deficits. The Thatcher administration, which won the general election
in 1979, aimed to curb inflation by controlling deficit spending and money
growth. Accordingly, the British monetary authorities tried to follow
a policy of ensuring smooth and predictable growth in broad money over
a medium-term horizon. By 1983, these stabilization efforts brought down
inflation in consumer prices to below 5%.
Starting in the second half of the 1980s, however, the monetary policy
focus started to shift to exchange rates for several reasons. First, by
then, erratic behavior in the velocity of the broad aggregates caused
by financial innovations made them unreliable. Second, the pound sterling
steadily appreciated against the German mark around the time of the Plaza
Accord in 1985 and the Louvre Accord in 1987; under these accords, the
major industrialized countries agreed to lower the value of the dollar
and to maintain stability in other key exchange rates. Third, partly in
reaction to the worsening current accounts situation, they let the exchange
rate depreciate, and thereafter sought to stabilize it by shadowing the
ERM. This emphasis on the exchange rate culminated in the pound's entry
in the Exchange Rate Mechanism (ERM), which formally prescribed keeping
the pound sterling within a narrow band, in October 1990.
During this time, the inflation performance started to deteriorate.
A surge in real GDP of 4 to 5% annually between 1985 and 1988 led to accelerating
inflation by 1988; by 1990, the inflation rate had reached 11%, but at
the same time, the economy was starting to slow. In 1991, real GDP actually
contracted by 2%, but the U.K. had little room to ease policy as it had
to defend the pegged sterling exchange rate in the face of high German
interest rates around the time of Germany's unification. This situation
became more and more untenable, and in September 1992 sterling left the
ERM when it came under overwhelming pressure caused by large-scale selling
of sterling in the foreign exchange markets. (Sweden left the ERM under
similar circumstances.) This withdrawal left no nominal anchor to guide
monetary policy and to stabilize expectations. To remedy this situation,
the Chancellor of Exchequer announced the adoption of IT.
Implementation of this framework involves first setting a goal in terms
of a specific measure of general price inflation. The consumer price index
(CPI) is the most common choices as it is perhaps the most familiar measure
for the general public. However, a central bank may want to exclude certain
components of the index that are inherently problematic for effective
inflation targeting. A clear example is housing costs: While the index
should go down when monetary policy is tightened, the housing component
goes up because it embodies the rise in mortgage interest rates. Thus,
many IT countries use the CPI excluding mortgage payments or a housing
cost component (e.g., the United Kingdom's RPIX, retail price index excluding
mortgage payments). Similarly, others, such as New Zealand and Canada,
exclude commodity prices from their targeted price index on the ground
that price changes in commodities like oil are beyond the control of monetary
authorities. Countries also differ in their treatment of value added taxes
whose changes affect the CPI but are determined by fiscal policy and not
monetary policy.
Once a price index is chosen, a target is enumerated in terms of a fixed
number and a band. A timetable for achieving the goal also is announced.
In the case of the United Kingdom, the goal is to keep the 12-month change
in the retail price index at 2 1/2% or lower where the target range is
between 1 to 4%. When this goal was first adopted in October 1992, the
U.K. government announced its intent to achieve it by spring 1997, when
the current parliament's term ends. Later the current Chancellor extended
the goal indefinitely.
This range might appear somewhat broad in light of the low inflation
seen in many OECD countries in recent years. However, the British inflation
rate has fallen inside this band only about 35% of the time since World
War II. For the U.S., the comparable proportion is about 50%. Even in
Germany, known for its exemplary inflation performance, the inflation
rate has fallen in this band only about 60% of the time. Hence, the British
target range is not so permissive when seen from a long-term perspective
(Bank of England Quarterly Bulletin 1994). Canada and New Zealand
originally adopted more stringent target ranges of 1-3% and 0-2%, respectively.
In Canada the current time frame runs up to 1998; in New Zealand it is
renewed periodically; in Sweden, the target since 1995 has been 2% with
a 1% tolerance band around it.
Institutional changes for central banks
In addition to the public announcement of goals, most countries that
have adopted IT also have granted their central banks greater autonomy
and have implemented measures to enhance transparency in monetary policy
deliberations. Before adopting IT, central banks in those countries were
less autonomous than the central banks of the U.S. or Germany, and policy
had been formulated through a consultative process in which the Treasury
or Finance Ministry held sway. With the adoption of IT in Canada and New
Zealand, a formal arrangement between the Treasury and the central bank
clearly delegated operational authority and assigned the responsibility
of achieving the goal to the central banks.
No such clear delegation took place in Britain, but measures to increase
the transparency of policy have been implemented. A regular monthly consultation
between the Chancellor of Exchequer and the Governor of the Bank of England
was formally instituted, and minutes of each meeting have been routinely
published with about a six-week lag since April 1994. The minutes have
shown that recently the Governor disagreed with the Chancellor's decision
on several occasions because of different assessments of incipient price
pressures. In addition, at the suggestion of the Chancellor in 1992, the
Bank of England started to publish a quarterly report in which the Bank
offers an inflation forecast based on the assumption that the current
monetary policy stance persists. The Bank uses it as an important vehicle
to offer an objective assessment of whether the current policy stance
is compatible with achieving the IT goal. For example, the August 1996
issue of the Bank of England's Inflation Report offered the following
assessment: "The Bank's latest view on inflation two years ahead
shows a central projection for RPIX inflation a little above 2 1/2% and
rising ... the implication of this projection is that a tightening of
monetary policy will be necessary at some point to achieve a better-than-even
chance of keeping inflation below 2 1/2% in the medium term" (p.
3).
Recent inflation performance
In most countries mentioned in this Letter, inflation in the
targeted price indexes has remained within the target range in the past
year or so. As a group, the average inflation in IT countries was lower
than that for other OECD countries for several years until 1995. However,
this better performance is not fully reflected in indicators of long-term
inflation expectations, such as long-term interest rates, in some of these
countries. Owing to its good inflation track record, Germany's long-term
interest rates contain a relatively small expected inflation and inflation
risk premium compared to other countries. Thus, one could gauge how much
additional expected inflation and risk premium exist in Britain, for example,
by looking at the difference between the yields on 10-year securities
in Germany and Britain. As shown in Figure 1, the British yield has been
higher than the German counterpart throughout but has narrowed during
the 1990s IT period. However, the yield difference between the two has
not narrowed to the extent that seems to be justifiable by Britain's recent
favorable inflation performance. Survey measures of inflation expectations
in Britain and Sweden also have edged lower at a very slow pace in the
same period. Thus it appears that while IT has helped gain credibility
for U.K. monetary policy, the markets are not yet fully convinced that
policy will stick with its current stringent IT approach in the long run.
Inflation targeting appears to have provided a successful nominal anchor
for conducting monetary policy in the countries that have adopted it so
far. However, indicators of long-term inflation expectations still seem
to reveal lingering doubts about whether current low inflation will be
extended into the future. This suggests how difficult it can be to establish
the credibility of monetary policy--while institutional changes may enhance
credibility, it will take years of solid performance to earn the public's
full belief in the central bank's commitment to low inflation.
Chan Huh
Economist
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
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