FRBSF Economic Letter
98-17; May 22, 1998
Central Bank Inflation Targeting
This Economic Letter summarizes the papers presented at
a conference on Central Bank Inflation Targeting held March 6-7, 1998,
under the joint sponsorship of the Federal Reserve Bank of San Francisco
and Stanford University's Center for Economic Policy Research.
The five conference papers (listed at the end) were centered around measuring
or evaluating the degree to which inflation should be the focus of the
operating framework used to implement monetary policy. Explicit inflation
targeting has been adopted by a number of central banks around the world.
In practice, inflation targeting is best described as an operational framework
for policy decisions in which the central bank makes an explicit commitment
to conduct policy to meet a publicly announced numerical inflation target
within a particular time frame. All the conference papers -- like much
of the research literature -- model this framework by focusing on "policy
rules," that is, specific formulas for adjusting the policy instrument
in response to inflation (or forecasts of inflation) and, in some cases,
to the state of the economy as measured by the gap between GDP and potential.
The research reported in these papers suggested that these simple inflation
targeting rules do a good job of capturing the way many central banks
behave and that these rules perform well in achieving a balance between
output variability and inflation variability.
Four of the conference papers compare the performance of various policy
rules in model simulations: The better a policy rule's performance, the
more stable output and inflation. This focus reflects a common emphasis
in recent policy discussions on the trade-off between variability in output
and variability in inflation (Walsh 1998).
The fifth paper takes a different tack. Rather than simulating data
from a model, this paper uses historical data to estimate the policy rules
that central banks have used. This exercise, by providing evidence on
how central banks have actually implemented policy, served to complement
the results from the first four papers on which rules perform best.
Policy rules for inflation targeting
The Rudebusch-Svensson paper uses a small empirical model of the U.S.
economy to examine the performance of policy rules that are consistent
with a policy regime of inflation targeting. Two special features of this
research are the choice of an empirical model and the large set of policy
The authors choose their model based on three considerations: it is
a small linear model with fairly clear and tractable results, it exhibits
properties that accord with the spirit of many policy discussions (e.g.,
a plausible interest rate elasticity), and it is able to reproduce the
salient dynamic features of the data relative to an unrestricted model
(such as a Vector AutoRegression). However, unlike the other three papers
evaluating policy rules, the Rudebusch-Svensson model has no forward-looking
expectational terms in the equations for price and spending determination.
While the Rudebusch-Svensson model appears to fit the data quite well
without these forward-looking terms, their absence raises some questions
about the robustness of the policy evaluation results.
The authors find that some simple policy rules that use inflation forecasts
do remarkably well in minimizing output and inflation variability. In
particular, an implicit rule that adjusts the policy instrument so that
the forecasted inflation rate matches the target rate at a horizon of
about three years does surprisingly well. Such a rule also appears to
be close to the actual decision framework of many central banks under
Operational policy rules
The McCallum-Nelson paper provides a different example of the type of
small, econometrically estimated model that can be used to investigate
monetary policy questions. Their model had two distinguishing features.
First, savings and portfolio decisions are consistent with optimizing
behavior by households. This is important, since it serves to incorporate
forward-looking expectations into the model. The expected effects of monetary
policy in the future can then have real effects in the present as decisions
about consumption, savings, and money holdings adjust in response to these
expectations. Second, McCallum and Nelson employ two alternative specifications
designed to capture the sluggish adjustment of prices to changes in macroeconomic
In addition to differing from the Rudebusch-Svensson paper in the choice
of model, the McCallum-Nelson paper differs in the approach taken to evaluating
policy rules. Rudebusch-Svensson generally start by specifying an objective
function for the policymaker and then deriving an optimal policy rule.
In contrast, McCallum and Nelson start with policy rules that seem to
capture actual central bank behavior and then report the value of output
and price level volatility for different values of the response coefficients
in the policy rules. The general type of policy rule they evaluate is
of the form suggested by Taylor in which the policy instrument (a nominal
rate of interest) is adjusted in response to inflation and the output
gap. In addition to Taylor type rules, the McCallum-Nelson paper includes
an analysis of interest rate and base money growth rate rules designed
to target nominal income.
One advantage of the McCallum and Nelson approach is that it avoids
the need to assume an objective function. A disadvantage is that there
is no natural way to rank the resulting outcomes with different policy
rules. One interesting finding, though, was that policy rules that incorporated
some degree of interest rate smoothing seemed to lower both price and
output variability. The nature of the inflation-output variability trade-off
also appears to be sensitive to the specification of the price adjustment
Implementing price stability
Like the McCallum-Nelson paper, the Tetlow-Williams paper also examines
simulations of a forward-looking model. However, the model Tetlow and
Williams used -- which is the Federal Reserve Board staff's main model
of the U.S. economy -- is large (containing about 30 behavioral equations
and several hundred identities). Consistent with the other conference
papers, monetary policy is represented by a rule for setting a nominal
short-term interest rate, in this case, the federal funds rate.
The Tetlow-Williams paper analyzes two issues related to inflation targeting.
The first is whether target bands for inflation can improve macroeconomic
performance. Under a target band system, the near-term inflation target
is allowed to fluctuate but must remain between upper and lower limits.
The role of such target bands is of interest since some inflation targeting
countries have used bands. Tetlow and Williams conclude that with forward-looking
expectations, bands can be useful in concentrating the public's expectations
of future inflation. To serve this purpose, however, the bands need to
be reasonably narrow.
The second issue Tetlow and Williams consider involves the constraint
that nominal interest rates cannot be less than zero. This lower bound
reflects the fact that no one would lend money with the sure prospect
of getting less of it back in nominal terms (a negative nominal interest
rate) because just holding on to the cash (say, under a mattress) will
ensure a zero nominal interest rate. With central banks typically using
the level of short-term interest rates as the instrument of monetary policy,
the zero bound on nominal interest rates might affect the ability of central
banks to implement monetary policy, and, particularly, to lower interest
rates sufficiently to stimulate the economy from recession. This constraint
is more likely to be a factor for very low inflation targets (recall that
the nominal interest rate is approximately equal to the sum of the inflation
rate and the real interest rate). Tetlow and Williams suggest that, except
with an inflation target of zero, the lower bound on interest rates is
unlikely to be a serious problem.
When economic behavior changes
The Amano-Coletti-Macklem paper also examines monetary policy rules
with a large forward-looking econometric model--in this case, a model
of the Canadian economy developed at the Bank of Canada. The authors focus
on how changes in economic behavior, and hence the equations of the model,
change the nature of the optimal monetary policy rule. The authors consider
three changes in economic behavior that are motivated by developments
in the 1990s: an increase in monetary policy credibility, a flattening
of the Phillips curve linking inflation and unemployment, and a greater
degree of counter-cyclical activism of fiscal policy.
The policy rules analyzed are "inflation-forecast-based" (IFB) rules.
According to this class of rules, the central bank raises (lowers) short-term
interest rates whenever the rule-consistent inflation forecast is above
(below) the target for inflation. As Amano, Coletti, and Macklem note,
this type of rule plays an important role in policy analysis at two leading
inflation targeting central banks, the Bank of Canada and the Reserve
Bank of New Zealand. (IFB rules are similar in spirit to the implicit
rule in the Rudebusch-Svensson paper, but they are too restrictive to
perform well in that analysis.)
Perhaps the most interesting results in this analysis concern changes
in central bank credibility, that is, changes in the degree to which the
public believes the central bank will meet its inflation target. The central
bank is assumed to follow a rule that alters short- term interest rates
by some proportion of the difference between the two-year-ahead inflation
forecast and the inflation target. As credibility increases, the central
bank can attain more stable inflation and output, but this is typically
true only if the central bank adjusts its rule and changes the amount
by which it reacts to inflation forecasts. Thus, the best rule for policy
may have to adjust to changes in the macroeconomy, even within a framework
of inflation targeting.
Some international evidence
In contrast to the other four papers, the conference paper by Clarida,
Galí, and Gertler provides empirical evidence on the way policy
actually has been implemented since 1979 by the central banks of Germany,
France, Italy, Japan, the United Kingdom, and the United States. Clarida,
Galí, and Gertler begin by assuming policy responds to expected
future inflation and to the current expected output gap. For the Bundesbank,
the Bank of Japan, and the Federal Reserve, the empirical evidence supports
the view that each responds to movements in expected inflation, with a
rise in expected future inflation causing a contractionary shift in policy.
In each case, however, there is evidence that policy responds to output
conditions as well. They also find that the Bundesbank and the Bank of
Japan seem to respond to exchange rate movements and to the U.S. federal
funds rate, although these effects are small.
Estimating the policy rule followed by the Banks of England, France,
and Italy is complicated by their participation in the European Exchange
Rate Mechanism (ERM). From 1990 until the European currency crisis in
September 1992, these countries abandoned independent monetary policy
in order to fix their exchange rates with the Deutschmark. In an interesting
approach to understanding monetary policy during this period, the authors
conduct a counterfactual experiment in which they estimate the domestic
interest rate that would have occurred in each country if policy had been
conducted using the same rule as employed by the Bundesbank. Thus, they
estimate the interest rate the Bank of England, for example, would have
set if it had responded to domestic inflation and output as the Bundesbank
did without being constrained to maintain a fixed exchange rate. The difference
between this estimated policy setting and the actual interest rate needed
to maintain the fixed exchange rate provides a measure of the economic
stress in each country as a result of ERM membership. For England, France,
and Italy, Clarida, Galí, and Gertler find that their stress measure
provided evidence of growing stress in the period immediately preceding
the exchange rate crisis in September 1992.
Glenn D. Rudebusch
Carl E. Walsh
Professor of Economics, UC Santa Cruz
and Visiting Scholar, FRBSF
Amano, Robert, Don Coletti, and Tiff Macklem. "Monetary Rules when Economic
Behavior Changes." Bank of Canada.
Clarida, Richard, Jordi Galí, and Mark Gertler. "Monetary Policy
Rules in Practice: Some International Evidence." Columbia University.
Rudebusch, Glenn, and Lars E.O. Svensson. "Policy Rules for Inflation
Targeting." Federal Reserve Bank of San Francisco.
McCallum, Bennett T., and Edward Nelson. "Performance of Operational
Policy Rules in an Estimated Semi-Classical Structural Model." Carnegie-Mellon
Tetlow, Robert, and John Williams. "Implementing Price Stability: Bands,
Boundaries and Inflation Targeting." Federal Reserve Board.
Walsh, Carl E. 1998. "The New Output-Inflation Trade-off." FRBSF
Economic Letter 98-04 (Feb. 6).
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