From Monetary Targeting to Inflation Targeting: Lessons from Industrialized Countries

Abstract

Experience with monetary targeting suggests that although it successfully controlled inflation in Switzerland and especially Germany, the special conditions that made it work reasonably well in those two countries are unlikely to be satisfied elsewhere. Inflation targeting is more likely to improve economic performance in countries that choose to have an independent domestic monetary policy, but there are subtleties in how inflation targeting is done. Lessons from industrial countries should be useful to central banks designing a framework for monetary policy. Mishkin examines changes in monetary policy in industrial countries by evaluating and providing case studies of monetary targeting and inflation targeting.

Inflation targeting has successfully controlled inflation, with some qualifications. It weakens the effects of inflationary shocks, as examples from Canada, Sweden, and the United Kingdom show. It can promote growth and does not lead to increased fluctuations in output. But inflation targets do not necessarily reduce the cost of reducing inflation.

The key to the success of inflation targeting is its stress on transparency and communication with the public. Inflation targeting increases accountability, which helps ameliorate the time-inconsistency trap (in which the central bank tries to expand output and employment in the short run by pursuing overly expansionary monetary policy). Time-inconsistency is more likely to come from political pressures on the central bank to engage in overly expansionary monetary policy. A key advantage of inflation targeting is that it helps focus the political debate on what a central bank can do in the long run (control inflation) rather than what it cannot do (raise economic growth and the number of jobs permanently through expansionary monetary policy).

By increasing transparency and accountability, inflation targeting helps promote central bank independence. Accountability to the general public seems to work as well as direct accountability to the government. Inflation targeting is consistent with democratic principles. In discussing operational design, Mishkin explains, among other things, that

- Inflation targeting is far from a rigid rule.

- Inflation targets have always been above zero with no loss of credibility.

- Inflation targeting does not ignore traditional stabilization goals.

- Avoiding undershoots of the inflation target is as important as avoiding overshoots.

- When inflation is initially high, inflation targeting may have to be phased in after disinflation.

- The edges of the target range can take on a life of their own.

- Targeting asset prices such as the exchange rate worsens performance.

This paper - a product of the Financial Sector Strategy and Policy Department - was prepared for the Bank of Mexico conference Stabilization and Monetary Policy: The International Experience, Mexico City, November 14-15, 2000. The author may be contacted at [e-mail].