The Conventional View on Inflation Targeting

  • Felix Hüfner
Part of the ZEW Economic Studies book series (ZEW, volume 23)


Since inflation targeting is a relatively new monetary policy strategy, this first chapter will present a survey of the main features and highlight the differences to other strategies. The aim is to give a broad overview rather than to present a detailed analysis in order to motivate the later analysis of the monetary policy instruments available to an inflation targeting central bank.


Exchange Rate Interest Rate Monetary Policy Central Bank Inflation Rate 
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  1. 7.
    4% of the respondents said they had no explicit target for monetary policy. These include the Bank of Japan, but not the US Federal Reserve Bank which in 1998 still published a monitoring range for broad money growth.Google Scholar
  2. 8.
    Lars Svensson (1997a) proposes that an appropriate intermediate target for inflation targeting is an inflation forecast. We will refer to this view, which has been criticised in the literature (Bernanke and Woodford, 1997) later on.Google Scholar
  3. 9.
    See e.g. Bemanke et al., 1999; Mishkin, 2000; Svensson, 2000a; Eichengreen, 2002. However, Mishkin and Schmidt-Hebbel (2001) point out, “classifying country cases into inflation targeting and other monetary regimes involves subjective choices […]”. This is because “[…] there is a lack of full agreement on the main conditions and features of inflation targeting[…]” (p. 1).Google Scholar
  4. 10.
    It is sometimes discussed whether instrument independence is a necessary feature of inflation targeting while goal independence is not required (see Bernanke et al., 1999). Goal independence refers to the final target of monetary policy and states that a central bank is able to formulate its own target. Instrument independence on the other hand means that the central bank is independent in the implementation of monetary policy, i.e. in its interest rate decisions. However, the Bank of England is a prominent example of an inflation targeter that did not have instrument independence in the first years. Only in 1997 the Bank was granted independence. However, this did not seem to have negative repercussions on the Bank’s policy as will be shown later.Google Scholar
  5. 11.
    A fourth strategy would be to target nominal GDP growth (see e.g. Hall and Mankiw, 1994). However, this is more a theoretical concept, because, as Bernanke et al. (1999) point out, no central bank “[…] has seriously considered adopting a nominal GDP target.” (p. 307).Google Scholar
  6. 12.
    As will be seen later on, Svensson attributes the inflation forecast of a central bank as an implicit intermediate target.Google Scholar
  7. 13.
    An alternative study is that of Issing et al. (2001) who, in contrast to DeGrauwe and Polan (2001), report a high correlation between money growth and inflation in the long run. Svensson (2002b), however, points out that given the short horizons of 1-3 years that are most relevant for monetary policy, even a stable long-run relationship between money growth and inflation would be of minor importance.Google Scholar
  8. 14.
    Governor Ian MacFarlane of the Reserve Bank of Australia states that the main reason for abandoning monetary targeting in Australia has been the instability of the relationship between money supply and the objectives of monetary policy. He concludes: “we didn’t abandon the monetary aggregates, they abandoned us.” (Address to the 26th Conference of Economists in Hobart on 29/9/97, available at See also Bernanke and Mishkin (1997) who write: “The fact that in most countries the relation between intermediate targets, such as money growth, and the central bank’s goal variables has proven to be relatively unstable […] is a major motivation for dropping formal intermediate targets and instead attempting to target the goal variable directly.” (p. 101).
  9. 15.
    The European Central Bank’s two pillar strategy bears some resemblance with this approach. Thus, Svensson (2000a) mentions that the Eurosystem monetary strategy to some extent “is quite similar to flexible inflation targeting” (p. 7).Google Scholar
  10. 16.
    Svensson (1997/1998: 5) mentions that a floating exchange rate is a common characteristic of inflation targeting. This follows from the fact, that besides the inflation target there are no other final or intermediate targets in such a policy. By definition this excludes any form of exchange rate targeting from inflation targeting (in the words of Debelle (1997): “[…] inflation targeting is not consistent with a fixed exchange rate regime.” (p. 8)).Google Scholar
  11. 17.
    In the words of McCallum (1996): “The pragmatic argument for inflation targeting begins with the proposition that, from a long-run (i.e. steady state) perspective, monetary policy has a dominating influence on an economy’s (average) inflation rate and a negligible influence on its rate of unemployment or output relative to capacity.” (p. 15).Google Scholar
  12. 18.
    See Svensson, 2001b.Google Scholar
  13. 19.
    See Debelle, 1997: 11–12.Google Scholar
  14. 20.
    Debelle (1997) writes that in an inflation targeting regime “any other goal can only be pursued to the extent that it is consistent with the inflation target.” (p. 8).Google Scholar
  15. 21.
    Underlying inflation as a guide for inflation targeting often excludes also mortgage interest payments (such as the RPIX in the UK). This prevents that an increase in short-term interest rates by the central bank leads to a rise in consumer price inflation through higher mortgage lending rates.Google Scholar
  16. 22.
    Price level targeting does not necessarily imply a constant price level (zero inflation). Rather, it could be implemented as increasing over time.Google Scholar
  17. 23.
    This includes giving explanations about the success or failure in achieving the inflation targets. As Bernanke et al. (1999) state: “The credibility of the central bank depends as much on the objectivity and plausibility of its communications as on its record of hitting targets.” (p. 37).Google Scholar
  18. 24.
    Bernanke and Mihov (1997) find that the Bundesbank put little weight on the money growth as an information variable for future inflation.Google Scholar
  19. 25.
    While some central banks report intervention on the day they are pursued (Bank of Canada), they do not publish time series.Google Scholar
  20. 26.
    See e.g. Kydland and Prescott, 1977; Barro and Gordon, 1983.Google Scholar
  21. 27.
    See Bank of Canada “Press release: Targets for reducing inflation”, Bank of Canada Review, March 1991, p. 5–6.Google Scholar
  22. 28.
    There is some discussion in the literature about differences in the implementation of inflation targeting frameworks in emerging markets and in industrial countries. Our focus lies on inflation targeting in industrial countries. Schaechter et al. (2000) point out that emerging market countries “tend to prefer a more formal institutional framework in support of inflation targeting” but “rely less on statistical models in the conduct of monetary policy” (p. 3). This is probably due to the fact that emerging market countries need to rely more on the trust of international investors than more advanced countries do. Furthermore, Schaechter et al. (2000) write that all emerging market countries (except for Poland and the Czech Republic), in contrast to industrial countries, include as central bank objective “stabilizing the value of the currency” (p. 6). According to Amato and Gerlach (2001: 10) this is primarily due to the financial structure of their economies.Google Scholar
  23. 29.
    Chile and Israel operated an exchange rate band and Spain and Finland were part of the European Monetary System. All four thus did have an intermediate target (the exchange rate) in place.Google Scholar
  24. 30.
    The following section draws on Bernanke et al. (1999) and Blejer et al. (1999).Google Scholar
  25. 31.
    This is one reason why the New Zealand inflation targeting framework is often characterised as the strictest and most “rule-like” of any (see e.g. Bernanke et al., 1999). McCallum (1996) writes that “the New Zealand setup [of inflation targeting] is significantly more ambitious than elsewhere.” (p. 1).Google Scholar
  26. 32.
    In the view of Bernanke et al. (1999) the starting date of inflation targeting in Australia has to be dated as September 1994 since only then the Governor of the Reserve Bank described 2-3% inflation rate as a “goal”. However, the Reserve Bank itself dates the starting point at March 1993 and we follow this interpretation. Nevertheless, this conflict shows that inflation targeting implementation in Australia has been more gradual and less direct as in other countries.Google Scholar
  27. 33.
    The theoretical framework was developed only years after many countries had already introduced the concept (see Bofinger, 2001: 389). See also Bofinger (2000a): “While monetary targeting had been prepared by an intensive academic discussion, inflation targeting was developed mainly as an ad-hoc solution.” (p. 4).Google Scholar
  28. 34.
    This idea of the transmission channel corresponds with the right side of our stylised model of monetary policy as displayed in Figure 1 (without the exchange rate). 35 A higher inflation rate in (2) decreases the real interest rate which increases output in the next period.Google Scholar
  29. 36.
    Bofinger (2000c) suggests a larger role for external inflation forecasts (from analysts, households as well as derived from financial market data) to supplement the central bank’s forecast.Google Scholar
  30. 37.
    Bofinger (2000b) argues similarly with respect to the difficulties of creating an inflation forecast. He mentions that “compared with a’ simple rule’ like a Taylor rule or the rule of monetary targeting which both reduce the complexity of a central banker’sGoogle Scholar
  31. 38.
    “All real-world inflation targeting economies are quite open economies with free capital mobility, where shocks originating in the rest of the world are important, and where the exchange rate plays a prominent role in the transmission mechanism of monetary policy.” (Svensson, 2000b: 2).Google Scholar
  32. 39.
    See Svensson (1997b).Google Scholar
  33. 40.
    See Menon (1995) for an extensive survey of theoretical and empirical studies on exchange rate pass-through and Hüfher and Schröder (2002) for a study of euro area exchange rate pass-through.Google Scholar
  34. 41.
    A popular explanation for this fact is pricing-to-market behaviour by firms: In competitive industries importing or exporting firms chose to adjust their mark-ups over prices instead of passing on exchange rate changes (see Krugman, 1987 and Dornbusch, 1987). A prominent example is the Japanese car industry: despite heavy fluctuations of the Yen versus the US dollar in the 1990s, the price of Japanese cars in the US remained relatively stable (see Goldberg and Knetter, 1997).Google Scholar
  35. 42.
    We will restrict the survey on the main features of the (complex) models in order to show how inflation targeting in an open economy differs from a closed economy and how the central bank is expected to act given the external influences.Google Scholar
  36. 43.
    The real exchange rate is defined as qt ≡ st + pt-pt with pt as the price level of domestically produced goods, pt is the foreign price level and st is the nominal exchange rate (domestic currency per unit of foreign currency).Google Scholar
  37. 44.
    Note that θ = 1 and a constant future exchange rate implies uncovered interest parity (if the current exchange rate appreciates after an increase in the interest rate and the future exchange rate is unchanged, then the exchange rate depreciates over time which is described by uncovered interest parity).Google Scholar

Copyright information

© Springer-Verlag Berlin Heidelberg 2004

Authors and Affiliations

  • Felix Hüfner
    • 1
  1. 1.Centre for European Economic Research (ZEW)MannheimGermany

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