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What are the costs and benefits of
inflation targeting? Should the
Fed adopt an inflation targeting
monetary policy regime?

March 2007
Listen to this article

What are the costs and benefits of inflation targeting? Should

the Fed adopt an inflation targeting monetary policy regime?

March 2007
Many economists and central bankers today would agree that
you ask a great question! Inflation targeting is a hot topic of
discussion at many central banks today.

First, what is inflation targeting?

You might be aware that the goals of monetary policy vary

across central banks. The Federal Reserve, for example, lists
its monetary policy goals as “to promote effectively the goals
of maximum employment, stable prices, and moderate long-
term interest rates”. The European Central Bank lists price
stability as its primary objective. There are also central banks
whose monetary policy centers on exchange rate stability.

A formal adoption of an inflation target is one way (although

not the only way) to achieve the goal of price stability.
The International Monetary Fund defines inflation targeting in
the following way1:
This involves the public announcement of medium-term
numerical targets for inflation with an institutional
commitment by the monetary authority to achieve these
targets. Additional key features include increased
communication with the public and the markets about the
plans and objectives of monetary policymakers and
increased accountability of the central bank for
attaining its inflation objectives. Monetary policy
decisions are guided by the deviation of forecasts of
future inflation from the announced target, with the
inflation forecast acting (implicitly or explicitly) as
the intermediate target of monetary policy.

Monetary economists often classify monetary policy as being

either “rules” or “discretion.” Rules are monetary policies that
require less macroeconomic analysis or judgments from the
monetary policy authority (think about the gold standard or the
constant-money-growth rule2). Discretionary monetary policies
allow policymakers to set monetary policy depending on their
assessment of current economic conditions. Both types of
policies have advantages and disadvantages that have been
studied by researchers and discussed by monetary
policymakers (see Meyer 2002).
 Inflation targeting is frequently classified as a “rule,” which, if
followed very strictly, could open it up to criticism (see the
discussion of the costs of inflation targeting that follows). Yet,
it is important to realize that not everyone views inflation
targeting as a strict rule. Bernanke et. al (1999) argue that
“there is no such thing in practice as an absolute rule for
monetary policy,” because every rule permits some discretion
in practice. Therefore, one might think of inflation targeting as
a framework for policy within which “constrained discretion”
can be exercised (Bernanke 2003).

So now I understand what inflation targeting is, but what

are its costs and benefits?

The fact that not all central banks that state price stability
among their goals of monetary policy have chosen an inflation
targeting framework is indicative of the fact that it is not clear
whether the benefits of inflation targeting exceed its costs.
While one obvious benefit of inflation targeting should be
lower inflation, inflation has come down worldwide (in inflation
targeting countries and other countries alike) in recent
decades.

Many benefits of inflation targeting have been proposed. Chief

among these are:

 Reduced inflation volatility (see, for example, Svensson

1997)
 Reduced inflationary impact of shocks (see, for example,
Mishkin 2004)
 Increased anchoring of inflation expectations (see Kohn
2007, Swanson 2006, Levin et. al 2004)

If inflation targeting were implemented as a very strict policy

rule (which many think it should not be) then it could have
some serious costs (Bernanke et. al 2003):

 Restricted ability of the central bank to respond to

financial crises or unforeseen events;
 Potentially poor outcomes in employment, exchange rate
and other macroeconomic variables beside inflation;
 Potential instability in the event of large supply-side
shocks;
 Lack of support from the public.

Is inflation targeting easy to implement?

The adoption of a numerical target for inflation poses many

operational questions that policymakers must address. In a
2003 speech, Dr. Bernanke, then a member of the Fed’s
Board of Governors, articulated his view that adopting an
inflation targeting framework entails “two components: 1) a
particular framework for making policy choices, and 2) a
strategy for communicating the context and rationale of these
policy choices to the broader public.”

Let’s address these one at a time.

1) Developing a framework for making policy choices

 Which measure of inflation should be targeted?

In principle, the inflation measure chosen should be broad-

based, accurate, timely, and familiar to the general public. The
inflation measure chosen should perhaps exclude price
changes in sectors that are volatile and where fluctuations are
unlikely to affect trend or “core” inflation. Also, it might be
important to assure the public that the central bank does not
manipulate inflation data (this can be done by choosing data
that is compiled by an agency that is independent of the
central bank).

 What numerical value should the target have?

Targeting an inflation rate that is too low or too high could

create problems. An inflation target that is too low might lead
to higher unemployment (Akerlof et. al 1996 suggest that an
inflation rate close to zero might increase the long-run level of
unemployment), might restrict the central bank’s ability to
support a recovery in times of recession due to the zero lower
bound on nominal interest rates (Meyer 2001), and might
increase the chances or frequency of deflation rather than
 inflation (to read about costs of deflation, please see
my February 2006 answer). Of course, no one wants to have
an inflation target that is too high either, as inflation costs can
be considerable (to read more about the costs of inflation,
please see my answer of March 2006). In practice, inflation
targets in developed economies are usually set at 1% to 3%
per year (Bernanke et. al 2003).3

 What should the time horizon be to (approximately) hit

the target?

Horizons of less than one year or greater than four years are
likely to be problematic. Monetary policy has considerable
lags, and, therefore, is likely to have difficulty affecting inflation
over such a short horizon as one year or less. On the other
hand, targets that are as distant as four years into the future
might not be viewed by the public as being very credible
(Bernanke et. al 2003). Still, there are plenty of time horizon
choices within the 1- to 4-year range.

2) A strategy for communicating guidelines of the

inflation targeting regime

You’ll see that communication is a major theme in the above

discussion of inflation targeting. Increased communication is
likely to better anchor inflation expectations if the public trusts
that the central bank will achieve its stated price stability
goals. The public will then price a more-stable expectation of
future inflation into contracts and asset prices (alternatively,
imagine if everyone expected inflation to continually rise – and
consequently priced this into contracts). In this way, anchored
inflation expectations make it easier for the central bank to
keep actual inflation stable, and deliver on its price stability
promise.

For ways in which the Fed communicates with the public , a

description of the benefits of Fed transparency, as well as
some of the limits to transparency, see my postings in June
2006 and September 2006.

For further information…

 The literature on the mechanics, costs, and benefits of
inflation targeting is rich. In addition to the references cited
below, try the “Fed in Print”, a search engine that will scour the
Fed System for research.

Also, many Federal Reserve officials have spoken publicly

about their opinion on whether the Fed should adopt an
inflation targeting regime. You can find speeches of Fed
governors on the Federal Reserve Board’s website, and you
can find speeches of Fed District presidents on each Fed
District’s website.

To see which central banks in the world are inflation targeters,

see my March 2006 posting about the different goals of central
banks around the world.

NOTE: On January 25, 2012, the Federal Open Market

Committee issued a "Statement of Longer-Term Goals and
Policy Strategy." The document expresses the FOMC's:

 Commitment to the Fed's "statutory mandate from the

Congress of promoting maximum employment, stable prices,
and moderate long-term interest rates."
 Specifies a longer-run goal for the personal consumption
expenditure price index of 2 percent.
 Provided an estimate of the longer-run normal rate of
unemployment in the 5.2 to 6.0 percent.

End Notes

1. Read more about the International Monetary Fund’s

classification of monetary policy framework and exchange rate
arrangements.

2. This is a rule associated with Milton Friedman, where the

money stock needs to grow by a fixed percentage each
period, regardless of the state of the economy.

3. To give some specific examples, the Bank of England sets

inflation target at 2%; European Central Bank aims at inflation
rates of below, but close to, 2% over the medium term; The
 Bank of Canada aims to keep inflation at the 2 per cent target,
the midpoint of the 1 to 3 per cent inflation-control target
range; Reserve Bank of New Zealand focuses on keeping
inflation between 1 and 3 percent on average over the
medium term; Reserve Bank of Australia has an inflation
target of 2-3 percent over the medium term.

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IV. Economics in Action

Inflation Targeting: Holding the Line

Central banks use interest rates to steer price increases toward a publicly
announced goal

Sarwat Jahan

In recent years, many central banks, the makers of monetary policy, have
adopted a technique called inflation targeting to control the general rise in the
price level. In this framework, a central bank estimates and makes public a
projected, or “target,” inflation rate and then attempts to steer actual inflation
toward that target, using such tools as interest rate changes. Because interest
rates and inflation rates tend to move in opposite directions, the likely actions
a central bank will take to raise or lower interest rates become more
transparent under an inflation targeting policy. Advocates of inflation targeting
think this leads to increased economic stability.

Why inflation targeting?

In general, a monetary policy framework provides a nominal anchor to the
economy. A nominal anchor is a variable policymakers can use to tie down
the price level. One nominal anchor central banks used in the past was a
currency peg—which linked the value of the domestic currency to the value of
the currency of a low-inflation country. But this approach meant that the
country’s monetary policy was essentially that of the country to which it
pegged, and it constrained the central bank’s ability to respond to such
shocks as changes in the terms of trade (the value of a country’s exports
relative to that of its imports) or changes in the real interest rate. As a result,
many countries began to adopt flexible exchange rates, which forced them to
find a new anchor.

Many central banks then began targeting the growth of money supply to
control inflation. This approach works if the central bank can control the
money supply reasonably well and if money growth is stably related to
inflation over time. Ultimately, monetary targeting had limited success
because the demand for money became unstable—often because of
innovations in the financial markets. As a result, many countries with flexible
exchange rates began to target inflation more directly, based on their
understanding of the links or “transmission mechanism” from the central
bank’s policy instruments (such as interest rates) to inflation.

How does inflation targeting work?

Inflation targeting is straightforward, at least in theory. The central bank

forecasts the future path of inflation and compares it with the target inflation
rate (the rate the government believes is appropriate for the economy). The
difference between the forecast and the target determines how much
monetary policy has to be adjusted. Some countries have chosen inflation
targets with symmetrical ranges around a midpoint, while others have
identified only a target rate or an upper limit to inflation. Most countries have
set their inflation targets in the low single digits. A major advantage of inflation
targeting is that it combines elements of both “rules” and “discretion” in
monetary policy. This “constrained discretion” framework combines two
distinct elements: a precise numerical target for inflation in the medium term
and a response to economic shocks in the short term.

Rather than focusing on achieving the target at all times, the approach has
emphasized achieving the target over the medium term—typically over a two-
to three-year horizon. This allows policy to address other objectives—such as
smoothing output—over the short term. Thus, inflation targeting provides a
rule-like framework within which the central bank has the discretion to react to
shocks. Because of inflation targeting’s medium-term focus, policymakers
need not feel compelled to do whatever it takes to meet targets on a period-
by-period basis.

What is required?
Inflation targeting requires two things. The first is a central bank able to
conduct monetary policy with some degree of independence. No central bank
can be entirely independent of government influence, but it must be free in
choosing the instruments to achieve the rate of inflation that the government
deems appropriate. Fiscal policy considerations cannot dictate monetary
policy. The second requirement is the willingness and ability of the monetary
authorities not to target other indicators, such as wages, the level of
employment, or the exchange rate.

Having satisfied these two basic requirements, a country can, in theory,

conduct a monetary policy centered on inflation targeting. In practice, the
authorities may also take certain preliminary steps:

•Establish explicit quantitative targets for inflation for a specific number of

periods ahead.

•Indicate clearly and unambiguously to the public that hitting the inflation
target takes precedence over all other objectives of monetary policy.

•Set up a model or methodology for inflation forecasting that uses a number of

indicators containing information about future inflation.

•Devise a forward-looking operating procedure through which monetary policy

instruments are adjusted (in line with the assessment of future inflation) to hit
the chosen target.

Target practitioners?

Central banks from advanced, emerging market, and developing economies

and from every continent have adopted inflation targeting (see table). Full-
fledged inflation targeters are countries that make an explicit commitment to
meet a specified inflation rate or range within a specified time frame, regularly
announce their targets to the public, and have institutional arrangements to
ensure that the central bank is accountable for meeting the target.

The first country to adopt inflation targeting was New Zealand. The only
central banks to have stopped inflation targeting once they started it are
Finland, Spain, and the Slovak Republic—in each case after they adopted the
euro as their domestic currency. Armenia, the Czech Republic, Hungary, and
Poland adopted inflation targeting while they were making the transition from
centrally planned to market economies. Several emerging market economies
adopted inflation targeting after the 1997 crisis, which forced a number of
countries to abandon fixed exchange rate pegs.

There are also a number of central banks in more advanced economies—

including the European Central Bank and the US Federal Reserve—that have
adopted many of the main elements of inflation targeting but do not officially
call themselves inflation targeters. These central banks are committed to
achieving low inflation, but some do not announce explicit numerical targets
(there are exceptions, such as the United States, which explicitly adopted an
inflation target of 2 percent in 2012) or have other objectives, such as
promoting maximum employment and moderate long-term interest rates, in
addition to stable prices.

On target?

It is difficult to distinguish between the specific impact of inflation targeting and

the general impact of more far-reaching concurrent economic reforms.
Nonetheless empirical evidence on the performance of inflation targeting is
broadly, though not totally, supportive of the effectiveness of the framework in
delivering low inflation, anchoring inflation expectations, and lowering inflation
volatility. Moreover, these gains in inflation performance were achieved with
no adverse effects on output and interest volatility.

Inflation targeters also seem to have been more resilient in turbulent

environments. Recent studies have found that in emerging market economies,
inflation targeting seems to have been more effective than alternative
monetary policy frameworks in anchoring public inflation expectations. In
some countries, notably in Latin America, the adoption of inflation targeting
was accompanied by better fiscal policies. Often, it has also been
accompanied by the enhancement of technical capacity in the central bank
and improvement of macroeconomic data. Because inflation targeting also
depends to a large extent on the interest rate channel to transmit monetary
policy, some emerging market economies also took steps to strengthen and
develop the financial sector. Thus, the monetary policy outcomes after the
adoption of inflation targeting may reflect improved broader economic, not just
monetary, policymaking.

Not a panacea

Inflation targeting has been successfully practiced in a growing number of

countries over the past 20 years, and many more countries are moving toward
this framework. Over time, inflation targeting has proved to be a flexible
framework that has been resilient in changing circumstances, including during
the recent global financial crisis. Individual countries, however, must assess
their economies to determine whether inflation targeting is appropriate for
them or if it can be tailored to suit their needs.
 SARWAT JAHAN is a senior economist in the IMF’s Asia and Pacific
Department.

References

Hammond, Gill. 2011. “State of the Art of Inflation Targeting.” Centre for

Central Banking Studies Handbook—No. 29. London: Bank of England.

Roger, Scott. 2010. “Inflation Targeting Turns 20.” Finance & Development.

March: 46–49.

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