Central banks and inflation targeting in perspective

Abstract

Beginning over a decade ago, a number of central banks have adopted the technique of “inflation targeting” in an effort to improve their performance. Under this approach, an agreement between a nation’s government and its central bank commits the latter to achieve a quantitative inflation target by a certain date. Typically, the target is specified as a low – but positive – rate of inflation. In 1990, New Zealand became the first industrialized country to institute a formula regime of inflation targeting. Next in line were Canada (1991), the United Kingdom and Israel (1992), and Australia and Sweden (1993). Switzerland took the step in 1999. Finland and Spain adopted inflation targeting prior to joining the European Monetary Union. The European Central Bank – while not describing its basic mode of operation as inflation targeting – behaves as though this were the case. The U.S. Federal Reserve has debated inflation targeting but has refrained from adopting it. Instead, it boasts that it has achieved its noticeable success through relying on its traditional instruments. This article provides an over-view of papers on inflation targeting in New Zealand, Canada, and Chile, and summarizes the discussion in the United States. In New Zealand, inflation was brought down sharply, and the approach created an expectations environment that made the policy credible. In Canada, the decline in actual inflation was also striking, and expectations of forecasters, businesses, and organized labor soon began to decrease in parallel with the target. Inflation targeting in Chile (dating back to 1990), cut the rate of inflation markedly and strengthened the credibility of monetary policy.