Inflation targeting: From “constrained discretion” to singularity

Abstract

In recent years, inflation targeting has become a staple of international monetary policy. The paper considers different challenges this monetary policy regime faces with regard to suppressed inflation, attaining the zero lower bound on the policy interest rates, and committing central banks to simultaneously pursue additional objectives such as financial stability. Inflation targeting has proved inefficient in raising inflation to the target zone from below, and unorthodox monetary policy tools have not proved their validity in this regard yet. As a result, monetary authorities are more inclined to discretion allowing them to compromise different aspects of “pure” inflation targeting. The value of this discretion is based on asymmetric information and boosted by additional functions assumed by central banks. However, it might bring about serious problems of dynamic inconsistency, compounded political uncertainty, and bureaucratic misconduct. Since none of the alternatives to inflation targeting currently looks fully satisfactory, it is concluded that the inflation targeting regime should be transformed to take into account the current situation, but a necessary precondition for the effectiveness of the new regime is enhanced accountability of central banks.