Explicit Inflation Targeting Research Articles

Beyond bipolar: A three‐dimensional assessment of monetary frameworks

AbstractA great deal of attention has been focused recently on the impact of exchange rate regimes, just as previous empirical research examined central bank autonomy and announced targets for domestic monetary policy. To date, however, these three elements of monetary frameworks have been assessed in isolation from one another, and all have been viewed in terms of a unidimensional spectrum of fixity versus flexibility. Using a newly constructed dataset, this paper jointly analyses and compares all three elements' effects on inflation and exchange rate behaviour. The results show that each of the three elements has independent and distinct effects on nominal outcomes. Key findings include: (1) although hard pegs do tend to reduce inflation and attenuate exchange rate fluctuations within some range, they are clearly characterized by large devaluations; (2) central bank autonomy is associated with a more stable exchange rate and lower inflation; and (3) explicit inflation targeting reduces both inflation and its persistence, consistent with the view that inflation targeting increases flexibility through transparency. These results raise the possibility that a combination of central bank autonomy, inflation targeting, and a free float might offer the same benefits as any intermediate exchange rate regime on its own, without the proclivity to occasional large depreciations. Copyright © 2001 Institute for International Economics and Federal Reserve Bank of New York.

Interest Rate Feedback Rules in an Open Economy with Forward Looking Inflation

With the adoption of an explicit inflation target in the UK, there has been renewed interest in the properties of alternative interest rate feedback rules. Following Svensson (1999) a literature examining the relative merits of inflation and price level targeting has also developed. In this paper we compare the stabilization properties of the two forms of feedback rule that have been used most frequently in the literature and which give rise to price level and inflation targeting, respectively. The model in which we embed our rules is significantly richer than those considered in the price level targeting literature and this allows us to explain why the relative performance of the rules is dependent upon the nature of the shock considered and whether or not excess inflation is defined in terms of consumer or output price inflation.

What is the optimal rate of disinflation to be targeted in the czech economy?

What is the optimal rate of disinflation to be targeted during transition? This question has attracted more attention under the inflation-targeting regime than under other monetary strategies, because explicit inflation targets are used to anchor expectations. These targets signal what rate of disinflation is targeted by policymakers. Deciding what level of disinflation is least costly in terms of the volatility of important economic variables is not straightforward, since costs depend on monetary transmission in a given economy. In this paper, a small, aggregate, forward-looking model of Czech monetary transmission is used to compare the consequences of different disinflation strategies that are approximated with alternative policy rules. Our results suggest that trajectories with a more linear tendency are superior to trajectories that postpone disinflation or reduce inflation suddenly.

Inflation Targeting in the Context of Imf-Supported Adjustment Programs

This paper argues that the IMF's traditional monetary conditionality - a ceiling on net domestic assets of the central bank and a floor on its net international reserves - should be adapted in IMF-supported adjustment programs with countries which have a framework of explicit inflation targets for the implementation of monetary policy. This adaptation should aim at enhancing correspondence and consistency between the monetary objectives of the central bank and the targets established under the IMF-supported adjustment program, as well as between the different instruments used to achieve the policy objectives and targets. The paper reviews various general options in this regard, and, using the case of Brazil as an example, demonstrates how these options may be implemented in practice.

Inflation Targeting in the Context of IMF-Supported Adjustment Programs

This paper argues that the IMF's traditional monetary conditionality-a ceiling on net domestic assets of the central bank and a floor on its net international reserves-should be adapted in IMF-supported adjustment programs with countries which have a framework of explicit inflation targets for the implementation of monetary policy. This adaptation should aim at enhancing correspondence and consistency between the monetary objectives of the central bank and the targets established under the IMF-supported adjustment program, as well as between the different instruments used to achieve the policy objectives and targets. The paper reviews various general options in this regard, and, using the case of Brazil as an example, demonstrates how these options may be implemented in practice.

Sacrifice Ratios and Monetary Policy Credibility: Do Smaller Budget Deficits, Inflation-Indexed Debt, and Inflation Targets Lower Disinflation Costs?

A growing empirical literature addresses the determinants of the sacrifice ratio, an imperfect measure of the tradeoff between inflation and aggregate output. This study endeavors to advance previous studies in three ways. First, the literature does not satisfactorily examine key fiscal and monetary policy practices that arguably affect policymaking credibility. These include the stock (and flow) of government debt, the issuance of inflation-indexed bonds, and the existence of explicit inflation targets. Second, previous studies unfortunately exclude non-OECD countries. Third, the literature is divided with respect to research design, and therefore this study produces sensitivity analyses of previous results. Given these addenda, the results generally suggest that credibility proxies are largely sensitive to research design. However, some data do support the hypothesis that governments with an incentive, rather than perhaps a publicized objective, to lower inflation achieve lower sacrifice ratios.

Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts

Inflation target regimes (like those of Canada, Finland, New Zealand, Sweden and the United Kingdom) are interpreted as having explicit inflation targets and implicit output/unemployment targets. Without output/unemployment persistence, delegation of monetary policy to a discretionary instrument-independent central bank with an optimal inflation target can eliminate the discretionary inflation bias, mimic the optimal linear inflation contract suggested by Walsh and extended by Persson and Tabellini, and achieve the equilibrium corresponding to an optimal rule with commitment. Thus an `inflation target-conservative' central bank with an inflation target equal to the socially-best inflation rate less any inflation bias dominates a Rogoff `weight-conservative' central bank with increased weight on inflation stabilization, which suboptimally increases output/unemployment variability. With ouput/unemployment persistence a constant inflation target is equivalent to a constant linear inflation contract. They can both eliminate the average inflation bias but not the state-contingent part of the inflation bias. Inflation variability is too high, and output variability too low, compared to the equilibrium corresponding to an optimal rule. An optimal state-contingent inflation target can remove all inflation bias, but in contrast to an optimal state-contingent linear inflation contract it still leaves inflation variability too high. Delegation with an optimal state-contingent inflation target to a Rogoff `weight-conservative' central bank can then achieve the equilibrium corresponding to an optimal rule. Inflation targets may on average be exceeded, and they may have imperfect credibility. Nevertheless they may usefully reduce inflation, and they appear much easier to implement than linear inflation contracts.

The European Union Harmonised Indices of Consumer Prices (HICP)

The European Union’s Harmonised Indices of Consumer Prices (HICPs) were developed as a response to the need for comparable CPIs to measure the convergence of inflation of EU Member States as a criterion for entry to the Monetary Union. They are now used mainly as a tool for monitoring price stability in the Monetary Union. Many Eastern European countries and Cyprus are developing HICPs in readiness for accession to EU membership. The paper describes the main features of HICPs and the plans for further development. 1. Background to the HICPs The first of January 1999 was a historic date in the process of European economic integration. Stage III of Economic and Monetary Union began with 11 countries participating in the single currency. From that date, there is a single interest rate applied in the euro-zone, fixed by the European Central Bank (ECB). Mr. Wim Duisenberg, the President of the ECB, announced in October 19981 that it would be operating a flexible monetary policy strategy, based on an explicit inflation target, a monetary reference value, and a mix of other indicators. In addition, Mr. Duisenberg said that as required by the Treaty the maintenance of price stability would be the primary objective of the European System of Central Banks (ESCB). He went on to say that: “price stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%”. This paper describes the essential aspects of the HICPs, and the work that remains to be done, including the preparations for the next enlargement of the EU. At the time when the Maastricht Treaty2 was written, each EU Member State used to compile its own CPI, which had developed according to the perceived needs of each country – often with the principal objective of having an index which could be used to uprate the wages of workers in order to preserve their purchasing power (a “compensation” index). The result was that a simple com1 See text distributed at ECB Press Conference, Frankfurt, 13.10.98. 2 Treaty on European Union (Office for Official Publications of the EC, Luxembourg, 1992).

Who targets inflation explicitly?

Several countries have recently adopted explicit inflation targeting (EIT). This paper applies probit analysis on data for 22 countries to show that the degree of central bank independence is positively correlated with the probability that inflation targeting is adopted. There is also evidence (depending on whether Iceland and Norway are included in the sample) that the probability that EIT is introduced is influenced by membership in the European Union, the commodity concentration and composition of exports (which are correlated with measures of the importance of supply and external shocks), and the degree of openness.

Incentive Schemes for Central Bankers Under Uncertainty: Inflation Targets versus Contracts

The implications of uncertain policy preferences for the targeting and contracting approaches to monetary policy are investigated. It is shown that, in the presence of uncertain preferences, a linear incentive contract in the sense of Walsh performs better than an explicit inflation target as proposed by Svensson. The reason is that an inflation target produces a higher variance of inflation. It is also shown that it is optimal to offer a linear inflation contract that does not depend on the degree of preference uncertainty.

Sacrifice Ratios and the Conduct of Monetary Policy in Conditions of Low Inflation

The focus of monetary policy has shifted markedly over the past 15 years away from attempts to fine tune the economy towards the longer-run goal of attaining price stability and creating the necessary conditions for sustainable economic growth. In an attempt to minimise the costs of such a transition, central banks have become more independent and monetary policy more transparent, changes intended to increase the credibility of monetary policy and to reduce short-run sacrifice ratios. However, concerns have been expressed that an environment of price stability and independent central banks may instead lead to higher sacrifice ratios and, perhaps, even higher rates of structural unemployment, because of the increased importance of nominal and real rigidities at low rates of inflation. The purpose of this paper is to analyse whether there are any grounds for such concerns. We do so by estimating sacrifice ratios for 19 industrialised countries, using three alternative approaches: (1) estimating aggregate supply curves; (2) estimating structural price and wage equations; and (3) comparing actual changes in inflation with changes in standard measures of output and labour market slack. The empirical evidence shows that, as the average rate of inflation for the 19 countries in our sample has fallen from 8% to 3½%, the average sacrifice ratio has increased from around 1.5 to about 2.5. Although sacrifice ratios appear to have risen in virtually all countries, the increases tend to be smallest in those that have adopted measures to deregulate labour and product markets and in countries where the central bank has adopted explicit inflation targets. However, the empirical evidence also reveals that point estimates of the sacrifice ratios for individual countries are quite sensitive to the econometric method adopted. This last result suggests that identification of the sources of higher sacrifice ratios remains elusive and thus that one should be cautious about drawing strong implications for monetary policy from these kinds of estimates.

The Relative Merits and Implications of Inflation Targeting for South Africa

This paper describes the main elements of inflation targeting, reviews its pros and cons, and examines the experiences thus far in countries using this framework. It discusses the implications and relative merits of such a framework for South Africa, and concludes that it would be feasible and desirable for South Africa to adopt explicit inflation targeting. Doing so could reduce uncertainties about the Reserve Bank’s objectives and enhance the transparency of monetary policy. However, further experience with the operational aspects of the repurchase system and a refinement of the inflation forecasting framework may be needed before inflation targeting is implemented.

The Inflation Target and the Structure of Labour Markets: Implications for Common Monetary Policy

Both the optimal inflation target and the optimal degree of output stabilization are found to be conditional on the prevailing wage bargaining structure. If monopolistic wage setters act as strategic leaders of the monetary policy game, an explicit inflation targeting regime removes inflation bias from monetary policy, but does not remove the trade-off related to average level of output and output stabilization. In contrast to usual results on inflation targeting, appointing a central banker who is more conservative than the government leads to welfare gains for society. If centralization within the national labor markets increases in the common monetary policy area, the monetary policy game with regard to the European Central Bank might be conducted under the strategic leadership of trade union confederations. This leads to a Pareto loss.

Résultats empiriques multi-pays relatifs à l'impact des cibles d'inflation sur la crédibilité de la politique monétaire

In this article, we discuss the recent literature analyzing the experience of countries having adopted inflation targets and provide some simple statistical tests for determining the link between the adoption of inflation targets and the credibility of monetary policy. The literature survey and empirical results lead us to conclude that certain statistical properties of inflation may have changed in recent years, and that monetary policy seems to have become more credible in a number of countries, including Canada. Yet the available data do not allow us to conclude with any certainty that explicit inflation targets have played a significant role in these changes.

The Canadian Experience with Targets for Inflation Control

L’auteur commente l’experience vecue par le Canada dans la poursuite de cibles pour la maitrise de l’inflation au cours des annees 1990. Dans un premier temps, il dresse un sommaire de l’evolution des cibles en matiere d’inflation par rapport a d’autres approches qui s’offrent aux responsables de la politique monetaire. Par la suite, il souligne les principaux avantages que presentent des cibles explicites pour la maitrise de l’inflation — lesquels vont bien au-dela des avantages reconnus d’un bas taux d’inflation. Parmi ceux-ci, la transparence accrue et l’amelioration de l’obligation de rendre compte de sa gestion ainsi que l’amelioration du processus de prise de decision a la Banque sont plus particulierement mis en lumiere. L’auteur avance egalement que les cibles peuvent s’averer utiles lorsqu’il faut affronter les chocs de demande ou d’offre, car elles permettent de reduire les fluctuations destabilisatrices. Les principales critiques a l’encontre de cibles d’inflation etablies a un bas niveau (qui concernent la rigidite des salaires, l’impossibilite d’avoir des taux d’interet negatifs et les craintes de deflation) sont egalement analysees. Quoiqu’il soit trop tot pour tirer des conclusions definitives, l’auteur considere que la poursuite de cibles en matiere d’inflation favorise la prise de decisions plus judicieuses dans la conduite de la politique economique, une meilleure tenue de l’economie a long terme, et un renforcement de l’obligation de rendre compte pour les banques centrales independantes. This article reflects on Canada’s experience with inflation targeting in the 1990s. The discussion opens with a synopsis of the evolution of inflation targets against a backdrop of other monetary policy approaches. The author then proceeds to outline the main advantages of explicit inflation targets — advantages that go beyond the wellknown benefits of low inflation. Increased transparency and accountability, and an imp rovement in the Bank’s internal decision making, are highlighted in particular. It is also argued that inflation targets provide a useful mechanism for dealing with demand and supply shocks in a way that reduces disruptive fluctuations. The major criticisms of targeting low rates of inflation (related to wage rigidity, a zero floor on nominal interest rates, and concerns about deflation) are also examined. Although it is too early for definitive conclusions, the author’s view is that inflation targets lead to better policy decisions, better economic performance over time, and greater

Monetary policy under EMU

This paper considers a number of issues connected with the implementation of monetary policy in the Euro zone. These include: the techniques of monetary control; whether to adopt an explicit inflation target and, if so, for what index; the politics of decision-making within the Governing Council of the European System of Central Banks; the likelihood of there being conflicts of interest between the member countries of the Euro zone; the interaction of monetary and fiscal policy; and the role of the ESCB in maintaining financial stability. Copyright 1998 by Oxford University Press.

The Bank of Canada's Monetary Policy Framework: Have Recent Changes Enhanced Central Bank Credibility?

In recent years the Bank of Canada has made important changes in the way it conducts monetary policy. In particular, the bank has adopted explicit inflation targets and introduced significant changes to its operational framework designed to increase transparency and reduce market uncertainty. This paper examines the key issues associated with the recent changes in the Bank of Canada’s monetary policy framework and analyzes various indicators of central bank credibility.

Are Federal Funds Rate Changes Consistent with Price Stability? Results from an Indicator Model

Several important central banks around the world have recently announced explicit inflation targets and have codified price stability as their overriding long-term objective. Some observers have urged the Federal Reserve to adopt similar inflation targets. But has recent Federal Reserve policy been markedly different from policies guided by inflation.

The Unending Search for Monetary Salvation

This paper discusses some recently popular strategies for improving the performance of monetary policy, including increasing the independence of the central bank, setting explicit inflation targets, and fixing the exchange rate. With respect to central bank independence, the most important conclusion is that a central bank should have instrument independence (the freedom to set its instruments as it chooses) but not goal independence (the freedom to set its ultimate objectives); this arrangement makes the central bank accountable, which is necessary both for the central banker to have proper incentives and for democratic oversight. The need for accountability is also a reason to set explicit inflation targets; inflation targeting does not necessarily imply greater output variability, if the target inflation rate is adjusted for supply shocks. Fixing the exchange rate-even temporarily-may help reduce inflation and inflationary expectations, particularly in an economy starting from a situation of low central bank credibility.

The Unending Search for Monetary Salvation

This paper discusses some recently popular strategies for improving the performance of monetary policy, including increasing the independence of the central bank, setting explicit inflation targets, and fixing the exchange rate. With respect to central bank independence, the most important conclusion is that a central bank should have instrument independence (the freedom to set its instruments as it chooses) but not goal independence (the freedom to set its ultimate objectives); this arrangement makes the central bank accountable, which is necessary both for the central banker to have proper incentives and for democratic oversight. The need for accountability is also a reason to set explicit inflation targets; inflation targeting does not necessarily imply greater output variability, if the target inflation rate is adjusted for supply shocks. Fixing the exchange rate-even temporarily-may help reduce inflation and inflationary expectations, particularly in an economy starting from a situation of low central bank credibility.