NBERWORKINGPAPERSERIESINFLATIONTARGETING:LESSONSFROMFOURCOUNTRIESFrederic S. MishkinAdam S.PosenWorkingPaper6126NATIONALBUREAUOFECONOMICRESEARCH1050 Massachusetts AvenueCambridge,MA02138August1997WethankBenBernanke,DonaldBrash,KevinClinton,JohnCrow,PeterFisher,CharlesFreedman,Andrew Haldane, Neal Hatch, Otmar Issing,Mervyn King, Thomas Laubach, William McDonough,Michel Peytrignet, Georg Rich, and Erich Spoerndli for their helpful comments. We are grateful toLaura Brookins for research assistance. The views expressed in this study are those of the authorsand not necessarily those of the Federal Reserve Bank of New York, the Federal Reserve System,Columbia University, the National Bureau of Economic Research,or the Institute for InternationalEconomics. This paper is part of NBER's research programs in Economic Fluctuations and Growthand Monetary Economics,Any opinions expressed are those of the authors and not those of theNationalBureauof EconomicResearch. 1997 by Frederic S. Mishkin and Adam S. Posen. All rights reserved. Short sections of text, notto exceed two paragraphs, may be quoted without explicit permission provided that full credit,includingnotice,is given to the source
InflationTargeting:LessonsfromFourCountriesFrederic S. Mishkin and Adam S. PosenNBER Working Paper No.6126August 1997JELNo.E5Economic Fluctuations and Growthand Monetary EconomicsABSTRACTIn recent years, a number of central banks have announced numerical inflation targets as thebasis for their monetary strategies.After outlining the reasons why such strategies might be adoptedin the pursuit of price stability,this study examines the adoption, operational design, and experienceof inflation targeting as a framework for monetary policy in the first three countries to undertakesuch strategies--New Zealand, Canada, and the United Kingdom. It also analyzes the operation ofthe long-standing German monetary targeting regime, which incorporated many of the same featuresas later inflation-targeting regimes. The key challenge for all these monetary frameworks has beenthe appropriate balancing of transparency and flexibility in policymaking. The study finds that allof the targeting countries examined have maintained low rates of inflation and increased thetransparency of monetary policymaking without harming the real economy through policy rigidityin the face of economic developments. A convergence of design choices on the part of targetingcountries with regard to operational questions emerges from this comparative study, suggesting somelinesofbestpracticeforinflation-targetingframeworksFrederic S. MishkinAdam S.PosenFederal Reserve Bank of New YorkFederal Reserve Bank of New York33LibertyStreet33 Liberty StreetNewYork,NY10045New York,NY 10045and NBERaposen@iie.comfrederic.mishkin@ny.frb.org
IntroductionThe key issue facing central banks as we approach the end of the twentieth century is whatstrategy to pursue in the conduct of monetary policy. One choice of monetary strategy thathas become increasingly popular in recent years is inflation targeting, which involvesthe public announcement of medium-term numerical targets for inflation with acommicment by the monetary authorities to achieve these targets. This study examinesthe experience in the first three countries that have adopted such an inflation-targetingschemeNew Zealand, Canada, and the United Kingdom-as well as in Germany,which adopted many elements of inflation targeting even earlier.Through closeexamination of the experience with inflation targeting, both how targeting operates andhow these economies have performed since its adoption, we seek ro obrain a perspective onwhat elements of inflation targeting work as a strategy for the conduct of monetary policy.Before looking in detail at the individual experiences of these countries, we firstdiscuss the racionale for inflation targeting and the design issues that arise in implementingan inflation-targeting strategy. Then, after the case studies of the individual countries, weprovide some preliminary evidence on the effectiveness of inflation targeting in thesecountries and conclude with an assessment of the inflation-targeting experience.1
monetary policy that is more expansionary than expected.As a result,policymakers whohave a stronger interest in output than in inflation performance will try to producemonetary policy that is more expansionary than expected. However, because workers andfirms make decisions about wages and prices on the basis of cheir expectations about policy,they will recognize the policymakers' incentive for expansionary monetary policy and sowill raise their expectations of inflation. As a result, wages and prices will rise.The outcome, in these time-inconsistency models, is that policymakers are actuallyunable to fool workers and firms, so that on average output will not be higher under sucha strategy; unfortunately, however, inflation will be. The time-inconsistency problemsuggests that a central bank actively pursuing output goals may end up with a biasto high inflation with no gains in output. Consequently, even though the centralbank believes itself to be operating in an optimal manner, it ends up with a suboptimaloutcome.McCallum (1995b) points out that the time- inconsistency problem by itself doesnot imply that a central bank will pursue expansionary monetary policy that leads toinflation. Simply by recognizing the problem that forward-looking expectations in thewage- and price-setting process create for a strategy of pursuing unexpectedly expansionarymonetary policy, central banks can decide not to play that game.Nonetheless, chetime-inconsistency literature points out both why there will be pressures on central banksto pursue overly expansionary monetary policy and why central banks whose commitmentto price stability is in doubt can experience higher inflation.A fourth intellectual development challenging the use of an activist monetarypolicy to stimulate output and reduce unemployment unduly is the recognition that pricestability promotes an economic system that functions more efficiently and so raises livingstandards.If price stability does not persist-that is, inflation occursthe society suffersseveral economic costs. While these costs tend to be much larger in economies with highrates of inflation (usually defined to be inflation in excess of 30 percent a year), recent workshows that substantial costs arise even at low rates of inflation.The cost that first received the attention of economists is the so-called shoe leathercost of inflation--the cost of economizing on the use of non-interest-bearing money (seeBailey [1956]).The history of prewar central Europe makes us all too familiar with thedifficulties of requiring vast and ever-rising quantities of cash to conduct daily transactions.Unfortunately, hyperinflations have occurred in emerging market countries within che lastdecade as well. Given conventional estimates of the interest elasticity of money and thereal interest rate when inflation is zero, this cost is quite low for inflation rates less than10 percent, remaining below 0.10 percent of GDP.Only when inflation rises to above100 percent do these costs become appreciable, climbing above 1 percent of GDP (Fischer1981).Another cost of inflation related to the additional need for transactions is theoverinvestment in the financial sector induced by inflation. At the margin, opportunities tomake profits by acting as a middleman on normal transactions, rather than investing in3
productive activities, increase with instability in prices. A number of estimates put therise in the financial sector share of GDP on the order of 1 percentage point for every10 percentagepoints of inflation up to an inflation rate of 100 percent (English1996).The transfer of resources out of productive uses elsewhere in the economy can be as largeas a few percentage points of GDP and can even be seen at relatively low or moderate ratesofinflation.The difficulties caused by inflation can also extend to decisions about fucureexpenditures. Higher inflation increases uncertainty about both relative prices and thefuture price level, which makes it harder to arrive ar the appropriate production decisions.For example, in labor markets, Groshen and Schweitzer (1996) calculate that the loss ofoutput due to inflation of 10 percent (compared with a level of 2 percent) is 2 percent ofGDP.More broadly,the uncertainty about relative prices induced by inflation can distortthe entire pricing mechanism. Under inflationary conditions, the risk premia demanded onsavings and the frequency with which prices are changed increase. Inflation also alters therelative attractiveness of real versus nominal assets for investment and short-term versuslong-termcontracting.5Themost obvious costs of inflation at low to moderate levels seemto come from theinteraction of che tax system with inflation. Because tax systems are rarely indexed forinflation,an increase in inflation substantiallyraises the cost ofcapital, causing investmentto drop below ics optimal level.In addition,higher taxation, which results from inflation,causes a misallocation ofcapital to different sectors,which in turn distorts the labor supplyand leads to inappropriate corporate financing decisions.Fischer (1994) calculates that thesocial costs from the tax-related distortions of inflation amount to 2 to 3 percent of GDP atan inflation rate of 10 percent. In a recent paper, Feldstein (1997) estimates this cost to beeven higher: he calculates the cost of an inflation rate of 2 percent rather than zero to be1 percent ofGDP.The costs of inflation outlined here decrease the level of resources productivelyemployed in an economy, and thereby the base from which the economy can grow.Mounting evidence from econometric studies shows that, at high levels, inflation alsodecreases the rate of growth of economies. While time series studies of individual countriesover long periods and cross-national comparisons of growth rates are not in total agreement,the consensus is that, on average, a l percent rise in inflation can cost an economy o.1 to0.5 percentage points in its rate of growth (Fischer 1993). This result varies greatly withthe level of inflation-the effects are usually thought to be much greater at higher levels.6However, a recent study has presented evidence that the inflation variability usuallyassociated with higher inflation has a significant negative effect on growth even at lowlevels of inflation, in addition to and distinct from the direct effect of inflation icself.?The four lines of argument ouclined here lead the vast majority of central bankersand academic monetary economists to the view that price stability should be the primarylong-term goal formonetarypolicy.&Furthermore,to avoid the tendency to an inflationarybias produced by the time-inconsistency problem (or uncertainty about monetary policy4