Price-level or inflation target? Boch price-level and inflation targets imply a targeted pathfor the price level. A price-level target sets the path for the price level so that if inflation isabove che targeted rate in one period, it must be below the targeted rate in the next periodin order to hit che price-level target. By contrast, an inflation target allows for "base drift,"in which bygones are bygones, and the miss on the inflation target does not need to beoffset.Relative to an inflation target,a price-level target has the advantage of helping to pindown price-level expectations over very long time horizons, but it may increase the volatility ofthe price level over shorter time horizons.TRANSPARENCYAn important rationale for inflation targeting is that it promotes transparency in monetarypolicy. Two questions need to be answered if transparency is to be achieved.Hou shbould inflation targets be used to communicate with the public and the markets? Inflationtargets can be an effective way of increasing transparency by communicating information tothe public and the markets about the stance and intentions of monetary policy. A variety ofinstitutional arrangements, published materials, testimony,and speeches can help in thiscommunication process and can emphasize theforward-looking nature of monetary policy.In addition, clear, regular explanations of monetary policy by central banks can build publicsupportfor and understanding of the pursuit of price stability.How should central banks be beld accountable for target performance? Because monetary policy hassuch important effects on the public, inflation targeting cannot be done without democraticaccountability. The extent to which this accountability takes the form of structureddiscussion rather than policical pressure can in part be determined by target design. Whoshould set the inflation target: the government, the central bank, or both together?FLEXIBILITYAs McDonough (1996a) suggests, price stability is a means to an end-the creation of astableeconomic environment that promotes economic growthrather than an end in itself.Control over inflation that is too tight might be costly in terms of higher output variability.Thus, the design of an inflation-targeting regime must answer questions about how muchflexibility should be built inco it.Wbat deviations from the inflation target should be allowed in response to shocks? As the discussion ofthe merits of an inflation target versus a nominal income growth target suggests, a rigidinflation target may not be sufficientlyflexible in response to some shocks. Because bothpolicymakers and the public care about output fluctuations, and che ulcimate reason forprice stability is to support a healthy real economy, an inflation-targeting regime may needescape clauses or some flexibility built into the target definition to deal with supply andother types of shocks.10
Sbould the target be a point or a range? Because of shocks to the inflation process anduncertainty about the effects of monetary policy, inflation outcomes will have a high degreeof uncertainty even with the best monetary policy settings.Should an inflation target have arange to allow for chis uncertainty? Estimates of this uncertainty are quite high (see, forexample, Haldaneand Salmon [1995] and Stevens and Debelle [1995]),and so an inflationtarget band would have to be quite wide--on the order of 5 or 6 percentage points--inorder to allow for this uncertainty. However, a band this wide might cause the public andthe markets to doubt the central bank's commitment to the inflation target. An alternativeapproach is a point target, which—in order to address che uncertainties of inflationoutcomeswould be accompanied bydiscussion ofthe shocks that mightdrive inflation awayfrom thetargetgoal.Should inflation targets be varied over time? If there is substantial inertia in the wage-and price-setting process and inflation is initially very high, the monetary authorities might want toavoid a rapid transition to the price stability goal. In this case, they might well choose atransicion path of inflation targets that trends downward over time, toward the pricestability goal. Similarly, even if the price stability goal were achieved, shocks to theeconomy might move the economy away from this goal, again raising the issue of whetherthe inflation targets should be varied over time. Varying inflation targets over time maythus be used as another tool to increase the flexibility of the inflation-targeting regimeso that it can cope with supply and other types of shocks to the economy.TIMINGTwo questions arise with respect to the timing of inflation targets:What is the appropriate time borizon for an inflation target? Because monetary policy affectsinflation with long lags,monetary policy cannot achieve a specific inflation targetimmediately, but instead achieves is goal over time. Also, economic shocks can occur inthe intervening period between policy and effect. Monetary policymakers must thus decidewhat time horizon is appropriate for meeting the inflation target.Wben is the best time to start implementing inflation targets? To establish credibility for aninflation-targeting regime, it may be important to have some initial successes in achieving theinflation targets. This suggests that certain periods may be better than others to introduceinflation targets.Furthermore, obtaining political support for the commitment to pricestability underlying an inflation-targeting regime may be easier at certain times than atothers, so choosing the correct time to implement inflation targeting may be an importantelement inits success orfailure.11
CASESTUDIESWe will see that these four categories of decisions about operational design are recurringthemes in the case study discussions that follow. What is striking is the extent to which anumber of the target-adopting countries have converged on a few design choices, perhapsindicating an emerging consensus on best practices.The case studies are structured as follows, The first section outlines why and underwhat circumstances the targeting regime was adopted. The next section describes theoperational framework of the targeting regime. The third section describes the actualtargeting experience.The final section provides a brief summary of the key lessons to bedrawn from each country's experience. The case studies begin with Germany because it wasone of thefirst countries (along with Switzerland) to implement many of the features of aninflation-targeting regime, even though Germany is not an inflation targeter per se.Although Germany focuses principally on monetary aggregates as the target variables, thereis much to learn from its experience, which has been longer than that of the other countriesdiscussed here. The remaining case studies then proceed according to the order in which thecouncries adopted inflation targeting: New Zealand, then Canada, and finally the UnitedKingdom.12
Part III.German Monetary Targeting:A Precursor to Inflation TargetingMany features of the German monetary targeting regime are also key elements of inflationtargeting in the other countries examined in this study. Indeed, as pointed out in Bernankeand Mishkin (1997),Germany might best be thought of as a"hybrid" inflation targeter, inthat it has more in common with inflation targeting than with a rigid application of amonetary targeting rule. The German experience with monetary targeting, which spansmore than twenty years,provides useful lessons for the successful operation of inflationtargeting, and this is why we study the German experience here.Several themes emerge from our review of Germany's experience with monetarytargeting:.A numerical inflation goal is a key element in German monetary targeting, suggestingthat the differences between monetary targeting as actually practiced by Germany andinflation targeting as conducted by other countries are not that great.. German monetary targeting is quite flexible: convergence of the medium-terminflation goal to the long-term goal has often been quite gradual.. Under the monetary targeting regime, monetary policy has been somewhat responsivein the short run to real output growth as well as to other considerations such as theexchangerate..The long-term goal of price stability has been defined as a measured inflation rategreater than zero.. A key element of the targeting regime is a strong commitment to transparency and tocommunication of monetary policy strategy to the general public.THEADOPTIONOFMONETARYTARGETINGThe decision to adopt monetary targeting in Germany, though prompted by the breakdownof the Bretton Woods fixed exchange rate regime, was a matter of choice. Germany wasnot under any pressure at the time to reform either its economy in general or its monetaryregime in particular-in fact, the breakdown of Bretton Woods was in part due to theextreme relative credibility of the German central bank's commitment to price stability andthe concomitant appreciation of the deutsche mark. Under these circumstances, the loss ofthe exchange rate anchor was not the sort of credibility crisis where macroeconomic effectsdemanded an immediate response,as demonstrated by the slow (two-to-three-year-long)move to the new regime.Close analysis of the historical record suggests that two main factors motivated theadoption of monetary targeting in Germany. The first factor was an intellectual argumentin favor of a nominal anchor for monetary policy grounded in an underlying belief thatmonetary policy should neither accommodate inflation nor pursue medium-term output13
goals.2The second factor was the perception that medium-term inflation expectations hadto be locked in when monetary policy eased as inflation came down after the first oil shock.The generalization over time of this latter motivation-that monetary targeting providesa means of transparently and credibly communicating the relationship between currentdevelopments and medium-term goals-was the guiding principle of the newly adoptedframeworkinGermany.On December 5, 1974, the Central Bank Council of the Deutsche Bundesbankannounced that "from the present perspective it regards a growth of about 8% in the centralbank money stock over the whole of 1975 as acceptable in the light of its stability goals.3The Bundesbank considered this target to "provide the requisite scope ... for the desiredgrowth of the real economy," while at the same time the target had been chosen "insuch a way that no new inflationary strains are likely to arise as a result of monetarydevelopments." Since 1973, the Bundesbank had used the central bank money stock (CBM)as its primary indicator of monetary developments, but never before had it announced atarget for che growth of CBM or any other monetary aggregate. Although this was aunilateral announcement on the part of the Bundesbank, the announcement stressed that "informulating its target for the growth of the central bank money stock [the Bundesbank] founditself in full agreement with the federal government."Although its statements at the time do not make the point explicitly, one of theBundesbank's primary concerns appears to have been that public misperceptions mightentrench high inflation expectations.At the beginning of 1975, the Bundesbank faced thetask of continuing to ease monetary policy in view of the already apparent weakness in theeconomy,withoutgiving the impression that its resolve to bring down inflation wasdiminishing. Recent experience had shown that wage-setting behavior in particular wasmostly unaffected by the Bundesbank's efforts to reduce inflation:Wage costs have gone up steadily in the last few monchs,partly as afrer-effects of[earlier] settlements...which were excessive (not least because management andlabor obviously underestimated the prospects of success of che stabilization policy). . ..Despite the low level of business activity and subdued inflation expectations, even invery recent wage negotiations two-figure rises have effectively been agreed.(Deutsche Bundesbank 1974b, December, p. 6)The credibility issue arose, therefore, in the context of the Bundesbank's desire to stop thepass-through of a onetime shock to the price level; chis concern for getting the public todistinguish between first-round and second-round effects of a price shock and to avoidlocking in expectations of high inflation characterizes the efforts of the inflation targetersas well.From this perspective, the German monetary target seems to have been adopted, atleast in part,to create a necessary means of communication about inflation uncertainty.AfterCBMhad grown by6percent during1974,the Bundesbank announced a targetgrowthrateof8percentfor1975:14