or to special circumstances indicating a role for other intermediate variables, it ceases to serveas a target rather than solely as an indicator.Strictly defined, the use of a money growth target means that the central bank notonly treats all unexpected fluctuations in money as informative in just this sense, butalso, as a quantitative matter, changes its instrument variable in such a way as torestore moneygrowth to the originally designated path.(Friedman and Kuttner1996, p.94)The acceleration in late 1991 notwithstanding, M3 grew by 5.2 percent during 1991, closeto the midpoint of the original target and just slightly above the revised target.On December 20, 1991, the Bundesbank raised the lombard and discount rates byanother 0.5 percent, to 9.75 percent and 8 percent, respectively, their highest levels sinceWorld War II (if the special lombard rates from the early 1970s are disregarded).In the light of the sharp monetary expansion, it was essential to preventpermanently higher inflation expectations from arising on account of the adoptedwage and fiscal policy stance and the faster pace of inflation--expectations whichwould have become ever more difficult and costly to restrain. (Deutsche Bundesbank1992a,p.43)The rhetoric invoked here by the Bundesbank is important to appreciate. Bothgovernment policies and union wagedemands could be (and were)cited for theirinflationary effects, that is, their pursuit of transfers beyond available resources. TheBundesbank may not have been able to override Chancellor Helmut Kohl's desiredexchange rate of ostmatks for deutsche marks, or his "solidarity"transfers, but theBundesbank Direktorium was comfortable in making it clear that the Kohl governmentand not the Bundesbank Direktorium should be held accountable for the inflationarypressures; the Bundesbank Direktorium took accountability for limiting the second-roundeffects of these pressures.In addition to this division of accountability, the Bundesbank also clearly expressedsome concern about the persistence of inflationary expectations and (if necessary) the cost oflowering them, thereby making clear its recognition of the substantial costs of disinflationeven for a credible central bank. Finally, the Bundesbank's emphasis on the ultimate goalmedium-term price stability and inflation expectations-did not lead it to cite measures ofprivate sector expectations directlysomething,as we will see,many inflation targetersbegan doing at this time.The December 20 increase in the lombard rate proved to be the last. During thefirst half of 1992, the repo rate slowly approached the lombard rate and peaked in August at9.7 percent before starting to fall from late August onward, as the Bundesbank started toease monetary policy in response to the appreciation of the deutsche mark and emergingtensions in the European Monetary System; of course, the decision to ease also coincidedwith the rapid slowdown in German GDP growth.The monetary targets for 1992 and25
1993 would not be met, but the challenge to German monetary policy from reunificationwas over.Thus in 1992, for example, when the money stock overshot the target by a largemargin, the Bundesbank made it clear by the interest rate policy measures itadopted, that it took this sharp monetary expansion seriously. The fact that, for anumber of reasons, it still failed in the end to meet the target ... has thereforeultimately had little impact on the Bundesbank's credibility and its strategy. (Issing1995b)Monetarypolicy transparencywas explicitly linked toflexibilityduring reunification,atleast according to Bundesbank Chief Economist Otmar Issing, and that flexibility wasexercised to minimize the real economic and political effects of maintaining long-term pricestability.Over the past five years or so, however, M3 has continued to prove itself aproblematic intermediate target, even after reunification.The Bundesbank's ownexplanations for the sizable fluctuations in annualized M3 growth since 1992 (Chart 3,p.98) suggest that demand for M3 behaves more and more like that for a financial assetrather than that for a medium of exchange. While the Bundesbank, in justifying deviationsfrom the M3 targets, has begun giving greater prominence to reports on "extended moneystock M3,a still broader aggregate that includes some recently growing forms of moneymarket accounts, it has given no signs of readiness to switch target aggregates again (seeDeutsche Bundesbank [1995b, July, p. 28].The Bundesbank has repeatedly described itself as"fortunate"because financialrelationships have been more stable in Germany than in other major economies that havetried monetary aggregate targeting. It has attributed this successful experience to the self-described earlier deregulation of financial markets in Germany and the lack of inflationaryor regulatory inducement for financial firms to pursue innovations. The targets continue asa structured framework by which the Bundesbank can regularly explain its monetarypolicy, even as the targets go unmet for periods of several years.14In the December 1996 Montbly Report, the Bundesbank announced that it would seta target of 5 percent annualized growth in M3 in both 1997 and 1998. This is the firsttime since Germany adopted monetary targeting in 1975 that it has announced a multiyearmonetary target. The explicit reason given for the multiyear targert is to allow Germanmonetary policy flexibility to respond to expected volatility in the currency markets in therun-up to European Monetary Union (EMU) in 1999, which would make these the lastGerman monetary targets. Clearly, domestic price stability is balanced with other goals forthe next two years and beyond, and flexibility, when viewed as publicly justifiable, isvalued. Moreover, given the lags between movements in German monetary policy and theireffects upon output and inflation, it is clear that the only variables that the Bundesbank canreasonably hope to influence significantly prior to EMU in 1999 are the evolving ExchangeRateMechanism (ERM)parities26
The target range for M3growth in 1997will be 3.5 to 6.5 percent; the target rangefor 1998 will be announced at the end of 1997,apparently in response to the differencebetween actual M3 growth in 1997 and what is needed to achieve the 5percent average.Bundesbank President Hans Tietmeyer indicated at the news conference announcing thenew targets that the rate of annualized M3 growth in 1997-98 may be computed againstthe fourth quarter of 1995 rather than of 1996, because"comparison with the last quarterof 1996 can be a distortion." In 1996, M3 growth did exceed the Bundesbank's targetrange of 4 to 7percent, with much of thedifferencebeing attributed tomovements in narrowmoney in the last quarter as private households participated in the oversubscribed purchaseof newly issued Deutsche Telecom stock.It is important to noteas well, however, that 1996inflation was at its lowest level in Germany since the adoption of monetary targets(1.4 percent growth in CPI)and that the Bundesbank cut all three of its instrument interestrates to historical nominal lowseven as M3 growth exceeded the stated target.The endgame nature of the current German monetary situation illustrates a pointthat is relevant for all inflation targeters with a fixed term for their targeting regime, apoint that has not been relevant for Germany until now. When the end of the targetingregime is tied to a specific event-such as an election or a treaty commitmentic is notclear how much discipline che target imposes as that time approaches.A central bankcould be less strict about target adherence in the early years of the period, making theclaim that it will make up for temporary overshootings later. Yet, when this later timearrives, the commitment to return the targeted variable to a level required under thetargeting regime will in effect predetermine the path of policy. The central bank is thenunable to respond to economic events as they unfold unless it abandons the target.In addition,the central bank may not behighly accountablefor its monetary policyif the targeting regime is unlikely to be kept in place. If the central bank cannot be heldaccountable, then how can its target commitment befully credible? This is not to suggest byany means that the Bundesbank will go "soft" on inflation in the run-up to EMU, but ratherthat it is best if target time horizons can be credibly extended before their expiration. Aswe will see in the case studies for both Canada and the United Kingdom, there was a needto reassure the public that targets would be maintained past election dates (and changesofpolitical power).KEYLESSONSFROMGERMANY'SEXPERIENCEGermany's twenty years of experience with monetary targeting suggests two mainlessons that are applicable to any targeting regime in which an inflation goal plays aprominent role.First, a targeting regime can be quite successful in restraining inflationeven when the regime is flexible, allowing both significant overshootings andundershootings of the target in response to other short-run considerations. Indeed, Germanmonetary targeting,although successful in keeping inflation low,must be seen as a significantdeparture from a rigid policy rule in which substantial target misses would not be tolerated.27
Second, a key element of a successful targeting regime is a strong commitment totransparency. The target not only increases transparency by itself, but also serves as avehicleto communicate often and clearlywith thepublicand to promoteanunderstanding of what the central bank is trying to achieve. We shall see that these keyelements of a successful targeting regime--flexibility and transparencyhave been presentnot only in the German case, but also in successful inflation-targeting regimes in othercountries.28
Part IV.New ZealandNew Zealand was the first country to adopt formal inflation targeting.In discussing itsexperience, we stress the following design choices and themes:. Inflation targeting in New Zealand followed legislation that mandated a Policy TargetsAgreement (PTA) between the elected government and the newly independentcentral bank, which resulted in a jointly decided numerical target for inflation.. Inflation targeting was adopted only after a successful disinflation had largely takenplace,? Rather than using the headline consumer price index (CPI), the central bank uses acore-type price index to construct the inflation target variable; the variableexcludes not only energy and commodity prices, but also, in particular, the effectsof consumer interest rates as well as other prices on an ad hoc basis..The same entity that is accountable for achieving the inflation target, the Reserve Bankof New Zealand, also defines and measures the target variable when"significant" first-round impacts from terms-of-trade movements, government charges, and indirecttaxes arise. The ultimate long-run target variable of CPI inflation, however, iscompiled by a separate agency, Statistics New Zealand. Although New Zealand's inflation-targeting regime is the most rigid of the inflation-targeting regimes discussed in this study, it still allows for considerable flexibility: asin Germany, the central bank responds to developments in variables other thaninflation, such as real output growth.. Accountability of the central bank is a key feature of the inflation-targeting regime;the Governor of the central bank is subject to possible dismissal by the government ifthe target is breached.. The inflation target is stated as a range, rather than as a point target-with themidpoint of this range above zero---again suggesting, as in the German case, that thelong-term goal of price stability is defined as a measured inflation rate above zero.. Strict adherence to the narrowness of the inflation target range and the one-year timehorizon of the target has resulted in two related problems: 1) a control problem-that is, the difficulty in keeping inflation within very narrow target rangesand 2) aninstrument instability problem-that is, wider swings in the policy instruments, interestrates, and exchange rates than might have been desirable.THE ADOPTION OF INFLATION TARGETSThe present framework for the conduct of monetary policy in New Zealand is explainedby the Reserve Bank of New Zealand Act of 1989.The Act was introduced intoParliament by the government on May 4, 1989, was passed by Parliament on December15,and took effect on February 1, 1990. It assigns to the Reserve Bank the statutory objective"toformulate and implement monetary policy directed to the economic objective of achievingand maintaining stability in the general level of prices" (Section 8)!29