Inflation targeting.

• Author: Bernanke, Ben

Undoubtedly the most interesting development in monetary policy in recent years is the widespread adoption by central banks of a policy framework called "inflation targeting." As the name suggests, this approach is characterized by the announcement of official inflation targets at one or more horizons, and by the explicit acknowledgment that low and stable inflation is the overriding long-term objective of monetary policy. In practice, other important features of inflation targeting include greater "transparency" of policy - that is, increased communication and clarity about the plans and objectives of monetary policymakers - and, in some cases, increased accountability of the central bank for attaining its announced objectives.

New Zealand and Canada were pioneers of the inflation targeting approach; although, as I discuss later, the monetary policy strategies of Germany and Switzerland were important precursors. Other countries that have officially adopted inflation targeting include Australia, Finland, Israel, Japan, Spain, Sweden, and the United Kingdom. Some developing countries, Chile being a leading example, use modified versions of this strategy. The United States has declined to adopt inflation targeting formally, although the focus of the Federal Reserve Board under Alan Greenspan on maintaining low inflation (including the use of pre-emptive strikes against possible future inflation) incorporates elements of this approach. Finally, the new European Central Bank is likely to adopt a modified form of inflation targeting, although political considerations (the need to demonstrate continuity with the policies of the Bundesbank) apparently will dictate that the ECB pay attention to monetary aggregates as well.

In light of the interest in and increasing application of inflation targeting, it is important to understand its potential strengths and weaknesses. My recent research has focused on the historical record of inflation targeting and the potential pitfalls for inflation targeters that are suggested by economic theory.(1)

The Bundesbank as Inflation Targeter

One barrier to empirically assessing inflation targeting is its short historical record: New Zealand, the first formal inflation targeter, adopted the approach only in 1990. In searching for relevant experiences, the student of inflation targeting is tempted to look to the post-1975 monetary policy regimes of Germany and Switzerland. Although both the Bundesbank and the Swiss National Bank refer to their approaches as "money targeting" rather than inflation targeting, there is a widespread perception that inflation targets are central to German and Swiss monetary policymaking. For example, the Bundesbank develops its money targets by starting with an inflation objective, then working backward to determine the rate of money growth that is consistent with that objective.

Ilian Mihov and I have analyzed the role of inflation targets in the Bundesbank's policymaking.(2) We ask the following question: Suppose that, after setting its money targets for the year, the Bundesbank were to observe higher money growth than the target; but because of offsetting factors, there is no accompanying change in its inflation...