It is not an easy task to find many areas in economics where almost full agreement has emerged in the last few years. However, there is today a widespread and growing consensus that the single most important goal of monetary policy should be the pursuit of price stability. Reflecting this recognition, an increasing number of central banks have been granted independence and charged with the exclusive objective of controlling inflation and preserving the stability of prices. But embracing price stability as the explicit primary goal for monetary policy does not preclude the adoption of different operating mechanisms, and the choice of monetary regime that will best serve the objective of price stability has, indeed, generated much debate.
The recent currency and financial crises in emerging markets have reignited the debate on viable exchange rate regimes for small, open economies. One common element in all of these crises was the adherence to a predetermined exchange rate. Thus, several analysts have concluded that only under very specific and demanding conditions might there be a comfortable middle ground between a floating exchange rate and the adoption of a common currency. In Latin America this polarization in the choice of exchange rate regimes is clearly represented by the different paths taken by Argentina and Mexico. After more than four years of experience with a floating exchange rate regime, Mexico provides an interesting case study for other emerging economies considering moving toward a more flexible exchange rate regime.
Since the 1980s there has been a growing consensus worldwide on the importance of price stability as the overriding long-term objective for monetary policy. This consensus stems in part from the fact that monetary policy can produce effects in the real economy only in the short run. Expansionary monetary policy may lead to higher levels of employment and economic activity, but only until businesses and workers start to react, adjusting their price and wage expectations accordingly. Thereafter the only result is higher inflation, with no output gains. More recently, empirical evidence has shown a negative correlation between high inflation and economic growth, suggesting that the best goal for monetary policy is to promote price stability.
Inflation targeting has emerged in recent years as the leading framework within which monetary policy is conducted around the world. In the United States, the Federal Reserve does not have an explicit inflation target, but it is fair to say that the Fed today, as never before in its history, is committed to maintaining low inflation. Likewise, the Bank of Japan is committed to maintaining stable prices, and the new Eurosystem has adopted an explicit target band for inflation in response to the price stability mandate in the Maastricht Treaty. Central banks in countries such as Australia, Canada, Israel, New Zealand, Sweden, and the United Kingdom today employ inflation targets.
The Reserve Bank of New Zealand Act of 1989, which established the independence of the Reserve Bank of New Zealand (RBNZ, New Zealand’s central bank) and set the single objective of price stability for the country’s monetary policy, came into force in 1990. The first Policy Targets Agreement (PTA) specifically defining the inflation target was signed in March of that year. However, in New Zealand the adoption of the concept and practice of inflation targeting, in the sense of an announced, numerical target, is dated from April 1988. Indeed, several years before that, in the middle of 1984, the government had made it clear that the achievement of low inflation was a key objective of its economic policy agenda.
An inflation target can serve as a nominal anchor, aiming at coordinating inflation expectations. As a nominal anchor, an inflation target also provides a commitment mechanism that increases the accountability of the monetary policy authority. The inflation target communicates to the public the inflation rate at which the central bank will aim in the future. It thus serves as a reference point against which the central bank can be judged.
Implementing an inflation targeting regime requires a clear understanding of the monetary policy transmission mechanism and methods of projecting inflation that are consistent with that understanding. This chapter deals with these two aspects of inflation targeting as they apply to the Canadian economy and the Bank of Canada’s monetary policy.
Inflation targeting has been adopted as the framework for monetary policy in a number of countries, including Australia, over the past decade. The adoption of a framework that focuses explicitly on inflation reflects the growing realization that the major contribution that monetary policy can make to economic growth and welfare in the long run is the maintenance of a low and stable inflation rate. Empirical evidence confirms the detrimental effects of higher inflation on economic growth.
When it adopted inflation targeting in September 1992, the United Kingdom had involuntarily exited from its fixed exchange rate regime and had experienced a sharp currency depreciation as a result. The macroeconomic background was one of high and rising inflation expectations but a contracting real economy. The initial conditions for inflation targeting were not, therefore, particularly propitious.
Inflation targeting is the new kid on the block of monetary regimes.2 Since the early 1990s, seven industrial countries and a few emerging economies, Chile among them, have adopted inflation targeting as the cornerstone of their monetary policy. This chapter reviews the conduct of monetary policy in Chile and the role of inflation targeting in the country’s gradual convergence toward price stability.3