Inflation Targeting in Concept

There is a tendency in some quarters to see inflation targeting as a complex solution, with the complexities arising from the perceived need for:

• a well-developed forecasting technology;

• certain specific forms of institutional structure, often including central bank independence;

• a sound and well-developed financial sector; and

• well-developed measures of inflation.

In fact, New Zealand scored rather poorly on each of those characteristics when the serious attack on inflation was first launched. Forecasting systems were not particularly sophisticated, as the existing econometric models had essentially been rendered redundant by the extensive structural reform then under way in New Zealand. The RBNZ Act was not passed until about five years after the country had embarked on the disinflationary process. New Zealand’s financial sector in the second half of the 1980s was far from sound and stable, with one significant collapse and a couple of near misses. And inflation measures were far from ideal—and in some respects they remain so.

The essence of inflation targeting seems to boil down to the following:

• Decide what level of inflation is appropriate to the economy.

• Ensure that there is political acceptance of that objective, however defined.

• Set monetary policy with the intention of meeting that inflation target and keeping inflation low thereafter.

The rest is essentially of second-order importance, albeit with plenty of scope for complication and distraction.

The New Zealand Context

The comprehensiveness of New Zealand’s policy reforms over the period since 1984 provides an important backdrop to any assessment of the effectiveness of the inflation targeting regime. Inflation targeting was not introduced in isolation. Rather, it was introduced in the midst of a process that involved substantial industry deregulation (including that of the financial sector); privatization and corporatization within the state enterprise sector; tariff and border protection reforms; sweeping tax reforms; labor market reforms; removal of industry subsidies; the complete removal of all capital controls and the subsequent free float of the exchange rate; and rigorous and comprehensive fiscal reform.¹

Many of these reforms contributed to the process of breaking down “institutionalized” inflation, as embodied in the indexation of wages and prices, a “cost plus” pricing mentality, and a crawling peg for the exchange rate. However, some reforms conspired to slow the disinflation process, such as the introduction of a goods and services tax (GST; a comprehensive consumption tax in the style of a value-added tax) and the move to “user pays” principles for many government-provided services.

Much of the public sector reform process in New Zealand drew heavily on the principal-agent model. As applied to most government agencies, this model required that the principal (that is, the government, as represented by the relevant cabinet minister) and the agent (the chief executive of the government department in question) enter into a contract specifying the “outputs” to be produced and the nature of the department’s accountabilities to the minister. The origins of inflation targeting in New Zealand flowed more or less directly from the application of that model to the central bank.

The New Zealand Framework

The key features of the New Zealand framework are as follows:²

• A single objective for monetary policy, price stability, is enshrined in law.

• The RBNZ has effective independence to implement monetary policy as it judges necessary to meet its contracted target, without limitations on the techniques it may use, except that its choices “must have regard to the efficiency and soundness of the financial system.”

• The legislation recognizes that any choices on the trade-offs between monetary policy and other economic policy objectives are the prerogative of the elected government.

• The way in which such trade-offs are made is a matter of public record and therefore transparent to the community at large.

• Operational independence is accompanied by clear accountability for all decisions on monetary policy implementation. The governor of the RBNZ is solely responsible for monetary policy outcomes in terms of the target to which he or she agreed when accepting the position.

A committee of nonexecutive directors of the RBNZ’s governing board exists whose principal function is to monitor the governor’s performance in terms of the PTA. The committee has no involvement in monetary policy decisions but is required to review those decisions and to report its views periodically to the national treasurer. The committee may recommend the dismissal of the governor should it conclude that he or she is not diligently striving to meet the target assigned in the PTA.

The Framework in Practice

The institutional framework just described has been in place now for a decade, but it has evolved considerably over those years. In part, the new developments have reflected shirting circumstances: the task of maintaining price stability is different, and in some senses more difficult, than the task of disinflating. In part, there have been shifts in the RBNZ’s thinking about key issues: in particular, its views on the relative roles of interest rates and exchange rates in monetary policy transmission have shifted. Also, the implementation structure has proved less than satisfactory at times and has been subject to change. As the implementation of inflation targeting has progressed, public acceptance of the price stability target has grown, and with that acceptance, inflation expectations appear to have become better anchored. That has allowed some latitude in policy implementation that was not available early in the process.

The international environment has changed as well: inflation pressures from abroad are not what they were a decade ago. That has an impact both on local inflation expectations and on the other external pressures that New Zealand faces. Finally, the RBNZ has learned from experience and from mistakes. No doubt, it will continue to learn from both.

The 1990 Model

As already noted, the first PTA under the RBNZ Act was signed in March 1990. At the time, the consumer price index (CPI) was running at a little over 5 percent a year (Figure 1), and the economy was in recession. The PTA formally confirmed a target of 0-2 percent for the CPI, to be achieved by the year ending December 1992. That original PTA also established a number of “caveats” or exceptions to the target. These were interpreted as providing a capacity to look through the direct impact on the CPI arising from interest rate changes, significant movements in public sector charges, shifts in the GST and local government taxes, or significant movements in export or import prices.

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New Zealand: Inflation as Measured by the Consumer Price Index, and Underlying Inflation

(In percent per year)

Source: Statistics New Zealand and Reserve Bank of New Zealand data.¹ Underlying inflation is derived from the Statistics New Zealand CPI-All Groups series, adjusted by excluding the impact of interest rates, taxes, and other significant price shocks as provided for in the RBNZ policy targets agreement at the time.

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In practice, these caveats were implemented through the preparation of a measure of underlying inflation that was “PTA consistent.” In other words, the underlying inflation measure was derived from the headline CPI measure calculated by the government statisticians, but adjusted to take account of the exceptions listed above. This underlying inflation measure became the operational target.

Although the PTA does not require it, the RBNZ opted to publish an indicative trajectory for inflation, bridging the gap between the starting point of over 5 percent and the targeted rate of less than 2 percent. Accordingly, targets of 3-5 percent were set for 1990 and 1.5-3.5 percent for 1991. A change in government in the second half of 1990 led to an amended PTA being signed, which deferred the 0-2 percent target by one year.

During the initial phases of formal inflation targeting, the RBNZ tended to emphasize the importance of not breaching the target. In its public discussion of policy and in its policy reactions, the central bank tended to treat the inflation target as “hard-edged.” Indeed, the target was sometimes described as being bounded by electric fences: approach if you must, but do not touch! The hard edges were not necessarily a conscious part of the original design of the framework. Rather, they emerged once inflation had fallen to within the target range. They came to prominence in the context of an extensive public communications program aimed at convincing New Zealanders that the central bank was indeed serious about its inflation target and intended to adhere to it over the long haul.

The RBNZ has a long history of publishing its forecasts. Continuation of that policy seemed natural in the context of the new regime with its emphasis on transparency and accountability. The new regime brought an additional publication requirement in the form of twice-yearly Monetary Policy Statements. Since forecasts were already being published every six months, this allowed the RBNZ to move to alternating quarterly publication of projections and statements. The early statements tended to concentrate on explaining and interpreting the new framework and describing the RBNZ’s policy reaction function: what indicators it was watching and how it might respond to movements in those indicators.

The 1999 Model

The PTA in effect as of this writing (May 1999) was signed in December 1997 and sets the inflation target in terms of the All Groups Consumers Price Index excluding Credit Services (CPIX), as published by Statistics New Zealand. The target is 12-monthly increases in the CPIX between zero and 3 percent. The PTA recognizes that significant temporary shocks can occur that mask the underlying trend in prices. The RBNZ is instructed to respond to such disturbances in a manner that prevents general inflationary pressures from emerging.

The PTA explicitly notes that there will be occasions when inflation out-comes deviate from the targeted range. On those occasions it requires the RBNZ to explain in its Monetary Policy Statements why such outcomes have occurred and the nature of its monetary policy response.

The edges of the target band have been softened compared with those in the original PTA. The RBNZ has moved away from any formal accounting of the various caveats embodied in its earlier underlying inflation measure. Instead, it has adopted a process of describing and accounting for, ex post, any shocks or exogenous influences on inflation and explaining how the central bank views these for the purposes of formulating policy.

In practice, as already noted, the monetary policy process revolves around a quarterly cycle centered on the production of comprehensive economic projections and their subsequent publication in the RBNZ’s quarterly statements.³ The projection process identifies, with all the usual constraints, qualifiers, and limitations, the monetary conditions that will be necessary to maintain CPIX inflation at the midpoint of the 0-3 percent target band over the next two to three years. On that basis, the RBNZ announces its official cash rate (OCR), the interest rate that is the principal instrument of policy. The OCR is reviewed formally, but without the aid of a fully developed set of projections, approximately midway between each of the quarterly statements, giving eight possible reset points for the OCR each year.

In general, when looking at the stance of policy, the RBNZ is making an assessment about likely domestic price pressures six to eight quarters ahead. Today’s policy settings are aimed at delivering an inflation rate in the middle part of the target range in that time frame. However, the RBNZ is also conscious that the starting point is uncertain. Important data series in New Zealand are slow to arrive and may be subject to revision. Thus, as much as one tries to look forward, the RBNZ knows that its attitude to current policy is likely to be heavily conditioned by emerging data on the recent past.

Lessons Learned

Bernanke and others (1999) identify a number of key operational issues that arise in the design and implementation of an inflation targeting regime. With the benefit of a decade of experience, how does the RBNZ think about some of those issues?

What Time Horizon Should Be Set?

The question of the appropriate policy horizon is essentially bound up with the nature of the chosen target and with the arrangements in place to ensure accountability. With a hard-edged target and rigorous accountability for outcomes relative to the target, the incentives facing the central bank lead it toward shorter horizons and more active manipulation of the policy instruments.

The RBNZ’s early horizons were around the one-year mark. That was broadly consistent with what the central bank felt its forecasting capacity to be. It was also consistent with the approach to implementation, which at the time put a good deal of emphasis on the direct price effects of exchange rate movements. More recently, more weight has been placed on interest rates and the indirect impact of the exchange rate on prices. It is now assumed, in the first instance and in the absence of evidence to the contrary, that shifts in the exchange rate are real rather than nominal in character and do not require an immediate interest rate response. The direct price consequences are therefore assumed to be transitory and, for that reason, best ignored. In this respect, New Zealand has moved in the direction of the Reserve Bank of Australia.

Consistent with that evolving view of the role of the exchange rate, the policy horizon was lengthened to between six and eight quarters. In doing so, the RBNZ acknowledges that the longer horizon leads directly to a greater risk that it will miss the target range more often. Work has recently been published that looks at these questions directly (Drew and Orr, 1999). The RBNZ’s stylized policy simulation work, summarized in Table 1, suggests that, with a band width of plus or minus 1.5 percent, given the RBNZ’s standard six- to eight-quarter policy horizon, the probability that inflation outcomes will be within the band is 66 percent under the least active policy rule. This probability rises to 92 percent under the most active policy rule. With all the usual qualifications that should accompany analysis of this sort, one can conclude that:

• The narrower the target range, the more active monetary policy must be.

• More activism implies more variability in interest rates, the exchange rate, and output, and (up to a point) less variability in inflation.

• Lower inflation expectations and a wider target range allow for a longer policy horizon and less active monetary policy.

Table 1.

New Zealand: Probabilities of Successful Targeting Under Different Band Widths and Policy Reactions

Source: Drew and Orr (1999).

¹The policy reaction is made more active by increasing the size of the interest rate response to a deviation from the inflation target.

Table 1.

New Zealand: Probabilities of Successful Targeting Under Different Band Widths and Policy Reactions

	Probability that inflation will lie within the band after six to eight quarters (percent)
Band width (percentage points)	Least active policy1	Less active policy	More active policy	Most active policy
± 1	50	70	64	75
± 1.5	66	82	90	92
± 2	80	93	97	98
±3	95	99	99	99

Source: Drew and Orr (1999).

¹The policy reaction is made more active by increasing the size of the interest rate response to a deviation from the inflation target.

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Table 1.

New Zealand: Probabilities of Successful Targeting Under Different Band Widths and Policy Reactions

	Probability that inflation will lie within the band after six to eight quarters (percent)
Band width (percentage points)	Least active policy1	Less active policy	More active policy	Most active policy
± 1	50	70	64	75
± 1.5	66	82	90	92
± 2	80	93	97	98
±3	95	99	99	99

Source: Drew and Orr (1999).

¹The policy reaction is made more active by increasing the size of the interest rate response to a deviation from the inflation target.

Assessing the New Zealand Experience

Inflation outcomes were consistent with the assigned target from 1991 to mid-1995, although some overshooting occurred through 1995 and 1996 before the target was adjusted. Perhaps a more relevant measure of success is New Zealand’s inflation performance relative to that in other countries (Figure 2). On that basis, one can see that New Zealand has moved from being one of the worst performers among the industrial countries with respect to inflation to somewhere clearly in the middle of the pack. In terms of the objectives set for monetary policy under the 1989 act, that can only be described as a successful performance.

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Inflation in New Zealand and Other Industrial Countries

(In percent per year)

Source: Brooke, Collins, and Smith (1998).¹ All Groups Consumer Price Index Excluding Credit Services.² Dashed lines represent 2 standard deviations above and below the average.

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Judging how much of that improved performance can be ascribed to the particular inflation targeting regime that was adopted is a much harder task. One could assign great importance to the shifts in political priorities, to the sweeping reforms that have occurred elsewhere in New Zealand’s macroeconomic and microeconomic policies, and to the shift in trading partners’ inflationary behavior. It could be argued, for instance, that the shift in political attitudes toward inflation was, ultimately, the only change that really mattered. One could also reasonably argue that the key changes came with the decisions to float the exchange rate and to commit to market financing of the government’s fiscal deficits.

To accept those arguments, however, would miss some important points. Certainly, the political will to adopt a price stability target was an essential prerequisite to any serious attack on institutionalized inflation. However, the inflation targeting regime has given that initial political commitment a degree of durability that transcends the influence of the particular set of politicians in power in 1989, when the RBNZ Act became law. Incentives were shifted from an acceptance of inflation arising from the usual time-inconsistent influences toward a more robust resistance to any future reemergence of inflationary tendencies.