“The IMF is not becoming a missionary for inflation targeting,” IMF Acting Managing Director Stanley Fischer assured his listeners as he opened a seminar on implementing inflation targets sponsored by the IMF Institute on March 21–22. Rather, he said, the purpose of the seminar was to discuss, in a neutral way, the merits and difficulties of inflation targeting—that is, when a country’s policymakers aim, as a goal of monetary policy, for an explicit inflation rate (for a related story, see IMF Survey, February 7, page 37). Fischer reviewed inflation targeting and mentioned a number of issues that arise when countries contemplate adopting such a framework.
Typically, high inflation is viewed as the problem. The countries that adopted inflation targeting started with a level of inflation higher than they felt was desirable. Fischer noted that these countries were generally successful in achieving their targets, as evidenced in a decline in inflation during the 1990s. The flip side of the problem is what countries should do when inflation is already low, as it is in Japan. How should a country with low inflation set the target range? Fischer noted that undershooting the target was also bad, because the monetary authorities were obliged to take steps to bring inflation back up or risk losing credibility with the public.
Other questions that arise, Fischer said, are whether the target should be a specific number or a range; what measure of inflation should be targeted—for example, the growth of the consumer price index versus a narrower price measure, or even an expectation of future inflation; and what the trade-offs are between inflation, on the one hand, and output, the exchange rate, and the current account, on the other. He also noted that although there is a trend toward implementing inflation targeting, the choice of this framework does not mean that the central bank should ignore other issues. The ultimate goal of monetary policy, Fischer said, should be the same in all countries—industrial, developing, and emerging market economies: a well-functioning, growing economy with stable prices.
The first two sessions of the seminar dealt with conceptual issues, both theoretical and empirical. In the context of a long-standing debate about whether monetary policy should be discretionary (flexible) or based on rules, Bennett McCallum analyzed several explicit rules for monetary policy. He found, for example, that whether these rules targeted the interest rate or a monetary aggregate (that is, a measure of the money supply), they would have implied a tighter monetary policy for the United States during the 1970s than was actually implemented. McCallum noted that discretion would never be eliminated from monetary policy. Nonetheless, he favored systematizing monetary policy as much as possible through rules rather than allowing policymakers complete discretion.
Lars Svensson explored how monetary policy should be conducted in countries that have already achieved price stability (low, stable inflation), which many countries succeeded in doing during the 1990s. He advocated forecast targeting (that is, targeting the central bank’s actual inflation forecast, which differs from private inflation expectations because it benefits from policy input), rather than either adhering to a simple instrument rule or targeting a monetary aggregate, as the best way to maintain price stability. In advocating discretion by policymakers, he felt that commitment to fixed rules was neither a desirable nor a practical way to maintain price stability.
For several decades, high inflation was the primary threat to monetary stability in the world, Svensson stated. Now, however, sustained low inflation has introduced a different risk—that falling prices may push countries into an economic decline. One way countries can prevent inflation rates from becoming too low is through inflation targeting, which he viewed as a form of constrained discretion. Commitment to a target is important, even when policy decisions are made with discretion, he concluded.
In the remaining sessions of the seminar, the inflation targeting experiences of Canada, New Zealand, the United Kingdom, Israel, Mexico, and Brazil were discussed by representatives from these countries’ central banks.
Canada. Charles Freedman focused his presentation on the reasons Canada adopted inflation targeting, how well the framework succeeded, and some lessons that Canada had learned. Countries that turn to inflation targeting generally share a number of characteristics, he said, including a history of high inflation, a floating exchange rate (whether voluntary or forced), and no other anchor for monetary policy. Canada fitted this description when it adopted an inflation targeting framework in February 1991, becoming only the second country in the world after New Zealand to do so.
In the mid-1970s, Canada targeted monetary aggregates, which worked until inflationary pressures emerged in the 1980s. In 1988, with a long-term goal of establishing credibility and lowering inflation, the authorities announced that monetary policy would center on price stability. Then, in February 1991, the government and the Bank of Canada together announced an inflation target of 3 percent a year, which they hoped to achieve over 22 months. The joint announcement, the choice of the consumer price index (CPI) as the measure of inflation, and the commitment to a gradual reduction all enhanced credibility and made success more likely, according to Freedman.
Canada’s experience with inflation targeting was very positive, Freedman said, and along the way, Canada learned a number of lessons:
The goal should be a well-functioning economy, not low inflation in itself.
It is a good idea to focus on an inflation forecast.
Transparency is important for the success of the inflation targeting framework.
New Zealand. New Zealand is the world’s inflation targeting veteran, having instituted this framework in 1989, David Archer said in discussing his country’s choices. He noted, first, that New Zealand adopted inflation targeting more by default than by design, as the Reserve Bank, contemplating reform, adopted the public sector’s recipe for its own reform—namely, choosing a clear, specific objective; designating the authority to manage it; and holding that authority accountable for meeting the objective. Inflation targeting, Archer said, emerged as the “least bad of the alternatives available.”
New Zealand’s version of inflation targeting has four features, Archer explained: choice of a single medium-term objective for monetary policy; emphasis on achieving the objective directly rather than indirectly through an intermediate target; an institutional structure that specifies the roles and responsibilities of the two main actors—the central bank and the government; and transparency in setting and implementing its goals.
How successful has New Zealand been in achieving price stability? Archer noted that it went from having the worst inflation record in the Organization for Economic Cooperation and Development before adopting inflation targeting to having the best.
United Kingdom. The number of countries that implement inflation targeting—primarily industrial countries—has grown to double digits over the past 10 years, evidence of how it has increased in importance as a framework for monetary policy. Andrew Haldane considered some issues related to the design of an inflation targeting regime through the lens of the United Kingdom’s experience. He recognized that no one framework can meet all countries’ needs, but suggested that all monetary regimes would benefit from the “ghostbusting” feature of the U.K. regime. This means, he explained, that countries’ monetary authorities must be proactive in setting monetary policy to offset incipient inflationary pressures—the “ghosts”—which will be invisible to the public but which the central bank must detect and exorcise by taking policy measures in good time.
Haldane addressed the institutional framework for monetary policy; target specification; dealing with lags in the transmission of monetary policy, as well as with inflation uncertainties, output objectives (in particular following supply shocks), and the exchange rate; and the transparency of monetary policy. Finally, Haldane noted that inflation targeting, because of its flexibility, transparency, and clarity, may be well suited to emerging market economies.
Israel. When Israel adopted inflation targeting in 1991–92, it started with a history of astronomical inflation—500 percent a year in the mid-1980s—but without a consensus that high inflation was bad. Therefore, Leo Leiderman said, monetary policy under inflation targeting was not fully credible. It fell to the central bank to persuade the public and politicians that inflation was bad and had to be reduced. In the time it took the central bank to establish credibility, it was obliged to take a strong, uncompromising stance in conducting monetary policy. As it gains credibility, Leiderman said, the central bank will be able to relax its conservative position and target inflation more flexibly.
Israel, like Brazil, but unlike Canada, New Zealand, and the United Kingdom, had fiscal imbalances that made inflation targeting more difficult. Another difference is that, because of Israel’s large public sector, which includes the defense industry, wage policy is very important.
Mexico. Since experiencing a currency and financial crisis in 1994–95, Mexico’s monetary policy has evolved. While it is not formally implementing inflation targeting, it is moving in that direction, according to Alejandro Werner. With the devaluation of the peso in December 1994, inflation rose, the Bank of Mexico lost credibility, and in 1995 the country adopted intermediate targets for monetary policy. Since 1996, the Bank of Mexico has had an annual inflation objective, which is decided jointly with the federal government. During the first year of this new monetary policy, Werner said, Mexico was hit by severe shocks—including huge movements in the exchange rate, increases in public sector prices, and wage negotiations that were inconsistent with the central bank’s inflation objectives.
Since 1998, Werner said, Mexico’s monetary policy has been more proactive and preventive, qualities that increase its credibility. Its goals are to lower inflation gradually and to offset inflationary shocks over time to lead to sustainable stabilization. With a more proactive monetary policy and flexible exchange rate, Werner noted, Mexico now has a wider range of options when responding to external shocks. The Bank of Mexico has adopted a medium-term objective for inflation—less than 10 percent for 2000—and so far inflation expectations have almost converged to the target.
Brazil. Brazil is a newcomer to inflation targeting, having adopted its framework in July 1999. Sérgio Werlang placed Brazil’s decision to target inflation in the context of both domestic and global uncertainties. Toward the end of 1998, Brazil began to feel the effects of the Asian financial crisis of 1997–98 and the Russian crisis of mid-1998. At the time, its fiscal deficit was sizable, and these “contagion” effects drained capital from the country. At the beginning of 1999, facing a run on its currency, Brazil abruptly abandoned its exchange rate peg and let market forces determine the value of its currency. With the regime change, the background paper explained, most of the central bank’s board of directors was replaced. Upon taking office in March 1999, the new board immediately took steps to calm the markets and proposed the adoption of inflation targeting as the new monetary policy regime.
There were institutional obstacles to surmount on the way to implementing the new regime, but on July 1, 1999, Brazil formally adopted inflation targeting. One of the hallmarks of Brazil’s new regime is the emphasis on transparency, through, among other channels, publication of the minutes of the Monetary Policy Committee. Werlang concluded that, although Brazil had met its inflation target for 1999 (8 percent), it was premature to announce the success of its inflation targeting regime.
Leo Leiderman returned to the podium to summarize the main issues that would be relevant for countries contemplating adopting inflation targeting.
The first point, he said, was the uncertainty about the staying power of such a framework. “Is it a fashion that may disappear?” he wondered. Although he declined to answer the question outright, he noted that inflation targeting was 11 years old and going strong, whereas exchange rate targeting and monetary aggregate targeting had been less successful. The main benefit of inflation targeting is that it makes monetary policy more focused than under other regimes but is not so narrowly focused that other elements cannot be incorporated.
Leiderman’s second point was that there is no clear formula for implementing inflation targeting. It is, he said, a framework rather than a rule, but he cautioned that the framework must be adapted to each country’s individual needs.
A third issue that will confront inflation targeting candidates, Leiderman said, is the “paradox of floating.” Inflation targeting can be implemented only under a flexible exchange rate regime. Paradoxically, monetary policy that is designed to reduce inflation will also reduce the degree of exchange rate flexibility by strengthening the currency.
Fourth, inflation targeting is extremely discretionary; it requires intuition, consensus, and common sense in determining the target. It involves trial and error to see how financial markets will react to central bank decisions. However, credibility is also important. Thus, the bias must be toward conservatism.
The final two points Leiderman raised were IMF conditionality and luck. Conditionality is a challenge, he said, because IMF programs and countries’ inflation targeting programs must be consistent. As for luck, he concluded that it was always necessary.
In his closing remarks, IMF Deputy Managing Director Eduardo Aninat offered some final thoughts on the status of inflation targeting in the world. He began by noting that policymakers and academics concurred that medium-term price stability—the usual goal of an inflation targeting regime—is the appropriate goal of monetary policy.
Given the success that a number of countries, primarily industrial, have achieved with such a regime over the past 11 years, he concluded that it appeared to hold promise for developing countries as well. He cautioned, however, that, although targeting inflation was a useful framework for conducting monetary policy, it was not a panacea. Ultimately, he said, maintaining sound macroeconomic fundamentals “remains the necessary condition for preserving price stability under any monetary framework”
The agenda for the conference, along with links to the papers delivered and relevant background documents, can be found on the IMF’s website at http://www.imf.org.external.pubs/ft/seminar/2000/targets/index/htm. The conference papers, unedited and in draft form, will be posted on the website as they become available.