Chapter 1. An Overview of Inflation-Forecast Targeting

Tobias Adrian, Douglas Laxton, and Maurice Obstfeld
Published Date:
April 2018
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Tobias Adrian, Douglas Laxton and Maurice Obstfeld 

In 1990, the Reserve Bank of New Zealand became the first central bank to announce an inflation target, followed a year later by the Bank of Canada. This was a significant step toward demystifying the objectives of monetary policy, and it signaled the start of a remarkable transition toward central bank transparency.

During the 1980s, global monetary policy objectives were diffuse, characterized by loose commitments to price stability and high employment, and central banks’ operational procedures were somewhat obscure. But by the mid-2000s, after the series of changes set in motion by New Zealand and Canada, many central banks used explicit inflation targets to govern monetary policy, informed by a structured framework of forecasting and policy analysis.

In the earliest phase, inflation-targeting central banks gave high priority to establishing the credibility of the new regime by adopting a rigid policy stance to ensure that inflation would not exceed the initial annual targets. This tough approach did succeed in bringing inflation expectations down. It soon became clear, however, that a more flexible approach that put more weight on output stability would be more effective and sustainable.1 Instead of rigidly targeting inflation from one year to the next, the key to maintaining credibility would be to react effectively and visibly to any deviation in order to return inflation to target over a medium-term horizon. Best practice would involve a flexible approach, taking account of the implications of policy actions for both output and inflation.

Swedish economist Lars Svensson (1997) developed the concept of inflation-forecast targeting, which provides a systematic way to implement the notion of flexible inflation targeting.2 Svensson points out that the central bank’s inflation forecast represents an ideal conditional intermediate target because it takes account of all available information, including the preferences of the policymakers and their views on how the economy works. Practitioners have come to view inflation-forecast targeting as an efficient and systematic way to make flexible inflation targeting operational. In the United States, the Federal Reserve gradually adopted a substantively similar approach under its dual mandate to stabilize prices and maximize employment, announcing a 2 percent inflation target in 2012. Although the Fed does not classify itself as an inflation targeter, the post-2012 regime embodies the fundamental principles of inflation-forecast targeting (Alichi and others 2015).

This book tracks the development of monetary policy over the past quarter century through the prism of the evolution of inflation-forecast targeting.

Principles and Practices

Principles and practices of inflation-forecast targeting are covered in Part II (Chapters 2–8). These chapters also describe some of the history since 1990, during which a striking consensus emerged that the main objective of monetary policy should be a low, stable rate of inflation with an explicit, fixed, long-term target rate. The actual numerical settings for this objective fall within a narrow range, with most advanced economies opting for 2 percent and others between 2 and 4 percent.

Compare this with the late 1980s, when central banks pursued multiple objectives. Many policy analysts in advanced economies argued that maintaining high levels of output and employment should be at the fore. Only New Zealand had an explicit inflation target. Two popular options for a nominal anchor were either a fixed exchange rate against a low-inflation currency or a target growth rate for one of many alternative monetary aggregates. Emerging market economies often prioritized stabilizing the exchange rate or a “managed float.”3 Yet repeated experience in the wake of asymmetric economic shocks showed that a flexible exchange rate provided a useful means of adjustment, and the evidence refuted the notion of stable and exploitable links between monetary aggregates and goal variables like inflation and output.

As described in Chapter 2, announcing a target for the inflation rate was a major step toward demystifying the objective of monetary policy and making central bank operations more transparent, which is important given that inflation levels affect everybody in a significant way. Regarding the policy instrument, generally accepted practice today in advanced economies has the central bank announce its setting for a key short-term interest rate, immediately after the monetary policy committee holds a rate-setting meeting. In some small, very open economies, the central bank may use the exchange rate as a systematic instrument to influence output and inflation (for example, Singapore).

In low-income countries that lack well-functioning financial markets, the exchange rate and monetary aggregates may conceivably be the only effective policy levers. In addition, even in economies where the normal instrument is a short-term interest rate, under exceptional circumstances, for example, at the effective lower bound of the policy interest rate, the central bank may use the exchange rate as a less conventional instrument—Svensson (2001) makes a theoretical argument for such a tactic, while the Czech National Bank provides an example of its actual use. Clarity of purpose and execution underlie the principles of inflation-forecast targeting as spelled out in Chapter 2.

Monetary policy involves managing public expectations. Chapter 3 explains how a transparent inflation-forecast-targeting framework helps policymakers manage expectations in support of an environment of steady low inflation. Establishing a firm nominal anchor under inflation targeting means ensuring that expectations for long-term inflation hold steady at the target rate, notwithstanding short-term fluctuations in the actual rate. In the earliest phase of inflation targeting, the Reserve Bank of New Zealand and the Bank of Canada put a high priority on establishing the credibility of the new regime. To this end, and in recognition of the history of inflation in these countries and considerable skepticism about the new regime, they adopted rigid policy stances to ensure that inflation would not exceed the initial annual targets.

The tough approach did indeed bring inflation expectations down over a few years, in line with the targets. However, it also started to become clear that a more flexible approach, that put more weight on output stability in the short term, would be more effective and sustainable. Given that most countries see substantial variations around the target from year to year, the key to maintaining credibility is to react effectively and visibly to any deviations in order to return inflation to the target over the medium term. Simultaneously with this realization, as noted, Svensson’s (1997) concept of inflation-forecast targeting provided a systematic way to implement the notion of flexible inflation targeting.

Of course, if policy is to return inflation to target following a disturbance, the policy instrument must have the power to influence goal variables appropriately. The effectiveness of the policy interest rate also depends on managing expectations. Households and firms borrow and lend at longer terms than the very short term of the policy rate. To affect inflation and output, a change in the policy rate must therefore shift the whole yield curve by changing expectations of future short-term rates.4 Chapter 3 summarizes the strong evidence that expectations have been better anchored in economies where monetary policy follows inflation-forecast-targeting principles.

One development that was less visible but no less essential for the conduct of policy was the establishment inside central banks of forecasting and policy analysis systems for the implementation of inflation targeting (Chapter 4). The Reserve Bank of New Zealand and the Bank of Canada soon recognized that, for inflation targeting, they needed a structure to supply the relevant economic information—forecasts, risk analyses, implications of alternative strategies, and so on—on a schedule determined by monetary policy committee decision meetings. These systems involve a team of economists with skills in macroeconomic modeling and forecasting; a core macroeconomic model; and an adequate, easily updated, macroeconomic database (Laxton, Rose, and Scott 2009). Timely, relevant forecasts and policy simulations for the deliberations of the monetary policy committee require an efficient production process, which includes adherence to a tight schedule of iterations and open communications between fore-casters and policymakers. The internal reallocation of central bank resources along these lines again represents a tremendous generational change: the maintenance of a fixed exchange rate, or of a given rate of money growth, had demanded much less in the way of updated economic information or analytical frameworks to help address policy issues.

The core macroeconomic model captures the main aspects of the complex transmission mechanism from the policy interest rate to output and inflation and takes account of a myriad of other factors that might influence these goal variables, using judgmental input from sectoral experts. An essential feature is an endogenous policy interest rate, such that following a disturbance, the interest rate systematically responds to bring inflation back to the target within a medium-term horizon. The coefficients of the policy reaction function reflect policymakers’ preferences about the short-term trade-off between inflation and output—for example, a higher weight on the current divergence of inflation from target would imply a faster return toward the target rate following a supply shock, at the cost of a sharper widening of the output gap.

Chapter 5 examines the operational control of the monetary policy instrument in both advanced and low-income countries. The framework in advanced and most emerging market economies hinges on the provision of balances for the settlement of interbank payments (that is, bank reserves), for which the central bank is the unique source. The central bank also sets the terms of provision through a “corridor” of rates on its accounts: the overnight lending rate (traditionally called the discount rate) is the ceiling of the corridor, whereas the central bank deposit rate (for excess balances) sets the floor. This corridor sets a band for the policy rate—that is, the very short-term money market rate targeted by pol-icy. Various facilities and processes—including averaging for reserve requirements and official repo operations—ensure that the actual policy rate stays close to the announced rate, which is usually the center of the band. This operational arrangement has been more complicated in the wake of the global financial crisis, however. The policy rate in many countries has been stuck for extended periods at the effective lower bound. Under this constraint, monetary policy-makers have deployed less conventional instruments to provide monetary ease, for example, quantitative easing, and setting the policy rate at the floor of the rate corridor; in addition, banks have held large balances of excess reserves at the central bank. In all circumstances, the efficacy of monetary policy can be enhanced by clear communications about how the central bank is using the policy instrument.

It goes without saying that economic performance benefits enormously from a safe and efficient financial system. Since the global financial crisis, central banks have used their public communications to raise the profile of the objective of financial stability. There is little dispute about the need for the postcrisis tightening of microprudential regulations, including increased capital requirements and stress testing for systemically important institutions. Likewise, there has been widespread support for the introduction of a macroprudential instrument—namely, cyclically variable capital requirements—to moderate excessive credit growth in the system as a whole. There is controversy, however, about the extent to which monetary policy should be used to address perceived financial imbalances. Chapter 6 argues that monetary policy should, as a rule, stick to targeting inflation, for which it has a strong comparative advantage, and that prudential policy instruments (micro and macro) should be used to deal with financial stability issues. That said, it is important that central banks continue to extend their analytical frameworks as new evidence emerges on macro-financial linkages. Many central banks around the world publish financial stability reports that feed into prudential and monetary policy decisions. Furthermore, financial conditions play an increasingly important role in the monetary policy process, because they contain powerful information about future economic conditions, particularly downside risks. In general, indices of financial conditions gauge how easily money and credit flow through the economy via financial markets by examining indicators such as borrowing costs, risk spreads, asset price volatility, exchange rates, inflation rates, and commodity prices. Chapter 7 provides a reduced-form monetary policy model with an explicit role for financial conditions in determining the conditional distribution of future GDP. The approach rationalizes why central banks need to monitor financial conditions to manage the output-inflation trade-off.

Improved communications have helped promote increased transparency (Chapter 8). Senior policymakers hold press conferences and address a variety of audiences immediately after policy decisions to explain their rationale explicitly in terms of the efficient achievement of the inflation target. Monetary Policy Reports, usually quarterly, provide more detailed justification for the central bank’s actions.5 Websites provide rapid public access to the latest information and policy statements, as well as to staff research. A key piece of information published by inflation-forecast-targeting central banks is the macroeconomic forecast on which actual decisions are based. The model-based forecast yields a coherent macroeconomic narrative linking the current and forecast settings of the interest rate instrument to the goal variables of inflation and output. Most central banks publish just a verbal, qualitative description of the forecast policy rate path. Their view is that the policy rate must be free to respond at any future monetary policy committee meeting to all possible contingencies and that they do not want to confuse the public by appearing to have a commitment of some kind toward the interest rate (Freedman and Laxton 2009). However, some leading-edge central banks release their full forecast, including the projected path of the policy rate.6 The publication of confidence bands and alternative scenarios embodying different sets of assumptions can help underline the uncertainties that attend the forecast and the conditionality of the interest rate path. In all cases, under inflation-forecast targeting, the central bank indicates to the public not simply a possible path for the future policy rate but also a sense of how this path might change in response to a variety of developments. One of the arguments put forward throughout this book is that an inflation-forecast-targeting framework seamlessly accommodates the introduction of financial conditions, as financial variables help in forecasting downside risks to GDP. More generally, financial vulnerability as monitored in financial stability reports is a key component of the macroeconomic information set. At the same time, we are not arguing for a separate financial stability objective for monetary policy, because that can create thorny communications and credibility issues for the central bank. But even central banks that implicitly place a small weight on output stabilization in their objective function will find the incorporation of financial conditions to be crucial. Indeed, financial conditions are mentioned with increasing frequency in monetary policy statements.

Country Experiences

Part III (Chapters 9–12) explores aspects of inflation-forecast targeting in four countries: Canada, the Czech Republic, India, and the United States. The very different structures and issues of these economies illustrate the adaptability of the inflation-forecast-targeting regime. The first three had a history of unstable inflation that led to unanchored, drifting expectations, and widespread skepticism greeted the initial announcements of numerical targets for inflation control. By contrast, the United States adopted an explicit numerical objective after long-term inflation expectations had become anchored at low levels.

The discussion starts, in Chapter 9, with Canada, which in 1991 was the first of these four countries to adopt inflation targeting.7 The mandate of the Bank of Canada includes objectives for stabilizing both output and inflation. Flexible inflation targeting, which takes account of the lagged effects of monetary policy on inflation and output and the short-term trade-offs between these goal variables, is squarely in line with this mandate. The economic conjuncture in the early 1990s was relatively favorable to an inflation control program: there was a recession, but not a profound economic upheaval. More fundamentally for the ongoing practice of inflation targeting, a large volume of research had established a good understanding of underlying variables, such as the real equilibrium interest rate and potential output growth, and of key relationships, such as the sensitivity of aggregate demand to interest rates in the aggregate demand function, and the short-term trade-off between output and inflation in the Phillips curve. The Bank of Canada had developed a model, QPM, well-suited for inflation targeting, with forward-looking, model-consistent expectations and an endogenous interest rate determined by a policy reaction function (Black and others 1994). Existing forecasting procedures at the Bank of Canada provided the basis of an efficient forecasting and policy analysis system. And the Bank of Canada drew on the experience of the Reserve Bank of New Zealand.

The main job of the policymakers at first was to lower long-term inflation expectations to the middle of the ultimate target range of 1–3 percent and to stabilize them there. Inflation fell somewhat more quickly than the announced targets envisaged. While this helped quickly dispel much of the skepticism, consensus long-term forecasts of inflation stabilized at 2 percent only after the 1995 federal government budget, which put the public finances on a clearly sustainable path.

Fast-forward to 2017. After a quarter-century the Canadian monetary framework has been well tested and, without question, proven sound. Inflation has varied around 2 percent; expectations of long-term inflation have been steady at that rate; and, compared to other advanced economies, output and employment have been relatively stable. Nevertheless, increased transparency about the future path of the policy rate—a step that can be called conventional forward guidance—would increase the effectiveness of monetary policy. Conventional forward guidance would involve routine publication of the forecast path of the policy rate and other relevant macroeconomic variables (for example, output gap and inflation) following the central bank’s policy decision meetings.

A risk-avoidance strategy seems best for Canada to keep the economy well away from bad equilibriums. These would involve destabilized expectations—for example, high and variable inflation or deflation. Technically, within a model, such a strategy is represented by loss-minimizing monetary policy with a quadratic loss function that puts an increasingly heavy penalty on deviations from the inflation target and from potential output. This implies strong, prompt policy actions whenever a shock threatens to put the economy into a dark corner. Noting that the Canadian public-sector balance sheet remains quite strong, fiscal stimulus is recommended in the event of a major negative demand shock when the policy interest rate is close to the effective lower bound. More generally, the argument is that coherent and coordinated deployment of all the main policy instruments is more likely to generate self-fulfilling expectations of a good outcome than the use of monetary policy alone.

In the Czech Republic of the 1990s, matters were more difficult by orders of magnitude (Chapter 10). The economy was in the middle of a transformation from a state-run to a market-based system. Mass privatization of former state enterprises was under way. A fixed exchange rate led to the rapid accumulation of foreign exchange reserves. Although the central bank had installed an operating framework based on reserve requirements, open-market operations, and daily monitoring of reserve provision, it could not completely sterilize this inflow; the banking system became flush with excess liquidity. Inflation seemed stuck in the high single digits. Banking regulation and supervision were at a rudimentary stage. A banking crisis and capital flight in 1997 forced the abandonment of the pegged rate for the koruna.

The Czech National Bank decided quite quickly in favor of inflation targeting for the nominal anchor, but this was neither an easy nor an uncontroversial decision. There were doubts that conventional monetary policy was effective at all, in view of the incomplete transition to a market economy. Prices for many important consumer items were to be deregulated in the years ahead, which would mean sporadic jumps in the consumer price index.8 And again, the history of inflation made for widespread skepticism about the central bank’s announcement of targets for inflation reduction and stabilization.

Just as in Canada, however, inflation fell quickly after the targets for inflation reduction were announced, largely because a recession was already under way. This grabbed the public’s attention and weakened the inflationary mindset. While this was happening, the Czech National Bank moved with all due speed on two fronts.

First, it installed a forecasting and policy analysis system, with forecasts deriving from a macroeconomic model with forward-looking expectations and an endogenous, policy-determined interest rate. IMF technical assistance is part of this story (Coats, Laxton, and Rose 2003).

Second, the Czech National Bank embarked on an open communications policy. The central bank emphasized early that its inflation targeting was not about rigidly hitting annual targets but about eventually returning inflation to target following any disturbance, taking account of the implications for output. This clear commitment to an inflation-forecast-targeting approach helped solidify its credibility.

The system has worked well. Although at times inflation has been way off the official target, Czech National Bank actions have brought inflation back into line over the medium term. If the foundation for confidence in the system has been that inflation does not long stray from target, transparent communications have made sure that the public understands that this is not by accident and that deliberate, systematic monetary policy actions are indeed responsible. The use of models in the forecasting and policy analysis system has allowed policymakers to provide a coherent macroeconomic narrative in support of their policy actions.

The Czech National Bank is today an international leader in central bank transparency. It is one of the few to publish the complete results of the model-based forecast used as input for policy decisions. This includes the projected path of the short-term interest rate. The public obtains the main quantitative information underlying each policy decision with minimal delay. Expectations of long-term inflation remain stable at 2 percent, notwithstanding the volatility caused by shocks to oil and food prices.

Chapter 11 traces monetary policy in India. The government and the Reserve Bank of India announced an inflation target range of 2–6 percent in 2016. Monetary policy had previously been based on a multiple-indicator approach, which failed to stabilize inflation: the rate of inflation had varied between 5 and 16 percent in the 20 years 1990–2010, and between 8 and 13 percent in the 5 years 2010–15. Thus, the Reserve Bank of India has faced a far more difficult legacy of inflation expectations than the Bank of Canada or the Czech National Bank.

There have been additional issues specific to India. Food prices account for 50 percent of the basket of goods that comprise the consumer price index. This has short-term and long-term aspects. The short-term aspect is that large year-to-year cycles in food prices often result from variations in harvest conditions (especially the monsoon rains), or from speculative hoarding by wholesalers, or from government interventions (minimum support prices, minimum wage regulations). This has made it difficult for the public and policymakers alike to perceive the influence of monetary policy on the inflation rate. Part of the reason for the large historical influence of food prices on inflation was that central bank policy did not effectively contain the second-round effects. People therefore came to expect that a food price shock would influence the inflation rate over an extended period. In India, slow adjustment of regulated prices does mean that the impact of a food price shock inevitably occurs over a considerable stretch of time: the risk that this will be misinterpreted as a durable rise in the inflation rate underscores the importance of establishing credibility for the new regime and of clear communications. Model simulations underline the need to prevent a shock from affecting long-term expectations in a situation where monetary policy credibility is imperfect. In practice, well-established inflation-forecast-targeting regimes have achieved a major dampening of the pass-through of one-off inflation shocks.

The long-term aspect is that, because of rising real incomes and structural shifts, the relative price of food has shown a trend increase. This is an issue for the definition of the long-term target. The presence of a permanent relative food price increase would justify a somewhat higher target for headline inflation, to avoid the risk of negative core inflation during a cyclical downturn. This is consistent with the choice of 4 percent as the long-term target; that is, two points above the typical target in advanced economies.

Another issue in India has been the uncertain transmission mechanism of monetary policy. This was a problem too in New Zealand and the Czech Republic, which began inflation targeting during a profound structural transformation. However, weakness of the transmission mechanism has been palpably more severe in India. In contrast to the more advanced economies, changes in Indian policy rates have had little effect on the administered interest rates of the commercial banks—that much of the system is state owned may be a factor. The exchange rate has responded rather sluggishly to changed policy rates, slowing the external channel of policy transmission. Foreign capital flows at times have had strong effects on domestic credit conditions at variance with monetary policy objectives. Statutory preemptions protect the availability of credit to certain types of borrowers (for example, in agriculture). A considerable segment of the population still does not have access to regular financial institutions despite tremendous progress over the last decade, and resorts to informal local lenders whose charges do not reflect the policy rates.

The Reserve Bank of India has developed macroeconomic models that incorporate these special features. Models that incorporate a credibility-building process are appropriate: in this process, expectations of long-term inflation converge on the official target rate only to the extent that the actual inflation rate does not stray far from the target. Weaknesses in policy transmission have effects that come out clearly in policy simulations: following shocks that threaten to push inflation off target, the appropriate interest rate responses may have to be larger than those typical in advanced economies.

Despite the special problems, early results from inflation-forecast targeting in India seem positive. As happened in several advanced economies after the adoption of explicit long-term targets, inflation has dropped substantially. This should raise confidence in the new regime. The system has yet to be tested, however, by a major shock to food prices. It remains to be seen whether, following such an event, long-term inflation expectations will remain anchored by the official targets.

Chapter 12 reviews recent monetary policy in the United States. The Federal Reserve has not formally adopted inflation targeting, but the Federal Open Market Committee’s (FOMC’s) 2012 clarification of the dual mandate for price stability and maximum employment was tantamount to a statement of inflation-forecast targeting. The FOMC announced, in effect, a target of 2 percent for the inflation rate, and nonquantitative commitment to maximum employment. The communications issues associated with forward guidance on the federal funds rate and quantitative easing are worth examination. These unconventional monetary instruments have been broadly successful in the purpose for which they were designed—that is, to reduce longer-term interest rates and ease the supply of bank credit after the funds rate had been cut to its effective lower bound. Nevertheless, as for Canada, this chapter recommends a strategy of prompt, aggressive responses to shocks that might push the economy into the trap of a bad equilibrium. The argument put forward in this book also calls for a further step forward in transparency for this already quite transparent central bank: publication of all key macroeconomic variables from the staff forecast, including the forecast path of the policy rate.

A Widened Perspective for Inflation-Forecast Targeting

Chapter 13 reviews the monetary policy challenges faced by low-income countries. Some are of a more severe form than those described above confronting India, or the Czech Republic in the 1990s. They include the predominance of supply shocks, the uncertainties regarding the monetary transmission mechanism in a context of structural transformation, and limited access to the formal financial sector. Other issues include limited and noisy macroeconomic and financial data, large exposure to domestic and foreign shocks, recurrent pressures arising from shifts in fiscal policy, and monetary policy regimes centered around exchange rate objectives or guidelines for monetary aggregates, which can make policy more opaque and reduce its effectiveness. The chapter makes the case that adopting key elements of inflation-forecast targeting—for example, an explicit commitment to a numerical long-term inflation target, and a strengthened policy interest rate instrument—can help central banks in these countries articulate clear policy responses, despite the challenging environment. And in fact, several of them are in the process of doing just that, with IMF support, notably in the area of forecasting and policy analysis system development.

Chapter 14 summarizes the main conclusion of the book, that inflation-forecast targeting can provide, and has provided, a robust and adaptable nominal anchor in countries with a wide variety of economic structures and circumstances. Because no alternative monetary regime has been as successful in this respect, or as durable, inflation-forecast targeting can be considered the state of the art for monetary policy. Like any exploration of frontiers, however, it is a project in progress.


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Output and employment are used interchangeably because these two variables are closely correlated over the business cycle.

The term “inflation targeting” is often interpreted as strict adherence to a particular inflation rate. Here, the term “flexible inflation targeting” is used to describe a policy regime under which the central bank pursues the primary objective of maintaining low and stable inflation while taking into account other objectives such as output or employment and ensuring that pursuit of those other objectives remains consistent with the primary inflation objective.

Some countries have used an exchange rate peg as a strategy to stop very high inflation (Calvo and Vegh 1999). However, success requires a quick transition to exchange rate flexibility as soon as a measure of credibility is achieved, to prevent a misalignment. An overvalued currency can be very harmful for macroeconomic and financial stability.

Woodford (2005) highlights that managing expectations is a key task in the practice of central banking. Clinton and others (2015) discuss practical issues involved with developing analytical frameworks and monetary policy models to support inflation-forecast-targeting regimes.

Some central banks refer to these reports as inflation reports.

Svensson (2007) argues for publishing the central bank’s forecast interest rate path.

For a discussion of the history of inflation targeting in Canada, see Lane (2015).

The Czech National Bank dealt with the transitional price-decontrol issue by defining the initial targets in terms of net inflation, which excluded the impact of changes in administered prices.

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