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GU ECON 102 - A Perspective on Inflation Targeting

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Remarks by Governor Ben S. BernankeAt the Annual Washington Policy Conference of the National Association of Business Economists,Washington, D.C.March 25, 2003A Perspective on Inflation TargetingOne of the more interesting developments in central banking in the past dozen years or so has been theincreasingly widespread adoption of the monetary policy framework known as inflation targeting. Theapproach evolved gradually from earlier monetary policy strategies that followed the demise of the BrettonWoods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's Bundesbankand the Swiss National Bank during the latter part of the 1970s and the 1980s. For example, theBundesbank, though it conducted short-term policy with reference to targets for money supply growth,derived those targets each year by calculating the rate of money growth estimated to be consistent with thebank's long-run desired rate of inflation, normally 2 percent per year. Hence, the Bundesbank indirectlytargeted inflation, using money growth as a quantitative indicator to aid in the calibration of its policy.Notably, the evidence suggests that, when conflicts arose between its money growth targets and inflationtargets, the Bundesbank generally chose to give greater weight to its inflation targets (Bernanke and Mihov,1997).1The inflation-targeting approach became more explicit with the strategies adopted in the early 1990s by anumber of pioneering central banks, among them the Reserve Bank of New Zealand, the Bank of Canada,the Bank of England, Sweden's Riksbank, and the Reserve Bank of Australia. Over the past decade, variantsof inflation targeting have proliferated, with newly industrialized and emerging-market economies (Brazil,Chile, Israel, Korea, Mexico, South Africa, the Philippines, and Thailand, among others) being among themost enthusiastic initiates. Most recently, this policy framework has also been adopted by several transitioneconomies, notably the Czech Republic, Hungary, and Poland.2 Central banks that have switched toinflation targeting have generally been pleased with the results they have obtained. The strongest evidenceon that score is that, thus far at least, none of the several dozen adopters of inflation targeting hasabandoned the approach.3As an academic interested in monetary policy, several years ago I became intrigued by inflation targetingand went on to co-author a book and several other pieces about this approach.4 As I continue to followdevelopments in the area, I must say, however, that discussions of inflation targeting in the American mediaremind me of the way some Americans deal with the metric system--they don't really know what it is, butthey think of it as foreign, impenetrable, and possibly slightly subversive. So, in the hope of cutting throughsome of the fog, today I will offer my own, perhaps somewhat idiosyncratic, view of inflation targeting andits potential benefits, at least in what I consider to be its best-practice form.5 I will also try to dispel what Ifeel are a few misconceptions about inflation targeting that have gained some currency. Finally, I will endwith a few words, and one modest suggestion, about the implications of the experience with inflationtargeting for the practice of monetary policymaking at the Federal Reserve.6 My main objective today,however, is to clarify, not to advocate. Of course, my comments today reflect my own views and do notnecessarily reflect those of my colleagues at the Federal Reserve Board or on the Federal Open MarketCommittee.Best-Practice Inflation Targeting: One ViewAlthough inflation targeting has a number of distinguishing features--the announcement of a quantitativetarget for inflation being the most obvious--capturing the essence of the approach is not entirelystraightforward. The central banks that call themselves inflation targeters, as well as the economies theyrepresent, are a diverse group indeed, and (not surprisingly) institutional and operational features differ.Moreover, many central banks that have not formally adopted the framework of inflation targeting haveclearly been influenced by the approach (or, if you prefer, the same ideas and trends have influenced bothinflation-targeters and non-inflation-targeters). For example, over the past twenty years, the FederalReserve, though rejecting the inflation-targeting label, has greatly increased its credibility for maintaininglow and stable inflation, has become more proactive in heading off inflationary pressures, and has workedhard to improve the transparency of its policymaking process--all hallmarks of the inflation-targetingapproach. In short, to draw a bright line between central banks practicing full-fledged inflation targeting andthose firmly outside the inflation-targeting camp is more difficult than one might first guess--a fact, by theway, that substantially complicates economists' attempts to assess empirically the effects of this approach.Nevertheless, for expository purposes, I find it useful to break down the inflation targeting approach intotwo components: (1) a particular framework for making policy choices, and (2) a strategy forcommunicating the context and rationale of these policy choices to the broader public. Let's call these twocomponents of inflation targeting the policy framework and the communications strategy, for short.The policy framework of inflation targetingBy the policy framework I mean the principles by which the policy committee decides how to set its policyinstrument, typically a short-term interest rate. In an earlier speech, I referred to the policy framework thatdescribes what I consider to be best-practice inflation targeting as constrained discretion.7 Constraineddiscretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lackof discipline and structure inherent in unfettered policymaker discretion. Under constrained discretion, thecentral bank is free to do its best to stabilize output and employment in the face of short-run disturbances,with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy(this is the "discretion" part of constrained discretion). However, a crucial proviso is that, in conductingstabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and,hence, public expectations of inflation--firmly under control (the "constrained" part of


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