Inflation targeting

Since the early 1990s, inflation targeting has become the predominant monetary policy choice for central banks in industrial and developing economies alike. New Zealand, the United Kingdom, Canada, Australia, Norway, Sweden, and Israel were among the first countries to adopt this policy. Since then, many emerging market economies have also adopted it, including Chile, Brazil, South Africa, Korea, Indonesia, Thailand, and the Philippines. Inflation targeting is currently regarded as best practice monetary policy for countries operating flexible exchange rate regimes.

At its core, inflation targeting is amonetary policy systemthatmanipulates a policy instrument (usually a short-termnominal interest rate, but sometimes the nominal effective exchange rate) according to available information with the objective of controlling inflation. The rate of inflation is the primary objective of this regime but is not the sole objective; the system permits the pursuit of secondary objectives such as smoothing changes in output, interest rates, or even the exchange rate.

The successful implementation of inflation targeting depends on a checklist of features:

1. A binding commitment to price stability as the primary policy objective. This is normally presented in a central bank act or similar piece of legislation that sets the objectives and operational rules for the functioning of a central bank.

2. Transparency. This takes the form of announced inflation targets, published minutes of meetings of the monetary policy committee, and the publication of periodic inflation reports.

3. An independent and accountable central bank.

4. A floating exchange rate. In a world of high capital mobility, having an exchange rate target compromises the efficacy of inflation targeting. Nonetheless, central banks in emerging markets often have a strong desire to manage exchange rate movements while maintaining an inflation targeting regime.

5. A monetary policy rule (MPR). The MPR is a policy rule that guides the instrument of the inflation targeting policy. If the nominal interest rate is the policy instrument, the MPR states how it should react to key economic variables such that the policy objective is attained (see Taylor 2001).

Inflation targeting has several advantages. First, it enables policymakers to focus on domestic policy considerations and to respond to those shocks affecting the domestic economy. Second, inflation targeting does not require a stable relationship between the money supply and inflation but uses all available information deemed useful in achieving the target. Third, inflation targeting is transparent and easily understood by the public (Mishkin 2000). Inflation targeting also has two notable disadvantages. The first is that, owing to the long and variable lags between the time a policy is instigated and point it begins to take effect, inflation is inherently difficult to control. The second, which is pertinent to emergingmarket economies, is that the exchange rate flexibility associatedwith inflationtargetingmay lead to financial instability.

A strict inflation target provides that inflation is the sole objective of monetary policy. In other words the only variable the central bank cares about is inflation. Flexible inflation targeting essentially targets inflation but allows for a secondary objective. The usual secondary objective is output, where the central bank seeks to minimize the gap between the current growth rate of output and some steady-state value. Other secondary objectives may include dampening the growth of asset prices, reducing the volatility of the exchange rate, or minimizing potential disruptions in domestic financial markets caused by sharp changes in interest rates. It is commonly held and demonstrated in simulation studies (see Svensson 1997) that output variability is lower under flexible inflation targeting and that the inflation target is attained more quickly under strict inflation targeting. Central banks are often under pressure to take output conditions into account, however, and in this situation, flexible inflation targeting is a viable option.

There are several other analytical and operational dimensions to inflation targeting that are significant in its construction. These include the central bank’s selection of a strict versus flexible inflation target, whether it should target domestic inflation (inflation in the price of those goods produced and consumed domestically) or consumer price index inflation (domestic inflation plus inflation in the price of tradable goods), whether the central bank should target current inflation or an inflation forecast, and the extent to which the central bank should respond to the exchange rate and asset prices.

See also exchange rate regimes; monetary policy rules; money supply; seigniorage

FURTHER READING

• Ball, L. 1997. ‘‘EfficientRules forMonetary Policy.’’NBER Working Paper No. 5952. Cambridge, MA: National Bureau of Economic Research. Presents the basic ana lytics for a closed economy strict and flexible inflation targeting system and the specification of the rule(s) re quired to reach the inflation objective.
•  Cavoli, T., and R. Rajan. 2006. ‘‘Inflation Targeting in East Asia: Exploring the Role of the Exchange Rate.’’ Briefing Notes in Economics, No. 74 (September October). Similar to Ball (1997) but for open economies where the role of the exchange rate as a policy objective is ex amined. 
• Debelle, G. 2001. ‘‘The Case for Inflation Targeting in East Asian Countries.’’ In Future Directions for Monetary Policy in East Asia, edited by D. Gruen. Canberra: Re serve Bank of Australia, 65 82. Examines the issues re garding the appropriateness of inflation targeting in developing economies particularly in Asia. 
• Mishkin, F. S. 2000. ‘‘Inflation Targeting in Emerging Market Countries.’’ American Economic Review Papers and Proceedings 90 (2): 105 9. Evaluates the checklist for inflation targeting for developing economies. 
• Svensson, L.E.O. 1997. ‘‘Inflation Forecast Targeting: Im plementing and Monitoring Inflation Targets.’’ Euro pean Economic Review 41 (6): 1111 46. Presents a technical treatment of the trade offs inherent in strict versus flexible inflation targeting and examines whether central banks should target actual current inflation or a forecast of future inflation.
•  Taylor, J. B. 2001. ‘‘The Role of the Exchange Rate in Monetary Policy Rules.’’ American Economic Review Papers and Proceedings 91: 263 67. Examines the issues of fitting the exchange rate in an inflation targeting framework. 

TONY CAVOL I