Inflation Targeting: Lessons from the International Experience 9780691187396, 0691086893, 0691059551, 9780691086897

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INFLATION TARGETING

INFLATION TARGETING

LESSONS F R O M T H E I N T E R N A T I O N A L EXPERIENCE

Ben S. Bernanke Thomas Laubach Frederic S. Mishkin Adam S. Posen

PRINCETON

UNIVERSITY

PRESS

PRINCETON

AND

OXFORD

Copyright © 1999 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 3 Market Place, Woodstock, Oxfordshire OX20 1SY All Rights Reserved Second printing, and first paperback printing, 2001 Paperback ISBN 0-691-08689-3 The Library of Congress has cataloged the cloth edition of this book as follows

Inflation Targeting : lessons from the international experience / Ben S. Bernanke. . . [et al. ] . p. cm. Includes bibliographical references and index. ISBN 0-691-05955-1 (cl : alk. paper) 1. Inflation (Finance)—Government policy—Case studies. 2. Monetary policy—Case studies. I . Bernanke, Ben. HG299.I457 1999 332.4'1—dc21 98-39632 This book has been composed in New Baskerville Printed on acid-free paper. www.pup.princeton.edu Printed in the United States of America 10 9 8

7 6

ISBN-13: 978-0-691-08689-7 ISBN-10: 0-691-08689-3

Contents

List of Figures Preface P A R T O N E : I N F L A T I O N T A R G E T I N G : T H E ISSUES 1. I n t r o d u c t i o n

vii ix 1 3

2. T h e R a t i o n a l e f o r I n f l a t i o n T a r g e t i n g

10

3. Issues o f D e s i g n a n d I m p l e m e n t a t i o n

26

P A R T T W O : CASE S T U D I E S A N D E M P I R I C A L E V I D E N C E

39

4. G e r m a n a n d Swiss M o n e t a r y T a r g e t i n g : Precursors t o Inflation Targeting 5. N e w Z e a l a n d : I n f l a t i o n - T a r g e t i n g P i o n e e r

41 86

6. Canada: I n f l a t i o n Targets as Tools o f C o m m u n i c a t i o n

115

7. U n i t e d K i n g d o m : T h e C e n t r a l B a n k as C o u n t e r i n f l a t i o n a r y Conscience

145

8. Sweden: S e a r c h i n g f o r a N o m i n a l A n c h o r

172

9. T h r e e S m a l l O p e n E c o n o m i e s : Israel, A u s t r a l i a , a n d S p a i n

203

10. I n f l a t i o n T a r g e t i n g : H o w Successful H a s I t Been? P A R T T H R E E : CONCLUSIONS

11. W h a t Have We Learned?

252 285

287

12. I n f l a t i o n T a r g e t i n g f o r t h e U n i t e d States a n d t h e E u r o p e a n Monetary U n i o n

309

Notes

335

References

355

Index

367

List of Figures

Figure 4.1

German Economic Indicators

48

F i g u r e 4.2

Swiss E c o n o m i c I n d i c a t o r s

54

F i g u r e 5.1

New Zealand Economic Indicators

103

F i g u r e 6.1

Canadian Economic Indicators

131

F i g u r e 7.1

U n i t e d K i n g d o m Economic Indicators

160

F i g u r e 8.1

Swedish E c o n o m i c I n d i c a t o r s

175

F i g u r e 9.1

Israeli E c o n o m i c Indicators

215

F i g u r e 9.2

Australian Economic Indicators

230

F i g u r e 9.3

Spanish E c o n o m i c I n d i c a t o r s

238

F i g u r e 10.1

I n f l a t i o n Forecasts f r o m P h i l l i p s Curves

265

F i g u r e 10.2

Consensus Forecasts o f I n f l a t i o n

267

F i g u r e 10.3

I n t e r e s t Rate D i f f e r e n t i a l s

272

F i g u r e 10.4

Dynamic Simulations

277

F i g u r e 10.5

Dynamic Simulations

278

F i g u r e 10.6

Dynamic Simulations

279

Preface

T H I S P R O J E C T was a n a t u r a l o u t g r o w t h o f t h e a u t h o r s ' i m m e r s i o n — a s re­ searchers a n d as p o l i c y advisers—in t h e process o f m a k i n g m o n e t a r y policy. O u r e x p e r i e n c e has c r e a t e d a s h a r e d c o n c e r n t h a t , despite t h e g r e a t success o f U.S. m o n e t a r y p o l i c y i n r e c e n t years, t o o l i t t l e consider­ a t i o n is b e i n g g i v e n t o e n s u r i n g t h a t f u t u r e p o l i c y w i l l be e q u a l l y ( o r even m o r e ) effective. I n p a r t i c u l a r , t h e U n i t e d States has l a g g e d b e h i n d other industrial countries i n considering monetary-policy frameworks a n d i n s t i t u t i o n s t h a t m i g h t h e l p ensure g o o d e c o n o m i c p e r f o r m a n c e i n the l o n g t e r m . Because m o n e t a r y p o l i c y is, n o t o r i o u s l y , a n a r t r a t h e r t h a n a science, t h e r e is m u c h t o be l e a r n e d f r o m o b s e r v i n g t h e e x p e r i e n c e s o f o t h e r p r a c t i t i o n e r s . M o s t o f this b o o k is s i m p l y t h a t : o u r observations o f w h a t o t h e r c o u n t r i e s ' policy-makers have d o n e a n d h o w w e l l t h e i r m e t h o d s have w o r k e d . O u r h o p e is t h a t b o t h policy-makers a n d t h e g e n e r a l p u b ­ lic w i l l l e a r n f r o m these studies o f t h e i n t e r n a t i o n a l e x p e r i e n c e , a n d t h a t t h e r e s u l t w i l l be m o r e i n t e l l i g e n t a n d m o r e c o h e r e n t p o l i c y - m a k i n g , i n t h e U n i t e d States a n d elsewhere. T h i s p r o j e c t was i n i t i a t e d at t h e F e d e r a l Reserve B a n k o f N e w Y o r k w h i l e F r e d e r i c M i s h k i n was a n executive vice p r e s i d e n t a n d D i r e c t o r o f Research at t h e B a n k a n d A d a m Posen was a n e c o n o m i s t i n t h e Bank's Research a n d M a r k e t s Analysis G r o u p . T h e o t h e r t w o co-authors also h a d affiliations w i t h t h e N e w Y o r k F e d at t h a t t i m e : B e n B e r n a n k e was a V i s i t i n g Scholar, a n d T h o m a s L a u b a c h served as a g r a d u a t e s t u d e n t i n ­ t e r n at t h e B a n k w h i l e c o m p l e t i n g his P h . D . i n E c o n o m i c s at P r i n c e t o n . We owe a d e e p d e b t o f g r a t i t u d e t o t h e N e w Y o r k F e d f o r p r o v i d i n g us w i t h t h e resources t o u n d e r t a k e this p r o j e c t a n d f o r t h e assistance o f m a n y i n d i v i d u a l s at t h e b a n k . I n p a r t i c u l a r , we w o u l d l i k e t o t h a n k D o r ­ othy Sobol a n d Valerie LaPorte o f the Publications function for their c o m m e n t s a n d e d i t o r i a l suggestions, a n d L a u r a B r o o k i n s f o r research assistance. W e also w a n t t o t h a n k w i t h o u t i m p l i c a t i n g Peter Fisher, ex­ ecutive vice p r e s i d e n t a n d h e a d o f t h e M a r k e t s G r o u p , a n d W i l l i a m M c D o n o u g h , p r e s i d e n t o f t h e F e d e r a l Reserve B a n k o f N e w Y o r k , f o r m a n y v a l u a b l e , b u t m o r e g e n e r a l , discussions a b o u t i n f l a t i o n t a r g e t i n g a n d m o n e t a r y policy.

X

PREFACE

W e also b e n e f i t e d f r o m d e t a i l e d c o m m e n t s p r o v i d e d by c e n t r a l b a n k ers w h o r e a d t h e case studies f o r t h e i r respective c o u n t r i e s . W e p a r t i c u l a r l y w o u l d l i k e t o t h a n k O t m a r Issing o f t h e D e u t s c h e B u n d e s b a n k ; M i c h e l P e y t r i g n e t , E r i c h S p o e r n d l i , a n d especially G e o r g R i c h o f t h e Swiss N a t i o n a l B a n k ; D o n a l d B r a s h o f t h e Reserve B a n k o f N e w Z e a l a n d ; K e v i n C l i n t o n a n d Charles F r e e d m a n o f t h e B a n k o f Canada; A n d r e w H a l d a n e , N e a l H a t c h , a n d M e r v y n K i n g o f t h e B a n k o f E n g l a n d ; Claes B e r g o f t h e Swedish R i k s b a n k ; O h a d Bar-Efrat o f t h e B a n k o f Israel; Jose V i ñ a l s o f t h e B a n c o d e E s p a ñ a ; a n d G u y D e b e l l e , Steve G r e n v i l l e , a n d G l e n n Stevens o f t h e Reserve B a n k o f A u s t r a l i a . W e are also g r a t e f u l t o a l l t h e c e n t r a l banks whose e x p e r i e n c e s we r e p o r t h e r e f o r t h e i r w i l l i n g provision o f data a n d d o c u m e n t a r y materials. Several o t h e r researchers a n d c e n t r a l b a n k e r s c o m m e n t e d o n p a r t o r a l l o f t h e m a n u s c r i p t . W e w a n t t o t h a n k Charles G o o d h a r t o f t h e L o n d o n School o f Economics a n d J o h n Taylor o f Stanford University for c o m m e n t i n g o n the entire manuscript. Others providing helpful comm e n t s o n various aspects o f this research i n c l u d e d A l a n B l i n d e r , J o h n Crow, B r a d D e L o n g , R i c h a r d Freeman, D o n a l d K o h n , A l a n Krueger, B e n n e t t M c C a l l u m , J u l i o R o t e m b e r g , Lars Svensson, a n d T i m Taylor. W e also b e n e f i t e d f r o m c o m m e n t s i n seminars g i v e n at t h e F e d e r a l Reserve B a n k o f N e w Y o r k , t h e F e d e r a l Reserve B a n k o f San Francisco, C o l u m b i a University, G e o r g e t o w n University, J o h n s H o p k i n s U n i v e r s i t y , t h e N a t i o n a l B u r e a u o f E c o n o m i c Research, t h e B a n k o f C a n a d a , t h e B a n k f o r I n t e r n a t i o n a l Settlements, t h e B a n k o f E n g l a n d , Rutgers U n i versity, a n d t h e Swiss N a t i o n a l B a n k . Finally, we w a n t t o e x t e n d a special t h a n k s t o Peter D o u g h e r t y , o u r e d i t o r at P r i n c e t o n U n i v e r s i t y Press, his assistant D a v i d H u a n g , a n d o u r d e v e l o p m e n t e d i t o r , E v e r e t t Sims, f o r t h e i r h e l p a n d advice. O f course, a l l e r r o r s are o u r o w n . A l l views expressed i n this b o o k are those o f t h e a u t h o r s a n d are n o t necessarily those o f P r i n c e t o n University, C o l u m b i a University, t h e I n s t i t u t e f o r I n t e r n a t i o n a l E c o n o m i c s , t h e N a t i o n a l B u r e a u o f E c o n o m i c Research, t h e F e d e r a l Reserve B a n k o f N e w Y o r k , t h e F e d e r a l Reserve B a n k o f Kansas City, o r t h e F e d e r a l Reserve System.

1 Introduction

A T T H E END o f t h e t w e n t i e t h c e n t u r y , w i t h c o m m u n i s m l a r g e l y g o n e a n d w i t h s t a t e - d o m i n a t e d strategies b e i n g r e p l a c e d e v e r y w h e r e b y m a r k e t o r i e n t e d r e f o r m s , t h e r e is a consensus t h a t p r o s p e r i t y a n d e c o n o m i c g r o w t h are c r e a t e d p r i m a r i l y b y p r i v a t e e n t e r p r i s e a n d free m a r k e t s . I t w o u l d b e a m i s t a k e , however, t o c o n c l u d e t h a t n o r o o m is l e f t f o r gov­ e r n m e n t p o l i c y t o p r o m o t e e c o n o m i c g r o w t h a n d stability. T h e gov­ e r n m e n t , t h r o u g h its fiscal, r e g u l a t o r y , t r a d e , a n d e n v i r o n m e n t a l p o l i ­ cies a n d t h r o u g h its r o l e i n b u i l d i n g i n f r a s t r u c t u r e , b o t h i n s t i t u t i o n a l {e.g., t h e l e g a l system) a n d p h y s i c a l (e.g., r o a d s a n d b r i d g e s ) , plays a v i t a l r o l e i n c r e a t i n g t h e c o n d i t i o n s t h a t give t h e p o w e r o f t h e m a r k e t f u l l play. M o n e t a r y policy, w h e t h e r d e t e r m i n e d solely b y a c e n t r a l b a n k o r b y a c e n t r a l b a n k i n c o n j u n c t i o n w i t h o t h e r officials, has e m e r g e d as o n e o f the most critical g o v e r n m e n t responsibilities. O n e element o f the new consensus is t h a t low, stable i n f l a t i o n is i m p o r t a n t f o r m a r k e t - d r i v e n g r o w t h , a n d t h a t m o n e t a r y p o l i c y is t h e m o s t d i r e c t d e t e r m i n a n t o f i n f l a ­ t i o n . F u r t h e r , o f a l l t h e g o v e r n m e n t ' s tools f o r i n f l u e n c i n g t h e e c o n o m y , m o n e t a r y p o l i c y has p r o v e n t o be t h e m o s t flexible i n s t r u m e n t f o r achiev­ i n g m e d i u m - t e r m s t a b i l i z a t i o n objectives. U n l i k e fiscal policy, w h i c h has m u l t i p l e goals a n d is hostage t o t h e slow a n d u n c e r t a i n legislative p r o ­ cess, m o n e t a r y p o l i c y c a n be adjusted q u i c k l y i n response t o m a c r o e c o n o m i c d e v e l o p m e n t s . I n d e e d , financial m a r k e t s o f t e n a n t i c i p a t e changes i n m o n e t a r y p o l i c y b e f o r e they are a n n o u n c e d . T h u s , w h e n g o v e r n m e n t s react t o fluctuations i n o u t p u t a n d e m p l o y m e n t , m o n e t a r y p o l i c y is usu­ ally t h e f a v o r e d t o o l . G i v e n t h e heavy b u r d e n t h a t has b e e n p l a c e d o n t h e m , c e n t r a l b a n k ­ ers i n t h e i n d u s t r i a l i z e d d e m o c r a c i e s g e n e r a l l y have m e t t h e i r responsi­ b i l i t i e s w e l l i n r e c e n t years. I n f l a t i o n has b e e n l o w e r i n m o s t c o u n t r i e s t h a n at any t i m e since t h e 1960s. M o r e o v e r , t h e r e has b e e n o n l y o n e m i l d g l o b a l recession since t h e early 1980s, a n d g r o w t h rates have b e e n reasonably g o o d . T h e U n i t e d States i n p a r t i c u l a r has b e e n able t o c o m ­ b i n e l o w levels o f i n f l a t i o n w i t h l o w levels o f u n e m p l o y m e n t . G o o d eco­ n o m i c p e r f o r m a n c e today, however, does n o t g u a r a n t e e g o o d p e r f o r -

4

CHAPTER 1

m a n c e i n t h e f u t u r e , as h i s t o r y has s h o w n us m a n y times. T h u s c e n t r a l b a n k e r s are s t r i v i n g t o d e v e l o p strategies f o r c o n d u c t i n g m o n e t a r y p o l i c y t h a t w i l l " l o c k i n " t h e gains o f r e c e n t years a n d c o n t r i b u t e t o c o n t i n u e d stability a n d g r o w t h i n t h e f u t u r e . T h i s b o o k is a b o u t o n e o f those strategies, inflation targeting. O v e r t h e past decade, this strategy has a r o u s e d c o n s i d e r a b l e i n t e r e s t a m o n g cen­ tral bankers a n d m o n e t a r y economists. I n f l a t i o n targeting i n one f o r m o r a n o t h e r has b e e n a d o p t e d b y a n u m b e r o f i n d u s t r i a l i z e d c o u n t r i e s , i n c l u d i n g N e w Z e a l a n d , C a n a d a , t h e U n i t e d K i n g d o m , Sweden, F i n l a n d , Israel, S p a i n , a n d A u s t r a l i a . J a p a n has r e c e n t l y a n n o u n c e d its i n t e n t i o n to a d o p t i n f l a t i o n targets. M o r e o v e r , m o s t o f t h e e l e m e n t s o f i n f l a t i o n t a r g e t i n g c a n be f o u n d i n t h e l o n g - s t a n d i n g a n d w e l l - r e g a r d e d m o n e t a r y p o l i c y o f G e r m a n y a n d S w i t z e r l a n d . I n t h e U n i t e d States, i n f l a t i o n tar­ g e t i n g has a t t r a c t e d some i n f l u e n t i a l advocates, b o t h w i t h i n a n d o u t s i d e t h e F e d e r a l Reserve System. F o r e x a m p l e , a b i l l i n t r o d u c e d b y Congress­ m a n B i l l S a x t o n ( " T h e Price Stability A c t o f 1997") calls e x p l i c i t l y f o r t h e use o f i n f l a t i o n targets b y t h e F e d . Finally, t h e M a a s t r i c h t Treaty, t h e basis f o r t h e p r o p o s e d E u r o p e a n m o n e t a r y u n i o n , m a n d a t e s p r i c e sta­ b i l i t y as t h e p r i m a r y objective o f t h e n e w E u r o p e a n C e n t r a l B a n k . T h e E u r o p e a n M o n e t a r y I n s t i t u t e has stated t h a t "the list o f p o t e n t i a l c a n d i ­ date strategies [ f o r t h e f u t u r e E C B ] has b e e n n a r r o w e d d o w n t o t w o , namely monetary targeting and direct inflation targeting." 1

2

3

What Is Inflation Targeting? I n f l a t i o n t a r g e t i n g is a f r a m e w o r k f o r m o n e t a r y p o l i c y characterized by t h e p u b l i c a n n o u n c e m e n t o f official quantitative targets ( o r target ranges) f o r the i n f l a t i o n rate over o n e o r m o r e time h o r i z o n s , a n d b y e x p l i c i t ac­ k n o w l e d g m e n t t h a t low, stable i n f l a t i o n is m o n e t a r y policy's p r i m a r y l o n g r u n g o a l . A m o n g o t h e r i m p o r t a n t features o f i n f l a t i o n t a r g e t i n g are vigor­ ous efforts to c o m m u n i c a t e w i t h t h e p u b l i c a b o u t the plans a n d objectives o f t h e m o n e t a r y a u t h o r i t i e s , a n d , i n m a n y cases, m e c h a n i s m s t h a t s t r e n g t h e n the c e n t r a l bank's a c c o u n t a b i l i t y f o r a t t a i n i n g those objectives.

A Framework,

Not a Rule

A p r i n c i p l e t h e m e o f this b o o k is t h a t , i n p r a c t i c e , i n f l a t i o n t a r g e t i n g serves as a framework f o r m o n e t a r y p o l i c y r a t h e r t h a n as a rule f o r m o n ­ etary policy. T h i s d i s t i n c t i o n r e q u i r e s a b i t o f e x p l a n a t i o n .

INTRODUCTION

5

F o l l o w i n g ideas o r i g i n a l l y p u t f o r w a r d b y t h e so-called C h i c a g o S c h o o l i n t h e 1930s, m o n e t a r y e c o n o m i s t s have l o n g c h a r a c t e r i z e d strategies f o r c o n d u c t i n g m o n e t a r y p o l i c y as b e i n g a f o r m o f e i t h e r "rules" o r " d i s c r e t i o n . " Rules are m o n e t a r y p o l i c i e s t h a t are essentially a u t o m a t i c , r e q u i r i n g l i t t l e o r n o t h i n g i n t h e way o f m a c r o e c o n o m i c analysis o r value j u d g m e n t s b y t h e m o n e t a r y a u t h o r i t i e s . A p u t a t i v e e x a m p l e o f such a r u l e is t h e g o l d s t a n d a r d , i n w h i c h t h e c o n d u c t o f m o n e t a r y p o l i c y (at least i n p r i n c i p l e ) a m o u n t e d t o l i t t l e m o r e t h a n m a i n t a i n i n g t h e p r i c e o f g o l d at t h e official parity. A n o t h e r e x a m p l e is t h e constant-moneyg r o w t h r u l e associated w i t h M i l t o n F r i e d m a n , u n d e r w h i c h some speci­ fied m e a s u r e o f t h e m o n e y stock is r e q u i r e d t o g r o w b y a fixed p e r c e n t ­ age each year, i n d e p e n d e n t o f e c o n o m i c o r financial c o n d i t i o n s . Advocates o f rules usually speak a b o u t t h e " d i s c i p l i n e " o r " c r e d i b i l i t y " t h e y create; b y a d h e r i n g r i g o r o u s l y t o a c e r t a i n r u l e , t h e m o n e t a r y au­ t h o r i t y supposedly reassures t h e p u b l i c t h a t i t w i l l n o t engage i n i n f l a ­ t i o n a r y p o l i c i e s o r o t h e r w i s e abuse its powers ( f o r e x a m p l e , b y s t i m u l a t ­ i n g t h e e c o n o m y i n o r d e r t o h e l p i n c u m b e n t office h o l d e r s t o get re­ e l e c t e d ) . Critics, however, have a r g u e d t h a t any d i s c i p l i n e c r e a t e d b y rules comes at a h i g h cost, since a r u l e r i g o r o u s l y f o l l o w e d deprives t h e c e n t r a l b a n k o f its a b i l i t y t o d e a l w i t h u n u s u a l o r u n f o r e s e e n c i r c u m ­ stances, l e t a l o n e w i t h f u n d a m e n t a l changes i n t h e e c o n o m y . T h e p o l a r opposite o f a rules-based strategy, a c c o r d i n g t o this t r a d i ­ t i o n a l classification o f p o l i c y regimes, is a n a p p r o a c h based o n discretion. A c e n t r a l b a n k t h a t follows a p u r e l y d i s c r e t i o n a r y a p p r o a c h t o policy-mak­ i n g makes n o p u b l i c c o m m i t m e n t s a b o u t its objectives o r f u t u r e actions, except perhaps i n very vague, g e n e r a l terms. Instead, i t reserves the right t o set m o n e t a r y p o l i c y f r o m m o n t h t o m o n t h o r week t o week a c c o r d i n g to t h e policy-makers' assessment o f c u r r e n t c o n d i t i o n s (a " l o o k at every­ t h i n g " strategy). Supporters o f this a p p r o a c h argue that discretionary policy­ m a k i n g preserves f l e x i b i l i t y a n d enables t h e c e n t r a l b a n k t o r e s p o n d t o n e w i n f o r m a t i o n o r u n e x p e c t e d developments. T h e flip side o f t h e c o i n , as advocates o f rules-based policies are q u i c k t o p o i n t o u t , is t h a t p u r e d i s c r e t i o n forfeits t h e d i s c i p l i n e i n h e r e n t i n a rules-based a p p r o a c h . T h e lack o f p e r c e i v e d d i s c i p l i n e may foster u n c e r t a i n t y i n t h e p u b l i c m i n d a n d increase t h e economy's p r o p e n s i t y t o w a r d i n f l a t i o n . T h e d i s t i n c t i o n b e t w e e n r u l e s a n d d i s c r e t i o n has p l a y e d a m a j o r r o l e i n debates a b o u t m o n e t a r y p o l i c y f o r m a n y decades. H o w e v e r , i n o u r view, t h i s d i c h o t o m y b e t w e e n r u l e s a n d d i s c r e t i o n is j u s t t o o s i m p l e t o c a p t u r e t h e r e a l i t i e s t h a t c e n t r a l b a n k e r s face. Specifically, i n o u r view, there is no such thing in practice as an absolute rule for monetary policy. F o r e x a m p l e , even t h e g o l d s t a n d a r d p e r m i t t e d m o d e r a t e p o l i c y discre-

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t i o n i n p r a c t i c e , p a r t i c u l a r l y f o r c o u n t r i e s w i t h a m p l e g o l d reserves. M o r e o v e r , t h e g o l d s t a n d a r d was r o u t i n e l y s u s p e n d e d d u r i n g wars a n d o t h e r emergencies before i t collapsed completely d u r i n g the Great De­ p r e s s i o n . M o r e recently, t h e supposedly " f i x e d " e x c h a n g e rates o f t h e E u r o p e a n M o n e t a r y System d i d n o t r e m a i n fixed d u r i n g t h e e x c h a n g e r a t e crises o f 1992 a n d 1993; i n s t e a d , t h e o f f i c i a l rates w e r e a l t e r e d o r even a b a n d o n e d a l t o g e t h e r as c e n t r a l b a n k e r s r e a c t e d t o c h a n g i n g c o n ­ d i t i o n s . As o f this w r i t i n g , t h e e x c h a n g e rates o f c o u n t r i e s i n t h e E M S are r e q u i r e d t o be k e p t o n l y w i t h i n r a t h e r w i d e bands, l e a v i n g consider­ able scope f o r v a r i a t i o n s i n m o n e t a r y p o l i c y . I n s h o r t , i n real-life m o n ­ etary p o l i c y - m a k i n g , t h e rules-versus-discretion d i s t i n c t i o n is a n e m p t y o n e ; i n p r a c t i c e , o n l y d i s c r e t i o n prevails. 4

T h o u g h we w o u l d a r g u e t h a t a l l m o n e t a r y p o l i c y r e g i m e s are i n fact d i s c r e t i o n a r y , i t is also t r u e t h a t d i s c r e t i o n is a m a t t e r o f d e g r e e . Discre­ t i o n m a y m a n i f e s t i t s e l f as t h e r e l a t i v e l y u n d i s c i p l i n e d a p p r o a c h t h a t we d e s c r i b e d above, l e a d i n g t o p o l i c i e s t h a t c h a n g e w i t h t h e p e r s o n a l views o f the central bankers or w i t h the direction o f the political winds. O r i t may operate w i t h i n a m o r e clearly articulated framework, i n w h i c h the g e n e r a l objectives a n d tactics o f t h e p o l i c y - m a k e r s — a l t h o u g h n o t t h e i r specific a c t i o n s — a r e c o m m i t t e d t o i n advance. W e w i l l p r e s e n t evidence i n t h i s b o o k t h a t , i n p r a c t i c e , i n f l a t i o n t a r g e t i n g has p r o v i d e d s u c h a framework, allowing monetary policy to operate i n an e n v i r o n m e n t that we c a l l " c o n s t r a i n e d d i s c r e t i o n . " By imposing a conceptual structure and its inherent discipline on the central bank, but without eliminating all flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with those ascribed to discretion. I n f l a t i o n t a r g e t i n g has h a d i m p o r t a n t b e n e f i t s f o r t h e c o u n t r i e s t h a t have u s e d i t . I n f l a t i o n - t a r g e t i n g c o u n t r i e s have a c h i e v e d l o w e r i n f l a ­ t i o n rates a n d l o w e r i n f l a t i o n e x p e c t a t i o n s ; t h e y e x p e r i e n c e less "passt h r o u g h " i n t o t h e i n f l a t i o n r a t e o f shocks t o t h e p r i c e l e v e l ; a n d t h e y t y p i c a l l y e n j o y l o w e r n o m i n a l i n t e r e s t rates as a r e s u l t o f t h e l o w e r i n ­ flation e x p e c t a t i o n s . ( O n t h e o t h e r h a n d , t h e r e is l i t t l e e v i d e n c e so far t h a t i n f l a t i o n t a r g e t i n g r e d u c e s t h e r e a l e c o n o m i c costs o f a c h i e v i n g a n i n i t i a l r e d u c t i o n i n t h e r a t e o f i n f l a t i o n . ) T h e r e is also e v i d e n c e t h a t t h e use o f i n f l a t i o n t a r g e t i n g increases p u b l i c u n d e r s t a n d i n g o f m o n e t a r y policy, improves policy-maker accountability, a n d provides a d i s c i p l i n e - e n h a n c i n g " n o m i n a l a n c h o r " f o r m o n e t a r y p o l i c y (see C h a p ­ ter 2 ) . O n net, the experience o f inflation-targeting countries appears t o be s u f f i c i e n t l y p o s i t i v e t o w a r r a n t close e x a m i n a t i o n o f t h i s n e w ap­ p r o a c h t o m o n e t a r y p o l i c y . T h e p u r p o s e o f t h i s b o o k is t o c o n d u c t j u s t such an examination.

INTRODUCTION

7

A Case-Study Approach A l t h o u g h t h e o r y can h i g h l i g h t the supposed strengths a n d weaknesses o f a m o n e t a r y - p o l i c y strategy, t h e r e is n o substitute f o r o b s e r v i n g h o w the strategy w o r k s i n practice. A t t e m p t s at f o r m a l statistical analysis o f the i m ­ pact o f i n f l a t i o n t a r g e t i n g are l i m i t e d by the fact t h a t m o s t o f t h e n a t i o n a l experiences w i t h this a p p r o a c h are s h o r t — e i g h t o r so years at t h e most. Moreover, m a n y o f the questions o f h o w best t o i m p l e m e n t i n f l a t i o n tar­ gets, a n d o f h o w the p o l i t i c a l a u t h o r i t i e s a n d the p u b l i c r e s p o n d t o infla­ tion t a r g e t i n g , c a n n o t be fully addressed by strictly q u a n t i t a t i v e m e t h o d s . F o r these reasons, a l t h o u g h we p r e s e n t e c o n o m e t r i c analyses o f t h e ef­ fects o f i n f l a t i o n t a r g e t i n g i n C h a p t e r 10, we have g o n e w e l l b e y o n d the p u r e l y statistical a p p r o a c h i n o u r research. T o l e a r n as m u c h as we c a n f r o m the available evidence, we have c o n d u c t e d d e t a i l e d case studies o f those c o u n t r i e s t h a t have h a d the m o s t extensive e x p e r i e n c e w i t h infla­ t i o n t a r g e t i n g . We also consider t h e e x p e r i e n c e o f G e r m a n y a n d Switzer­ l a n d , w h i c h are n o t self-described inflation-targeters b u t whose monetarypolicy strategies have m u c h i n c o m m o n w i t h i n f l a t i o n targeting. These case studies, w i t h t h e i r analysis a n d i n t e r p r e t a t i o n , f o r m the core o f this b o o k . A l t h o u g h t h e case-study m e t h o d has b e e n u s e d o n l y r a r e l y i n m a c r o ­ e c o n o m i c s , i t has p r o v e d e x t r e m e l y useful i n o u r e x p l o r a t i o n o f i n f l a ­ t i o n t a r g e t i n g . W e f o u n d t h a t case studies p r o v i d e i n v a l u a b l e i n f o r m a ­ t i o n a b o u t t h e b r o a d features a n d effects o f i n f l a t i o n t a r g e t i n g a n d a b o u t t h e p r a c t i c a l i m p l e m e n t a t i o n a n d o p e r a t i o n o f this a p p r o a c h . F o r ex­ a m p l e , analysis o f t h e cases w i l l e n a b l e us t o address issues s u c h as h o w t h e i n f l a t i o n t a r g e t s h o u l d be d e f i n e d , h o w t h e r e s p o n s i b i l i t y f o r s e t t i n g t h e i n f l a t i o n t a r g e t s h o u l d be assigned, h o w t h e m o n e t a r y a u t h o r i t i e s s h o u l d d e a l w i t h v a r i o u s m a c r o e c o n o m i c shocks, a n d h o w t h e a u t h o r i ­ ties s h o u l d c o m m u n i c a t e t h e i r goals a n d i n t e n t i o n s t o t h e p u b l i c . I n a d d i t i o n , t h e case studies have h e l p e d us t o u n d e r s t a n d t h e p o l i t i c a l setting o f i n f l a t i o n t a r g e t i n g , p r o v i d i n g i n s i g h t o n questions such as: W h a t p o l i t i c a l c o n d i t i o n s are c o n d u c i v e t o t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g as a strategy? H o w does i n f l a t i o n t a r g e t i n g affect t h e b a l a n c e o f p o w e r b e t w e e n t h e c e n t r a l b a n k a n d t h e rest o f t h e g o v e r n m e n t r e g a r d i n g c o n ­ t r o l o f m o n e t a r y policy? Does i n f l a t i o n t a r g e t i n g a l l o w t h e p o l i t i c a l p r o ­ cess t o g e n e r a t e m o r e r a t i o n a l p o l i c y decisions? Finally, t h e case studies have suggested w h y m a n y q u a l i t a t i v e aspects o f t h e e x p e r i e n c e w i t h i n ­ flation t a r g e t i n g have b e e n s i m i l a r across c o u n t r i e s . T o facilitate cross-country c o m p a r i s o n s a n d g e n e r a l i z a t i o n s , we have u s e d a p a r a l l e l s t r u c t u r e f o r t h e case studies. O u r study o f e a c h c o u n t r y

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CHAPTER 1

b e g i n s w i t h a b r i e f i n t r o d u c t i o n a n d a list o f some i m p o r t a n t t h e m e s h i g h l i g h t e d b y t h e case. T h e first s e c t i o n o u t l i n e s w h y a n d u n d e r w h a t e c o n o m i c a n d p o l i t i c a l c i r c u m s t a n c e s t h e i n f l a t i o n - t a r g e t i n g r e g i m e was a d o p t e d . T h e s e c o n d s e c t i o n describes t h e o p e r a t i o n a l f r a m e w o r k o f t h e t a r g e t i n g r e g i m e i n t h e c o u n t r y u n d e r study. T h e t h i r d s e c t i o n p r o ­ vides a n a r r a t i v e r e v i e w a n d discussion o f t h e c o u n t r y ' s a c t u a l e x p e r i ­ e n c e w i t h i n f l a t i o n targets. T h e final s e c t i o n s u m m a r i z e s t h e lessons t o be d r a w n f r o m the experiences o f the c o u n t r y o r countries studied. By a p p l y i n g t h e same q u e s t i o n s t o t h e experiences o f a l l t h e c o u n t r i e s e x a m i n e d , we b r i n g some m e a s u r e o f r i g o r t o o u r cross-country c o m ­ parisons a n d g e n e r a l i z a t i o n s . T h e use o f t h e p a r a l l e l s t r u c t u r e has also a l l o w e d us t o o r g a n i z e t h e w e a l t h o f i n s t i t u t i o n a l a n d h i s t o r i c a l i n f o r m a ­ t i o n available o n r e c e n t e x p e r i e n c e s w i t h m o n e t a r y p o l i c y - m a k i n g . W e h o p e t h a t this analytical r e c o r d w i l l be o f i n d e p e n d e n t interest. O u r casestudy-based analysis o f i n f l a t i o n t a r g e t i n g is, as far as we are aware, t h e first t o d a t e — a n d o n e o f t h e few studies o f m a c r o e c o n o m i c p o l i c y m o r e b r o a d l y — i n w h i c h a single t e a m o f a u t h o r s has e x a m i n e d t h e e x p e r i ­ ences u n d e r g o n e b y a b r o a d g r o u p o f c o u n t r i e s , as o p p o s e d t o t h e u s u a l p r a c t i c e o f c o l l e c t i n g u n c o o r d i n a t e d pieces o n i n d i v i d u a l c o u n t r i e s w r i t ­ t e n b y e c o n o m i s t s f a m i l i a r w i t h each.

A Reader's Guide T h e rest o f t h e b o o k p r o c e e d s as follows: C h a p t e r 2 considers i n g r e a t e r d e t a i l t h e r a t i o n a l e f o r i n f l a t i o n t a r g e t i n g . I t develops f u r t h e r t h e i d e a t h a t i n f l a t i o n t a r g e t i n g is n e i t h e r a n i r o n c l a d r u l e n o r a f o r m o f u n ­ b r i d l e d d i s c r e t i o n , b u t r a t h e r a f r a m e w o r k w i t h i n w h i c h c o n s t r a i n e d dis­ c r e t i o n m a y be exercised. C h a p t e r 3 i n t r o d u c e s some i m p o r t a n t o p e r a ­ t i o n a l issues a r i s i n g f r o m t h e use o f i n f l a t i o n t a r g e t i n g i n p r a c t i c e . T h e case studies b e g i n i n C h a p t e r 4, w h e r e we e x a m i n e t h e e x p e r i ­ e n c e o f G e r m a n y a n d S w i t z e r l a n d . A l t h o u g h these c o u n t r i e s are n o t for­ m a l a d h e r e n t s o f i n f l a t i o n t a r g e t i n g , t h e y have h a d l o n g e x p e r i e n c e w i t h m a n y o f t h e features t h a t c h a r a c t e r i z e this a p p r o a c h . T h e c h a p t e r s t h a t follow proceed i n the order i n w h i c h the countries adopted inflation targeting: N e w Zealand (Chapter 5 ) , Canada (Chapter 6 ) , the U n i t e d K i n g d o m (Chapter 7 ) , a n d Sweden (Chapter 8 ) . Chapter 9 recounts the e x p e r i e n c e s o f t h r e e relatively s m a l l , o p e n e c o n o m i e s : Israel, S p a i n , a n d A u s t r a l i a . C h a p t e r 10 presents e c o n o m e t r i c evidence o n t h e success o f i n f l a t i o n t a r g e t i n g , u s i n g data f r o m t h e m a j o r c o u n t r i e s s t u d i e d i n this v o l u m e .

INTRODUCTION

9

T h e b o o k ' s t w o final chapters review a n d s u m m a r i z e w h a t we have learned, drawing conclusions a n d m a k i n g recommendations for the i m p l e m e n t a t i o n o f t h e i n f l a t i o n - t a r g e t i n g a p p r o a c h . I n p a r t i c u l a r , we c o n s i d e r w h e t h e r i t is desirable f o r i n f l a t i o n t a r g e t i n g t o be e m b r a c e d by t h e U n i t e d States o r by t h e E u r o p e a n M o n e t a r y U n i o n . T h i s study is i n t e n d e d n o t o n l y f o r m o n e t a r y e c o n o m i s t s , b u t also f o r central bankers a n d o t h e r policy-makers, practitioners i n the financial m a r k e t s , a n d students o f p o l i t i c a l science, p u b l i c policy, c o n t e m p o r a r y history, a n d e c o n o m i c s . W e also h o p e t h a t g e n e r a l readers i n t e r e s t e d i n c u r r e n t d e v e l o p m e n t s i n m o n e t a r y policy, i n p a r t i c u l a r t h e ways t h a t those w h o w i e l d this i m p o r t a n t p o l i c y t o o l are a c c o u n t a b l e t o d e m o c r a t i c p o ­ litical institutions, w i l l benefit f r o m this b o o k . R e f l e c t i n g t h e v a r i e t y o f possible audiences, t h e b o o k c a n be r e a d o n several levels. T h e r e a d e r w a n t i n g a q u i c k o v e r v i e w o f i n f l a t i o n t a r g e t i n g a n d t h e p o l i c y r e c o m m e n d a t i o n s t h a t we d r a w f r o m o u r case studies s h o u l d r e a d C h a p t e r s 2, 3, 1 1 , a n d 12. T h o s e i n t e r e s t e d p r i m a r i l y i n t h e p o l i c y i m p l i c a t i o n s o f t h e case studies m a y w i s h t o r e v i e w t h e s u m m a r y boxes at t h e b e g i n n i n g s o f C h a p t e r s 4 t h r o u g h 9, as w e l l as t h e final sections o f those chapters, w h i c h o u t l i n e t h e key lessons o f each case. Finally, those readers m o s t i n t e r e s t e d i n t h e h i s t o r i c a l e x p e r i e n c e s o f t h e v a r i o u s c o u n t r i e s m i g h t c o n c e n t r a t e t h e i r r e a d i n g o n t h e first a n d t h i r d sections o f each o f C h a p t e r s 4-9, w h i c h discuss t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g a n d t h e p o l i c y e x p e r i e n c e u n d e r this r e g i m e i n each c o u n t r y , respectively. O f course, we believe t h a t t h e case studies w i l l p r o v e m o s t r e w a r d i n g t o those w h o r e a d t h e m i n t h e i r e n t i r e t y . Some p r i o r k n o w l e d g e o f e c o n o m i c s a n d e c o n o m i c p o l i c y w i l l be h e l p ­ f u l t o t h e reader, p a r t i c u l a r l y f o r r e a d i n g t h e case studies. H o w e v e r , t h e o n l y c h a p t e r t h a t requires special t e c h n i c a l expertise is C h a p t e r 10, w h i c h presents e c o n o m e t r i c evidence t o assess t h e success o f i n f l a t i o n target­ i n g . Readers a l l e r g i c t o f o r m a l statistics c a n s k i p this c h a p t e r w i t h o u t loss o f c o n t i n u i t y . We h o p e t h a t i n w h a t e v e r m a n n e r t h e r e a d e r chooses t o d i p i n t o this b o o k , h e o r she w i l l be r e w a r d e d w i t h a d e e p e r u n d e r s t a n d i n g o f h o w m o n e t a r y p o l i c y has b e e n c o n d u c t e d i n some i m p o r t a n t i n d u s t r i a l i z e d countries a n d o f h o w the framework a n d institutions o f m o n e t a r y policy­ m a k i n g c a n be i m p r o v e d .

2 The Rationale for Inflation Targeting

I N GENERAL, m a c r o e c o n o m i c p o l i c y has m a n y goals besides l o w i n f l a t i o n , i n c l u d i n g h i g h r e a l g r o w t h , l o w u n e m p l o y m e n t , financial stability, a n o t too-excessive t r a d e d e f i c i t , a n d so o n . Yet a c e n t r a l t e n e t o f i n f l a t i o n tar­ g e t i n g is t h a t p r i c e stability m u s t be t h e p r i m a r y l o n g - r u n g o a l o f m o n ­ etary policy. T h i s emphasis o n p r i c e stability t o t h e s e e m i n g e x c l u s i o n o f o t h e r objectives d e m a n d s some e x p l a n a t i o n . T h e i n f l a t i o n targeter's case f o r stressing l o n g - r u n p r i c e stability i n f o r m u l a t i n g m o n e t a r y policy, a n d i n c o m m u n i c a t i n g p o l i c y i n t e n t i o n s t o t h e p u b l i c , rests o n t h r e e a r g u ­ ments. First, t h e i n c r e a s e d emphasis o n c o n t r o l l i n g i n f l a t i o n arises n o t be­ cause u n e m p l o y m e n t a n d r e l a t e d p r o b l e m s have b e c o m e less u r g e n t c o n c e r n s , b u t because e c o n o m i s t s a n d p o l i c y - m a k e r s are c o n s i d e r a b l y less c o n f i d e n t t o d a y t h a n t h e y w e r e t h i r t y years ago t h a t m o n e t a r y p o l i c y c a n be used effectively t o m o d e r a t e s h o r t - r u n fluctuations i n t h e economy, e x c e p t p e r h a p s fluctuations t h a t are p a r t i c u l a r l y severe o r p r o t r a c t e d . F u r t h e r , m o s t m a c r o e c o n o m i s t s agree t h a t , in the long run, t h e i n f l a t i o n rate is t h e o n l y m a c r o e c o n o m i c v a r i a b l e t h a t m o n e t a r y p o l i c y c a n affect. W h e n m o n e t a r y p o l i c y - m a k e r s set a l o w rate o f i n f l a t i o n as t h e i r p r i m a r y l o n g - r u n g o a l , t o some s i g n i f i c a n t e x t e n t t h e y are s i m p l y a c c e p t i n g t h e reality o f what monetary policy can a n d cannot do. S e c o n d , t h e r e is b y n o w s o m e t h i n g o f a consensus t h a t even m o d e r a t e rates o f i n f l a t i o n are h a r m f u l t o e c o n o m i c efficiency a n d g r o w t h , a n d t h a t t h e m a i n t e n a n c e o f a l o w a n d stable i n f l a t i o n rate is i m p o r t a n t , per­ haps necessary, f o r a c h i e v i n g o t h e r m a c r o e c o n o m i c goals. T h i r d , a n d i n o u r view m o s t essentially, t h e e s t a b l i s h m e n t o f p r i c e stability as t h e p r i m a r y l o n g - r u n g o a l o f m o n e t a r y p o l i c y p r o v i d e s a key conceptual element i n the overall framework o f policy-making. T h a t framework helps policy-makers to c o m m u n i c a t e t h e i r intentions to the p u b l i c a n d t o i m p o s e some d e g r e e o f a c c o u n t a b i l i t y a n d d i s c i p l i n e o n t h e c e n t r a l b a n k a n d o n t h e g o v e r n m e n t itself. F o r e x a m p l e , o n those occasions w h e n m o n e t a r y p o l i c y is used t o address s h o r t - r u n s t a b i l i z a t i o n objectives, the constraint t h a t l o n g - r u n i n f l a t i o n goals m u s t n o t be c o m p r o ­ m i s e d forces policy-makers t o consider the l o n g e r - t e r m consequences o f

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those s h o r t - r u n measures, i m p o s i n g a consistency a n d r a t i o n a l i t y o n t h e i r p o l i c y choices t h a t t h e y m i g h t n o t o t h e r w i s e e x h i b i t . I n t h e j a r g o n o f m o n e t a r y e c o n o m i c s , e x p l a i n e d f u r t h e r below, a n i n f l a t i o n t a r g e t serves as a nominal anchor f o r m o n e t a r y policy. I n d o i n g so, i t p r o v i d e s a focus f o r t h e e x p e c t a t i o n s o f financial m a r k e t s a n d t h e g e n e r a l p u b l i c , as w e l l as a r e f e r e n c e p o i n t against w h i c h c e n t r a l b a n k e r s c a n j u d g e t h e desir­ ability o f short-run policies. W e n o w d e v e l o p these t h r e e a r g u m e n t s i n g r e a t e r d e t a i l .

What Monetary Policy Can and Cannot Do T h i r t y years ago, p o l i c y - m a k e r s a n d m o s t e c o n o m i s t s s u p p o r t e d "activ­ ist" m o n e t a r y p o l i c i e s , w h i c h w e r e d e f i n e d as p o l i c i e s whose p u r p o s e was t o k e e p o u t p u t a n d u n e m p l o y m e n t close t o t h e i r " f u l l e m p l o y m e n t " levels at a l l times. S u p p o r t e r s o f activism b e l i e v e d t h a t t h e r e was a l o n g r u n t r a d e o f f b e t w e e n i n f l a t i o n a n d u n e m p l o y m e n t , k n o w n as t h e P h i l l i p s curve ( P h i l l i p s , 1958; S a m u e l s o n a n d Solow, 1 9 6 0 ) . A c c o r d i n g t o this view, t h e m o n e t a r y a u t h o r i t i e s c o u l d m a i n t a i n a permanently l o w e r rate o f u n e m p l o y m e n t b y a c c e p t i n g some d e g r e e o f i n f l a t i o n , a n d vice versa. A t a b o u t t h e same t i m e , large e c o n o m e t r i c m o d e l s o f t h e U . S . e c o n o m y b e c a m e available t h a t p r o m i s e d t o give p o l i c y - m a k e r s t h e q u a n t i t a t i v e i n f o r m a t i o n they n e e d e d t o i m p l e m e n t e c o n o m i c s t a b i l i z a t i o n p o l i c i e s . T o m a n y e c o n o m i s t s a n d p o l i c y - m a k e r s , i t s e e m e d possible t h a t actively m a n a g e d m o n e t a r y ( a n d fiscal) p o l i c i e s c o u l d be used t o m a i n t a i n m a x i ­ m u m e m p l o y m e n t pretty m u c h all the time. T h a t h a p p y o u t c o m e was n o t t o be. T h e business cycle d i d n o t d i e a q u i e t d e a t h i n t h e 1960s, as h a d b e e n p r e d i c t e d b y t h e m o r e o p t i m i s t i c p r o p o n e n t s o f activist p o l i c i e s . I n d e e d , t h e recessions o f 1973-74 a n d 1981-82 w e r e t h e m o s t severe o f t h e postwar p e r i o d . N o r d i d i n f l a t i o n vanish: T h e late 1960s a n d t h e decade o f t h e 1970s w e r e p l a g u e d w i t h r i s i n g a n d v a r i a b l e rates o f i n f l a t i o n , i n t h e U n i t e d States a n d i n m a n y o t h e r c o u n t r i e s as w e l l . F u r t h e r , i n t h e view o f m o s t e c o n o m i s t s , t h e se­ vere 1981-82 recession was l a r g e l y t h e result o f restrictive m o n e t a r y policy, w h i c h i n t u r n h a d b e e n m a d e necessary b y s u r g i n g i n f l a t i o n . I n s h o r t , t h e activist m o n e t a r y p o l i c i e s o f t h e 1960s a n d 1970s n o t o n l y f a i l e d t o deliver t h e i r p r o m i s e d benefits, they h e l p e d t o generate i n f l a t i o n a r y pres­ sures t h a t c o u l d be s u b d u e d o n l y at h i g h e c o n o m i c cost. I n t e l l e c t u a l d e v e l o p m e n t s , t o o , have c o n t r i b u t e d t o t h e f a d i n g r e p u ­ t a t i o n o f s t r o n g l y activist p o l i c i e s . T h r e e s u c h d e v e l o p m e n t s have b e e n p a r t i c u l a r l y i n f l u e n t i a l : (1) M i l t o n F r i e d m a n ' s m o n e t a r i s t c r i t i q u e , par-

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CHAPTER 2

t i c u l a r l y his o b s e r v a t i o n t h a t m o n e t a r y p o l i c y w o r k s o n l y w i t h " l o n g a n d v a r i a b l e lags"; ( 2 ) t h e c o n c l u s i o n , r e a c h e d first by F r i e d m a n a n d E d m u n d Phelps, t h a t t h e r e is n o l o n g - r u n t r a d e o f f b e t w e e n i n f l a t i o n a n d u n e m p l o y m e n t ; a n d (3) i n c r e a s e d u n d e r s t a n d i n g o f t h e p o t e n t i a l i m p o r t a n c e o f c e n t r a l b a n k c r e d i b i l i t y t o t h e effectiveness o f m o n e t a r y policy. F r i e d m a n , the f o u n d e r o f the school o f macroeconomic t h o u g h t k n o w n as monetarism, n e v e r d o u b t e d t h a t m o n e t a r y p o l i c y c a n have p o w ­ e r f u l effects o n t h e e c o n o m y . H e d o c u m e n t e d this c l a i m extensively i n his p a t h - b r e a k i n g b o o k , A Monetary History of the United States, 1867-1960, c o - a u t h o r e d w i t h A n n a J . Schwartz. B u t F r i e d m a n also a r g u e d t h a t those effects set i n o n l y w i t h lags t h a t are b o t h l o n g a n d v a r i a b l e ( t h a t is, vary­ i n g f r o m episode t o episode i n essentially u n p r e d i c t a b l e ways). Conse­ q u e n t l y F r i e d m a n a r g u e d t h a t m o n e t a r y policy, t h o u g h p o w e r f u l , is n o t a t o o l t h a t c a n be u s e d w i t h p r e c i s i o n . F r i e d m a n ' s critics p o i n t e d o u t t h a t p o l i c y lags, even i f t h e y are as l o n g a n d v a r i a b l e as F r i e d m a n c l a i m e d , d o n o t r u l e o u t t h e p o s s i b i l i t y o f suc­ cessful activism; they o n l y m a k e c o n t r o l o f t h e e c o n o m y t e c h n i c a l l y m o r e d i f f i c u l t . F o r e x a m p l e , t h e y suggested, t h e t e c h n i q u e s o f " o p t i m a l c o n ­ t r o l " ( t h e m a t h e m a t i c a l a n d e n g i n e e r i n g m e t h o d s used i n g u i d i n g r o c k ­ ets) c o u l d be used t o c o m p e n s a t e f o r lags b e t w e e n a g i v e n p o l i c y a c t i o n a n d its effect. P o l i c y m a y b e less effective u n d e r these c o n d i t i o n s , F r i e d m a n ' s critics observed, b u t t h e active p u r s u i t o f s h o r t - r u n e c o n o m i c stability w o u l d still b e p r e f e r a b l e t o passive, non-reactive p o l i c y - m a k i n g . I n t u r n , various a r g u m e n t s against t h e o p t i m a l c o n t r o l p a r a d i g m f o r m o n e t a r y p o l i c y have b e e n p u t f o r w a r d . N o t a b l y , 1995 N o b e l Prize w i n ­ n e r R o b e r t E. Lucas, Jr., p o i n t e d o u t (Lucas, 1976) t h a t t h e r e is a n i m ­ p o r t a n t d i f f e r e n c e b e t w e e n rockets a n d t h e p e o p l e w h o m a k e u p a n e c o n o m y , w h i c h is t h a t p e o p l e t r y t o u n d e r s t a n d a n d p r e d i c t t h e actions o f t h e i r " c o n t r o l l e r s " ( t h e p o l i c y - m a k e r s ) , w h i l e rockets d o n o t . M o r e specifically, Lucas s h o w e d t h a t o p t i m a l c o n t r o l m e t h o d s m a y b e useless f o r g u i d i n g p o l i c y i f t h e y d o n o t take i n t o a c c o u n t t h e possibility t h a t t h e public's expectations about the future will change w h e n policies change. T h e p u b l i c ' s expectations a b o u t t h e f u t u r e , i n c l u d i n g expectations a b o u t f u t u r e p o l i c y actions, are i m p o r t a n t because they affect c u r r e n t e c o n o m i c behavior. C o n s e q u e n t l y , Lucas a r g u e d , p o l i c y - m a k i n g takes o n e l e m e n t s o f a strategic g a m e b e t w e e n t h e p o l i c y - m a k e r s a n d t h e p u b l i c . A n a l y z i n g s u c h a g a m e is a c o n s i d e r a b l y m o r e d i f f i c u l t p r o b l e m t h a n g u i d i n g a r o c k e t . M o r e o v e r , g i v e n t h e d i f f i c u l t y o f a n t i c i p a t i n g changes i n p u b l i c e x p e c t a t i o n s , Lucas's a r g u m e n t i m p l i e s , i t is d o u b t f u l t h a t p o l i c y - m a k e r s w i l l be able t o c o n t r o l t h e e c o n o m y w i t h any d e g r e e o f p r e c i s i o n .

THE RATIONALE FOR INFLATION TARGETING

13

Lucas's a r g u m e n t has h a d a m a j o r i m p a c t i n t h i n k i n g a b o u t m a c r o e c o n o m i c policy, t h o u g h t h e r e is still some d i s a g r e e m e n t a b o u t its e m ­ p i r i c a l relevance. T h e r e is, i n any case, a n o t h e r e x p l a n a t i o n o f w h y l o n g a n d v a r i a b l e lags m a k e activist p o l i c y c o u n t e r p r o d u c t i v e — a n e x p l a n a ­ t i o n t h a t , i n o u r view, is possibly m o r e r e l e v a n t t h a n t h e m o r e t e c h n i c a l e x p l a n a t i o n s (such as Lucas's). T h i s a l t e r n a t i v e e x p l a n a t i o n rests o n t h e t e n d e n c y o f t h e p u b l i c a n d p o l i t i c i a n s i n m o d e r n d e m o c r a c i e s t o take a m y o p i c view o f p u b l i c p o l i c y issues. G i v e n t h e pressures o f f r e q u e n t elec­ t i o n s a n d t h e a l m o s t i n s t a n t a n e o u s r e p o r t i n g o f p o l l results, i t is d i f f i ­ c u l t f o r p o l i t i c i a n s t o a p p r e c i a t e t h a t w a t c h f u l w a i t i n g is s o m e t i m e s t h e best policy. Instead, i n practice, politicians (and politically i n f l u e n c e d central b a n k e r s ) t e n d t o o v e r - m a n i p u l a t e t h e levers o f m o n e t a r y p o l i c y i n at­ t e m p t s t o c o n t r o l t h e e c o n o m y . T h e y m a y react t o a rise i n u n e m p l o y ­ m e n t , f o r e x a m p l e , by c u t t i n g i n t e r e s t rates sharply, i g n o r i n g t h e possi­ b i l i t y t h a t t h e s i t u a t i o n m i g h t have r i g h t e d i t s e l f b y t h e t i m e t h e effects o f t h e i r a c t i o n are felt. As a result, t h e e c o n o m y m a y overheat, l e a d i n g e i t h e r t o a b o u t o f i n f l a t i o n o r t o a n o t h e r s h a r p p o l i c y shift, w h i c h gen­ erates m o r e , r a t h e r t h a n less, e c o n o m i c instability. T h u s , because o f t h e i n t e r a c t i o n o f l o n g p o l i c y lags a n d s h o r t p o l i t i c a l h o r i z o n s , activist p o l i ­ cies m a y l e a d t o worse results t h a n w o u l d a p o l i c y o f r e s t r a i n t . T h e s e c o n d b l o w t o p o l i c y activism also was s t r u c k b y F r i e d m a n , i n his 1967 p r e s i d e n t i a l address t o t h e A m e r i c a n E c o n o m i c A s s o c i a t i o n ( F r i e d ­ m a n , 1 9 6 8 ) . ( A r g u m e n t s s i m i l a r t o F r i e d m a n ' s were m a d e at a b o u t t h e same t i m e b y E d m u n d Phelps [Phelps, 1968] ) . I n his address, F r i e d m a n c r i t i c i z e d t h e a s s u m p t i o n t h a t permanent r e d u c t i o n s i n u n e m p l o y m e n t c o u l d be a c h i e v e d b y a c c e p t i n g a h i g h e r level o f i n f l a t i o n ( t h e P h i l l i p s curve tradeoff). H e agreed that h i g h e r i n f l a t i o n m i g h t stimulate the economy a n d lower u n e m p l o y m e n t for short periods: For example, i f wage rates are fixed b y c o n t r a c t a n d prices u n e x p e c t e d l y rise, t h e n t h e p r o f i t m a r g i n s o f firms w i l l increase, g i v i n g t h e m a n i n c e n t i v e t o p r o ­ d u c e m o r e goods a n d services. ( T h i s is j u s t o n e o f m a n y stories t h a t have b e e n t o l d t o e x p l a i n w h y i n f l a t i o n m a y s t i m u l a t e t h e e c o n o m y . ) I n ef­ fect, firms choose t o p r o d u c e m o r e because u n e x p e c t e d i n f l a t i o n i m ­ plies a n u n e x p e c t e d d e c l i n e i n t h e r e a l cost o f p r o d u c t i o n . However, F r i e d m a n p o i n t e d o u t , w o r k e r s are n o m o r e l i k e l y t h a n firms to i g n o r e t h e i r o w n e c o n o m i c interests. O n c e t h e y realize t h a t i n f l a t i o n has r i s e n , t h e y w i l l d e m a n d m o r e r a p i d wage increases t o c o m p e n s a t e f o r t h e i r lost b u y i n g power. As t h e rate o f increase i n wages begins t o m a t c h t h e rate o f increase i n prices, t h e p r o f i t m a r g i n s o f firms, a n d h e n c e t h e i r rate o f p r o d u c t i o n , w i l l r e t u r n t o n o r m a l . T h e n e t r e s u l t is 1

14

CHAPTER 2

t h a t , i n t h e l o n g r u n , o n l y t h e i n f l a t i o n rate has b e e n affected b y t h e e x p a n s i o n a r y m o n e t a r y p o l i c y ; o u t p u t a n d u n e m p l o y m e n t have r e t u r n e d to t h e i r n o r m a l , o r " n a t u r a l , " rates. H e n c e , F r i e d m a n c o n c l u d e d , t h e n o t i o n t h a t b y a c c e p t i n g a rise i n i n f l a t i o n t h e c o u n t r y c a n b u y a l o n g t e r m decrease i n u n e m p l o y m e n t is w r o n g : There is no long-run tradeoff between inflation and unemployment. Or, i f t h e r e is such a r e l a t i o n s h i p , F r i e d ­ m a n a d d e d i n his 1977 N o b e l l e c t u r e ( F r i e d m a n , 1 9 7 7 ) , i t goes t h e " w r o n g " way: Because i n f l a t i o n i n h i b i t s e c o n o m i c g r o w t h a n d efficiency, a n increase i n i n f l a t i o n m a y i n fact l e a d t o s l i g h t l y h i g h e r ( r a t h e r t h a n lower) u n e m p l o y m e n t i n the l o n g r u n . T h i s a l l e g e d absence o f any l o n g - r u n r e l a t i o n s h i p b e t w e e n i n f l a t i o n a n d u n e m p l o y m e n t has i m p o r t a n t i m p l i c a t i o n s f o r activist m o n e t a r y policy. C o n t r a r y t o w h a t was b e l i e v e d t h i r t y years ago, i t appears t h a t t h e benefits o f e x p a n s i o n a r y p o l i c i e s ( s u c h as l o w e r u n e m p l o y m e n t ) are l a r g e l y t r a n s i t o r y , whereas t h e costs o f e x p a n s i o n a r y p o l i c i e s ( p r i m a r i l y t h e i n e f f i c i e n c i e s associated w i t h h i g h e r i n f l a t i o n ) t e n d t o b e p e r m a ­ n e n t , absent any c o u n t e r v a i l i n g p o l i c i e s . T h u s , l o n g after t h e benefits o f t h e e x p a n s i o n a r y p o l i c i e s have d i s a p p e a r e d , p o l i c y - m a k e r s w i l l have to choose b e t w e e n a c c e p t i n g a h i g h e r p e r m a n e n t level o f i n f l a t i o n ( w i t h its negative i m p a c t o n t h e e c o n o m y ) a n d r e i n i n g i n t h e e c o n o m y b y restrictive policies. Restraining the e c o n o m y w i t h t i g h t m o n e t a r y a n d fiscal p o l i c i e s curtails i n f l a t i o n b u t m a y also "give back" m u c h o f t h e e m p l o y m e n t gains, so t h a t o f t e n a l l t h a t has b e e n a c c o m p l i s h e d i n t h e l o n g r u n is t o increase t h e i n s t a b i l i t y o f t h e e c o n o m y . T o p u t F r i e d m a n ' s p o i n t a n o t h e r way, i n t h e l o n g r u n t h e o n l y m a c r o e c o n o m i c v a r i a b l e t h a t t h e c e n t r a l b a n k c a n affect systematically is t h e i n f l a t i o n rate. I t is u n l i k e l y that m o n e t a r y policy can be used to reduce the u n e m p l o y m e n t r a t e on average over any substantial p e r i o d o f t i m e . 2

T h e t h i r d c h a l l e n g e t o activist p o l i c y arose f r o m t h e policy credibility problem ( k n o w n also i n t h e t e c h n i c a l l i t e r a t u r e as t h e " t i m e i n c o n s i s t e n c y p r o b l e m " ) , analyzed i n i m p o r t a n t w o r k by K y d l a n d a n d Prescott ( 1 9 7 7 ) , Calvo ( 1 9 7 8 ) , B a r r o a n d G o r d o n ( 1 9 8 3 ) , a n d m a n y s u b s e q u e n t a u t h o r s . T h e p o l i c y c r e d i b i l i t y p r o b l e m has t o d o w i t h t h e l i k e l i h o o d t h a t , even i f i t wants t o k e e p i n f l a t i o n low, a n activist c e n t r a l b a n k w i l l o f t e n have a s t r o n g i n c e n t i v e t o increase t h e rate o f i n f l a t i o n above t h e level e x p e c t e d by t h e p u b l i c . T h e reason is t h a t i n t h e s h o r t r u n wages a n d m a n y o t h e r i n p u t costs are fixed b y c o n t r a c t o r by i n f o r m a l a g r e e m e n t ; h e n c e , b y creating m o r e inflation t h a n expected, the central bank can stimulate p r o d u c t i o n , e m p l o y m e n t , a n d p r o f i t s , at least t e m p o r a r i l y . Since h i g h rates o f e m p l o y m e n t a n d p r o f i t s are p o p u l a r , t h e c e n t r a l b a n k w i l l b e t e m p t e d to boost inflation.

15

THE RATIONALE FOR INFLATION TARGETING

B u t w i l l t h e c e n t r a l b a n k i n fact be able t o achieve these s h o r t - r u n gains? K y d l a n d a n d Prescott a n d t h e a u t h o r s t h a t f o l l o w e d , i n a n a r g u ­ m e n t r e m i n i s c e n t o f F r i e d m a n ' s e a r l i e r c r i t i q u e , p o i n t e d o u t t h a t i t was u n l i k e l y t h a t t h e c e n t r a l b a n k c o u l d consistently f o o l w o r k e r s a n d firms i n t o e x p e c t i n g i n f l a t i o n l o w e r t h a n w h a t subsequently o c c u r r e d . Even­ tually, w o r k e r s a n d firms w o u l d c o m e t o u n d e r s t a n d t h e c e n t r a l bank's incentives, l e a d i n g t h e m t o adjust t h e i r i n f l a t i o n expectations ( a n d h e n c e t h e i r wage- a n d p r i c e - s e t t i n g b e h a v i o r ) a c c o r d i n g l y . T h e o u t c o m e , o n c e t h e p u b l i c u n d e r s t a n d s t h e c e n t r a l bank's behavior, is t h a t o u t p u t a n d e m p l o y m e n t are, o n average, n o h i g h e r t h a n t h e y o t h e r w i s e w o u l d be; b u t i n f l a t i o n is h i g h e r t h a n i t o t h e r w i s e w o u l d be, w i t h n o benefits t o compensate. 3

T h e p o l i c y c r e d i b i l i t y a r g u m e n t suggests t h a t activist c e n t r a l banks, n o m a t t e r h o w m u c h t h e y declare t h e i r i n t e n t i o n t o k e e p i n f l a t i o n low, w i l l be over-expansionist a n d h e n c e i n f l a t i o n - p r o n e i n p r a c t i c e . As t h e p u b l i c comes t o u n d e r s t a n d a n d a n t i c i p a t e this behavior, h i g h e r i n f l a ­ t i o n w i l l b e c o m e i n g r a i n e d i n t h e system, w i t h o u t any c o m p e n s a t i n g i n ­ crease i n o u t p u t o r e m p l o y m e n t . T h i s " i n f l a t i o n bias" is a n o t h e r pos­ sible d r a w b a c k o f a n activist m o n e t a r y policy. T h u s a n u m b e r o f d e v e l o p m e n t s have a c t e d t o d i m t h e o p t i m i s t i c v i e w o f t h e c a p a b i l i t i e s o f m o n e t a r y p o l i c y t h a t was d o m i n a n t i n t h e 1960s. W e d o n o t w a n t t o take t h i s p o i n t t o o far: D e s p i t e a l l we have said, we d o n o t d e n y t h a t m o n e t a r y p o l i c y c a n have p o w e r f u l effects o n o u t p u t a n d e m p l o y m e n t , o r even t h a t t h e r e are t i m e s w h e n m o n e t a r y p o l i c y c a n be u s e d c o n s t r u c t i v e l y t o stabilize o u t p u t a n d e m p l o y m e n t . M o r e o v e r , i t is u n r e a l i s t i c t o t h i n k t h a t p o l i t i c i a n s a n d p o l i c y - m a k e r s c a n ever b e i n d u c e d t o a b s t a i n c o m p l e t e l y f r o m activist p o l i c i e s , g i v e n the p o l i t i c a l pressures to "do s o m e t h i n g " a b o u t slowdowns i n the e c o n o m y . I n d e e d , we w i l l see i n t h i s b o o k t h a t even t h e m o s t a v i d i n f l a ­ t i o n - t a r g e t i n g c e n t r a l b a n k s c a n a n d d o use m o n e t a r y p o l i c y t o address s h o r t - t e r m p o l i c y objectives, w i t h i n a f r a m e w o r k o f m a i n t a i n i n g l o n g r u n p r i c e stability. Still, to reiterate, activist p o l i c y o r i e n t e d to k e e p i n g the e c o n o m y c o n t i n u o u s l y at f u l l e m p l o y m e n t c o m e s w i t h i m p o r t a n t caveats: First, because o f l o n g a n d v a r i a b l e lags b e t w e e n m o n e t a r y p o l i c y a c t i o n s a n d effects, t h e effectiveness o f activist p o l i c i e s m a y b e s e r i o u s l y c u r t a i l e d ; i n d e e d , i f these p o l i c i e s are c o n t r o l l e d b y m y o p i c p o l i t i c i a n s , t h e y m a y b e d e s t a b i l i z i n g , r a t h e r t h a n s t a b i l i z i n g . S e c o n d , t h e a p p a r e n t absence o f any l o n g - r u n t r a d e o f f b e t w e e n u n e m p l o y m e n t a n d i n f l a t i o n reduces t h e attractiveness o f activist policies, since t h e benefits o f such policies ( h i g h e r o u t p u t a n d e m p l o y m e n t ) are largely transitory, w h i l e t h e i r costs

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CHAPTER 2

( h i g h e r i n f l a t i o n ) are p e r m a n e n t . I n d e e d , i n t h e l o n g r u n , t h e c e n t r a l b a n k c a n affect o n l y i n f l a t i o n , a n d n o t real variables such as o u t p u t . F i ­ nally, t h e r e are reasons t o believe t h a t c e n t r a l banks t h a t engage i n activist policies m a y b e p r o n e to opportunistic behavior, w h i c h leads (once the p u b l i c has c o m e to u n d e r s t a n d i t ) to h i g h e r i n f l a t i o n b u t n o h i g h e r o u t p u t o r e m p l o y m e n t (the policy c r e d i b i l i t y p r o b l e m ) . T h i s awareness o f w h a t m o n ­ etary policy can a n d c a n n o t d o has m o v e d m a n y m o n e t a r y policy-makers t o w a r d a greater focus o n p r i c e stability, particularly i n the l o n g r u n . T o f o r e s t a l l c o n f u s i o n : O u r c r i t i c i s m s o f " p o l i c y a c t i v i s m " does n o t i m p l y t h a t p o l i c y - m a k e r s s h o u l d b e r e l u c t a n t t o m o v e t h e p o l i c y levers, b u t r a t h e r t h a t d o i n g so i n a n a t t e m p t t o m a i n t a i n c o n t i n u o u s f u l l e m ­ p l o y m e n t is l i k e l y t o be c o u n t e r p r o d u c t i v e . I n d e e d , a focus o n p r i c e sta­ bility, as i m p l i e d b y t h e i n f l a t i o n - t a r g e t i n g a p p r o a c h , m a y r e q u i r e active m a n i p u l a t i o n o f m o n e t a r y policy instruments. Policy activism, i n the b r o a d e r sense o f p o l i c y r e a c t i n g sensitively t o n e w i n f o r m a t i o n as i t ar­ rives, is n o t r u l e d o u t b y these a r g u m e n t s .

The Benefits of Low Inflation A n o t h e r reason f o r s e t t i n g p r i c e stability as t h e p r i m a r y g o a l o f m o n ­ etary p o l i c y is a g r o w i n g b e l i e f a m o n g e c o n o m i s t s a n d c e n t r a l b a n k e r s t h a t l o w i n f l a t i o n helps t o p r o m o t e e c o n o m i c efficiency a n d g r o w t h i n the l o n g r u n . T h a t h i g h i n f l a t i o n is d e t r i m e n t a l t o t h e e c o n o m y has l o n g b e e n rec­ o g n i z e d . C o u n t r i e s e x p e r i e n c i n g h i g h i n f l a t i o n (or, i n e x t r e m e cases, " h y p e r i n f l a t i o n " o f 5 0 0 % t o 1 0 0 0 % o r m o r e p e r year) usually e x h i b i t p o o r e c o n o m i c p e r f o r m a n c e . A m o n g t h e costs o f h i g h i n f l a t i o n are: overe x p a n s i o n o f t h e financial system, as i n d i v i d u a l s a n d businesses d e v o t e m o r e a n d m o r e o f t h e i r resources t o a v o i d i n g t h e effects o f i n f l a t i o n o n t h e i r cash h o l d i n g s ; a n i n c r e a s e d s u s c e p t i b i l i t y t o financial crisis, as d i f f i ­ culties i n a d j u s t i n g t o h i g h i n f l a t i o n m a k e t h e f i n a n c i a l system m o r e fragile; p o o r f u n c t i o n i n g o f p r o d u c t a n d l a b o r m a r k e t s , as prices be­ c o m e noisy measures o f t h e relative e c o n o m i c values o f g o o d s a n d ser­ vices; t h e costs o f f r e q u e n t r e - p r i c i n g , a l o n g w i t h t h e costs o f m o n i t o r i n g t h e prices o f s u p p l i e r s a n d c o m p e t i t o r s ; a n d d i s t r i b u t i o n a l effects, o f t e n i n c l u d i n g t h e d e s t r u c t i o n o f t h e m i d d l e class ( m u c h o f whose savings b e c o m e w o r t h l e s s ) , w i t h t h e associated social c o n s e q u e n c e s . F i s c h e r ( 1 9 9 3 ) a n d o t h e r s have p r o v i d e d evidence t h a t m a c r o e c o n o m i c stabil­ ity, i n c l u d i n g c o n t r o l o f i n f l a t i o n , is a n i m p o r t a n t p r e c o n d i t i o n f o r eco­ nomic growth.

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P e r i o d s o f v e r y r a p i d i n f l a t i o n are c l e a r l y d e s t r u c t i v e . B u t w h e t h e r m o r e m o d e r a t e i n f l a t i o n ( b e l o w , say, 1 0 % p e r y e a r ) is h a r m f u l , is m o r e c o n t r o v e r s i a l . S o m e e c o n o m i s t s have a r g u e d t h a t t h e p u b l i c ' s consis­ t e n t a n t i p a t h y t o w a r d i n f l a t i o n (as e v i d e n c e d b y o p i n i o n p o l l s , f o r ex­ a m p l e ) is p r i m a r i l y t h e r e s u l t o f c o n f u s i o n a b o u t w h a t i n f l a t i o n r e a l l y is. S t r i c t l y s p e a k i n g , i n f l a t i o n is a g e n e r a l rise i n a l l p r i c e s , wages, a n d i n c o m e s . As s u c h , i t s h o u l d have l i t t l e o r n o effect o n r e a l p u r c h a s i n g p o w e r o r t h e e c o n o m i c i n c e n t i v e s o f i n d i v i d u a l s , since a g e n e r a l rise i n p r i c e s leaves r e l a t i v e p r i c e s u n a f f e c t e d . W h e n m e m b e r s o f t h e p u b l i c t a l k a b o u t i n f l a t i o n , however, t h e y o f t e n stress t h e effects o f changes i n r e l a t i v e p r i c e s ( o f f o o d o r energy, f o r e x a m p l e ) o n t h e i r s t a n d a r d o f l i v i n g . T h e s e are l e g i t i m a t e c o n c e r n s , o f course, b u t t h e y are l a r g e l y i n d e p e n d e n t o f t h e r a t e o f i n f l a t i o n per se. M o r e o v e r , t h e y are b e y o n d the power o f monetary policy to correct. "True" inflation, economists have s o m e t i m e s suggested, s h o u l d b e n o m o r e h a r m f u l t o t h e e c o n o m y t h a n a d e c i s i o n t o p r i c e a l l g o o d s a n d services i n t e r m s o f d i m e s i n ­ stead o f d o l l a r s . Yet i n r e c e n t years e c o n o m i s t s a n d c e n t r a l b a n k e r s have t e n d e d t o t r e a t even r e l a t i v e l y l o w rates o f i n f l a t i o n as a p r o b l e m , as e v i d e n c e d b y t h e aggressive d i s i n f l a t i o n s t h a t p o l i c y - m a k e r s have u n d e r t a k e n i n a l ­ m o s t every i n d u s t r i a l i z e d c o u n t r y i n t h e past t w o decades. S o m e w h a t p a r a d o x i c a l l y , t o a d e g r e e i n f l a t i o n has b e c o m e p e r c e i v e d as a serious e c o n o m i c p r o b l e m p r e c i s e l y because o f t h e p u b l i c ' s c o n f u s i o n o v e r w h a t i n f l a t i o n is a n d a b o u t h o w t o m a k e a d j u s t m e n t s f o r i t . F o r ex­ a m p l e , because p e o p l e find i t d i f f i c u l t t o adjust f o r i n f l a t i o n i n t h e i r c a l c u l a t i o n s , m a n y o f t h e i r d e c i s i o n s — p a r t i c u l a r l y l o n g - t e r m decisions, s u c h as h o w m u c h t o save f o r r e t i r e m e n t a n d h o w t o invest t h e i r c a p i ­ t a l — a r e less a p p r o p r i a t e t h a n t h e y m i g h t o t h e r w i s e b e . A n d i t is t r u e , g i v e n c o m p o u n d i n t e r e s t , t h a t o v e r a t h i r t y - o r forty-year p e r i o d , even s l i g h t d i f f e r e n c e s i n a n n u a l i n f l a t i o n rates have a l a r g e effect o n t h e p u r c h a s i n g p o w e r o f t h e d o l l a r . M a k i n g i t d i f f i c u l t t o assess b o t h cur­ r e n t r e l a t i v e p r i c e s a n d t h e f u t u r e p r i c e l e v e l , i n f l a t i o n c a n also d i s t o r t t h e decisions o f firms a b o u t p r o d u c t i o n a n d i n v e s t m e n t . M o r e s o p h i s t i c a t e d savers, investors, a n d m a n a g e r s , o f c o u r s e , find ways t o i n s u l a t e themselves f r o m t h e effects o f i n f l a t i o n . B u t t h a t e f f o r t is n o t w i t h o u t its o w n e c o n o m i c costs, i n c l u d i n g costs o f a t t e n t i o n a n d c a l c u l a t i o n as w e l l as t h e cost o f resources d e v o t e d t o ( f o r e x a m p l e ) t h e d e v e l o p m e n t o f a l t e r n a t i v e financial i n s t r u m e n t s . Less s o p h i s t i c a t e d i n d i v i d u a l s are less l i k e l y t o i n s u l a t e t h e i r i n c o m e a n d savings f r o m i n f l a t i o n ; t h e i r i n a b i l i t y t o d o so r e p r e s e n t s o n e o f several c h a n n e l s b y which inflation induces redistribution o f wealth a m o n g groups.

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S h i l l e r ' s ( 1 9 9 6 ) o p i n i o n surveys o f p u b l i c a t t i t u d e s t o w a r d i n f l a t i o n , w h i l e c o n f i r m i n g t h e s u s p i c i o n s o f e c o n o m i s t s t h a t t h e p u b l i c is c o n ­ f u s e d a b o u t w h a t i n f l a t i o n is, s h o w t h a t p e o p l e b e l i e v e i n f l a t i o n t o b e h i g h l y u n e v e n i n its d i s t r i b u t i o n a l i m p a c t s a n d h e n c e c o r r o s i v e o f t h e social compact. T h e absence o f c o m p l e t e i n d e x a t i o n ( a u t o m a t i c a d j u s t m e n t s f o r i n ­ flation) i n virtually all legal a n d contractual arrangements (which i n t u r n reflects t h e m a n y t e c h n i c a l d i f f i c u l t i e s w i t h i n d e x a t i o n i n t h e r e a l w o r l d ) also allows i n f l a t i o n , e v e n a t r e l a t i v e l y l o w levels, t o have a d ­ verse e c o n o m i c effects. T h e m o s t i m p o r t a n t costs o f i n f l a t i o n at l o w t o m o d e r a t e levels s e e m t o c o m e f r o m t h e i n t e r a c t i o n o f i n f l a t i o n w i t h t h e t a x system, w h i c h is r a r e l y i f ever f u l l y i n d e x e d t o i n f l a t i o n . F o r example, the c o m m o n practice o f basing capital d e p r e c i a t i o n allow­ ances o n t h e h i s t o r i c a l costs o f i n v e s t m e n t s , r a t h e r t h a n o n c u r r e n t values, i m p l i e s t h a t i n f l a t i o n e r o d e s a k e y tax b e n e f i t o f c a p i t a l f o r m a ­ t i o n , r e d u c i n g t h e i n c e n t i v e t o i n v e s t a n d p e r h a p s (because o f s e c t o r a l differences i n capital lifetimes a n d depreciation methods) l e a d i n g to a m i s a l l o c a t i o n o f i n v e s t m e n t a m o n g sectors. F i s c h e r ( 1 9 9 4 ) calculates t h e social costs o f t a x - r e l a t e d d i s t o r t i o n s t o be a b o u t 2 % t o 3% o f G D P at a n i n f l a t i o n rate o f 1 0 % , a n d F e l d s t e i n (1997) argues t h a t t h e r e w o u l d b e s o c i a l gains f r o m r e d u c i n g i n f l a t i o n even w h e n i n i t i a l i n f l a t i o n is v e r y l o w . E v e n m o d e r a t e i n f l a t i o n c a n also p r o d u c e serious d i s t o r t i o n s i n a c c o u n t i n g systems, i n l a b o r c o n t r a c t s , a n d i n t h e risks a n d r e t u r n s o f financial i n s t r u m e n t s . T o b e sure, o b t a i n i n g d i r e c t e m p i r i c a l c o n f i r m a t i o n o f a l i n k be­ tween inflation and the overall economic performance o f the economy is v e r y d i f f i c u l t . I n f l a t i o n is, after a l l , d e t e r m i n e d b y t h e i n t e r a c t i o n o f m a n y forces. W e r a r e l y see v a r i a t i o n s i n i n f l a t i o n t h a t are n o t associ­ a t e d w i t h factors s u c h as s u p p l y shocks o r p o l i t i c a l i n s t a b i l i t y . Conse­ q u e n t l y , i t is p r o b a b l y i m p o s s i b l e t o c o n d u c t c o m p l e t e l y " c l e a n " tests o f t h e d i r e c t effects o f i n f l a t i o n o n r e a l e c o n o m i c p e r f o r m a n c e . S t i l l , a n u m b e r o f e c o n o m e t r i c studies are available t h a t associate h i g h e r i n f l a t i o n w i t h l o w e r p r o d u c t i v i t y a n d w i t h l o w e r rates o f g r o w t h (see A n d e r s e n a n d G r u e n [ 1 9 9 5 ] f o r a survey). I n o n e o f t h e m o s t c i t e d articles i n v o l v i n g cross-national c o m p a r i s o n s o f g r o w t h rates, Fischer (1993) finds that, o n average, a 1-percentage-point rise i n t h e r a t e o f i n f l a t i o n c a n cost a n e c o n o m y m o r e t h a n o n e - t e n t h o f a p e r c e n t a g e p o i n t i n its g r o w t h rate. T h e effect o n t h e g r o w t h rate o f t e n varies s i g n i f i c a n t l y w i t h t h e r a t e o f i n f l a t i o n , a c c o r d i n g t o e m p i r i c a l studies. F o r instance, Sarei ( 1 9 9 6 ) f o u n d t h a t t h e negative effects o f i n f l a t i o n increase s h a r p l y at h i g h e r rates o f i n f l a t i o n b u t are n o t i m p o r t a n t at rates o f i n f l a t i o n

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b e l o w 8% o r so; a n d B r u n o a n d Easterly (1998) a r g u e t h a t o n l y " i n f l a ­ t i o n crises," w h e n i n f l a t i o n reaches very h i g h levels, have s i g n i f i c a n t nega­ tive effects o n g r o w t h . However, some r e c e n t studies suggest t h a t t h e g r e a t e r u n p r e d i c t a b i l i t y o f p r i c e changes associated w i t h i n f l a t i o n m a y s i g n i f i c a n t l y r e t a r d e c o n o m i c g r o w t h , even at l o w levels o f i n f l a t i o n (Judson a n d O r p h a n i d e s , 1996; Hess a n d M o r r i s , 1 9 9 6 ) . T h e g r e a t e r t h e l o n g - t e r m effects o f i n f l a t i o n o n e c o n o m i c g r o w t h , t h e m o r e r e a s o n m o n e t a r y a u t h o r i t i e s have t o focus o n l o n g - r u n p r i c e stability as a p o l i c y goal.

The Need for a Nominal Anchor We have discussed t w o b r o a d reasons f o r a n i n c r e a s e d e m p h a s i s o n p r i c e stability i n m o n e t a r y p o l i c y - m a k i n g ; namely, r e d u c e d c o n f i d e n c e i n ac­ tivist p o l i c i e s a n d i n c r e a s e d c o n c e r n a b o u t t h e adverse effects o f even m o d e r a t e rates o f i n f l a t i o n . W h i l e these d e v e l o p m e n t s have i n c r e a s e d t h e r e c e p t i v i t y o f c e n t r a l b a n k e r s t o i n f l a t i o n t a r g e t i n g as a strategy f o r policy, we w o u l d a r g u e t h a t n e i t h e r o f these t w o reasons is absolutely essential f o r j u s t i f y i n g this p o l i c y a p p r o a c h . T h e strongest a r g u m e n t f o r i n f l a t i o n t a r g e t i n g is, instead, t h a t i t c a n h e l p t o p r o v i d e m o n e t a r y p o l i c y w i t h w h a t e c o n o m i s t s c a l l a " n o m i n a l anchor." T h e p r i c e o f any g o o d — b r e a d , f o r e x a m p l e — i s m e a s u r e d i n u n i t s o f w h a t e v e r i t is t h a t serves as m o n e y i n t h e society. F o r e x a m p l e , u n d e r a g o l d s t a n d a r d , as w i t h any o t h e r c o m m o d i t y m o n e y s t a n d a r d , t h e p r i c e o f b r e a d is m e a s u r e d i n ounces o f g o l d . U n d e r a g o l d s t a n d a r d , i t is n o t d i f f i c u l t t o see h o w t h e p r i c e o f b r e a d is d e t e r m i n e d : Because b r e a d a n d g o l d are b o t h i n t r i n s i c a l l y useful c o m m o d i t i e s , t h e p r i c e o f b r e a d i n terms o f g o l d c a n n o t d i f f e r b y t o o m u c h f r o m t h e relative m a r g i n a l values o f t h e t w o c o m m o d i t i e s t o t h e i r users. I f t h e r e is a f a m i n e , f o r e x a m p l e , b r e a d w i l l b e c o m e r e l a t i v e l y m o r e v a l u e d , a n d its p r i c e i n t e r m s o f g o l d w i l l rise; b u t i f g o l d j e w e l r y b e c o m e s m o r e f a s h i o n a b l e , t h e d e m a n d f o r g o l d w i l l rise, a n d t h e p r i c e o f b r e a d i n t e r m s o f g o l d w i l l f a l l . H o w prices are d e t e r m i n e d u n d e r a n u n b a c k e d p a p e r - m o n e y stan­ d a r d , w h i c h is t h e n e a r l y u n i v e r s a l type o f m o n e t a r y system at p r e s e n t , is far less o b v i o u s . W i t h p a p e r m o n e y i n t r i n s i c a l l y a l m o s t w o r t h l e s s , w h a t t h e n d e t e r m i n e s w h e t h e r a l o a f o f b r e a d is w o r t h o n e d o l l a r o r t h r e e dollars? T h e s h o r t answer, s w e e p i n g a l o t o f c o m p l i c a t i o n s u n d e r t h e r u g , is t h a t i n a p a p e r - m o n e y system t h e r e is a n e e d f o r s o m e a d d i t i o n a l c o n s t r a i n t o n m o n e t a r y policy, c a l l e d a nominal anchor, t o tie d o w n t h e p r i c e level t o a specific value at a g i v e n t i m e . A n o m i n a l a n c h o r c a n take 4

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t h e f o r m o f a q u a n t i t y c o n s t r a i n t , s u c h as a l i m i t o n t h e a m o u n t o f p a p e r m o n e y t h a t c a n be p u t i n t o c i r c u l a t i o n ; o r o f a p r i c e c o n s t r a i n t , w h i c h legally fixes t h e value o f t h e p a p e r m o n e y i n t e r m s o f some g o o d o r asset ( s u c h as g o l d o r a f o r e i g n c u r r e n c y ) . B o t h types have b e e n used, a n d b o t h c a n ensure t h a t t h e e c o n o m y ' s p r i c e level takes a w e l l - d e t e r m i n e d , specific value, despite t h e fact t h a t p a p e r m o n e y itself is i n t r i n s i c a l l y n e a r l y worthless. C o n d u c t i n g m o n e t a r y p o l i c y w i t h o u t a firmly established n o m i n a l a n c h o r is possible b u t risky. Suppose, f o r e x a m p l e , t h a t t h e r e is n o q u a n ­ t i t y o r p r i c e c o n s t r a i n t o n m o n e t a r y policy, a n d t h a t f o r some r e a s o n t h e r e is a sharp increase i n t h e rate o f i n f l a t i o n e x p e c t e d b y t h e p u b l i c . ( G o o d f r i e n d [ 1 9 9 3 ] has c a l l e d s u c h episodes " i n f l a t i o n scares" a n d ar­ gues t h a t they have o c c u r r e d f r e q u e n t l y i n postwar U . S . m o n e t a r y his­ tory.) S u c h shifts i n i n f l a t i o n e x p e c t a t i o n s pose a d i l e m m a f o r t h e m o n ­ etary a u t h o r i t i e s : Say t h e y a c c o m m o d a t e t h e shift by c o n d u c t i n g m o n ­ etary p o l i c y i n such a way t h a t t h e e x p e c t a t i o n s p r o v e c o r r e c t . B y d o i n g so t h e y have n o t o n l y p e r m i t t e d a rise i n i n f l a t i o n , b u t t h e y have also c o m m u n i c a t e d t o t h e p u b l i c t h a t t h e r e is n o t h i n g t o p r e v e n t i n f l a t i o n f r o m r i s i n g still f u r t h e r . I f , o n t h e o t h e r h a n d , they resist t h e rise i n i n f l a ­ t i o n e x p e c t a t i o n s b y k e e p i n g m o n e t a r y p o l i c y t i g h t , t h e y risk p u t t i n g t h e e c o n o m y i n t o a recession. I n t h e absence o f a n o m i n a l a n c h o r , shifts i n i n f l a t i o n e x p e c t a t i o n s c o u l d be i n d u c e d by any n u m b e r o f d i f f e r e n t fac­ tors, m a k i n g m a c r o e c o n o m i c p r e d i c t i o n a n d c o n t r o l e x c e p t i o n a l l y d i f f i ­ cult. Clearly, t h e n , m o n e t a r y p o l i c y is m o s t effective i n t h e p r e s e n c e o f a firmly established n o m i n a l a n c h o r , a n d t h e m o r e u n d e r s t a n d a b l e t h a t a n c h o r is t o t h e p u b l i c t h e better. A n effective c o m m i t m e n t t o l o n g - r u n p r i c e stability is j u s t s u c h a n o m i n a l a n c h o r , since ( g i v e n t h e c u r r e n t level o f p r i c e s ) , a t a r g e t rate o f i n f l a t i o n c o m m u n i c a t e s t o t h e p u b l i c t h e p r i c e level t h e c e n t r a l b a n k is a i m i n g t o achieve at specified dates i n t h e f u t u r e . W e w i l l discuss o t h e r possible ways t o establish a n o m i n a l a n c h o r i n a l a t e r chapter, w h e n we c o n s i d e r alternatives t o i n f l a t i o n t a r g e t i n g . We w i l l see, t h o u g h , t h a t each o f these alternatives has i m p o r t a n t p r o b ­ lems. As we have e m p h a s i z e d , t h e fact t h a t i n f l a t i o n t a r g e t i n g m a y b e a n effective m e a n s o f p r o v i d i n g a n o m i n a l a n c h o r f o r m o n e t a r y p o l i c y is, we believe, a sufficient reason i n i t s e l f t o c o n s i d e r this a p p r o a c h seri­ ously. I n p a r t i c u l a r , i n f l a t i o n t a r g e t i n g w o u l d r e m a i n a useful f r a m e w o r k f o r p o l i c y even i f t h e i n f l a t i o n targets w e r e set at m o d e r a t e r a t h e r t h a n l o w levels, p e r h a p s because i t m a y b e d e t e r m i n e d t h a t very l o w i n f l a t i o n is n o t b e n e f i c i a l t o t h e e c o n o m y . A n d , as we w i l l see r e p e a t e d l y i n this

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b o o k , i n f l a t i o n t a r g e t i n g does n o t p r e c l u d e some d e g r e e o f p o l i c y activ­ i s m ; rather, i t p r o v i d e s a f r a m e w o r k w h i c h allows f o r t h e p u r s u i t o f ob­ jectives o t h e r t h a n p r i c e stability i n a m o r e d i s c i p l i n e d a n d consistent m a n n e r . O f t h e t h r e e a r g u m e n t s we have discussed f o r m a k i n g t h e c o n ­ t r o l o f i n f l a t i o n t h e p r i m a r y l o n g - r u n g o a l o f m o n e t a r y policy, t h e a b i l i t y o f i n f l a t i o n targets t o h e l p establish a n o m i n a l a n c h o r f o r t h e p r i c e level seems t o us t h e m o s t essential.

Inflation Targeting: A Framework, Not a Rule T h e classification o f m o n e t a r y p o l i c y strategies as "rules" o r " d i s c r e t i o n " (see C h a p t e r 1) has b e e n a m a j o r t h e m e i n t h e h i s t o r y o f m o n e t a r y eco­ n o m i c s , a n d t h e c u r r e n t debate over i n f l a t i o n t a r g e t i n g reflects t h a t tra­ d i t i o n . R e c e n t c r i t i q u e s have t e n d e d t o place i n f l a t i o n t a r g e t i n g o n t h e " r u l e " side o f t h e d i c h o t o m y (see, f o r e x a m p l e , [ B e n j a m i n ] F r i e d m a n a n d K u t t n e r [ 1 9 9 6 ] ) . As we have already n o t e d , we believe t h a t this is n o t t h e best way t o t h i n k a b o u t i n f l a t i o n t a r g e t i n g . 5

7f i n f l a t i o n t a r g e t i n g w e r e t o be t r e a t e d as a p o l i c y r u l e i n t h e classical sense ( w h i c h , a g a i n , we d o n o t t h i n k i t s h o u l d b e ) , i t w o u l d i n d e e d be o p e n t o some serious criticisms. First, t h e i d e a t h a t m o n e t a r y p o l i c y liter­ ally has n o goals o t h e r t h a n t o c o n t r o l i n f l a t i o n w o u l d find l i t t l e s u p p o r t f r o m t h e p u b l i c , f r o m c e n t r a l bankers, o r f r o m m o n e t a r y economists. Second, g i v e n t h a t g o v e r n m e n t s a n d c e n t r a l banks d o care a b o u t p r o ­ d u c t i o n , e m p l o y m e n t , e x c h a n g e rates, a n d o t h e r variables besides i n f l a ­ t i o n , t r e a t i n g i n f l a t i o n t a r g e t i n g as a n i r o n c l a d p o l i c y r u l e c o u l d l e a d t o very p o o r e c o n o m i c outcomes. For example, F r i e d m a n a n d K u t t n e r (1996) emphasize t h a t a n exclusive focus o f p o l i c y o n i n f l a t i o n c o u l d l e a d to a h i g h l y unstable e c o n o m y i n t h e event o f large supply-side shocks, such as t h e s h a r p increases i n o i l prices t h a t have b u f f e t e d t h e w o r l d economy f r o m time to time. Finally, critics o f i n f l a t i o n t a r g e t i n g t h a t characterize this a p p r o a c h as a r u l e m i g h t w e l l ask w h a t w o u l d be g a i n e d b y p r e c o m m i t t i n g m o n e t a r y p o l i c y i n such a way. T h e academic l i t e r a t u r e argues t h a t " t y i n g t h e hands" o f m o n e t a r y policy-makers s h o u l d reduce o p p o r t u n i s m a n d hence the i n f l a t i o n bias associated w i t h t h e p o l i c y c r e d i b i l i t y p r o b l e m . I t also ar­ gues t h a t rules-based p o l i c i e s s h o u l d d i m i n i s h t h e costs o f d i s i n f l a t i o n , since i n c r e a s e d c r e d i b i l i t y leads t h e p u b l i c t o m o d e r a t e its i n f l a t i o n ex­ p e c t a t i o n s m o r e q u i c k l y . H o w e v e r , critics p o i n t o u t ( a n d o u r o w n analy­ sis w i l l c o n f i r m ) t h a t , a l t h o u g h i n f l a t i o n - t a r g e t i n g c o u n t r i e s have gener­ ally a c h i e v e d a n d m a i n t a i n e d l o w rates o f i n f l a t i o n , t h e r e is l i t t l e evi-

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d e n c e t h a t i n f l a t i o n t a r g e t i n g has s i g n i f i c a n t l y r e d u c e d t h e r e a l costs o f b r i n g i n g i n f l a t i o n d o w n . E v e n t h e D e u t s c h e B u n d e s b a n k a n d t h e Swiss N a t i o n a l B a n k , whose d o g g e d p u r s u i t o f l o w i n f l a t i o n over t h e past t w o decades has p r e s u m a b l y g i v e n t h e m m a x i m u m c r e d i b i l i t y , have m a n a g e d t o achieve r e d u c t i o n s i n i n f l a t i o n o n l y at h i g h costs i n lost o u t p u t a n d e m p l o y m e n t ( D e b e l l e a n d Fischer, 1994; Posen, 1995a). N o r is t h e r e evidence t h a t t h e i n t r o d u c t i o n o f i n f l a t i o n targets per se m a t e r i a l l y af­ fects e x p e c t a t i o n s o f i n f l a t i o n , as revealed e i t h e r b y surveys o r b y t h e level o f l o n g - t e r m n o m i n a l i n t e r e s t rates. I n f l a t i o n e x p e c t a t i o n s have c o m e d o w n , i n m o s t cases, o n l y as i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k s have d e m o n s t r a t e d t h a t t h e y c a n achieve, a n d w i l l m a i n t a i n , l o w i n f l a t i o n (as we w i l l discuss i n C h a p t e r 10; see also L a u b a c h a n d Posen [ 1 9 9 7 a ] ) . T h e s e o b j e c t i o n s are v a l i d , as far as t h e y g o . However, we have already expressed s k e p t i c i s m ( i n C h a p t e r 1) t h a t any m o n e t a r y - p o l i c y strategy t h a t has actually b e e n u s e d has m e t t h e classical c r i t e r i a f o r a p o l i c y r u l e . As we w i l l see, t h a t s k e p t i c i s m applies p a r t i c u l a r l y t o i n f l a t i o n t a r g e t i n g , at least as i t is actually p r a c t i c e d b y c o n t e m p o r a r y c e n t r a l b a n k s . I n f l a ­ t i o n t a r g e t i n g is n o t a p o l i c y r u l e i n t h e classical sense, a n d a n a l y z i n g i t as i f i t w e r e a s t r i c t p o l i c y r u l e leads t o i m p o r t a n t m i s c o n c e p t i o n s . W h y d o we believe t h a t i t is w r o n g t o t h i n k o f i n f l a t i o n t a r g e t i n g as a p o l i c y rule? First, at a t e c h n i c a l level, i n f l a t i o n t a r g e t i n g does n o t p r o ­ vide simple, mechanical operating instructions to the central bank. Rather, i n f l a t i o n t a r g e t i n g r e q u i r e s t h e c e n t r a l b a n k t o use s t r u c t u r a l a n d j u d g m e n t a l models o f the economy, i n c o n j u n c t i o n w i t h whatever i n f o r m a t i o n i t deems relevant, t o p u r s u e its price-stability o b j e c t i v e . I n o t h e r w o r d s , i n f l a t i o n t a r g e t i n g is v e r y m u c h a " l o o k at e v e r y t h i n g " strat­ egy, a l b e i t o n e w i t h a f o c u s e d g o a l . S e c o n d , a n d m o r e i m p o r t a n t l y , i n f l a t i o n t a r g e t i n g as i t is a c t u a l l y prac­ t i c e d confers a c o n s i d e r a b l e d e g r e e o f d i s c r e t i o n o n p o l i c y - m a k e r s . As t h e case studies i n this b o o k w i l l d o c u m e n t i n d e t a i l , i n f l a t i o n - t a r g e t i n g c e n t r a l bankers, w i t h i n t h e constraints i m p o s e d by t h e i r m e d i u m - t o l o n g t e r m i n f l a t i o n targets, have left themselves considerable scope t o r e s p o n d t o u n e m p l o y m e n t c o n d i t i o n s , e x c h a n g e r a t e fluctuations, a n d o t h e r short-run phenomena. B u t i f i n f l a t i o n t a r g e t i n g is n o t a r u l e i n t h e classical sense, t h e n w h a t is i t , a n d w h a t g o o d is it? As we have suggested, we find i t f r u i t f u l t o t h i n k o f i n f l a t i o n t a r g e t i n g n o t as a p o l i c y r u l e , b u t as a f r a m e w o r k f o r p o l i c y w i t h i n w h i c h " c o n s t r a i n e d d i s c r e t i o n " c a n be exercised. I t is h e r e t h a t t h e n o m i n a l a n c h o r f u n c t i o n o f i n f l a t i o n targets is c e n t r a l : L i k e a real-life a n c h o r , i n f l a t i o n targets k e e p t h e e c o n o m i c s h i p i n t h e d e s i r e d area i n t h e l o n g t e r m , w h i l e p e r m i t t i n g i t t o r e s p o n d i n t h e s h o r t r u n t o

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u n p r e d i c t a b l e swells a n d c u r r e n t s . Less fancifully, we see t h e i n f l a t i o n t a r g e t i n g f r a m e w o r k as s e r v i n g t w o i m p o r t a n t f u n c t i o n s : ( 1 ) i m p r o v i n g c o m m u n i c a t i o n between policy-makers and the public, and, n o t u n relate dly, (2) p r o v i d i n g d i s c i p l i n e a n d a c c o u n t a b i l i t y i n t h e m a k i n g o f m o n e t a r y policy. T h e a n n o u n c e m e n t o f i n f l a t i o n targets c o m m u n i c a t e s t h e c e n t r a l bank's i n t e n t i o n s t o t h e financial m a r k e t s a n d t o t h e p u b l i c , a n d i n so d o i n g helps t o r e d u c e u n c e r t a i n t y a b o u t t h e f u t u r e course o f i n f l a t i o n . M a n y o f t h e costs o f i n f l a t i o n arise f r o m its u n c e r t a i n t y o r v a r i a b i l i t y r a t h e r t h a n f r o m its level; f o r e x a m p l e , u n c e r t a i n t y a b o u t i n f l a t i o n exac­ erbates t h e v o l a t i l i t y o f relative prices ( r e d u c i n g t h e i n f o r m a t i o n c o n ­ t e n t o f prices) a n d increases t h e riskiness o f n o n - i n d e x e d financial i n ­ s t r u m e n t s a n d contracts set i n n o m i n a l t e r m s . I n a d d i t i o n , u n c e r t a i n t y a b o u t t h e i n t e n t i o n s o f t h e c e n t r a l b a n k creates v o l a t i l i t y i n financial m a r k e t s — a c o m m o n p h e n o m e n o n i n t h e U n i t e d States, w h e r e stockm a r k e t analysts parse every sentence u t t e r e d b y t h e Federal Reserve chair­ m a n i n search o f h i d d e n m e a n i n g s . By m a k i n g e x p l i c i t t h e c e n t r a l bank's m e d i u m - t e r m p o l i c y i n t e n t i o n s , i n f l a t i o n targets i m p r o v e p l a n n i n g i n t h e p r i v a t e sector, e n h a n c e t h e p u b l i c debate a b o u t t h e d i r e c t i o n o f m o n ­ etary policy, a n d increase t h e a c c o u n t a b i l i t y o f t h e c e n t r a l b a n k . Trans­ p a r e n c y — c l a r i t y a n d ease o f u n d e r s t a n d i n g b y t h e p u b l i c — h a s b e e n c l a i m e d f o r o t h e r p o l i c y strategies as w e l l , b u t t h e p u b l i c is far m o r e l i k e l y to u n d e r s t a n d w h a t is m e a n t by t h e p r e d i c t e d rate o f c h a n g e o f c o n s u m e r prices t h a n , f o r instance, t h e g r o w t h rate o f t h e M l m o n e y stock. C o n s i d e r t h e f a m i l i a r scenario i n w h i c h a n u p c o m i n g e l e c t i o n o r a slow e c o n o m i c r e c o v e r y p r o m p t s t h e g o v e r n m e n t t o pressure t h e cen­ tral bank to apply some short-run stimulus to the economy. I n an infla­ t i o n - t a r g e t i n g r e g i m e , t h e c e n t r a l b a n k w o u l d be a b l e — i n d e e d , w o u l d be r e q u i r e d — t o m a k e i t clear t h a t t h e s h o r t - r u n benefits o f t h a t a c t i o n (faster r e a l g r o w t h ) m a y have t o be p u r c h a s e d at t h e cost o f h i g h e r i n f l a ­ t i o n i n t h e m e d i u m a n d l o n g t e r m s . T h e accuracy o f t h e c e n t r a l b a n k ' s i n f l a t i o n p r o j e c t i o n s , a n d t h e w i l l i n g n e s s o f t h e g o v e r n m e n t t o accept t h e h i g h e r i n f l a t i o n , c o u l d t h e n be d e b a t e d i n p u b l i c . T h e issue o f l o n g r u n i n f l a t i o n w o u l d be o n t h e table, w h e r e i t c o u l d be seen as a c o u n t e r ­ w e i g h t t o t h e p r o j e c t e d s h o r t - r u n benefits o f a n e c o n o m i c s t i m u l u s . M a k i n g visible t h e c o n n e c t i o n b e t w e e n s h o r t - t e r m adjustments o f m o n ­ etary p o l i c y a n d t h e i r l o n g - t e r m consequences w o u l d clarify f o r t h e p u b ­ lic a n d f o r p o l i c y - m a k e r s w h a t i t is t h a t m o n e t a r y p o l i c y c a n a n d c a n n o t d o . A t t h e very least, t h e n e e d t o c o n s i d e r l o n g - t e r m consequences m i g h t h e l p o v e r c o m e t h e m y o p i a o f policy-makers a n d d a m p e n t h e i r readiness to o v e r - m a n i p u l a t e t h e levers o f p o l i c y i n a d e s t a b i l i z i n g way.

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A g g r e g a t e s u p p l y shocks, s u c h as o i l - p r i c e shocks, p r e s e n t a t h o r n i e r p r o b l e m f o r i n f l a t i o n targeters (as stressed b y F r i e d m a n a n d K u t t n e r [ 1 9 9 6 ] ) . O n c e a severe s u p p l y s h o c k h i t s t h e e c o n o m y , k e e p i n g i n f l a t i o n close t o t h e t a r g e t m a y p r o v e v e r y costly i n t e r m s o f l o s t o u t p u t a n d e m ­ p l o y m e n t . As t h e case studies i n this b o o k w i l l show, however, a w e l l d e s i g n e d i n f l a t i o n - t a r g e t i n g r e g i m e can c o p e w i t h s u p p l y shocks f a i r l y w e l l . F o r e x a m p l e , t h e i n f l a t i o n t a r g e t i n m o s t c o u n t r i e s is d e s i g n e d t o e x c l u d e at least t h e first-round effects o f c e r t a i n s u p p l y shocks, s u c h as rises i n t h e prices o f f o o d o r energy, o r i n v a l u e - a d d e d taxes. Escape clauses t h a t p e r m i t t h e c e n t r a l b a n k t o c h a n g e its m e d i u m - t e r m targets i n response t o u n e x p e c t e d d e v e l o p m e n t s are a n o t h e r way o f c o p i n g w i t h s u p p l y shocks. As w e w i l l see i n C h a p t e r 4, f o l l o w i n g t h e 1979 o i l - s u p p l y shock, t h e B u n d e s b a n k raised its one-year i n f l a t i o n g o a l i n o r d e r t o de­ fine a n e w t r a n s i t i o n p a t h f o r i n f l a t i o n . T h e B u n d e s b a n k set its shortt e r m i n f l a t i o n goals so that, o v e r t i m e , t h e i n f l a t i o n i n d u c e d b y t h e sup­ p l y s h o c k was g r a d u a l l y e l i m i n a t e d , u n t i l t h e l o n g - r u n i n f l a t i o n objec­ tive was o n c e a g a i n r e a c h e d . I n c o n t r a s t t o a p u r e l y d i s c r e t i o n a r y ap­ p r o a c h , i n w h i c h t h e c e n t r a l b a n k e r s d e a l w i t h s u p p l y shocks b y t h e seat o f t h e i r pants, t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k gives t h e c e n t r a l b a n k a b e t t e r c h a n c e o f c o n v i n c i n g t h e p u b l i c t h a t t h e effects o f a s u p p l y s h o c k w i l l be l i m i t e d t o a o n e - t i m e rise i n t h e p r i c e level, r a t h e r t h a n c r e a t i n g a p e r m a n e n t rise i n t h e i n f l a t i o n rate. The idea that inflation targeting requires an accounting to the p u b l i c o f t h e p r o j e c t e d l o n g - r u n i m p l i c a t i o n s o f its s h o r t - r u n p o l i c y a c t i o n s is also c e n t r a l t o t h e a r g u m e n t t h a t i n f l a t i o n t a r g e t i n g c a n h e l p t o disci­ p l i n e m o n e t a r y policy. J u s t w h o needs " d i s c i p l i n i n g " m a y d i f f e r f r o m country to c o u n t r y (and f r o m p e r i o d to p e r i o d ) , d e p e n d i n g o n politics, institutional arrangements, a n d personalities. I n the academic literature o n c e n t r a l b a n k c r e d i b i l i t y , i t is g e n e r a l l y assumed t h a t i t is t h e c e n t r a l b a n k t h a t needs t o b e d i s c i p l i n e d , because i t desires a n u n e m p l o y m e n t r a t e l o w e r t h a n t h e n a t u r a l rate. T h i s desire creates a n i n c e n t i v e f o r t h e c e n t r a l b a n k t o t r y t o e n g i n e e r "surprise" i n f l a t i o n s i n o r d e r t o s t i m u l a t e p r o d u c t i o n a n d e m p l o y m e n t . As we discussed w h e n d e s c r i b i n g t h e p o l i c y c r e d i b i l i t y p r o b l e m , however, since t h e p u b l i c c a n n o t b e f o o l e d repeat­ edly, t h e l o n g - r u n o u t c o m e o f s u c h p o l i c i e s is higher-than-necessary i n ­ flation, w i t h o u t sustained gains i n o u t p u t a n d e m p l o y m e n t . I f this t h e o r e t i c a l story is a p p l i c a b l e , t h e n a n i n f l a t i o n - t a r g e t i n g f r a m e ­ w o r k w i l l n o t directly p r e v e n t t h e c o u n t e r p r o d u c t i v e a t t e m p t s o f t h e c e n ­ t r a l b a n k t o a p p l y s h o r t - r u n s t i m u l u s . I n this respect, i n f l a t i o n t a r g e t i n g is i n f e r i o r t o a n i r o n c l a d r u l e , a s s u m i n g t h a t s u c h a r u l e c o u l d ever b e i m p l e m e n t e d . However, i n contrast to a purely discretionary situation 6

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w i t h n o e x p l i c i t targets, u n d e r a n i n f l a t i o n - t a r g e t i n g r e g i m e t h e c e n t r a l b a n k w o u l d b e f o r c e d t o calculate a n d p u b l i c i z e t h e l o n g - r u n i m p l i c a ­ t i o n s o f its s h o r t - r u n actions, t h u s e n s u r i n g t h a t t h e y w o u l d be subject t o p u b l i c s c r u t i n y a n d d e b a t e . T o t h e e x t e n t t h a t t h e c e n t r a l b a n k gover­ n o r s d i s l i k e a d m i t t i n g p u b l i c l y t h a t t h e y m a y miss t h e i r l o n g - r u n i n f l a ­ t i o n targets (or, alternatively, t o t h e e x t e n t t h a t t h e y d i s l i k e h a v i n g t h e i r i n f l a t i o n p r o j e c t i o n s c r i t i c i z e d as biased o r m a n i p u l a t e d ) , t h e existence o f an inflation-targeting framework provides an incentive for the central b a n k t o l i m i t its s h o r t - r u n o p p o r t u n i s m . A l t h o u g h e c o n o m i c theorists have typically assumed t h e c e n t r a l b a n k is t h e e n t i t y t h a t chooses t o i n f l a t e o p p o r t u n i s t i c a l l y , t h e executive a n d legislative b r a n c h e s o f g o v e r n m e n t are m o r e l i k e l y i n p r a c t i c e t o have t h e g r e a t e r i n c e n t i v e t o engage i n ( o r i n d u c e ) s u c h behavior. I n fact, c e n t r a l b a n k e r s t e n d t o view themselves as d e f e n d e r s o f t h e c u r r e n c y . T h a t view m a y be t h e r e s u l t o f t h e a p p o i n t m e n t o f " t o u g h " c e n t r a l b a n k ­ ers ( f o r reasons d e s c r i b e d b y R o g o f f [ 1 9 8 5 ] ) , o r i t m a y j u s t b e t h a t t h e i r professional backgrounds a n d socialization t e n d to make central bank­ ers relatively h a w k i s h o n i n f l a t i o n . I n e i t h e r case, t h e existence o f i n f l a ­ t i o n targets can h e l p t h e c e n t r a l b a n k t o p r o t e c t i t s e l f f r o m i n f l a t i o n i s t pressures e x e r t e d b y t h e g o v e r n m e n t . I n p a r t i c u l a r , b y p o i n t i n g o u t t h e l o n g - r u n , as w e l l as t h e s h o r t - r u n , i m p l i c a t i o n s o f over-expansionist p o l i ­ cies, t h e c e n t r a l b a n k m a y b e able t o w i n s u p p o r t f r o m t h e g e n e r a l p u b ­ lic a n d f r o m t h e financial c o m m u n i t y i n r e s i s t i n g s u c h p o l i c i e s . A g a i n , t h e case studies i n this b o o k w i l l i l l u s t r a t e this s c é n a r i o . T o s u m m a r i z e , we see a close r e l a t i o n s h i p b e t w e e n t h e roles o f i n f l a ­ t i o n t a r g e t i n g as a n o m i n a l a n c h o r a n d as t h e l i n c h p i n i n a f r a m e w o r k f o r m a k i n g m o n e t a r y policy. By l i n k i n g p o l i c y t o m e d i u m - a n d l o n g - t e r m horizons, b u t w i t h o u t c r i p p l i n g the central bank's ability to r e s p o n d to s h o r t - r u n d e v e l o p m e n t s , i n f l a t i o n t a r g e t i n g creates a r o u g h c o m p r o m i s e b e t w e e n t h e d i s c i p l i n e a n d a c c o u n t a b i l i t y o f r i g i d rules a n d t h e flexibil­ ity o f t h e d i s c r e t i o n a r y a p p r o a c h . O f course, this c l a i m , w h a t e v e r its su­ p e r f i c i a l plausibility, needs t o be s u p p o r t e d b y evidence f r o m t h e field. M o r e o v e r , i t is i m p o r t a n t t o k n o w a g r e a t d e a l m o r e a b o u t t h e a c t u a l d e s i g n a n d i m p l e m e n t a t i o n o f successful i n f l a t i o n - t a r g e t i n g r e g i m e s . M u c h o f t h e rest o f this b o o k is d e v o t e d t o a d d r e s s i n g these issues.

3 Issues of Design and Implementation

I N T H E L A S T c h a p t e r we o u t l i n e d some o f t h e p o t e n t i a l benefits o f i n f l a ­ t i o n t a r g e t i n g as a strategy f o r m o n e t a r y policy. W h e t h e r those benefits are r e a l i z e d , however, d e p e n d s o n h o w effectively t h e strategy is d e s i g n e d a n d i m p l e m e n t e d . I n this c h a p t e r we discuss, i n a p r e l i m i n a r y way, some o f t h e choices c e n t r a l b a n k e r s have faced w h e n t h e y a d o p t e d i n f l a t i o n t a r g e t i n g . As we w i l l see i n later chapters, i n f l a t i o n - t a r g e t i n g c e n t r a l banks have t e n d e d t o i m p l e m e n t this a p p r o a c h i n b r o a d l y s i m i l a r ways. T h a t c o n v e r g e n c e appears t o r e f l e c t similar, t h o u g h o f t e n i n d e p e n d e n t l y de­ r i v e d , j u d g m e n t s a b o u t h o w t o h a n d l e t h e tradeoffs raised b y t h e i n f l a ­ t i o n - t a r g e t i n g strategy. T r a n s p a r e n c y a n d flexibility are t w o m a j o r advantages o f i n f l a t i o n tar­ g e t i n g , i n o u r view, a n d these features have figured p r o m i n e n t l y i n t h e o f f i c i a l rationales f o r a d o p t i n g this a p p r o a c h . By transparency we m e a n clear a n d t i m e l y c o m m u n i c a t i o n o f p o l i c y objectives, plans, a n d tactics to t h e p u b l i c . A m o n g t h e goals o f p o l i c y t r a n s p a r e n c y are t h e h e i g h t e n ­ i n g o f p u b l i c u n d e r s t a n d i n g o f what monetary policy can a n d c a n n o t do; the r e d u c t i o n o f e c o n o m i c a n d financial uncertainty; a n d the strengthening o f the accountability to the government a n d the general p u b l i c o f t h e m o n e t a r y a u t h o r i t i e s . By flexibility we m e a n t h e a b i l i t y o f c e n t r a l banks t o react effectively t o s h o r t - r u n m a c r o e c o n o m i c d e v e l o p ­ m e n t s w i t h i n t h e b r o a d c o n s t r a i n t s i m p o s e d b y the i n f l a t i o n - t a r g e t i n g f r a m e w o r k . O v e r t h e l o n g h a u l , these t w o features t e n d t o be m u t u a l l y r e i n f o r c i n g ; i n p a r t i c u l a r , we w i l l see i n t h e case studies h o w transpar­ ency o f t e n serves t o c o n t r i b u t e t o flexibility o f p o l i c y over t h e l o n g r u n . A t t h e level o f day-to-day i m p l e m e n t a t i o n , however, o p e r a t i o n a l choices t h a t p r o m o t e t r a n s p a r e n c y s o m e t i m e s e n d u p r e d u c i n g flexibility, a n d vice versa. T h u s , in the design of an inflation-targeting strategy, often a key issue is the proper balancing of transparency and flexibility. T h e s h o r t - r u n t r a d e o f f b e t w e e n t r a n s p a r e n c y a n d flexibility is r e m i ­ n i s c e n t o f t h e rules-versus-discretion debate we discussed i n t h e p r i o r chapters. Generally, t h e m o s t t r a n s p a r e n t p o l i c i e s are s i m p l e a n d l a r g e l y n o n - c o n t i n g e n t ; i n t h e event t h a t p r e v i o u s l y a n n o u n c e d p o l i c i e s ( f o r e x a m p l e , a d h e r e n c e t o a specific i n f l a t i o n target) have t o be c h a n g e d i n

ISSUES

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m i d s t r e a m , m a x i m u m transparency requires t h a t t h e change be f o r clearly specified reasons t h a t are o b v i o u s t o t h e p u b l i c . T h e m o s t flexible p o l i ­ cies, i n contrast, r e q u i r e t h a t t h e c e n t r a l b a n k be able t o r e s p o n d t o u n f o r e s e e n events as t h e y o c c u r a n d t o t h e availability o f n e w i n f o r m a ­ t i o n t h a t is d i f f i c u l t t o e x p l a i n t o t h e p u b l i c . H o w t h e c e n t r a l b a n k de­ signs a n d i m p l e m e n t s its i n f l a t i o n - t a r g e t i n g strategy has a s i g n i f i c a n t ef­ fect o n h o w w e l l t r a n s p a r e n c y a n d flexibility are b a l a n c e d . W e n o w t u r n t o some o f t h e o p e r a t i o n a l issues t h a t arise i n i n f l a t i o n t a r g e t i n g , a n d t o t h e m a n n e r i n w h i c h t h e c e n t r a l b a n k m i g h t best c o m ­ municate to the public.

Operational Issues Key o p e r a t i o n a l issues t h a t arise i n t h e i m p l e m e n t a t i o n o f i n f l a t i o n tar­ g e t i n g i n c l u d e : t h e d e f i n i t i o n o f t h e target; t h e c h o i c e o f t h e n u m e r i c a l values f o r t h e targets; t h e t i m e h o r i z o n over w h i c h t h e t a r g e t is relevant; t h e c o n d i t i o n s , i f any, u n d e r w h i c h t h e t a r g e t s h o u l d b e m o d i f i e d ; h o w t o g o a b o u t h i t t i n g t h e target; a n d h o w t o h a n d l e u n i n t e n t i o n a l t a r g e t misses.

Which Measure of Inflation Should Be Used? T h e first step i n d e s i g n i n g a n i n f l a t i o n - t a r g e t i n g r e g i m e is t o d e c i d e o n t h e p r i c e i n d e x whose rate o f c h a n g e is t o be t a r g e t e d . F o r m a x i m u m transparency, t h e p r i c e i n d e x s h o u l d be o n e t h a t p e o p l e are f a m i l i a r w i t h a n d t h a t is broad-based, accurate, a n d timely. F o r m a x i m u m flex­ i b i l i t y , t h e i n d e x s h o u l d e x c l u d e p r i c e changes i n n a r r o w l y d e f i n e d sec­ tors a n d o n e - t i m e p r i c e j u m p s t h a t are u n l i k e l y t o affect t r e n d o r "core" i n f l a t i o n — f o r e x a m p l e , a rise i n a value-added tax o r i n a sales tax. T h e i n d e x c h o s e n s h o u l d e x c l u d e at least t h e first-round effects o f s u c h changes. A l l i n f l a t i o n - t a r g e t i n g c e n t r a l banks have c h o s e n t o m e a s u r e t h e rate o f i n f l a t i o n by r e f e r e n c e t o some v e r s i o n o f t h e c o n s u m e r p r i c e i n d e x ( C P I ) , o f t e n a v e r s i o n o f t h e i n d e x t h a t excludes c e r t a i n v o l a t i l e c o m p o ­ n e n t s i n o r d e r t o focus o n "core" i n f l a t i o n . I n m a k i n g t h a t c h o i c e , h o w ­ ever, t h e c e n t r a l b a n k m u s t e x p l a i n t o t h e p u b l i c h o w t h e p r i c e i n d e x is c o n s t r u c t e d a n d h o w i t is r e l a t e d t o t h e h e a d l i n e C P I i n d e x . T h e p u b l i c s h o u l d n o t get t h e i m p r e s s i o n t h a t t h e c e n t r a l b a n k has c h o s e n this o n e i n d e x f r o m a m o n g a l t e r n a t i v e i n d e x e s i n o r d e r t o g u a r a n t e e favorable

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results. F o r this reason, t h e i n d e x c h o s e n s h o u l d be used c o n s i s t e n t l y t h r o u g h o u t t h e p e r i o d f o r w h i c h t h e t a r g e t is i n effect, a n d i t s h o u l d b e clearly d e f i n e d a n d r e p r o d u c i b l e by others. O n e way o f assuring t h e p u b l i c t h a t t h e c e n t r a l b a n k is n o t m a n i p u l a t i n g t h e data is t o have t h e d a t a c o m p i l e d b y a n agency (such as t h e B u r e a u o f L a b o r Statistics i n t h e U n i t e d States) t h a t is i n d e p e n d e n t o f t h e m o n e t a r y a u t h o r i t i e s .

What Numerical Value Should the Target Have? I n c h o o s i n g a n u m e r i c a l value f o r an i n f l a t i o n target, central bank­ ers h a v e u s u a l l y stressed " p r i c e s t a b i l i t y " as t h e i r p o l i c y o b j e c t i v e . F e d ­ eral C h a i r m a n A l a n Greenspan r e p o r t e d l y once d e f i n e d p r i c e stabil­ i t y as a r a t e o f i n f l a t i o n so l o w t h a t businesses a n d h o u s e h o l d s d o n o t have to take i t i n t o a c c o u n t i n m a k i n g everyday decisions. T h a t defi­ n i t i o n does n o t , however, p r o v i d e m u c h p r a c t i c a l g u i d a n c e i n s e t t i n g i n f l a t i o n targets. A s t r i c t d e f i n i t i o n o f p r i c e stability suggests a n i n f l a t i o n r a t e at o r v e r y n e a r z e r o . B u t t a r g e t i n g t h e i n f l a t i o n rate at zero w o u l d create s o m e serious p r o b l e m s . R e c e n t r e s e a r c h suggests t h a t o r d i n a r y CPI-based measures o f i n f l a t i o n m a y be biased u p w a r d . O n e r e a s o n is t h a t a fixedw e i g h t i n d e x does n o t r e f l e c t t h e p o s s i b i l i t y t h a t c o n s u m e r s m a y stop b u y i n g goods whose prices are r i s i n g a n d substitute s i m i l a r goods t h a t sell f o r l o w e r prices. A n o t h e r r e a s o n is t h a t a fixed-weight i n d e x m a y f a i l t o r e f l e c t changes i n q u a l i t y , a n d p r i c e rises d u e t o i m p r o v e d q u a l i t y s h o u l d n o t be c o u n t e d as i n f l a t i o n . A c c o r d i n g t o studies o f i n f l a t i o n i n t h e U n i t e d States, i n c l u d i n g t h e officially c o m m i s s i o n e d study k n o w n as t h e " B o s k i n R e p o r t , " t h e C P I overstates i n f l a t i o n b y f r o m 0.5 t o 2.0 per­ centage p o i n t s p e r year ( B o s k i n et al, 1996; M o u l t o n , 1996; a n d S h a p i r o a n d W i l c o x , 1 9 9 6 ) . Few studies are available f o r o t h e r c o u n t r i e s , b u t p r e s u m a b l y a s i m i l a r s i t u a t i o n prevails a b r o a d as w e l l . Because o f this a p p a r e n t bias i n m e a s u r e m e n t , even i f a c e n t r a l b a n k d e c i d e d t h a t its t a r g e t f o r t h e " t r u e " r a t e o f i n f l a t i o n s h o u l d be zero, t h e i m p l i e d t a r g e t f o r measured i n f l a t i o n w o u l d have t o be g r e a t e r t h a n zero. P u t t i n g m e a s u r e m e n t issues aside, t h e r e are p r o b a b l y substantive eco­ n o m i c risks t o t a r g e t i n g i n f l a t i o n at t o o l o w a level, j u s t as t h e r e are risks t o t a r g e t i n g i n f l a t i o n at t o o h i g h a level. F o r e x a m p l e , A k e r l o f , D i c k e n s , a n d P e r r y (1996) p o i n t o u t t h a t i f n o m i n a l wages are r i g i d d o w n w a r d , w h i c h t h e y a r g u e is consistent w i t h t h e evidence, t h e n r e d u c t i o n s i n r e a l wages (wages m e a s u r e d i n t e r m s o f p u r c h a s i n g p o w e r ) c a n o c c u r o n l y t h r o u g h i n f l a t i o n . T h a t m e a n s t h a t a very l o w rate o f i n f l a t i o n m i g h t

I S S U E S O F D E S I G N AND I M P L E M E N T A T I O N

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p r e v e n t r e a l wages f r o m f a l l i n g i n response t o d e c l i n i n g l a b o r d e m a n d i n certain industries o r regions, thereby leading to increased unemploy­ m e n t a n d b l o c k i n g t h e r e - a l l o c a t i o n o f l a b o r f r o m d e c l i n i n g sectors t o e x p a n d i n g sectors. S i m u l a t i o n s c o n d u c t e d b y A k e r l o f et al suggest t h a t i n f l a t i o n rates close t o zero m i g h t increase t h e l o n g - r u n o r " n a t u r a l " r a t e of unemployment. A n o t h e r a r g u m e n t against s e t t i n g t h e i n f l a t i o n t a r g e t t o o l o w ( S u m ­ mers, 1991) is t h a t l o w i n f l a t i o n w i l l i n d u c e a l o w level o f n o m i n a l i n t e r ­ est rates, l e a v i n g t h e c e n t r a l b a n k w i t h very l i t t l e r o o m t o l o w e r i n t e r e s t rates i n t h e e v e n t o f a recession (since n o m i n a l rates c a n n o t g o b e l o w z e r o ) . Some Japanese c e n t r a l b a n k e r s have c l a i m e d t h a t t h e S u m m e r s a r g u m e n t applies t o t h e r e c e n t recession i n t h e i r c o u n t r y , d u r i n g w h i c h n o m i n a l i n t e r e s t rates f e l l b e l o w 1 % , b l u n t i n g t h e a b i l i t y o f m o n e t a r y p o l i c y t o s u p p o r t a recovery. 1

T h e s i g n i f i c a n c e o f these a r g u m e n t s s h o u l d n o t b e o v e r s t a t e d . A c ­ c o r d i n g t o A k e r l o f et ai, t h e i n f l a t i o n rates t h a t w o u l d s i g n i f i c a n t l y af­ fect t h e n a t u r a l r a t e o f u n e m p l o y m e n t are q u i t e l o w — t h a t is, m e a s u r e d (as o p p o s e d t o " t r u e " ) rates o f i n f l a t i o n o f 2 % p e r a n n u m o r less. M o r e ­ over, t h e y d o n o t take i n t o a c c o u n t forces t h a t m a y w o r k i n t h e o p p o ­ site d i r e c t i o n . F o r e x a m p l e , G r o s h e n a n d S c h w e i t z e r ( 1 9 9 6 ) p o i n t o u t t h a t h i g h a n d v a r i a b l e i n f l a t i o n rates m a y i n c r e a s e t h e "noise" i n rela­ tive wages, r e d u c i n g t h e i r i n f o r m a t i o n c o n t e n t a n d h e n c e t h e e f f i c i e n c y o f t h e process b y w h i c h w o r k e r s are a l l o c a t e d across o c c u p a t i o n s a n d i n d u s t r i e s . T h u s , a c c o r d i n g t o G r o s h e n a n d Schweitzer, h i g h e r i n f l a ­ t i o n c a n r e p r e s e n t "sand" as w e l l as "grease" i n t h e w h e e l s o f t h e l a b o r market. S u m m e r s ' a r g u m e n t a b o u t n o m i n a l i n t e r e s t rates neglects t h e fact that m o n e t a r y policy works t h r o u g h channels o t h e r t h a n short-term i n ­ terest rates (see, f o r e x a m p l e , M i s h k i n [ 1 9 9 6 ] ) . L o w i n t e r e s t rates d i d n o t p r e v e n t t h e Japanese d u r i n g t h e i r r e c e n t recession f r o m e n g i n e e r i n g a large d e p r e c i a t i o n o f t h e y e n , w h i c h h e l p e d t o s t i m u l a t e t h e i r e c o n o m y . F u r t h e r , a l t h o u g h n o m i n a l i n t e r e s t rates c a n n o t be negative, r e a l i n t e r ­ est rates ( t h e n o m i n a l i n t e r e s t r a t e less t h e i n f l a t i o n r a t e ) c a n i n d e e d b e n e g a t i v e ; a n d s t a n d a r d t h e o r y suggests t h a t r e a l , r a t h e r t h a n n o m i ­ n a l , rates are t h e m o r e i m p o r t a n t f o r a g g r e g a t e s p e n d i n g a n d r e a l ac­ tivity. A m o r e persuasive a r g u m e n t against a i m i n g f o r a n i n f l a t i o n r a t e o f z e r o is t h a t such a p o l i c y risks t i p p i n g t h e e c o n o m y i n t o d e f l a t i o n , w i t h t h e t r u e (as o p p o s e d t o t h e m e a s u r e d ) p r i c e level a c t u a l l y f a l l i n g . Persis­ t e n t d e f l a t i o n — p a r t i c u l a r l y i f u n a n t i c i p a t e d — c a n create serious l i q u i d ­ ity a n d solvency p r o b l e m s t h a t m a y i n t e r f e r e w i t h t h e financial system's

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n o r m a l f u n c t i o n i n g , precipitating o r exacerbating an economic contrac­ t i o n ( B e r n a n k e a n d James, 1 9 9 1 ; M i s h k i n , 1 9 9 1 ) . I n s h o r t , u n d e r s h o o t ­ i n g a zero i n f l a t i o n t a r g e t (i.e., d e f l a t i o n ) is p o t e n t i a l l y m o r e costly t h a n o v e r s h o o t i n g a zero i n f l a t i o n t a r g e t b y t h e same a m o u n t . T h e s e risks suggest t h a t t h e i n f l a t i o n t a r g e t s h o u l d p r o b a b l y be set above zero—say, a r o u n d 1 % t o 3% p e r a n n u m . T h i s has b e e n t h e prac­ tice o f a l l t h e i n f l a t i o n - t a r g e t i n g c e n t r a l banks we discuss i n t h e c h a p t e r s t o c o m e . O n e o f t h e advantages o f i n f l a t i o n t a r g e t i n g is t h a t i t p r o v i d e s a floor as w e l l as a c e i l i n g f o r t h e i n f l a t i o n rate. T h u s a w e l l - r u n i n f l a t i o n t a r g e t i n g r e g i m e s h o u l d be as v i g i l a n t i n p r o t e c t i n g t h e e c o n o m y f r o m d e f l a t i o n a r y forces, a n d t h e risks o f " t o o l i t t l e " i n f l a t i o n , as f r o m t h e costs o f excessive i n f l a t i o n . A n i n t e r e s t i n g h i s t o r i c a l e x a m p l e is t h a t o f Sweden i n t h e 1930s, w h i c h a d o p t e d a " n o r m o f p r i c e s t a b i l i z a t i o n " after l e a v i n g t h e g o l d s t a n d a r d i n 1 9 3 1 . As a result, Sweden escaped t h e devas­ t a t i n g d e f l a t i o n e x p e r i e n c e d by m a n y o t h e r c o u n t r i e s d u r i n g t h e G r e a t D e p r e s s i o n a n d enjoyed m u c h b e t t e r e c o n o m i c p e r f o r m a n c e d u r i n g t h e 1930s ( J o n u n g , 1 9 7 9 ) .

A Price-Level Target or an Inflation Target? T h e r e is a lively, o n g o i n g d e b a t e o v e r w h e t h e r t a r g e t i n g s h o u l d b e o f t h e i n f l a t i o n r a t e per se or o f t h e p r i c e l e v e l . O f course, a t a r g e t e d p r i c e l e v e l n e e d n o t i m p l y a c o n s t a n t p r i c e level; t h e t a r g e t e d l e v e l c o u l d b e allowed to drift u p w a r d over t i m e , analogous to a crawling p e g f o r the e x c h a n g e rate ( G o o d h a r t a n d V i n a l s , 1994; Svensson, 1 9 9 6 ) . T h e dis­ a d v a n t a g e o f t a r g e t i n g t h e i n f l a t i o n r a t e is t h a t u n a n t i c i p a t e d shocks t o t h e p r i c e level m a y be t r e a t e d as bygones a n d n e v e r offset. As a re­ sult, l o n g - t e r m forecasts o f t h e p r i c e l e v e l m i g h t s h o w a l a r g e v a r i a n c e that c o u l d i m p e d e private-sector p l a n n i n g . T h e practical i m p o r t o f t h i s p h e n o m e n o n , so l o n g as i n f l a t i o n r e m a i n s low, is u n c l e a r . O n t h e o t h e r h a n d , strict price-level t a r g e t i n g requires that overshoots o r u n ­ d e r s h o o t s o f t h e t a r g e t be f u l l y m a d e u p . T h a t r e q u i r e m e n t r e d u c e s t h e v a r i a n c e o f l o n g - r u n forecasts o f t h e p r i c e l e v e l b u t m a y i m p a r t significantly m o r e volatility to monetary policy and the real economy i n t h e s h o r t r u n . I n p a r t i c u l a r , t h e r e m i g h t have t o be p e r i o d s o f defla­ t i o n to compensate f o r periods o f i n f l a t i o n greater t h a n the target. I n p r a c t i c e , c e n t r a l b a n k s set i n f l a t i o n r a t h e r t h a n p r i c e - l e v e l targets b u t t e n d t o c o m p e n s a t e p a r t i a l l y f o r t a r g e t misses, p a r t i c u l a r l y at s h o r t e r horizons. 2

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What Horizons? I n f l a t i o n targets can be set f o r o n e o r m o r e h o r i z o n s . I n practice, targets o f less t h a n o n e year o r m o r e t h a n f o u r years are u n l i k e l y t o be m e a n i n g ­ f u l , t h e f o r m e r because i n f l a t i o n is n o t c o n t r o l l a b l e by m o n e t a r y p o l i c y at such s h o r t h o r i z o n s a n d t h e latter because such d i s t a n t targets w o u l d have l i t t l e credibility. W i t h i n the l-to-4 year range, t h e c e n t r a l bank's c h o i c e o f target influences t h e t r a d e o f f b e t w e e n transparency a n d flexibility: T h e m o r e t i g h t l y t h e target is specified over t h e s h o r t e r t e r m , t h e less a m b i g u ­ ity t h e r e is i n t h e c e n t r a l bank's c o m m u n i c a t i o n w i t h t h e p u b l i c , b u t t h e greater t h e constraints o n t h e c e n t r a l bank's f r e e d o m o f a c t i o n i n the s h o r t r u n . A variety o f choices are observed i n practice. As we w i l l see i n C h a p t e r 4, t h e p r a c t i c e o f t h e B u n d e s b a n k illustrates o n e m e a n s o f c o m b i n i n g e x p l i c i t s h o r t - t e r m m o n e t a r y targets w i t h a n e x p l i c i t l o n g - r u n i n f l a t i o n g o a l i n a n e f f o r t t o s e n d clear signals t o t h e p u b l i c a b o u t its i n t e n t i o n s . Every D e c e m b e r , t h e B u n d e s b a n k a n n o u n c e s a n i n f l a t i o n target f o r t h e c o m i n g year ( n o w c a l l e d t h e " n o r m a t i v e rate o f p r i c e increase"), f r o m w h i c h t h e m o r e w e l l - k n o w n m o n e t a r y targets are d e r i v e d . T h i s objective, w h i l e technically o n l y f o r t h e c u r r e n t year, is rarely c h a n g e d ; its f u n c t i o n is t o i n f o r m t h e p u b l i c o f t h e level t o w h i c h the B u n d e s b a n k i n t e n d s to m a i n t a i n o r l o w e r t h e i n f l a t i o n rate i n t h e s h o r t t e r m . I t also, however, signals w h i c h i n f l a t i o n a r y shocks t h e B u n d e s b a n k plans t o a c c o m m o d a t e f o r a few years a n d w h i c h i t w i l l n o t , d e p e n d i n g o n w h e t h e r t h e target is c h a n g e d . T h u s w h e n a s u p p l y shock o c c u r r e d , as i n 1979, t h e Bundesbank's p o l i c y was t o a c k n o w l e d g e reality b y r a i s i n g t h e a n n u a l i n f l a t i o n goal, t h e r e b y n o t d e m a n d i n g t o o - r a p i d progress o n infla­ t i o n i n the short r u n . O n the other hand, by labeling the h i g h e r inflation target as t h e "unavoidable rate o f p r i c e increase," as t h e B u n d e s b a n k d i d i n t h e early 1980s, i t i n d i c a t e d t h a t i t w o u l d m a i n t a i n constant pressure t o w a r d t h e l o n g - r u n i n f l a t i o n objective, w i d e l y k n o w n t o be a b o u t 2 % p e r a n n u m . ( I n d e e d , f r o m 1984 t o 1996, w h e n i t was l o w e r e d t o 1.5% t o 2 % , t h e Bundesbank's i n f l a t i o n target r e m a i n e d constant at 2 % p e r year.) T h e B u n d e s b a n k ' s a p p r o a c h illustrates t h a t s o m e t i m e s i t makes sense to vary i n f l a t i o n targets over t i m e . T h e r e are at least t w o scenarios i n w h i c h v a r y i n g targets m i g h t p r o v e useful: first, i n t h e t r a n s i t i o n t o a l o w e r rate o f i n f l a t i o n at t h e b e g i n n i n g o f a n i n f l a t i o n - t a r g e t i n g r e g i m e ; a n d second, i n response t o shocks t o t h e e c o n o m y t h a t m a k e i t t o o costly to h o l d t o t h e l o n g - r u n i n f l a t i o n g o a l i n t h e s h o r t o r m e d i u m t e r m . We discuss t h e l a t t e r case l a t e r i n t h e chapter.

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A Point or a Range? As w i t h t h e c h o i c e o f h o r i z o n a n d t h e n u m e r i c a l values o f targets, t h e i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k has some d i s c r e t i o n a b o u t w h e t h e r t o a n n o u n c e its targets as a single p o i n t o r as a r a n g e a r o u n d some m i d ­ p o i n t . T h e i m p l i c a t i o n s o f t h i s c h o i c e ( i n t e r m s o f h o w e x p e c t a t i o n s are i n f l u e n c e d a n d h o w t h e p u b l i c r e s p o n d s t o a t a r g e t "miss") are m u c h d e b a t e d , as we w i l l see. I n t h e event t h a t t h e c e n t r a l b a n k chooses t o a n n o u n c e a r a n g e f o r its target, a n a r r o w e r r a n g e c o m m u n i c a t e s g r e a t e r c o m m i t m e n t by t h e c e n t r a l b a n k t o n e a r i n g its i n f l a t i o n g o a l t h a n does a b r o a d e r r a n g e . A t t h e same t i m e ( p e r t h e u s u a l t r a d e o f f ) , i t s o m e w h a t r e d u c e s t h e b a n k ' s a b i l i t y t o r e s p o n d t o u n f o r e s e e n events. U n a v o i d a b l e e r r o r s i n c o n t r o l l i n g i n f l a t i o n m a y d r i v e i n f l a t i o n o u t s i d e o f its r a n g e , despite t h e best efforts o f t h e c e n t r a l b a n k . M o r e o v e r , t h e d a m a g e t o c r e d i b i l i t y o f m i s s i n g a t a r g e t r a n g e e n t i r e l y is g r e a t e r t h a n t h a t o f miss­ ing a target point. T h e spread o f t h e target range c o m m u n i c a t e s useful i n f o r m a t i o n a b o u t t h e c e n t r a l bank's assessment o f t h e u n c e r t a i n t y s u r r o u n d i n g t h e effects o f its policies. Some a u t h o r s have estimated t h e u n c e r t a i n t y associated w i t h i n f l a t i o n o u t c o m e s t o be q u i t e h i g h (see, f o r e x a m p l e , H a l d a n e a n d S a l m o n [ 1 9 9 5 ] , a n d Stevens a n d D e b e l l e [ 1 9 9 5 ] ) , i m p l y i n g t h a t t h e target r a n g e w o u l d have t o be r a t h e r w i d e — o n t h e o r d e r o f 5 o r 6 p e r c e n t a g e p o i n t s — t o a c c o u n t f o r this f a c t o r a l o n e . However, a b a n d t h a t w i d e m i g h t well lead the public a n d the markets to d o u b t the central bankers' com­ m i t m e n t t o t h e i n f l a t i o n target. I t r e m a i n s t o be seen w h e t h e r u n c e r t a i n t y a b o u t i n f l a t i o n w i l l be as h i g h u n d e r i n f l a t i o n - t a r g e t i n g regimes as i t has b e e n historically; as t h e p u b l i c comes to e x p e c t t h a t t h e c e n t r a l b a n k w i l l act s t r o n g l y t o resist i n f l a t i o n a r y pressures, t h e p r e d i c t a b i l i t y a n d c o n t r o l ­ l a b i l i t y o f i n f l a t i o n may w e l l i m p r o v e endogenously. T h e r e does a p p e a r t o have b e e n a significant d e c l i n e i n the variability o f i n f l a t i o n i n n e a r l y a l l i n d u s t r i a l c o u n t r i e s , w h e t h e r i n f l a t i o n - t a r g e t i n g o r n o t , i n r e c e n t years.

What Information Should Be Used in Policy-Making? O n c e t h e c e n t r a l b a n k has s e t t l e d o n a n i n f l a t i o n target, i t m u s t t u r n t o t h e p r a c t i c a l p r o b l e m o f a c h i e v i n g t h a t target. W h a t i n f o r m a t i o n s h o u l d i t use i n its efforts t o k e e p i n f l a t i o n w i t h i n t h e d e s i r e d range? T h e answer t o t h i s q u e s t i o n is "any i n f o r m a t i o n t h a t is r e l e v a n t t o t h e f o r e c a s t i n g o f i n f l a t i o n . " T h a t answer h i g h l i g h t s a n i m p o r t a n t d i f f e r e n c e

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b e t w e e n i n f l a t i o n t a r g e t i n g a n d o t h e r m o n e t a r y - p o l i c y strategies. M o s t o t h e r strategies, such as m o n e y - g r o w t h t a r g e t i n g , m a k e heavy use o f soc a l l e d intermediate targets—variables, s u c h as t h e m o n e y stock, t h a t c a n be c o n t r o l l e d reasonably w e l l b y t h e m o n e t a r y a u t h o r i t i e s b u t w h i c h have o n l y a n i n d i r e c t a n d statistically u n c e r t a i n r e l a t i o n s h i p t o u l t i m a t e g o a l variables, s u c h as i n f l a t i o n . P r o p o n e n t s o f s u c h strategies have c r i t i c i z e d i n f l a t i o n t a r g e t i n g as b e i n g n o n - o p e r a t i o n a l , since t h e c e n t r a l bank's c o n ­ t r o l o f i n f l a t i o n is r e l a t i v e l y t e n u o u s a n d takes effect o n l y after l o n g lags. W h i l e i t is t r u e t h a t i t is m o r e d i f f i c u l t t o c o n t r o l i n f l a t i o n t h a n t o c o n t r o l (say) m o n e y g r o w t h , t h a t p o i n t is o f l i t t l e h e l p i n c o m p a r i n g t h e value o f t h e t w o a p p r o a c h e s . M o n e y g r o w t h is o f n o i n t r i n s i c i n t e r e s t , so t h e fact t h a t i t is easier t o c o n t r o l is useful o n l y i n s o f a r as i t is a g o o d forecaster o f u l t i m a t e g o a l variables. I f t h e r e l a t i o n s h i p o f m o n e y g r o w t h o r o t h e r s i m p l e i n t e r m e d i a t e targets w i t h g o a l variables is u n r e l i a b l e , as has p r o v e n t o be t h e case i n m a n y c o u n t r i e s , t h e n l i t t l e advantage ( i n t e r m s o f b e t t e r o u t c o m e s f o r t h e u l t i m a t e objectives) is g a i n e d b y e m ­ p l o y i n g these i n t e r m e d i a t e targets. I n d e e d , o n t h e g e n e r a l p r i n c i p l e t h a t m o r e i n f o r m a t i o n is b e t t e r t h a n less i n f o r m a t i o n , i t is a l m o s t never de­ sirable t o rely e n t i r e l y o n a single i n t e r m e d i a t e target, since t h e r e is l i k e l y t o be at least some a d d i t i o n a l i n f o r m a t i o n available t h a t c a n a i d i n fore­ casting a n d c o n t r o l l i n g t h e u l t i m a t e g o a l v a r i a b l e (s). Svensson (1997a) has m a d e this basic p o i n t i n a n i n t e r e s t i n g way: H e suggests t h a t i n f l a t i o n t a r g e t i n g r e g i m e s do use a n i n t e r m e d i a t e target; b u t t h a t t h e i n t e r m e d i a t e t a r g e t is a n i n f e r r e d r a t h e r t h a n d i r e c t l y ob­ served q u a n t i t y , namely, t h e c u r r e n t forecast o f i n f l a t i o n at t h e t a r g e t h o ­ r i z o n . I n o t h e r w o r d s , i n Svensson's f o r m u l a t i o n , a n i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k s h o u l d set its i n s t r u m e n t s ( i n t e r e s t rates, f o r e x a m p l e ) at each date so t h a t t h e forecast o f i n f l a t i o n equals its t a r g e t level. T h i s f o r m u l a t i o n h i g h l i g h t s t h e fact t h a t a n i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k uses strictly m o r e i n f o r m a t i o n t h a n a c e n t r a l b a n k e m p l o y i n g a n i n t e r ­ m e d i a t e target, e x c e p t i n t h e e x t r e m e case t h a t t h e i n t e r m e d i a t e t a r g e t embodies all i n f o r m a t i o n relevant to forecasting the goal variable ( i n w h i c h case t h e i n t e r m e d i a t e - t a r g e t i n g r e g i m e a n d i n f l a t i o n t a r g e t i n g are functionally identical). A l t h o u g h i t is u n d e n i a b l e t h a t i n f l a t i o n t a r g e t i n g i m p l i e s t h e use o f m o r e i n f o r m a t i o n t h a n t r a d i t i o n a l i n t e r m e d i a t e - t a r g e t i n g strategies, w h i c h w o u l d seem t o be a positive feature o f t h a t a p p r o a c h , some cave­ ats m u s t be n o t e d . First, even Svensson's f o r m u l a t i o n begs t h e i m p o r ­ t a n t q u e s t i o n o f exactly w h i c h i n f o r m a t i o n t h e c e n t r a l b a n k s h o u l d l o o k at, a n d h o w i t s h o u l d react t o t h e i n f o r m a t i o n i t receives. I n p a r t i c u l a r , as s h o w n f o r m a l l y b y W o o d f o r d (1994) a n d B e r n a n k e a n d W o o d f o r d

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( 1 9 9 7 ) , i t is not t h e case t h a t t h e i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k c a n r e a c t m e c h a n i c a l l y t o d e v i a t i o n s f r o m t h e t a r g e t o f a private-sector f o r e ­ cast o f i n f l a t i o n o r o f a forecast m a d e b y its o w n e c o n o m i s t s . S u c h a n a p p r o a c h risks a perverse c i r c u l a r i t y , i n w h i c h forecasters find i t o p t i m a l always t o p r o j e c t i n f l a t i o n e q u a l t o t h e a n n o u n c e d target, so t h a t t h e i r forecasts p r o v i d e n o i n f o r m a t i o n t o t h e c e n t r a l b a n k . A l t e r n a t i v e l y , o n e c a n show t h a t u n d e r some c o n d i t i o n s , t y i n g cur­ r e n t m o n e t a r y p o l i c y actions t o o s t r o n g l y t o forecasts o f f u t u r e i n f l a t i o n can lead to a multiplicity o f e q u i l i b r i u m outcomes, i n w h i c h the actual p a t h o f i n f l a t i o n is essentially a r b i t r a r y . T h e reason is t h a t s t r o n g d e p e n ­ dence o f policy o n expectations can lead to many different expectations o f i n f l a t i o n b e c o m i n g "self-fulfilling p r o p h e c i e s , " as e x p e c t a t i o n s i n d u c e t h e p o l i c i e s necessary t o m a k e those expectations c o m e t r u e . R a t h e r t h a n b a s i n g p o l i c y d i r e c t l y o n i n f l a t i o n forecasts, t h e c e n t r a l b a n k m u s t use a f u l l s t r u c t u r a l m o d e l capable o f a n a l y z i n g t h e effects o f v a r i o u s p o l i c y p a t h s i n o r d e r t o i m p l e m e n t its i n f l a t i o n targets (see B e r n a n k e a n d W o o d f o r d [ 1 9 9 7 ] f o r f u r t h e r d i s c u s s i o n ) . Successful use o f a s t r u c t u r a l m o d e l t o calculate t h e p o l i c i e s necessary t o t a r g e t i n f l a t i o n w i l l l e a d t h e r a t i o n a l forecast o f i n f l a t i o n t o e q u a l t h e target, a l a Svensson, b u t o n l y as a b y p r o d u c t o f t h e process. A s e c o n d caveat arises f r o m t h e o b s e r v a t i o n t h a t o n e objective o f a m o n e t a r y p o l i c y strategy is t o c o m m u n i c a t e w i t h t h e p u b l i c , a n d i n par­ t i c u l a r t o establish c r e d i b i l i t y f o r t h e c e n t r a l b a n k ' s a n n o u n c e d goals a n d tactics. I t c o u l d be a r g u e d t h a t t h e l o n g lags a n d u n c e r t a i n t y i n ­ v o l v e d i n c o n t r o l l i n g i n f l a t i o n are a p r o b l e m f o r a c e n t r a l b a n k t h a t wants q u i c k l y t o c o n v i n c e t h e p u b l i c t h a t i t is serious a b o u t m e e t i n g its targets, a n d t h a t i t i n t e n d s t o be a c c o u n t a b l e . F o r t h i s reason, i t w o u l d seem t h a t t h e strategy o f t a r g e t i n g a m o r e c o n t r o l l a b l e v a r i a b l e (such as t h e m o n e y s u p p l y ) m i g h t be desirable, since i n t h a t case t h e p u b l i c w i l l b e able t o observe i n r a t h e r s h o r t o r d e r w h e t h e r t h e c e n t r a l b a n k is m e e t i n g its c o m m i t m e n t s . H o w e v e r , a t h e o r e t i c a l analysis by L a u b a c h ( 1 9 9 7 ) shows t h a t t h i s i n t u i t i o n does n o t necessarily h o l d t r u e . I n p a r t i c u l a r , i f t h e i n t e r m e d i a t e t a r g e t has o n l y w e a k c o n n e c t i o n s t o t h e u l t i m a t e g o a l , as is o f t e n t h e case, t h e c e n t r a l b a n k ' s w i l l i n g n e s s o r a b i l i t y t o h i t t h e i n t e r ­ m e d i a t e t a r g e t m a y convey l i t t l e i n f o r m a t i o n a b o u t its c o m m i t m e n t t o t h e u l t i m a t e target, a n d t h u s d o l i t t l e f o r its c r e d i b i l i t y . I n actual practice, as they have m o v e d away f r o m i n t e r m e d i a t e targets, i n f l a t i o n - t a r g e t i n g c e n t r a l banks have r e l i e d m o r e o n variables t h a t p r o ­ v i d e useful i n f o r m a t i o n a b o u t t h e state o f t h e economy, k n o w n as informa­ tion variables o r indicator variables. A n i n f o r m a t i o n variable is usually c h o ­ sen t o a i d i n forecasting a n d p l a n n i n g because historically i t has s i g n a l e d

ISSUES

OF DESIGN AND

IMPLEMENTATION

35

f u t u r e changes i n the e c o n o m y . A l t h o u g h i n f o r m a t i o n variables p r o v i d e some basis f o r p o l i c y - m a k i n g , however, they are n o t t r e a t e d as p o l i c y tar­ gets themselves. A n e x a m p l e o f a n i n f o r m a t i o n variable used by several i n f l a t i o n - t a r g e t i n g c e n t r a l banks ( n o t a b l y Canada, Sweden, a n d , recently, N e w Z e a l a n d ) is t h e so-called " m o n e t a r y c o n d i t i o n s i n d e x , " a w e i g h t e d c o m b i n a t i o n o f interest a n d exchange rates, w h i c h is supposed t o h e l p t h e c e n t r a l b a n k d e t e r m i n e w h a t the f u t u r e p a t h o f i n f l a t i o n is l i k e l y t o be. I n f o r m a t i o n variables s h o u l d be used w i t h care, since t h e r e is n o guar­ antee t h a t t h e i n f o r m a t i o n they c o n t a i n w i l l r e m a i n c o n s t a n t over t i m e , p a r t i c u l a r l y i f t h e m o n e t a r y p o l i c y r e g i m e is c h a n g i n g . T h e best a p p r o a c h is t o c o m b i n e t h e use o f i n f o r m a t i o n variables w i t h s o m e o t h e r m e a n s o f p r e d i c t i n g m a c r o e c o n o m i c c o n d i t i o n s , s u c h as e c o n o m e t r i c m o d e l s .

When Should Deviations from the Target Be Allowed? I n f l a t i o n targets are s o m e t i m e s missed, a n d some o f t h e misses, far f r o m b e i n g a c c i d e n t a l , are t h e r e s u l t o f decisions b y t h e m o n e t a r y a u t h o r i t i e s . W h e n , i f ever, is i t l e g i t i m a t e t o miss a t a r g e t o n purpose? W h e n , i f ever, s h o u l d targets be re-set p r i o r t o t h e e n d o f t h e a n n o u n c e d t i m e h o r i z o n ? Because i n f l a t i o n t a r g e t i n g is a f r a m e w o r k f o r " c o n s t r a i n e d discre­ t i o n , " c o n c e r n s a b o u t m a c r o e c o n o m i c variables o t h e r t h a n i n f l a t i o n s o m e t i m e s j u s t i f y m i s s i n g o r c h a n g i n g a p r e v i o u s l y a n n o u n c e d target. T h e decision about whether to change the target depends pretty m u c h o n t h e type o f s h o c k h i t t i n g t h e e c o n o m y . I n g e n e r a l , t h e r e is n o c o n f l i c t between o u t p u t a n d inflation stabilization w h e n the p r e c i p i t a t i n g shock is a n u n e x p e c t e d c h a n g e i n aggregate s p e n d i n g ; u s i n g m o n e t a r y p o l i c y t o offset a n aggregate d e m a n d shock is n e a r l y always t h e c o r r e c t response. However, a n aggregate s u p p l y shock, such as a sharp increase i n o i l prices, m a y cause a c o n f l i c t b e t w e e n s t a b i l i z i n g o u t p u t a n d e m p l o y m e n t i n t h e short r u n a n d stabilizing inflation i n the l o n g r u n . Targeting a price i n d e x t h a t excludes t h e first-round effects o f c o m m o n s u p p l y shocks can, as we have seen, a m e l i o r a t e this c o n f l i c t t o some d e g r e e . B u t a s u p p l y shock t h a t is great e n o u g h , o r t h a t arises f r o m some u n a n t i c i p a t e d source, may j u s t i f y m i s s i n g o r c h a n g i n g a p r e v i o u s l y a n n o u n c e d i n f l a t i o n target. Missing a target n e e d n o t signal t h a t t h e e n t i r e i n f l a t i o n - t a r g e t i n g strat­ egy s h o u l d be a b a n d o n e d , however. So l o n g as t h e c e n t r a l b a n k is able t o e x p l a i n t h a t the miss is t h e result o f u n f o r e s e e n events, t h e c r e d i b i l i t y o f t h e c e n t r a l b a n k w i t h the p u b l i c n e e d n o t be c o m p r o m i s e d . As i n the case o f the B u n d e s b a n k m e n t i o n e d above, re-setting a target m a y c o m m u n i ­ cate t o t h e p u b l i c h o w t h e c e n t r a l b a n k i n t e n d s t o a c c o m m o d a t e t h e u n -

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foreseen c o n t i n g e n c y a n d at t h e same t i m e d e f i n e t h e t r a n s i t i o n p a t h b a c k to p r i c e stability. S u c h a strategy, t h o u g h i t w i l l n o t e l i m i n a t e t h e s h o r t - r u n i n f l a t i o n a r y effects o f s u p p l y shocks, m a y l i m i t those effects a n d p r e v e n t t h e m f r o m f e e d i n g i n t o t h e t r e n d rate o f i n f l a t i o n . I n d e e d , Svensson ( 1 9 9 7 b ) has s h o w n f o r m a l l y t h a t g r a d u a l a d j u s t m e n t o f t h e m e d i u m t e r m i n f l a t i o n t a r g e t t o w a r d t h e l o n g - r u n i n f l a t i o n g o a l is a g o o d ap­ p r o a c h f o r p o l i c y - m a k e r s w h o are c o n c e r n e d a b o u t b o t h m i n i m i z i n g o u t p u t fluctuations a n d m a i n t a i n i n g l o w a n d stable i n f l a t i o n .

When Is the Best Time to Start Implementing Inflation Targets? To achieve c r e d i b i l i t y f o r a n inflation-targe t i n g r e g i m e , a n d t o ensure p o ­ l i t i c a l s u p p o r t , i t is i m p o r t a n t t o have some i n i t i a l successes i n a c h i e v i n g i n f l a t i o n targets. We w i l l see t h a t c e r t a i n periods, o r c e r t a i n stages i n the business cycle, are m o r e p r o p i t i o u s t h a n others f o r the i n t r o d u c t i o n o f i n ­ f l a t i o n targeting. I t is i n t e r e s t i n g that i n f l a t i o n targets have m o s t often b e e n i n t r o d u c e d at times w h e n i n f l a t i o n was already l o w a n d f a l l i n g , r a t h e r t h a n (as o n e m i g h t expect) at times w h e n i n f l a t i o n was o n t h e rise a n d threat­ e n i n g t o get o u t o f c o n t r o l . Inevitably, p o l i t i c a l considerations play a n i m p o r t a n t r o l e i n t h e design a n d i m p l e m e n t a t i o n o f i n f l a t i o n t a r g e t i n g .

Communications Issues As we have seen, o n e o f t h e benefits o f i n f l a t i o n t a r g e t i n g is t h a t i t p r o ­ motes the transparency a n d accountability o f m o n e t a r y policy. Achiev­ i n g t h a t b e n e f i t , however, r e q u i r e s a n s w e r i n g a n u m b e r o f i m p o r t a n t questions.

What Should Be Communicated ? In What Forum? B e y o n d t h e i n f l a t i o n targets themselves, w h a t i n f o r m a t i o n does t h e i n ­ flation-targeting central b a n k need to c o m m u n i c a t e to the public? To m a i n t a i n c r e d i b i l i t y i n t h e eyes o f t h e p u b l i c , t h e c e n t r a l b a n k needs t o p r o v i d e t i m e l y i n f o r m a t i o n a b o u t t h e e c o n o m y at l a r g e , t h e b a n k ' s m o n ­ e t a r y policy, a n d its p o l i c y i n t e n t i o n s . T h a t has b e e n t h e p r a c t i c e o f m o s t i n f l a t i o n - t a r g e t i n g c e n t r a l banks. M o r e specifically, t h e b a n k s h o u l d c o m ­ m u n i c a t e t h e r a t i o n a l e t h a t u n d e r l i e s t h e i n f l a t i o n targets c h o s e n a n d t h e p o l i c y strategy itself; t h e c u r r e n t o u t l o o k f o r t h e e c o n o m y ; a n d re­ p o r t s a n d analyses o f i n f l a t i o n i n d i c a t o r s , i n c l u d i n g private-sector f o r e ­ casts a n d t h e c e n t r a l bank's o w n forecasts. I t s h o u l d also p r o v i d e progress

I S S U E S O F D E S I G N AND I M P L E M E N T A T I O N

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r e p o r t s o n its success o r f a i l u r e i n m e e t i n g its targets, w i t h e x p l a n a t i o n s o f w h y a t a r g e t m i g h t have b e e n c h a n g e d o r missed. T h e c r e d i b i l i t y o f t h e c e n t r a l b a n k d e p e n d s as m u c h o n t h e o b j e c t i v i t y a n d p l a u s i b i l i t y o f its c o m m u n i c a t i o n s as o n its r e c o r d o f h i t t i n g targets. B e y o n d such i n f o r m a t i o n , t h e i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k has a responsibility t o educate t h e p u b l i c a b o u t , f o r e x a m p l e , p o l i c y tradeoffs a n d what monetary policy can a n d cannot do. Encouraging the public to u n d e r s t a n d a n d t o get i n v o l v e d i n t h e p o l i c y - m a k i n g process w i l l i m p r o v e t h e policy-makers' a c c o u n t a b i l i t y to the p u b l i c a n d l e a d t o b e t t e r e c o n o m i c outcomes. As we m e n t i o n e d i n C h a p t e r 2, f o r e x a m p l e , t h e c e n t r a l bank's assessment o f t h e l o n g - r u n i n f l a t i o n a r y consequences o f a p r o p o s e d p o l i c y m i g h t p r o v i d e a corrective t o t h e u r g i n g s o f short-sighted p o l i t i c i a n s . T h e c e n t r a l b a n k has access t o m a n y f o r u m s f o r c o m m u n i c a t i n g w i t h t h e p u b l i c , i n c l u d i n g speeches, press conferences, t e s t i m o n y b e f o r e t h e legislature, statistical releases, a n d occasional p u b l i c a t i o n s . I t m u s t also c o m m u n i c a t e i n f o r m a t i o n o n a r e g u l a r schedule i n o r d e r t o f o r e s t a l l t h e s u s p i c i o n t h a t t h e t i m i n g m a y be p o l i t i c a l l y m o t i v a t e d . C o n s e q u e n t l y t h e p u b l i c a t i o n o f a f o r m a l r e p o r t at s p e c i f i e d i n t e r v a l s s h o u l d be a fea­ t u r e o f t h e c e n t r a l bank's i n f o r m a t i o n a l c a m p a i g n . Several i n f l a t i o n - t a r ­ g e t i n g c e n t r a l banks n o w p u b l i s h r e g u l a r " I n f l a t i o n R e p o r t s , " o r s i m i l a r d o c u m e n t s , w h i c h c o n t a i n d e t a i l e d assessments o f e c o n o m i c c o n d i t i o n s a n d c u r r e n t i n f o r m a t i o n o n i n f l a t i o n a n d m o n e t a r y policy. T h e s e re­ p o r t s advance t h e p u b l i c ' s u n d e r s t a n d i n g a n d a c c e p t a n c e o f t h e b a n k ' s m o n e t a r y p o l i c i e s a n d c o n t r i b u t e t o its a c c o u n t a b i l i t y .

To What Degree Should Central Banks Be Held Accountable ? S o m e observers believe t h a t c e n t r a l banks s h o u l d b e h e l d d i r e c t l y ac­ c o u n t a b l e t o t h e p u b l i c . O t h e r s insist t h a t t h e y s h o u l d be i n d e p e n d e n t o f a l l p o l i t i c a l pressure. M o n e t a r y p o l i c y o b v i o u s l y has a s i g n i f i c a n t i n ­ fluence o n t h e welfare o f t h e c i t i z e n r y a n d o f t e n involves tradeoffs be­ t w e e n t h e interests o f v a r i o u s g r o u p s i n t h e society, so t h e r e is a p r e ­ s u m p t i o n t h a t close o v e r s i g h t is w a r r a n t e d . O n t h e o t h e r h a n d , t h e r e are s t r o n g a r g u m e n t s t o s u p p o r t t h e view t h a t m o n e t a r y p o l i c y w o r k s b e t t e r w h e n i t is i n s u l a t e d f r o m s h o r t - r u n m a n i p u l a t i o n . T h o s e w h o be­ lieve t h a t t h e m a i n sources o f m y o p i a i n p o l i c y - m a k i n g reside i n t h e ex­ ecutive a n d legislative b r a n c h e s a n d w h o are c o n v i n c e d t h a t c e n t r a l bank­ ers are capable o f f u n c t i o n i n g o n t h e i r o w n as d i s i n t e r e s t e d p r o f e s s i o n ­ als a n d p u b l i c servants t e n d t o a r g u e f o r i n d e p e n d e n c e . A n d t h e r e is i n d e e d a w o r l d w i d e t r e n d toward increased independence f o r central

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banks. T h a t t r e n d is s u p p o r t e d b y a c a d e m i c l i t e r a t u r e t h a t h o l d s t h a t i n d e p e n d e n t c e n t r a l banks, c o m p a r e d t o c e n t r a l banks s u b o r d i n a t e d t o t h e g o v e r n m e n t , d e l i v e r b e t t e r o u t c o m e s f o r i n f l a t i o n , as w e l l as o u t ­ comes f o r r e a l variables s u c h as o u t p u t a n d e m p l o y m e n t t h a t are n o worse t h a n those a c h i e v e d b y less i n d e p e n d e n t c e n t r a l banks (e.g., see Alesina a n d Summers [1993]). A c o m p r o m i s e is suggested b y D e b e l l e a n d Fischer ( 1 9 9 4 ) , w h o dis­ t i n g u i s h b e t w e e n goal independence a n d instrument independence f o r t h e c e n t r a l b a n k . U n d e r goal independence, t h e c e n t r a l b a n k is free t o set its o w n p o l i c y objectives, i n c l u d i n g i n f l a t i o n targets. U n d e r instrument inde­ pendence, p o l i c y goals are set b y t h e g o v e r n m e n t a l o n e o r b y t h e g o v e r n ­ m e n t i n c o n s u l t a t i o n w i t h t h e c e n t r a l b a n k , b u t t h e c e n t r a l b a n k is solely r e s p o n s i b l e f o r t h e i n s t r u m e n t settings (such as t h e level o f s h o r t - t e r m i n t e r e s t rates) n e e d e d t o achieve those goals. O f t h e t w o , i t seems t h a t i n s t r u m e n t i n d e p e n d e n c e w o u l d be m o r e l i k e l y t o m i n i m i z e s h o r t - r u n political interference a n d maximize central-bank accountability while s t i l l l e a v i n g t h e u l t i m a t e goals o f p o l i c y t o b e d e t e r m i n e d at least i n p a r t by d e m o c r a t i c processes. I n f l a t i o n t a r g e t i n g is f u l l y c o m p a t i b l e w i t h i n s t r u m e n t i n d e p e n d e n c e f o r t h e c e n t r a l b a n k . T h i s strategy calls f o r t h e i n f l a t i o n targets t h e m ­ selves t o be set b y a p o l i t i c a l process i n w h i c h t h e c e n t r a l b a n k e r s c o n s u l t w i t h t h e a p p r o p r i a t e legislators o r m i n i s t e r s . T h e e x e c u t i o n o f t h e p o l i c y is t h e n left c o m p l e t e l y t o t h e c e n t r a l b a n k , a d i v i s i o n o f r e s p o n s i b i l i t y t h a t reflects its s u p e r i o r t e c h n i c a l expertise i n i m p l e m e n t i n g m o n e t a r y p o l i c y a n d t h e n e e d t o i n s u l a t e t h e b a n k f r o m s h o r t - r u n p o l i t i c a l pres­ sures a n d a r b i t r a r y i n t e r v e n t i o n s . T h e bank's a c c o u n t a b i l i t y is assured i n t w o ways: first, b y c o m p a r i n g i n f l a t i o n o u t c o m e s w i t h t h e targets; a n d second, by the central bank's o b l i g a t i o n to provide the p u b l i c w i t h con­ v i n c i n g rationales f o r t h e p o l i c y choices i t makes. Because i n f l a t i o n re­ s p o n d s t o p o l i c y o n l y after l o n g lags, a n d because i n f l a t i o n targets are r a r e l y h i t exactly, this s e c o n d m e a n s o f m a i n t a i n i n g a c c o u n t a b i l i t y is es­ sential u n d e r an inflation-targeting regime. I t provides a n o t h e r reason f o r i s s u i n g regular, d e t a i l e d i n f l a t i o n r e p o r t s t o t h e p u b l i c . As we shall see, t h e d e g r e e o f i n d e p e n d e n c e e n j o y e d b y i n f l a t i o n - t a r ­ g e t i n g c e n t r a l banks varies q u i t e a b i t i n p r a c t i c e . Some c e n t r a l banks, s u c h as t h e B u n d e s b a n k , c o m m a n d s i g n i f i c a n t g o a l i n d e p e n d e n c e as w e l l as i n s t r u m e n t i n d e p e n d e n c e . I n t h e U n i t e d K i n g d o m ( u n t i l r e c e n t l y ) a n d Canada, i n contrast, t h e g o v e r n m e n t retains some c o n t r o l over even t h e i n s t r u m e n t settings o f m o n e t a r y policy. T h e case studies i n t h e c h a p ­ ters t h a t f o l l o w w i l l e x p l o r e t h e efficacy o f various p o l i t i c a l a r r a n g e m e n t s a n d t h e effect o f i n f l a t i o n targets o n those a r r a n g e m e n t s .

4 German and Swiss Monetary Targeting: Precursors to Inflation Targeting

O U R C A S E S T U D I E S o f m o n e t a r y - p o l i c y strategies i n o p e r a t i o n b e g i n w i t h G e r m a n y a n d S w i t z e r l a n d , c o u n t r i e s l o n g associated w i t h p r i c e stability a n d " h a r d " c u r r e n c i e s . Officially, f o r t h e past t w o decades G e r m a n y a n d S w i t z e r l a n d have classified themselves as " m o n e t a r y targeters"; t h a t is, t h e i r c e n t r a l banks have expressed t h e i r m o n e t a r y - p o l i c y objectives at least i n p a r t i n t e r m s o f t h e g r o w t h rate o f t h e m o n e y stock (variously defined), rather t h a n p r i m a r i l y i n terms o f inflation o r some other goal variable. Some observers have c i t e d t h e s t r o n g p e r f o r m a n c e o f these c e n t r a l banks as evidence i n favor o f rules-based m o n e t a r y p o l i c i e s t h a t i m p o s e s t r i c t l i m i t a t i o n s o n t h e d i s c r e t i o n exercised by t h e m o n e t a r y policy authorities. However, as we w i l l see, m a n y features o f t h e G e r m a n a n d Swiss m o n ­ etary regimes are features o f i n f l a t i o n t a r g e t i n g as w e l l . T h o s e features i n c l u d e n o t o n l y a basic o r i e n t a t i o n o f m o n e t a r y p o l i c y t o w a r d t h e p u r ­ suit o f l o w i n f l a t i o n ( a n d a successful r e c o r d i n a c h i e v i n g i t ) , b u t m a n y o t h e r aspects o f c e n t r a l b a n k o p e r a t i o n s a n d strategy u s e d b y self-de­ scribed i n f l a t i o n targeters. I n d e e d , as suggested by B e r n a n k e a n d M i s h k i n ( 1 9 9 7 ) , G e r m a n y a n d S w i t z e r l a n d m i g h t best be t h o u g h t o f as " h y b r i d " i n f l a t i o n targeters a n d m o n e t a r y targeters, r a t h e r t h a n as s t r i c t adher­ ents t o a m o n e y - t a r g e t i n g r u l e . T h u s t h e experiences o f these t w o c o u n ­ tries over m o r e t h a n t w e n t y years s h o u l d p r o v i d e useful lessons f o r prac­ titioners o f inflation targeting. T h i s chapter, l i k e t h e s u b s e q u e n t case studies, is d i v i d e d i n t o t h r e e m a i n parts. First, we discuss t h e circumstances s u r r o u n d i n g t h e i n i t i a l a d o p t i o n o f t h e m o n e t a r y - p o l i c y r e g i m e . N e x t we describe a n d analyze the operational framework o f monetary policy i n the countries b e i n g c o n s i d e r e d , w i t h p a r t i c u l a r a t t e n t i o n t o h o w this f r a m e w o r k supports t h e substantive e c o n o m i c objectives o f t h e p o l i c y r e g i m e . Finally, we review the historical r e c o r d o f m o n e t a r y policy u n d e r the p a r t i c u l a r p o l i c y r e g i m e , c o n c l u d i n g w i t h s o m e b r o a d lessons f r o m t h e p o l i c y ex­ perience.

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Key Features of German and Swiss Monetary Targeting •

G e r m a n y a n d S w i t z e r l a n d are self-described " m o n e t a r y targeters," a n d targets f o r t h e g r o w t h rates o f v a r i o u s m o n ­ e t a r y a g g r e g a t e s are a n n o u n c e d e a c h year. H o w e v e r , a n ­ n o u n c e d n u m e r i c a l goals f o r i n f l a t i o n also p l a y a key r o l e i n G e r m a n a n d Swiss m o n e t a r y p o l i c y (they are used, f o r ex­ a m p l e , i n d e r i v i n g t h e m o n e t a r y targets), a n d t h e r e is c o n s i d ­ e r a b l e evidence t h a t t h e i n f l a t i o n goals have u l t i m a t e p r i o r i t y i n d e t e r m i n i n g p o l i c y decisions. O v e r a l l , t h e substantive dif­ ferences b e t w e e n m o n e t a r y t a r g e t i n g as p r a c t i c e d by G e r m a n y a n d S w i t z e r l a n d a n d i n f l a t i o n t a r g e t i n g as p r a c t i c e d b y o t h e r c o u n t r i e s s t u d i e d i n this b o o k are n o t t h a t great.

•

B o t h c o u n t r i e s a d o p t e d m o n e t a r y t a r g e t i n g i n o r d e r t o es­ t a b l i s h a " n o m i n a l a n c h o r " f o r m o n e t a r y policy, w i t h t h e h o p e o f i n c r e a s i n g p o l i c y flexibility by m o d e r a t i n g a n d " t y i n g d o w n " the public's inflation expectations.

•

M o n e t a r y t a r g e t i n g , far f r o m b e i n g a r i g i d p o l i c y r u l e , has b e e n q u i t e flexible i n p r a c t i c e . M o n e t a r y targets are o f t e n missed because o f c e n t r a l b a n k c o n c e r n a b o u t o t h e r objec­ tives, i n c l u d i n g o u t p u t a n d e x c h a n g e rates. T h e c o n v e r g e n c e o f s h o r t - r u n i n f l a t i o n targets w i t h t h e l o n g - r u n i n f l a t i o n g o a l has o f t e n b e e n q u i t e g r a d u a l , w h i c h also p e r m i t s flexibility r e g a r d i n g s h o r t - r u n objectives.

•

T h e c o m m i t m e n t t o p r i c e stability has b e e n d e f i n e d i n b o t h c o u n t r i e s as a t a r g e t f o r m e a s u r e d i n f l a t i o n t h a t is g r e a t e r t h a n zero.

•

G e r m a n y has settled o n t h e use o f a r a n g e f o r its m o n e t a r y targets, w h i c h i t views as a source o f some s h o r t - r u n p o l i c y d i s c r e t i o n . S w i t z e r l a n d a n n o u n c e s a p o i n t target, w h i c h i t ar­ gues does n o t give t h e p u b l i c t h e false i m p r e s s i o n t h a t m o n e y is c o n t r o l l a b l e over a n a r r o w r a n g e .

•

B o t h regimes have d e m o n s t r a t e d s t r o n g c o m m i t m e n t t o t h e c o m m u n i c a t i o n o f strategy t o t h e g e n e r a l p u b l i c . T h e m o n ­ etary targets are u s e d as a f r a m e w o r k f o r e x p l a n a t i o n , b u t c e n t r a l b a n k r e p o r t s t o t h e p u b l i c go w e l l b e y o n d t h e ques­ t i o n o f w h e t h e r t h e t a r g e t was h i t t o cover a w i d e variety o f e c o n o m i c issues a n d d e v e l o p m e n t s .

43

G E R M A N A N D SWISS MONETARY T A R G E T I N G

The Adoption of Monetary Targeting in Germany and Switzerland T h e decision to adopt monetary targeting i n Germany a n d Switzerland, t h o u g h p r o m p t e d b y t h e b r e a k d o w n o f t h e B r e t t o n W o o d s fixed-ex­ change-rate r e g i m e i n 1973, was a m a t t e r o f c h o i c e b y b o t h c o u n t r i e s . N e i t h e r was u n d e r any pressure at t h e t i m e t o r e f o r m e i t h e r its e c o n o m y i n g e n e r a l o r its m o n e t a r y r e g i m e . I n fact, t h e b r e a k d o w n o f B r e t t o n W o o d s was d u e i n p a r t t o t h e c o m m i t m e n t o f these c e n t r a l banks t o p r i c e stability a n d t o t h e c o n c o m i t a n t a p p r e c i a t i o n o f t h e i r c u r r e n c i e s . T h e loss o f t h e exchange-rate a n c h o r was n o t t h e s o r t o f crisis t h a t de­ m a n d e d a n i m m e d i a t e response. I n fact, i t t o o k b o t h c o u n t r i e s f r o m t w o t o t h r e e years t o m o v e t o t h e n e w r e g i m e . T w o m a i n factors l e d t o t h e a d o p t i o n o f m o n e t a r y t a r g e t i n g i n Ger­ m a n y a n d S w i t z e r l a n d . T h e first was a c o n v i c t i o n t h a t a n o m i n a l a n c h o r was n e e d e d f o r m o n e t a r y p o l i c y a n d t h a t m o n e t a r y p o l i c y s h o u l d n e i ­ t h e r a c c o m m o d a t e i n f l a t i o n n o r set m e d i u m - t e r m o u t p u t goals. T h e sec­ o n d was a p e r c e p t i o n t h a t m e d i u m - t e r m i n f l a t i o n e x p e c t a t i o n s h a d t o be l o c k e d i n t o p e r m i t t h e c e n t r a l banks some flexibility i n t h e f u t u r e . I n o t h e r w o r d s , t h e r e was a desire t o c o o r d i n a t e t h e i n f l a t i o n e x p e c t a t i o n s o f t h e p u b l i c w i t h t h e p o l i c y objectives o f t h e c e n t r a l banks. O v e r t i m e , the broader proposition emerged that monetary targeting w o u l d pro­ vide a means o f c o m m u n i c a t i n g the relationship between c u r r e n t c o n d i ­ t i o n s a n d m e d i u m - t e r m goals t o t h e p u b l i c . Switzerland a n d Germany adopted monetary targeting i n December 1974; t h e U n i t e d States a n d C a n a d a f o l l o w e d suit w i t h s i m i l a r t a r g e t i n g a p p r o a c h e s i n 1975. A l t h o u g h t h e r e seems t o b e a t e n d e n c y f o r c o u n ­ tries t o a d o p t m o n e t a r y targets i n times o f h i g h i n f l a t i o n ( B e r n a n k e a n d M i s h k i n , 1992, p . 1 8 6 ) , t h e G e r m a n s a n d t h e Swiss seem t o have b e e n most concerned w i t h k e e p i n g inflation expectations u n d e r c o n t r o l once i n f l a t i o n h a d b e g u n its d o w n w a r d t r e n d . A l l f o u r c o u n t r i e s set a q u a n t i ­ fied t a r g e t f o r t h e i n t e n d e d rate o f m o n e t a r y e x p a n s i o n . T h e e m e r g e n c e o f i n f l a t i o n i n t h e early 1970s d r e w t h e a t t e n t i o n o f m o n e t a r y policy-makers t o t h e r o l e o f m o n e y g r o w t h i n t h e i n f l a t i o n a r y process. As early as O c t o b e r 3 1 , 1 9 7 2 , b e f o r e t h e first o i l shock, t h e C o u n ­ c i l o f M i n i s t e r s o f t h e E u r o p e a n C o m m u n i t y h a d passed a r e s o l u t i o n t h a t c a l l e d f o r t h e m e m b e r states t o 1

progressively reduce the growth rate o f the [broad] money s u p p l y . . . u n t i l i t equals that o f the real [GNP], augmented by the normative price rise deter-

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m i n e d i n accordance with overall economic aims and after taking account o f the structural development o f the relationship between money supply and national product. This target is to be reached n o t later than the end o f 1974. (Deutsche Bundesbank, 1972a, p. 24) T h i s r e s o l u t i o n o u t l i n e d a c o n c e p t o f m o n e t a r y t a r g e t i n g based o n t h e so-called q u a n t i t y t h e o r y , w h i c h states t h a t n o m i n a l s p e n d i n g i n t h e e c o n o m y is d e t e r m i n e d b y changes i n t h e q u a n t i t y o f m o n e y . Use o f t h i s r e l a t i o n s h i p a l l o w e d c e n t r a l b a n k s t o c o n s i d e r o u t p u t as w e l l as i n f l a t i o n i n s e t t i n g targets f o r m o n e t a r y policy. Ever since, t h e q u a n t i t y t h e o r y has b e e n used f o r target-setting i n b o t h G e r m a n y a n d S w i t z e r l a n d . A l t h o u g h t h e r e s o l u t i o n foresaw t h e n e e d t o p r o v i d e f o r flexibility i n t h e e v e n t o f shocks t o t h e r e l a t i o n s h i p b e t w e e n t h e stock o f m o n e y a n d n o m i n a l s p e n d i n g (so-called "velocity s h o c k s " ) , i t r e c o m m e n d e d a p o i n t t a r g e t rather t h a n a target range. M i s s i n g f r o m t h e E C r e s o l u t i o n is any m e n t i o n o f t h e n e e d t o an­ n o u n c e t h e t a r g e t t o t h e p u b l i c o r any c o n c e r n a b o u t t h e t r a n s p a r e n c y o f policy. W e m u s t r e m e m b e r , however, t h a t w h i l e t h e i n t e l l e c t u a l cur­ r e n t o f t h e t i m e was r u n n i n g t o w a r d m o n e t a r i s m , a n d t o w a r d rules r a t h e r t h a n d i s c r e t i o n , t h e focus o n t h e r o l e o f p u b l i c e x p e c t a t i o n s a n d c e n t r a l b a n k credibility i n m o n e t a r y policy-making h a d n o t yet emerged. I n a d o p t i n g t h e i r m o n e y - t a r g e t i n g policy, G e r m a n y a n d S w i t z e r l a n d d o n o t a p p e a r t o have b e e n m o t i v a t e d b y any desire t o increase c r e d i b i l i t y b y " t y i n g t h e h a n d s " ( t h a t is, l i m i t i n g t h e d i s c r e t i o n ) o f t h e c e n t r a l b a n k . N o r , f o r t h a t matter, d i d t h e y m a k e any i n s t i t u t i o n a l p r o v i s i o n f o r ensur­ i n g o v e r s i g h t a n d a c c o u n t a b i l i t y . T h e effective i n d e p e n d e n c e o f t h e Swiss a n d G e r m a n c e n t r a l banks, a n d t h e i n f l u e n c e o f t h e p o l i t i c a l c o a l i t i o n s that s u p p o r t e d central b a n k independence, l i m i t e d the incentives o f the c e n t r a l banks t o r e d u c e t h e i r r a n g e o f p o l i c y flexibility.

Germany O n D e c e m b e r 5, 1 9 7 4 , t h e C e n t r a l B a n k C o u n c i l o f t h e D e u t s c h e B u n d e s b a n k a n n o u n c e d t h a t " f r o m t h e p r e s e n t perspective i t regards a g r o w t h o f a b o u t 8 p e r c e n t i n t h e c e n t r a l b a n k m o n e y stock o v e r t h e w h o l e o f 1975 as acceptable i n t h e l i g h t o f its stability goals." ( D e u t s c h e B u n d e s b a n k , 1974b, D e c e m b e r , p . 8 ) . T h e B u n d e s b a n k c o n s i d e r e d t h i s t a r g e t t o " p r o v i d e t h e r e q u i s i t e scope . . . f o r t h e d e s i r e d g r o w t h o f t h e real economy" a n d declared that the target h a d been chosen " i n such a way t h a t n o n e w i n f l a t i o n a r y strains are l i k e l y t o arise as a r e s u l t o f m o n ­ etary d e v e l o p m e n t s . " Since 1973, t h e B u n d e s b a n k h a d b e e n u s i n g t h e

G E R M A N A N D SWISS MONETARY

45

TARGETING

c e n t r a l b a n k m o n e y stock, o r C B M , as its p r i m a r y i n d i c a t o r o f m o n e t a r y d e v e l o p m e n t s . ( T h e c e n t r a l b a n k m o n e y stock is d e f i n e d as c u r r e n c y i n c i r c u l a t i o n p l u s s i g h t deposits, t i m e deposits w i t h m a t u r i t y u n d e r f o u r years, a n d savings deposits a n d savings b o n d s w i t h m a t u r i t y u n d e r f o u r years, t h e l a t t e r t h r e e w e i g h t e d at t h e i r r e q u i r e d reserve ratios as o f j a n u ary 1974. T h e B u n d e s b a n k ' s r a t i o n a l e f o r this c h o i c e o f i n t e r m e d i a t e t a r g e t v a r i a b l e is discussed i n t h e n e x t section.) A l t h o u g h this was a u n i ­ lateral a n n o u n c e m e n t o n the part o f the Bundesbank, the announce­ m e n t stressed t h a t " i n f o r m u l a t i n g its t a r g e t f o r t h e g r o w t h o f t h e c e n t r a l b a n k m o n e y stock [ t h e B u n d e s b a n k ] f o u n d i t s e l f i n f u l l a g r e e m e n t w i t h t h e f e d e r a l g o v e r n m e n t . " C o m i n g n e a r l y t w o years after t h e d e m i s e o f the fixed-exchange-rate system o f B r e t t o n W o o d s i n M a r c h 1973, t h e Bundesbank's a n n o u n c e m e n t m a r k e d the e n d o f a fairly lengthy p e r i o d d u r i n g which German monetary policy had been conducted without an explicit n o m i n a l anchor. T h e new approach reflected the Bundesbank's response t o t h e p r o b l e m s t h a t h a d beset m o n e t a r y p o l i c y d u r i n g t h e last years o f B r e t t o n W o o d s a n d t h e i m m e d i a t e a f t e r m a t h . T h e B u n d e s b a n k h a d always i n t e r p r e t e d its m a n d a t e o f "safeguard­ i n g t h e c u r r e n c y " u n d e r A r t i c l e 3 o f t h e B u n d e s b a n k A c t o f 1957 as re­ q u i r i n g t h a t i t strive f o r p r i c e stability i n its c o n d u c t o f m o n e t a r y policy. D u r i n g t h e last years o f B r e t t o n W o o d s , its p u r s u i t o f t h a t g o a l h a d b e e n i m p e r i l e d b y t h e f l o w o f massive a m o u n t s o f c a p i t a l o u t o f t h e U . S . d o l ­ lar i n t o t h e d e u t s c h e m a r k . T h e f l o w was also d i r e c t e d i n t o t h e c u r r e n ­ cies o f c o u n t r i e s t h a t w e r e f o l l o w i n g G e r m a n m o n e t a r y p o l i c y m o s t closely—namely, A u s t r i a , B e l g i u m , t h e N e t h e r l a n d s , a n d S w i t z e r l a n d . T h a t flow, w h i c h was t r i g g e r e d i n p a r t b y t h e sluggish g r o w t h a n d t h e relatively h i g h i n f l a t i o n t h a t t h e U n i t e d States h a d b e e n e x p e r i e n c i n g since 1968, repeatedly f o r c e d t h e B u n d e s b a n k t o tolerate excessively h i g h rates o f m o n e y g r o w t h , despite its d o m e s t i c objectives. U p o n its release f r o m its e x c h a n g e i n t e r v e n t i o n o b l i g a t i o n f o l l o w i n g t h e B r e t t o n W o o d s collapse i n M a r c h 1973, t h e B u n d e s b a n k i m m e d i ­ ately started t o r e d u c e t h e "free l i q u i d reserves" o f t h e c o u n t r y ' s b a n k ­ i n g system. Free l i q u i d reserves w e r e d e f i n e d as excess reserves p l u s l i q ­ u i d assets t h a t c o u l d b e c o n v e r t e d i n t o C B M at any t i m e . T h e q u a n t i t y o f these reserves p r o v i d e d a m e a s u r e o f t h e e x t e n t t o w h i c h t h e b a n k i n g sector c o u l d e x p a n d its balance sheets w i t h o u t f a c i n g a s h o r t a g e o f cen­ t r a l b a n k m o n e y . S h o r t o f i m p o s i n g reserve r e q u i r e m e n t s o n b a n k loans, r e d u c i n g t h e free l i q u i d reserves o f t h e b a n k s t o a l m o s t z e r o was seen as t h e m o s t effective m e a n s o f c o n t r o l l i n g t h e e x p a n s i o n o f b a n k l e n d i n g , w h i c h was t h e B u n d e s b a n k ' s p r i m a r y c o n c e r n . Since t h e B u n d e s b a n k was n o l o n g e r o b l i g e d t o b u y f o r e i g n c u r r e n c y o n d e m a n d , t h e balances 2

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t h a t t h e banks m a i n t a i n e d a b r o a d h a d ( m o s t l y ) lost t h e i r q u a l i t y o f be­ i n g p o t e n t i a l c e n t r a l b a n k m o n e y . W i t h i n a few weeks t h e B u n d e s b a n k s u c c e e d e d i n r e d u c i n g free l i q u i d reserves t o n e a r zero. A s e c o n d step was t o d e t e r b a n k s f r o m e x p a n d i n g t h e i r balance sheets by i n c r e a s i n g t h e cost o f c e n t r a l b a n k money. O n M a y 30, the B u n d e s b a n k decided n o t to grant L o m b a r d credit u n t i l further notice. ( L o m b a r d c r e d i t is analogous t o t h e Fed's loans v i a t h e d i s c o u n t w i n d o w t o U . S . c o m m e r c i a l banks. T h e B u n d e s b a n k p r o v i d e s a d d i t i o n a l f u n d s t o c o m ­ m e r c i a l banks t h r o u g h w h a t are c a l l e d r e d i s c o u n t quotas, loans at a sub­ s i d i z e d rate k n o w n as t h e d i s c o u n t rate. T h e i n t e r b a n k i n t e r e s t rate, t h e m a r k e t rate at w h i c h b a n k s l e n d t o each other, is usually b o u n d e d f r o m above b y t h e L o m b a r d rate a n d f r o m b e l o w b y t h e d i s c o u n t rate.) T h e effect is c l e a r l y visible i n t h e m o v e m e n t o f t h e o v e r n i g h t rate i n P a n e l B o f F i g u r e 4 . 1 , w h i c h shows t h e h i s t o r y o f some basic e c o n o m i c i n d i c a t o r s f o r G e r m a n y . T h i s m e a s u r e was c o u p l e d w i t h f u r t h e r increases i n t h e d i s c o u n t rate a n d r e d u c t i o n s i n t h e r e d i s c o u n t quotas over t h e f o l l o w ­ i n g m o n t h s . F r o m late 1973 o n , t h e B u n d e s b a n k g r a n t e d special L o m b a r d c r e d i t t o l i m i t t h e v o l a t i l i t y i n t h e o v e r n i g h t rate, b u t s t i l l at p u n i t i v e rates. I t was at this stage t h a t g r o w t h i n t h e s u p p l y o f c e n t r a l b a n k m o n e y b e c a m e t h e m a i n focus o f m o n e t a r y policy. I n a s e c t i o n o f t h e S e p t e m ­ b e r 1973 Monthly Report e n t i t l e d " M o n e t a r y p o l i c y t h r o u g h c o n t r o l o f t h e c e n t r a l b a n k m o n e y supply," t h e B u n d e s b a n k stated t h a t i t "based its policy o n the consideration that the banks' need for central bank m o n e y u l t i m a t e l y d e p e n d s o n t h e scale o f t h e e x p a n s i o n i n b a n k l e n d i n g , " a n d t h a t i t was p r e p a r e d t o m a k e a d d i t i o n a l c e n t r a l b a n k m o n e y available " o n l y i n so far as s u c h [ p r o v i s i o n ] was consistent w i t h its m o n e t a r y p o l i c y t a r g e t o f r e d u c i n g t h e i n f l a t i o n - i n d u c e d excess m o n e y supply" ( D e u t s c h e B u n d e s b a n k , 1973b, September, p . 9 ) . T h e r e w e r e signs t h a t t h e r e s t r i c t i v e p o l i c y o f t h e B u n d e s b a n k was b e g i n n i n g t o slow b o t h i n f l a t i o n , w h i c h h a d p e a k e d at a l m o s t 8% i n m i d - 1 9 7 3 , a n d G D P g r o w t h (Panels A a n d C o f F i g u r e 4 . 1 ) . T h e n , i n O c t o b e r 1973, t h e first o i l crisis b r o k e . T h e B u n d e s b a n k ' s efforts t o b r i n g d o w n i n f l a t i o n w e r e t h u s j e o p a r d i z e d at t h e very t i m e o u t p u t g r o w t h was e x p e c t e d t o f a l l drastically. I n p a r t i c u l a r , t h e B u n d e s b a n k was c o n c e r n e d t h a t t h e o i l p r i c e increases w o u l d q u i c k l y l e a d t o a s e c o n d - r o u n d wagep r i c e s p i r a l . A c c o r d i n g l y , b y its o w n a c c o u n t , "the B u n d e s b a n k endeav­ o r e d t o k e e p m o n e t a r y e x p a n s i o n w i t h i n relatively s t r i c t l i m i t s d u r i n g 1974. A l t h o u g h i t d i d n o t expressly c o m m i t itself—as i t d i d i n D e c e m b e r 1 9 7 4 — t o any q u a n t i t a t i v e target, i t t r i e d t o ensure t h a t m o n e t a r y e x p a n ­ s i o n was n o t t o o great, b u t n o t t o o s m a l l e i t h e r " ( D e u t s c h e B u n d e s b a n k , 1974a, p . 1 7 ) . D e s p i t e t h e fact t h a t i t d i d n o t specify a q u a n t i t a t i v e tar-

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get, t h e B u n d e s b a n k was d e t e r m i n e d t o c o m m u n i c a t e its message o f re­ s t r a i n t as clearly as possible. It is o f the utmost importance that i n the field o f price and wage policy man­ agement and labor behave i n a way appropriate to the new situation. I n their decisions management and labor will have to consider the fact that i f the o i l shortage continues, hardly more goods will be available for distribution next year than i n 1973. (Deutsche Bundesbank, 1973b, December, p. 7) H e r e t h e B u n d e s b a n k was e x p l a i n i n g t o t h e p u b l i c t h a t p o l i c y m u s t be f o r w a r d - l o o k i n g a n d o r i e n t e d t o w a r d i n f l a t i o n expectations. Its justifica­ t i o n f o r a "just r i g h t " m o n e t a r y expansion reflected its c o n c e r n f o r real-side effects, a c o n c e r n w h i c h l e d i t t o u n d e r t a k e disinflation o n l y gradually. T h e a n n o u n c e m e n t o f a g r o w t h target f o r central b a n k m o n e y i n D e c e m b e r 1974 c a n t h u s be seen as a n o t h e r step i n t h e g r a d u a l r e o r i e n ­ t a t i o n o f G e r m a n y ' s m o n e t a r y policy. I t c o m b i n e d t h e m o v e m e n t t o w a r d basing m o n e t a r y policy o n c o n t r o l o f the central b a n k m o n e y supply a n d t h e p e r c e i v e d n e e d t o c o m m u n i c a t e clearly t h e objectives o f t h a t p o l i c y t o t h e p u b l i c . " U n d e r t h e i n f l u e n c e o f t h e g r o w i n g weakness o f business activity a n d t h e first signs o f progress i n fighting i n f l a t i o n , a c h a n g e was m a d e i n t h e last q u a r t e r o f 1974; t h e target b e c a m e a s l i g h t l y faster rate o f m o n e t a r y g r o w t h , w h i c h was p u b l i c l y a n n o u n c e d towards t h e e n d o f t h e year" ( D e u t s c h e B u n d e s b a n k , 1974a, p . 1 7 ) . T h i s a n n o u n c e m e n t is i n t e r e s t i n g f o r t h r e e reasons. First, a l t h o u g h t h e B u n d e s b a n k was m a i n l y c o n c e r n e d w i t h r e v e r s i n g t h e i n f l a t i o n a r y t r e n d o f t h e p r e v i o u s five years, its n e w m o n e t a r y p o l i c y d i d n o t i g n o r e r e a l activity as a g o a l . S e c o n d , i t speaks o f m o n e t a r y p o l i c y as a c t i n g i n a p r e e m p t i v e m a n n e r ("first signs"). T h i r d , i t declares t h a t m o n e t a r y tar­ gets w e r e b e i n g a d o p t e d at a t i m e w h e n b o t h i n f l a t i o n a n d m o n e y g r o w t h w e r e e x p e c t e d t o slow d o w n , m a k i n g i t easy t o m e e t targete b u t at t h e same t i m e n o u r i s h i n g t h e fear t h a t t h a t very easing m i g h t u n l e a s h i n f l a ­ t i o n a r y e x p e c t a t i o n s . As P a n e l G o f F i g u r e 4.1 shows, G e r m a n y was en­ t e r i n g a s h o r t b u t d e e p recession, s i m i l a r to t h a t o f 1967. I m m e d i a t e l y f o l l o w i n g t h e o i l crisis i n O c t o b e r 1973, G D P g r o w t h h a d started t o slow, a n d b y t h e first q u a r t e r o f 1975 i t h a d t u r n e d negative. T h e B u n d e s b a n k , i n discussing its p l a n t o a d h e r e t o t h e E C r e s o l u ­ t i o n q u o t e d above, r e m a r k e d t h a t the formulation o f this objective is based o n the recognition that the persis­ tent and accelerating decline i n the value o f money is impossible without a corresponding expansion o f the stock o f money held by the public and, i n ­ deed, that the monetary sphere i n its own right not infrequently promotes the inflation o f prices and wages. (Deutsche Bundesbank, 1972a, p. 24)

A. CPI and Unavoidable/Normative Inflation

C. GDP Growth and Unemployment Rate

E. Monetary Targets and Outcomes

B. Overnight and Long-Term Interest Rates

D. Nominal Effective Exchange Rate

Figure 4.1 German economic indicators. Sources: A) Bank for International Settle­ ments database, Deutsche Bundesbank; B) Bank for International Settlements database; C) Main economic indicators o f the Organisation for Economic Co­ operation and Development; D) Bank for International Settlements database; E) Bank for International Settlements database, Deutsche Bundesbank.

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A p p a r e n t l y m o n e t a r i s m was h a v i n g a s i g n i f i c a n t i m p a c t o n policy-mak­ ers i n s i d e t h e B u n d e s b a n k . S t i l l , a l t h o u g h t h e B u n d e s b a n k based its an­ n u a l m o n e t a r y targets o n t h e q u a n t i t y theory, i t was n e v e r d o g m a t i c i n d o i n g so. O t m a r Issing, t h e C h i e f E c o n o m i s t o f t h e B u n d e s b a n k , n o t e d (Issing, 1996, p . 1 2 0 ) , " O n e o f t h e secrets o f t h e success o f t h e G e r m a n p o l i c y o f m o n e y - g r o w t h t a r g e t i n g was t h a t . . . i t o f t e n d i d n o t feel b o u n d by m o n e t a r i s t o r t h o d o x y as far as its m o r e t e c h n i c a l details were c o n ­ c e r n e d . " ( I n d e e d , Issing accepts t h e c h a r a c t e r i z a t i o n o f G e r m a n m o n ­ etary p o l i c y as "pragmatic m o n e t a r i s m " [Issing, 1997, p . 7 2 ] ) . T h i s state­ m e n t indicates t h a t t h e B u n d e s b a n k makes a l i n k between " t e c h n i c a l de­ tails" a n d m o n e t a r y p o l i c y success. T h e c o m m i t m e n t t o p r i c e stability alone is n o t e n o u g h w i t h o u t t h e p r o p e r design o f t h e o p e r a t i o n a l f r a m e w o r k f o r targeting. A n o t h e r i m p e t u s f o r m o n e t a r y t a r g e t i n g , t h e c o o r d i n a t i o n o f t h e ex­ p e c t a t i o n s o f e c o n o m i c agents, was a subject o f lively i n t e r e s t at t h e t i m e t h e B u n d e s b a n k a n n o u n c e d its first target. From the immediately preceding period o f fixed exchange rates [trade unions and enterprises] were accustomed to the Bundesbank's monetary policy measures becoming ineffective when they resulted i n massive inflows of funds from abroad. As a consequence the Bundesbank initially failed to influence wage and price behavior i n the way i t wished. I n the light o f this adverse experience, the Bundesbank, together with the Federal Government and the independent Council o f Economic Experts, concluded that i t w o u l d be use­ ful to explicitly define the 'monetary framework' for the growth o f produc­ tion and prices. (Schlesinger, 1983, p. 6) A l t h o u g h its statements at t h e t i m e d o n o t m a k e t h e p o i n t e x p l i c i t l y , o n e o f t h e B u n d e s b a n k ' s p r i m a r y c o n c e r n s appears t o have b e e n t h a t p u b l i c m i s p e r c e p t i o n s m i g h t l e a d t o expectations o f h i g h i n f l a t i o n . A t t h e b e g i n n i n g o f 1975, i n view o f t h e a p p a r e n t weakness i n t h e e c o n o m y , t h e B u n d e s b a n k c o n t i n u e d t o ease m o n e t a r y p o l i c y w h i l e a v o i d i n g any sug­ gestion t h a t its d e t e r m i n a t i o n t o b r i n g d o w n i n f l a t i o n was d i m i n i s h i n g . R e c e n t e x p e r i e n c e h a d s h o w n t h a t wage-setting b e h a v i o r i n p a r t i c u l a r h a d b e e n l i t t l e affected by t h e Bundesbank's efforts t o l o w e r i n f l a t i o n : Wage costs have gone up steadily i n the last few months, partly as after-effects o f [earlier] settlements . . . which were excessive (not least because manage­ ment and labor obviously underestimated the prospects o f success o f the stabilization p o l i c y ) . . . . Despite the low level o f business activity and sub­ dued inflation expectations, even i n very recent wage negotiations two-fig­ ure rises have effectively been agreed. (Deutsche Bundesbank, 1974b, De­ cember, p. 6)

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T h e c r e d i b i l i t y issue arose, t h e n , i n association w i t h t h e B u n d e s b a n k ' s efforts t o stop t h e pass-through o f a o n e - t i m e s h o c k ( t h e o i l crisis) t o t h e p r i c e level. F r o m this perspective, G e r m a n y seems t o have a d o p t e d m o n ­ etary t a r g e t i n g , at least i n p a r t , i n o r d e r t o create a m e a n s o f c o m m u n i ­ c a t i o n w i t h t h e p u b l i c w i t h t h e h o p e o f e x e r t i n g some leverage o n i n f l a ­ t i o n e x p e c t a t i o n s . A f t e r c e n t r a l b a n k m o n e y h a d g r o w n b y 6% d u r i n g 1974, t h e B u n d e s b a n k a n n o u n c e d a t a r g e t g r o w t h rate o f 8% f o r 1975: A n acceleration o f money growth was intended to stimulate demand and provide the monetary scope necessary for the desired real growth o f the economy. O n the other hand, the target was also intended to show that no precipitate action would be taken to ease monetary conditions, i n order not to jeopardize further progress towards containing the inflationary tenden­ cies. (Deutsche Bundesbank, 1976a, p. 5) T h i s e x p l a n a t i o n was m a d e o n l y after t h e t a r g e t h a d b e e n a n n o u n c e d , h o w e v e r — n o t c o n t e m p o r a n e o u s l y w i t h t h e a n n o u n c e m e n t itself.

Switzerland I n m a n y respects S w i t z e r l a n d a n d G e r m a n y f o l l o w e d t h e same m o n e t a r y p o l i c y d u r i n g t h e early 1970s. I n b o t h c o u n t r i e s , massive c a p i t a l inflows h a d caused excessive m o n e t a r y e x p a n s i o n d u r i n g t h e final years o f B r e t t o n Woods, a n d i n b o t h countries the central bank h a d suspended its i n t e r v e n t i o n s i n early 1973. O n e o f t h e reasons t h e y e x p e r i e n c e d such h u g e c a p i t a l inflows was t h e p e r c e p t i o n t h a t b o t h c e n t r a l banks e n j o y e d c o n s i d e r a b l e p o l i t i c a l i n d e p e n d e n c e as w e l l as p u b l i c s u p p o r t f o r t h e i r p u r s u i t o f a n t i - i n f l a t i o n a r y p o l i c i e s . Finally, at t h e e n d o f 1974, after a t r a n s i t i o n p e r i o d o f a l m o s t t w o years, b o t h c o u n t r i e s a d o p t e d a m o n ­ etary t a r g e t as a n o m i n a l a n c h o r , r e p l a c i n g t h e fixed e x c h a n g e rate. T h e G e n e r a l D i r e c t o r a t e o f t h e Swiss N a t i o n a l B a n k " d e c i d e d , at t h e b e g i n n i n g o f t h e year [ 1 9 7 5 ] , t o fix t h e e x p a n s i o n o f o f f i c i a l m e a n s o f p a y m e n t f o r 1975. . . . U n d e r [ t h e e c o n o m i c ] circumstances, t h e G e n ­ e r a l D i r e c t o r a t e e s t i m a t e d t h a t a n e x p a n s i o n by 6% o f t h e m o n e y stock M l . . . w o u l d be a p p r o p r i a t e " (Swiss N a t i o n a l B a n k , 1975a, p p . 7-8, trans­ l a t i o n by a u t h o r s ) . W i t h this as a target, t h e Swiss N a t i o n a l B a n k i n t e n d e d t o p r o v i d e m o n e t a r y c o n d i t i o n s " t h a t are c o n d u c i v e t o f u r t h e r i n g t r a n ­ q u i l l i t y at t h e p r i c e f r o n t w i t h o u t o b s t r u c t i n g t h e b r o a d e r e c o n o m i c de­ v e l o p m e n t s " (Swiss N a t i o n a l B a n k , 1975b, January, p . 3, t r a n s l a t i o n b y a u t h o r s ) . T h e a n n o u n c e m e n t o f t h e t a r g e t was a c c o m p a n i e d b y l i t t l e p u b l i c fanfare o r e x p l a n a t i o n , r e f l e c t i n g a l a c k o f c o n c e r n over t h e coor-

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d i n a t i o n o f e x p e c t a t i o n s a n d t h e a s s u m p t i o n t h a t t h e t a r g e t was s i m p l y t o g u i d e policy. As i n t h e case o f G e r m a n y , i t appears t h a t t h e d e c i s i o n t o a d o p t a m o n e t a r y target was t a k e n u n i l a t e r a l l y by t h e Swiss N a t i o n a l B a n k b u t w i t h the support o f the Federal Government, t h o u g h n o reference was m a d e t o t h e G o v e r n m e n t ' s i n v o l v e m e n t i n t h e d e c i s i o n . T h e d e c i ­ s i o n t o t a r g e t a n a r r o w m o n e t a r y aggregate, i n c o n t r a s t t o G e r m a n y ' s c h o i c e o f a b r o a d m e a s u r e o f m o n e y , is discussed i n t h e n e x t s e c t i o n . 3

As i n G e r m a n y , t h e Swiss N a t i o n a l Bank's a n n o u n c e m e n t m a r k e d t h e e n d o f a p e r i o d o f a l m o s t t w o years d u r i n g w h i c h m o n e t a r y p o l i c y h a d b e e n c o n d u c t e d w i t h o u t a n o m i n a l a n c h o r . T h e Swiss e x p e r i e n c e d u r ­ i n g t h e final years o f B r e t t o n W o o d s a n d t h e i m m e d i a t e a f t e r m a t h was, however, even m o r e e x t r e m e t h a n t h a t o f G e r m a n y . Since S w i t z e r l a n d is b o t h a s m a l l e c o n o m y a n d a n i m p o r t a n t i n t e r n a t i o n a l financial center, t h e speculative c a p i t a l i n f l o w s i n t o t h e Swiss franc i n 1971 a n d 1972 as a p r o p o r t i o n o f t h e m o n e y stock w e r e even l a r g e r t h a n i n G e r m a n y . I n t h e year t o D e c e m b e r 1971 t h e m o n e t a r y base a n d M l i n S w i t z e r l a n d g r e w b y 1 8 % a n d 2 1 % respectively, a l t h o u g h f r o m A u g u s t t o D e c e m b e r t h e fixed e x c h a n g e rate h a d b e e n t e m p o r a r i l y s u s p e n d e d . Since m o s t o f t h e e x p a n s i o n was caused b y t h e i n f l o w o f f u n d s f r o m a b r o a d , i n t e r e s t rates w e r e i m p o t e n t as a t o o l t o slow t h e m o n e t a r y e x p a n s i o n . O n e t o o l t h a t was h e a v i l y used t o s t e m t h e f l o w was t h e i m p o s i t i o n o f m i n i m u m re­ serve r e q u i r e m e n t s , b o t h o n l i a b i l i t i e s t o residents a n d even m o r e so t o n o n r e s i d e n t s . I n view o f t h e scale o f t h e m o n e t a r y e x p a n s i o n , t h e Swiss N a t i o n a l B a n k w e n t o n e step f u r t h e r b y i n t r o d u c i n g , i n J u l y 1972, a ceil­ i n g o n t h e g r o w t h o f b a n k c r e d i t t o persons a n d c o m p a n i e s d o m i c i l e d i n S w i t z e r l a n d . I f a b a n k e x c e e d e d t h e c e i l i n g , i t h a d t o pay a c e r t a i n frac­ t i o n o f t h e excess a m o u n t i n t o a b l o c k e d a c c o u n t at t h e Swiss N a t i o n a l Bank. D e s p i t e these a n d o t h e r measures, r e n e w e d i n f l o w s o f s p e c u l a t i v e c a p i t a l i n t o t h e Swiss f r a n c f o l l o w e d t h e a n n o u n c e m e n t o f t h e u n p r e c e d e n t e d l y large U . S . t r a d e d e f i c i t . O n J a n u a r y 23, 1973, t h e Swiss N a t i o n a l B a n k was finally f o r c e d t o suspend its i n t e r v e n t i o n s against t h e d o l l a r , t h u s f r e e i n g i t s e l f t o c o p e w i t h t h e task o f c o n t r o l l i n g m o n e t a r y e x p a n s i o n . D u r i n g 1973, t h e B a n k k e p t b o t h t h e restrictive reserve re­ q u i r e m e n t s a n d t h e c e i l i n g o n c r e d i t g r o w t h i n place. I n J u l y 1973 t h e c e i l i n g o n c r e d i t g r o w t h f o r t h e year e n d i n g J u l y 1974 was fixed at 6%. WHiile i t is d i f f i c u l t t o gauge t h e stance o f m o n e t a r y p o l i c y i n view o f t h e m u l t i t u d e o f instruments that were b e i n g employed, the trends o f all the n o n - i n t e r e s t rate p o l i c y measures suggest t h a t t h e Swiss i n s t r u m e n t rate u n d e r s t a t e d j u s t h o w t i g h t m o n e t a r y p o l i c y was at t h e t i m e . T h e m o v e ­ m e n t o f t h e o v e r n i g h t rate s h o w n i n t h e Swiss E c o n o m i c I n d i c a t o r s ( F i g -

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u r e 4.2, P a n e l B ) suggests t h a t m o n e t a r y p o l i c y was k e p t t i g h t u n t i l at least m i d - 1 9 7 4 . M o v e m e n t s o f t h e i n t e r e s t rate, however, d o n o t seem t o have b e e n very large c o m p a r e d t o t h e m o v e m e n t s o f t h e G e r m a n o v e r n i g h t rate d u r i n g t h e same p e r i o d . O n e reason t h a t t h e Swiss N a t i o n a l B a n k c o n ­ t i n u e d t o r e l y o n c r e d i t r e s t r i c t i o n s , i n a d d i t i o n t o its o t h e r i n s t r u m e n t s , was t h a t changes i n t h e i n t e r e s t rate were k n o w n t o f e e d t h r o u g h very q u i c k l y i n t o t h e C P I . I n S w i t z e r l a n d r e n t increases w e r e , a n d still are, t i e d t o increases i n m o r t g a g e rates ( t h r o u g h a l e g a l appeals process avail­ able t o t e n a n t s ) , a n d t h e share o f rents i n t h e C P I at t h a t t i m e was 1 7 % . " T h e a u t h o r i t i e s nevertheless d i d supervise t h e m o v e m e n t s o f b a n k l i ­ quidity i n o r d e r to . . . prevent liquidity f r o m c o n t r a c t i n g too m u c h a n d c a u s i n g a s h a r p rise i n i n t e r e s t rates, such a d e v e l o p m e n t b e i n g c o n s i d ­ e r e d u n d e s i r a b l e m a i n l y because o f t h e effect o f r i s i n g l o n g - t e r m rates o n t h e t r e n d o f prices" ( O E C D , 1975, p . 3 3 ) . T h e d i f f i c u l t i e s t h e Swiss have h a d w i t h m o n e t a r y c o n t r o l as a r e s u l t o f p e c u l i a r i t i e s i n t h e i r b a n k i n g a n d r e n t a l m a r k e t s suggest w h y some i n f l a t i o n - t a r g e t i n g c o u n t r i e s have c h o s e n t a r g e t series o t h e r t h a n t h e h e a d l i n e C P I . T h e U n i t e d K i n g d o m , f o r e x a m p l e , targets R P I X i n f l a ­ t i o n , w h i c h excludes t h e f i r s t - r o u n d effect o f i n t e r e s t rates o n m o r t g a g e rates. T h e Swiss N a t i o n a l B a n k , w h i l e clearly aware o f these d i f f i c u l t i e s f r o m t h e start, appears t o have felt t h a t h a v i n g a m o r e c l e a r l y u n d e r ­ s t o o d t a r g e t series a n d g o a l ( M l a n d l a t e r t h e m o n e t a r y base, a n d C P I i n f l a t i o n ) , a n d t h e n a t t r i b u t i n g d e v i a t i o n s f r o m t a r g e t t o these factors as t h e y arose, was t h e b e t t e r strategy. As we w i l l see, t h e B a n k has consis­ t e n t l y c h o s e n s i m p l e rules w i t h c o m p l i c a t e d e x p l a n a t i o n s over c o m p l i ­ cated rules w i t h s i m p l e e x p l a n a t i o n s . As t h e Swiss e c o n o m y b e g a n t o w e a k e n i n t h e course o f 1974, t h e B a n k a p p l i e d b o t h t h e reserve r e q u i r e m e n t s a n d t h e c r e d i t c e i l i n g m o r e flexibly. T h e c r e d i t c e i l i n g i n p a r t i c u l a r was c o n s i d e r a b l y r e l a x e d i n J a n u ­ ary 1975 a n d was a b o l i s h e d o n M a y 1, 1975. I n a s i t u a t i o n i n w h i c h u n p r e c e d e n t e d l y h i g h i n t e r e s t rates w e r e n o l o n g e r n e e d e d t o c o n t r o l the expansion o f b a n k l e n d i n g w i t h o u t quantitative restrictions, the B a n k s h i f t e d t o w a r d a focus o n t h e c o n t r o l o f t h e m o n e y supply. T h e a d o p t i o n o f m o n e t a r y targets was t h u s less g r a d u a l t h a n i n G e r m a n y , p a r t l y be­ cause o f t h e faster response o f t h e Swiss f i n a n c i a l system t o m o n e t a r y i m p u l s e s . S t i l l , t h e a d o p t i o n o f t h e n e w p o l i c y was l a r g e l y a response t o t h e loss o f t h e n o m i n a l a n c h o r d u r i n g t h e last years o f B r e t t o n W o o d s . A n d , as i n G e r m a n y , m o n e t a r y targets w e r e a d o p t e d at a t i m e w h e n b o t h i n f l a t i o n a n d m o n e y g r o w t h were s l o w i n g d o w n , m a k i n g the targets easier to meet. 4

A. CPI Inflation

B. Overnight and Long-Term Interest Rotes

1974

1978

1982

1986

1990

1994

1998

1994

1998

D. Nominal Effective and DM/SFR Exchange Rate

1974

1978

1982

1986

1990

F. SAMB (Bin SFR) and Medium-Term Growth Paths

— SAMB - - Target 1 9 9 0 - 1 9 9 4 Target 1 9 9 5 - 1 9 9 9

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Figure 4.2 Swiss economic indicators. Sources: A) Bank for International Settle­ ments database; B) Bank for International Settlements database; C) M a i n eco­ nomic indicators o f the Organiasation for Economic Cooperation and Develop­ ment; D ) Bank for International Settlements database; E) Bank for Interna­ tional Settlements database, Swiss National Bank; F) Bank for International Settle­ ments database, Swiss National Bank.

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A t t h e b e g i n n i n g o f 1975, S w i t z e r l a n d was a b o u t t o e n t e r t h e w o r s t re­ cession i n its postwar h i s t o r y ( F i g u r e 4.2, Panel C ) . T h e o i l shock h a d t r i g g e r e d a d o w n t u r n t h a t m u s t already have b e e n u n d e r way. A l s o , al­ t h o u g h t h e s t r o n g Swiss franc h e l p e d t o absorb t h e i n f l a t i o n a r y i m p a c t o f t h e shock ( F i g u r e 4.2, Panels A a n d D ) , t h a t i m p a c t posed a serious t h r e a t t o t h e Swiss e x p o r t sector, w h i c h c o n s t i t u t e d a b o u t a t h i r d o f G N P at t h e t i m e . D u r i n g 1975 e x p o r t s o f m e r c h a n d i s e f e l l by 8% i n r e a l t e r m s . M o r e ­ over, t h o u g h s u b d u e d g r o w t h i n r e a l wages s u p p o r t e d t h e B a n k ' s f i g h t against i n f l a t i o n , i t also c o n t r i b u t e d t o a s h a r p d e c l i n e i n r e a l c o n s u m p ­ t i o n , w h i c h was w o r s e n e d by a s i g n i f i c a n t o u t f l o w o f f o r e i g n w o r k e r s . T h e m o n e y - t a r g e t i n g initiative d i d n o t h i n g t o ease the h i g h cost o f Switzerland's d i s i n f l a t i o n , n o r d i d t h e B a n k suggest t h a t t h e t a r g e t i n g w o u l d p r o v i d e a c o o r d i n a t i n g f u n c t i o n f o r wage- a n d price-setters t h a t w o u l d l o w e r t h a t cost. T h e a d o p t i o n o f a target was i n t e n d e d t o cap i n f l a t i o n expectations by i n d i c a t i n g a p o l i c y c o m m i t m e n t , a n d n o t h i n g m o r e .

The Operational Framework in Germany and Switzerland F r o m 1975 t o 1980, b o t h t h e B u n d e s b a n k a n d t h e Swiss N a t i o n a l B a n k a d h e r e d t o t h e strategy o f s e t t i n g a n d a n n o u n c i n g t h e i r m o n e t a r y tar­ gets, a l t h o u g h t h e y m a d e a n u m b e r o f changes i n t h e i r p r o c e d u r e s a l o n g t h e way t h a t r e f l e c t e d t h e i r e x p e r i e n c e w i t h those targets. Since 1980, however, t h e o p e r a t i o n a l f r a m e w o r k o f t h e i r t a r g e t i n g has d i s p l a y e d a r e m a r k a b l e d e g r e e o f c o n t i n u i t y . B o t h b a n k s have c o p e d successfully w i t h o v e r s h o o t i n g s o f t h e i r targets, f o r e x a m p l e . M o r e o v e r , b o t h have m a d e changes i n t h e p a r t i c u l a r m o n e t a r y aggregates t a r g e t e d a n d i n t a r g e t i n g p r o c e d u r e s w h e n t h e y f e l t circumstances w a r r a n t e d , w i t h o u t t r i g g e r i n g a persistent rise i n i n f l a t i o n o r i n f l a t i o n e x p e c t a t i o n s . We n o w t u r n t o a r e v i e w o f t h e key features o f t h e o p e r a t i o n a l f r a m e ­ w o r k o f each c o u n t r y . W e t h e n analyze t h e r a t i o n a l e b e h i n d t h e c h o i c e o f t h e i n t e r m e d i a t e target v a r i a b l e — n a r r o w m o n e y i n S w i t z e r l a n d , b r o a d m o n e y i n G e r m a n y — a n d the c o n n e c t i o n between the choice o f opera­ t i o n a l f r a m e w o r k a n d p r o c e d u r e s f o r d e a l i n g w i t h d e v i a t i o n s f r o m an­ n o u n c e d targets. O u r h i s t o r i c a l - i n s t i t u t i o n a l analysis i n this a n d t h e f o l l o w i n g s e c t i o n c o n f i r m s t h e view o f G e r m a n a n d Swiss m o n e t a r y p o l i c y - m a k i n g raised i n Bernanke a n d M i s h k i n (1992) a n d s u p p o r t e d by later e c o n o m e t r i c studies, t h a t 1) n e i t h e r c o u n t r y ' s c e n t r a l b a n k treats p r i c e stability as t h e o n l y g o a l o f policy, p a r t i c u l a r l y i n t h e short- a n d m e d i u m - r u n ; a n d 2) n e i t h e r c e n t r a l b a n k views t h e c o r r e l a t i o n s b e t w e e n m o n e y g r o w t h 5

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a n d g o a l variables t o be s t r o n g e n o u g h t o j u s t i f y s t r i c t a d h e r e n c e t o t h e targets o r e x c l u s i o n o f o t h e r r e l e v a n t i n f o r m a t i o n . I n fact, t h e m a i n f u n c ­ t i o n o f m o n e t a r y t a r g e t i n g i n b o t h c o u n t r i e s has b e e n t o p r o v i d e a frame­ w o r k w i t h i n w h i c h t h e c e n t r a l b a n k c o u l d convey t o t h e p u b l i c its l o n g t e r m c o m m i t m e n t t o p r i c e stability, w h i l e r e t a i n i n g s o m e flexibility f o r shorter-term policy discretion. 6

Germany F r o m 1975 u n t i l 1987, t h e B u n d e s b a n k a n n o u n c e d targets f o r t h e g r o w t h o f c e n t r a l b a n k m o n e y ( C B M ) . A g a i n , C B M is d e f i n e d as c u r r e n c y i n c i r c u l a t i o n p l u s s i g h t ( t h a t is, d e m a n d ) deposits, t i m e deposits w i t h m a ­ t u r i t y u n d e r f o u r years, a n d savings deposits a n d savings b o n d s w i t h m a t u r i t y o f less t h a n f o u r years, w i t h t h e latter t h r e e c o m p o n e n t s w e i g h t e d by t h e i r respective required-reserve ratios as o f j a n u a r y 1974. ( T h e weights are 16.6%, 1 2 . 4 % , a n d 8.2%, respectively.) C B M differs f r o m t h e m o n ­ etary base i n t h a t t h e excess balances o f banks are e x c l u d e d a n d t h e weights o f deposits subject t o reserve r e q u i r e m e n t s are based o n h i s t o r i ­ cal, n o t c u r r e n t , ratios. Since 1988, however, t h e B u n d e s b a n k has u s e d t h e g r o w t h rate o f M 3 r a t h e r t h a n C B M as its o f f i c i a l target. M 3 is d e f i n e d as t h e s u m o f cur­ r e n c y i n c i r c u l a t i o n , s i g h t deposits, t i m e deposits w i t h m a t u r i t y u n d e r f o u r years, a n d savings deposits at t h r e e m o n t h s ' n o t i c e . A p a r t f r o m t h e fact t h a t C B M does n o t i n c l u d e savings deposits w i t h l o n g e r m a t u r i t i e s , o r savings b o n d s , t h e m a j o r d i f f e r e n c e b e t w e e n M 3 a n d C B M is t h a t C B M is a w e i g h t e d - s u m aggregate, w h i l e M 3 is a s i m p l e s u m . Because t h e w e i g h t s a s c r i b e d t o t h e t h r e e types o f deposits i n C B M are f a i r l y s m a l l , t h e o n l y source f o r large divergences b e t w e e n t h e g r o w t h o f t h e t w o aggregates is a s i g n i f i c a n t fluctuation i n t h e h o l d i n g s o f c u r r e n c y as c o m ­ p a r e d w i t h deposits. S u c h a d i v e r g e n c e b e c a m e c r i t i c a l i n late 1987 i n t h e face o f s h i f t i n g financial i n c e n t i v e s , a n d a g a i n i n 1990-91, after Ger­ m a n monetary unification. T h e B u n d e s b a n k has always set its m o n e t a r y t a r g e t f o r t h e n e x t year at t h e e n d o f t h e c u r r e n t year. T o d e r i v e a m o n e t a r y target, i t uses a q u a n t i t y e q u a t i o n t h a t states t h a t t h e a m o u n t o f n o m i n a l transactions i n a n e c o n o m y w i t h i n a g i v e n p e r i o d o f t i m e is e q u a l t o t h e a m o u n t o f t h e m e a n s o f p a y m e n t m u l t i p l i e d b y t h e v e l o c i t y at w h i c h t h e m e a n s o f pay­ m e n t changes hands. I n rate-of-change f o r m , t h e q u a n t i t y e q u a t i o n states t h a t t h e s u m o f r e a l o u t p u t g r o w t h a n d t h e i n f l a t i o n rate is e q u a l t o t h e sum o f m o n e y g r o w t h a n d the change i n (the appropriately defined)

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velocity. T h e B u n d e s b a n k derives t h e t a r g e t g r o w t h rate o f t h e c h o s e n m o n e t a r y aggregate ( e i t h e r C B M o r M 3 ) by e s t i m a t i n g t h e g r o w t h o f t h e l o n g - r u n p r o d u c t i o n p o t e n t i a l over t h e c o m i n g year, a d d i n g t h e rate o f p r i c e c h a n g e i t considers u n a v o i d a b l e ( d e s c r i b e d b e l o w ) , a n d sub­ t r a c t i n g t h e e s t i m a t e d c h a n g e i n t r e n d v e l o c i t y over t h e year. 7

T h e B u n d e s b a n k does n o t use forecasts o f r e a l o u t p u t g r o w t h o v e r t h e c o m i n g year i n its t a r g e t d e r i v a t i o n . I n s t e a d , i t estimates t h e g r o w t h i n p r o d u c t i o n p o t e n t i a l . T h i s emphasis o n p o t e n t i a l r a t h e r t h a n a c t u a l o u t p u t is consistent w i t h t h e B u n d e s b a n k ' s p u b l i c p o s i t i o n t h a t i t s h o u l d n o t engage i n p o l i c i e s a i m e d at s h o r t - t e r m s t i m u l a t i o n ( a l t h o u g h t h e effect o f t h e a p p r o a c h , t o a d e g r e e , is t o create some c o u n t e r c y c l i c a l i t y i n i n t e r e s t rates). T h i s a p p r o a c h allows t h e B u n d e s b a n k t o c l a i m t h a t i t is n o t m a k i n g any c h o i c e a b o u t t h e business cycle w h e n i t sets policy. I t also de-emphasizes any p u b l i c discussion o f its f o r e c a s t i n g efforts f o r t h e real economy, f u r t h e r d i s t a n c i n g m o n e t a r y p o l i c y f r o m t h e considerations o f e x p e c t e d fluctuations i n o u t p u t a n d e m p l o y m e n t . T h u s t h e q u a n t i t y a p p r o a c h serves t o take c e r t a i n i t e m s o f f t h e m o n e t a r y p o l i c y a g e n d a ( o r at least t o de-emphasize t h e m ) b y l i m i t i n g t h e list o f t h e c e n t r a l bank's responsibilities. 8

A second element i n the Bundesbank's procedure for deriving the t a r g e t g r o w t h rate o f a g i v e n m o n e t a r y aggregate is t h e c o n c e p t o f " u n ­ a v o i d a b l e p r i c e increases," w h i c h measures prices a c c o r d i n g t o t h e a l l i t e m s c o n s u m e r p r i c e i n d e x ( C P I ) . These goals f o r i n f l a t i o n , w h i c h are set each year b e f o r e t h e m o n e t a r y t a r g e t is set, specify t h e i n t e n d e d p a t h f o r i n f l a t i o n , w h i c h i n t u r n drives m o n e t a r y policy. I n view o f the unfavorable underlying situation, the Bundesbank felt obliged u n t i l 1984 to include an "unavoidable" rate o f price rises i n its calculation. By so doing, i t took due account o f the fact that price increases which have already entered into the decisions o f economic agents cannot be eliminated immediately, but only step by step. O n the other hand, this tolerated rise i n prices was invariably below the current inflation rate, or the rate forecast for the year ahead. The Bundesbank thereby made i t plain that, by adopting an unduly "gradualist" approach to fighting inflation, i t d i d not wish to contrib­ ute to strengthening inflation expectations. Once price stability was virtually achieved at the end o f 1984, the Bundesbank abandoned the concept o f "unavoidable" price increases. Instead, i t has since then included . . . a me­ dium-term price assumption o f 2 percent. (Deutsche Bundesbank, 1995c, pp. 80-1) T h e s e t t i n g o f t h e a n n u a l u n a v o i d a b l e p r i c e increase t h u s e m b o d i e s f o u r n o r m a t i v e j u d g m e n t s b y t h e B u n d e s b a n k : First, a m e d i u m - t e r m g o a l f o r

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i n f l a t i o n is t h e p r i n c i p a l d e t e r m i n a n t o f p o l i c y decisions. S e c o n d , t h e convergence o f the m e d i u m - t e r m inflation goal w i t h the l o n g - t e r m i n ­ flation g o a l s h o u l d be g r a d u a l , since t h e costs o f m o v i n g f r o m o n e g o a l to t h e o t h e r c a n n o t be i g n o r e d . T h i r d , t h e m e d i u m - t e r m i n f l a t i o n g o a l s h o u l d be a n u m b e r greater t h a n zero. F o u r t h , i f i n f l a t i o n e x p e c t a t i o n s r e m a i n c o n t a i n e d , t h e r e is n o n e e d t o reverse p r i o r p r i c e - l e v e l rises. T h e t a r g e t set f o r 1975 was a p o i n t t a r g e t f o r C B M g r o w t h f r o m D e ­ c e m b e r 1974 t o D e c e m b e r 1975. Since this t a r g e t t u r n e d o u t t o be sus­ c e p t i b l e t o s h o r t - t e r m fluctuations i n m o n e y g r o w t h a r o u n d year-end, t h e targets f o r 1976 t o 1978 w e r e f o r m u l a t e d as p o i n t targets f o r t h e average g r o w t h o f C B M relative t o t h e average level o f C B M over t h e p r e v i o u s year. I n 1979, two changes were m a d e . First, w i t h t h e e x c e p t i o n o f 1989, a l l targets have b e e n f o r m u l a t e d i n terms o f a target range o f plus o r m i n u s 1 % o r 1.5% a r o u n d t h e target d e r i v e d f r o m t h e q u a n t i t y e q u a t i o n . I n view o f the o i l price hikes i n 1974 and 1979-80, the erratic movements i n "real" exchange rates and the weakening o f traditional cyclical patterns, i t appeared advisable to grant monetary policy from the outset l i m i t e d r o o m for discretionary maneuver i n the form o f such target ranges. To ensure that economic agents are adequately informed . . . the central bank must be pre­ pared to define from the start as definitely as possible the overall economic conditions under which i t will aim at the top or b o t t o m end o f the range. (Schlesinger, 1983, p. 10) I n d e c i d i n g t o express targets i n t e r m s o f a r a n g e r a t h e r t h a n as a single p o i n t , t h e B u n d e s b a n k gave i t s e l f r o o m t o r e s p o n d t o e c o n o m i c devel­ o p m e n t s . I n fact, t h e t o n e o f its e x p l a n a t i o n suggests t h a t i t was confer­ r i n g some d i s c r e t i o n o n i t s e l f r a t h e r t h a n b u y i n g r o o m f o r e r r o r i n a difficult control p r o b l e m . T h e s e c o n d c h a n g e m a d e i n 1979 was t o r e f o r m u l a t e t h e targets as g r o w t h rates o f t h e average m o n e y stock i n t h e f o u r t h q u a r t e r over t h e average m o n e y stock i n t h e f o u r t h q u a r t e r o f t h e p r e c e d i n g year. T h e p u r p o s e was t o i n d i c a t e "the d i r e c t i o n i n w h i c h m o n e t a r y p o l i c y is a i m ­ i n g m o r e accurately t h a n a n average target does" (Deutsche B u n d e s b a n k , 1979b, January, p . 8 ) . P a n e l E o f F i g u r e 4.1 shows q u a r t e r l y g r o w t h rates o f C B M ( t h r o u g h 1987) a n d o f M 3 ( t h e r e a f t e r ) o v e r t h e f o u r t h - q u a r t e r level o f t h e p r e c e d i n g year a n d t h e targets since 1979. ( T h e e a r l i e r tar­ gets have b e e n o m i t t e d f r o m F i g u r e 4.1 because t h e y w e r e n o t f o r m u ­ l a t e d i n t e r m s o f year-on-year rates.) T h e B u n d e s b a n k has d e c l a r e d t h a t o n occasion i t m i g h t a l l o w devia­ tions f r o m the a n n o u n c e d target p a t h to occur i n o r d e r to s u p p o r t o t h e r

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e c o n o m i c objectives. As m e a n s o f s u p p o r t i n g s h o r t - r u n p o l i c y goals, such d e v i a t i o n s w o u l d be i n a d d i t i o n t o those i m p l i c i t i n t h e s e t t i n g o f a tar­ get r a n g e a n d i n t h e e s t a b l i s h m e n t o f a g r a d u a l p a t h f o r m o v e m e n t s i n u n a v o i d a b l e i n f l a t i o n . I n 1977, f o r e x a m p l e , signs o f weakness i n eco­ n o m i c activity, c o m b i n e d w i t h a s t r o n g a p p r e c i a t i o n o f t h e deutsche­ mark, p r o m p t e d the Bundesbank to tolerate the overshooting o f the target. As t h e p o l i c y s t a t e m e n t said at t h e t i m e : However, the fact that the Bundesbank deliberately accepted the risk o f a major divergence from its quantitative money target does not imply that i t abandoned the more medium-term orientation which has marked its poli­ cies since 1975. . . . There may be periods i n which the pursuit o f an "inter­ mediate target variable," as reflected i n the announced growth rate o f the central bank money stock, cannot be given priority. (Deutsche Bundesbank, 1978a, p. 22) T h e m a i n reason t h a t C B M was c h o s e n as t h e t a r g e t aggregate was its p e r c e i v e d advantages i n t e r m s o f p o l i c y t r a n s p a r e n c y a n d c o m m u n i c a ­ t i o n w i t h t h e p u b l i c . T h e B u n d e s b a n k e x p l a i n e d its c h o i c e o f C B M as follows: [CBM] brings out the central bank's responsibility for monetary expansion especially clearly. The money creation o f the banking system as a whole and the money creation o f the central bank are closely linked through currency i n circulation and the banks' obligation to maintain a certain p o r t i o n o f their deposits with the central bank. Central bank money, which comprises these two components, can therefore readily serve as an indicator o f both. A rise by a certain rate i n central bank money shows not only the size o f the money creation o f the banking system but also the extent to which the central bank has provided funds for the banks' money creation. (Deutsche Bundesbank, 1976a, p. 12) T h e Bundesbank's confidence that i t can explain target deviations a n d r e - d e f i n i t i o n s t o t h e p u b l i c is r e f l e c t e d i n t h e d e s i g n o f its r e p o r t ­ i n g m e c h a n i s m s . T h e r e is n o l e g a l r e q u i r e m e n t i n t h e B u n d e s b a n k A c t o r i n l a t e r l e g i s l a t i o n f o r t h e B u n d e s b a n k t o give a f o r m a l a c c o u n t o f its p o l i c y t o any p u b l i c b o d y . G o v e r n m e n t o v e r s i g h t is l i m i t e d t o a c o m ­ m i t m e n t t h a t "the D e u t s c h e B u n d e s b a n k s h a l l advise t h e F e d e r a l C a b i ­ n e t o n m o n e t a r y p o l i c y issues o f m a j o r i m p o r t a n c e , a n d s h a l l f u r n i s h i t w i t h i n f o r m a t i o n u p o n request" (Act Section 13). T h e only publica­ t i o n s t h e B u n d e s b a n k is r e q u i r e d t o issue are a n n o u n c e m e n t s i n t h e Federal Gazette o f t h e s e t t i n g o f i n t e r e s t rates, d i s c o u n t rates, a n d t h e l i k e ( A c t S e c t i o n 3 3 ) . A c c o r d i n g t o A c t S e c t i o n 18, t h e B u n d e s b a n k

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may, at its d i s c r e t i o n , p u b l i s h t h e m o n e t a r y a n d b a n k i n g statistics i t collects. T h e B u n d e s b a n k m a k e s heavy use o f t h i s last o p p o r t u n i t y . T h e B u n d e s b a n k ' s Monthly Report is described, o n t h e i n s i d e o f t h e f r o n t cover, as a response t o S e c t i o n 18 o f t h e B u n d e s b a n k A c t ; b u t t h e r e p o r t does m u c h m o r e t h a n s i m p l y r e p o r t statistics. Every m o n t h , after a " S h o r t C o m m e n t a r y " o n m o n e t a r y d e v e l o p m e n t s , securities m a r k e t s , p u b l i c fi­ n a n c e , e c o n o m i c c o n d i t i o n s , a n d t h e balance o f p a y m e n t s , several ar­ ticles appear. Some o f t h e m are o n o n e - t i m e t o p i c s ( f o r e x a m p l e , " T h e State o f E x t e r n a l A d j u s t m e n t after G e r m a n R e u n i f i c a t i o n " ) , a n d o t h e r s are r e c u r r i n g r e p o r t s ( f o r e x a m p l e , " T h e P r o f i t a b i l i t y o f G e r m a n C r e d i t I n s t i t u t i o n s " [ a n n u a l ] a n d " T h e E c o n o m i c Scene i n G e r m a n y " [ q u a r ­ t e r l y ] ) . I n each J a n u a r y issue, t h e m o n e t a r y t a r g e t a n d its j u s t i f i c a t i o n are p u b l i s h e d ( b e t w e e n 1989 a n d 1992, those i t e m s w e r e m a d e available i n D e c e m b e r ) . T h e Annual Report carries a d e t a i l e d r e v i e w o f e c o n o m i c ( n o t j u s t m o n e t a r y ) d e v e l o p m e n t s d u r i n g t h e previous year, lists a l l m o v e ­ m e n t s i n m o n e t a r y policy, a n d offers c o m m e n t a r y o n t h e fiscal p o l i c y o f t h e f e d e r a l g o v e r n m e n t a n d t h e Länder. W i t h these t w o p u b l i c a t i o n s , a l o n g w i t h r e g u l a r l y u p d a t e d "special p u b l i c a t i o n s " s u c h as The Monetary Policy of the Bundesbank, n o B u n d e s b a n k p o l i c y d e c i s i o n o r its l i k e l y ef­ fects are left undiscussed. 9

D e s p i t e its c o m m i t m e n t t o transparency, t h e B u n d e s b a n k imposes c e r t a i n l i m i t s o n its a c c o u n t a b i l i t y . N o articles i n t h e Monthly Report are s i g n e d b y t h e a u t h o r o r a u t h o r s , a n d t h e Annual Report has o n l y a b r i e f foreword signed by the Bundesbank President ( a l t h o u g h all the m e m ­ bers o f t h e C e n t r a l B a n k C o u n c i l are l i s t e d o n t h e pages p r e c e d i n g i t ) . Speeches g i v e n b y t h e P r e s i d e n t o r b y o t h e r c o u n c i l m e m b e r s are n e v e r r e p r i n t e d i n e i t h e r d o c u m e n t . T h i s p r a c t i c e is s o m e w h a t c o m p e n s a t e d f o r by t h e e n o r m o u s l y active s p e a k i n g a n d p u b l i s h i n g s c h e d u l e e n g a g e d i n by a l l c o u n c i l m e m b e r s ( n o t j u s t t h e P r e s i d e n t a n d C h i e f E c o n o m i s t ) a n d b y some s e n i o r staffers. S t i l l , t h e a n o n y m i t y o f t h e p u b l i s h e d r e p o r t s weakens t h e l i n k b e t w e e n p o l i c y a n d t h e p e o p l e w h o m a k e i t . A n o t h e r l i m i t a t i o n o n a c c o u n t a b i l i t y is t h a t t h e Monthly Report a n d t h e Annual Report d e a l o n l y w i t h t h e c u r r e n t s i t u a t i o n a n d past p e r f o r ­ m a n c e . N o forecasts o f any e c o n o m i c v a r i a b l e are m a d e p u b l i c , a n d n e i ­ t h e r private-sector forecasts n o r even e x p e c t a t i o n s are m e n t i o n e d . A p ­ parently, t h e B u n d e s b a n k is a c c o u n t a b l e f o r its past p e r f o r m a n c e , b u t n o t f o r its plans f o r t h e f u t u r e . I n fact, its a b i l i t y t o offer e x p l a n a t i o n s f o r e c o n o m i c a n d p o l i c y d e v e l o p m e n t s after t h e fact, a l o n g w i t h its r e l i a n c e o n p o t e n t i a l G D P a n d n o r m a t i v e i n f l a t i o n as t h e basis f o r t h e m o n e t a r y targets, o f t e n enables t h e B u n d e s b a n k t o shift r e s p o n s i b i l i t y f o r short10

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t e r m e c o n o m i c p e r f o r m a n c e t o o t h e r factors as i t chooses. N e v e r t h e ­ less, those same m o n e t a r y targets are seen by t h e B u n d e s b a n k as t h e m a i n source o f a c c o u n t a b i l i t y a n d t r a n s p a r e n c y f o r policy, because t h e y at least c o m m i t t h e B u n d e s b a n k t o e x p l a i n i n g p o l i c y o n a r e g u l a r basis a n d w i t h respect t o a n e x p l i c i t b e n c h m a r k .

Switzerland F r o m 1975 u n t i l 1978, t h e Swiss N a t i o n a l B a n k a n n o u n c e d g r o w t h tar­ gets f o r t h e n a r r o w m o n e t a r y aggregate M l . I n t h e f a l l o f 1978, after a t r a d e - w e i g h t e d a p p r e c i a t i o n o f t h e Swiss franc o f 4 0 % i n n o m i n a l t e r m s a n d 3 0 % i n r e a l t e r m s over t h e p r e v i o u s 12 m o n t h s , t h e B a n k d e c i d e d t o shift f r o m a m o n e t a r y t a r g e t t o a n exchange-rate target. I t m i g h t be said t h a t t h e B a n k was t h e r e b y i n t r o d u c i n g a n i m p l i c i t "escape clause" i n t o its t a r g e t i n g c o m m i t m e n t . I n t h e s p r i n g o f 1979, t h e B a n k r e t u r n e d t o m o n e y - t a r g e t i n g , " a l t h o u g h this c h a n g e was n o t p u b l i c l y a n n o u n c e d " ( S c h i l t k n e c h t 1983, p . 7 4 ) . F r o m 1980 o n , i t r e s u m e d a n n o u n c i n g m o n e t a r y targets. T h i s t i m e , however, i t chose a n even n a r r o w e r m o n e t a r y aggregate as its target. F r o m 1980 u n t i l 1988, t h e targets w e r e f o r m u l a t e d f o r t h e adjusted m o n e t a r y base ( A M B ) , d e f i n e d as t h e m o n e t a r y base adjusted f o r t h e B a n k ' s end-ofm o n t h a c c o m m o d a t i o n o f t h e l i q u i d i t y needs o f c o m m e r c i a l banks. Since 1989, t h e t a r g e t v a r i a b l e has b e e n t h e seasonally adjusted m o n e t a r y base ( S A M B ) . I n r e c e n t years, c u r r e n c y i n c i r c u l a t i o n has c o n s t i t u t e d r o u g h l y 9 0 % o f t h e S A M B , w i t h t h e deposits o f c o m m e r c i a l banks at t h e Swiss N a t i o n a l B a n k m a k i n g u p t h e rest. C o n s e q u e n t l y S A M B is a n a r r o w e r m o n e t a r y aggregate even t h a n M l . G i v e n t h e p r o p o r t i o n a l l y g r e a t e r d e p t h a n d i n n o v a t i o n o f t h e Swiss financial system relative t o t h a t o f G e r m a n y , t h e b e n e f i t o f c h o o s i n g a n aggregate as n a r r o w as S A M B m a y b e its g r e a t e r i m m u n i t y t o p o r t f o l i o shifts, as its d e m a n d is l a r g e l y deter­ m i n e d b y p a y m e n t s t e c h n o l o g y . M o r e o v e r , g i v e n t h e s m a l l e r size a n d t h e g r e a t e r openness o f t h e Swiss e c o n o m y , c o n t r o l o f a b r o a d e r aggregate m a y have s e e m e d t o o d a u n t i n g a c h a l l e n g e . U n t i l 1990, t h e Swiss N a t i o n a l B a n k h a d a n n o u n c e d m o n e t a r y targets f o r t h e c o m i n g year at t h e e n d o f each c a l e n d a r year. T h e n , at t h e e n d o f 1990, i t d e c l a r e d t h a t i t w o u l d a i m "to increase t h e m o n e t a r y base t o a p p r o a c h a m e d i u m - t e r m e x p a n s i o n p a t h " (Swiss N a t i o n a l B a n k , 1990c, December, p . 273), w i t h o u t specifying either the t i m e h o r i z o n o f the t a r g e t o r t h e s t a r t i n g p o i n t o f t h e p a t h . As we w i l l see, w h a t t h e B a n k w a n t e d was g r e a t e r s h o r t - r u n f l e x i b i l i t y t h a n t h e full-year m o n e t a r y tar-

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get p r o v i d e d . Given the credibility demonstrated by the B a n k over the years, l o n g - r u n i n f l a t i o n expectations w o u l d p r e s u m a b l y stand u n c h a n g e d so l o n g as t h e g o a l was m a d e clear. S h o r t l y thereafter, t h e B a n k s p e c i f i e d t h a t t h e t i m e h o r i z o n o f t h e t a r g e t was a p e r i o d o f 3 t o 5 years. A t t h e e n d o f 1992, i t a n n o u n c e d t h a t i t h a d c h o s e n t h e average stock o f S A M B d u r i n g t h e f o u r t h q u a r t e r o f 1989 as t h e basis f o r t h e e x p a n s i o n p a t h , t h e r e b y p r o v i d i n g a means o f verifying p e r f o r m a n c e (Swiss N a t i o n a l B a n k , 1992c, D e c e m b e r , p . 3 1 2 ) . A p p a r e n t l y t h e l a c k o f a m e a s u r a b l e m o n ­ etary t a r g e t f o r t w o years d i d n o t cause t h e p u b l i c t o d o u b t t h e Bank's u n d e r l y i n g c o m m i t m e n t . P a n e l E o f F i g u r e 4.2 shows q u a r t e r l y A M B g r o w t h ( s o l i d l i n e ) a n d S A M B g r o w t h (dashed l i n e ) over t h e c o r r e s p o n d ­ i n g q u a r t e r o f t h e p r e c e d i n g year, a l o n g w i t h t h e a n n u a l targets f r o m 1980 t o 1990 ( t r i a n g l e s ) a n d t h e target o u t c o m e s ( b o l d h o r i z o n t a l l i n e s ) . P a n e l F o f t h e figure shows t h e level o f S A M B f r o m 1980 o n , as w e l l as t h e first t w o five-year m e d i u m - t e r m g r o w t h paths. Finally, at t h e e n d o f 1994 ,the B a n k a n n o u n c e d a n e w m e d i u m - t e r m g r o w t h p a t h f o r S A M B f o r t h e p e r i o d 1995 t o 1999, a n d t h u s r e t r o a c ­ tively revealed t h a t t h e h o r i z o n o f t h e first p a t h also h a d b e e n five years. T h e i m p l i c i t a n d t h e n explicit multi-year h o r i z o n o f the Bank's m o n ­ etary a n d i n f l a t i o n targets is i n c o n t r a s t t o t h e B u n d e s b a n k ' s insistence o n one-year targets f o r b o t h . T h e r e is n o t m u c h evidence t h a t t h e differ­ e n t choices i n t a r g e t h o r i z o n s have m a d e m u c h d i f f e r e n c e i n t e r m s o f p o l i c y o r i n f l a t i o n o u t c o m e s . However, t h e m u l t i - y e a r targets have e n ­ a b l e d t h e Swiss N a t i o n a l B a n k t o c o m m u n i c a t e its p l a n s t o t h e p u b l i c w h i l e at t h e same t i m e m i s s i n g fewer targets. Since m o n e t a r y p o l i c y af­ fects i n f l a t i o n o n l y after a l a g o f 1-2 years o r m o r e , a n d since i n f l a t i o n a r y shocks c a n be reversed o n l y gradually, a m u l t i - y e a r t a r g e t seems t o re­ flect m o r e accurately t h e realities o f p o l i c y - m a k i n g . T h e m a i n risk o f a m u l t i - y e a r t a r g e t occurs d u r i n g its final year, i f t h e c e n t r a l b a n k is l o c k e d i n t o a p r e - d e t e r m i n e d a n d possibly less-than-credible p a t h . W e w i l l see t h a t m o s t t a r g e t i n g c e n t r a l banks a v o i d this b o x b y r e s e t t i n g t h e t a r g e t h o r i z o n before the e n d o f the target p e r i o d , o r by explicitly r o l l i n g the horizon forward. T h e m a n n e r i n w h i c h t h e Swiss N a t i o n a l B a n k arrives at its m o n e t a r y targets has b e e n s i m i l a r t o G e r m a n p r a c t i c e . D u r i n g t h e p e r i o d w h e n its t a r g e t aggregate was M l , t h e B a n k a i m e d at l o w e r i n g t h e g r o w t h rate o f M l t o "an average rate o f 3 p e r c e n t over t h e n e x t [business] cycle," f o r t h e reason " t h a t t h e r e h a d b e e n a f a i r l y close r e l a t i o n s h i p b e t w e e n M l a n d t h e c o n s u m e r p r i c e i n d e x a n d t h a t g r o w t h rates o f M l h a d fluctu­ a t e d a r o u n d 3 p e r c e n t d u r i n g p e r i o d s o f stable prices" ( S c h i l t k n e c h t , 1983, p . 7 2 ) . T h e t a r g e t "was based o n t h e e x p e c t e d a n d d e s i r e d eco11

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n o m i c g r o w t h f o r t h e year t o c o m e a n d o n t h e a s s u m p t i o n a b o u t n e x t year's i n c o m e velocity" ( S c h i l t k n e c h t , 1983, p . 7 3 ) . A f t e r c h a n g i n g t o S A M B as t h e t a r g e t v a r i a b l e , t h e B a n k c o n s i d e r e d a n a n n u a l g r o w t h rate of 2% to be sufficient for stabilizing the price level i n the m e d i u m term. The n u m ­ ber o f 2 percent rests o n the assumption that (a) the Swiss National Bank equates an annual inflation rate o f 0-1 percent with price stability and (b) the potential growth o f the Swiss real GDP is unlikely to be higher than 2 percent. The n o m i n a l potential growth resulting from these assumptions o f 2-3 percent is thought to increase the demand for base money by 2 percent per year. (Rich, 1989, p. 350; translation by authors) T h e B a n k e x p l a i n s its c h o i c e o f a greater-than-zero t a r g e t f o r m e a s u r e d i n f l a t i o n b y r e f e r r i n g t o t h e u p w a r d bias r e s u l t i n g f r o m i n c o m p l e t e ac­ c o u n t i n g f o r q u a l i t y i m p r o v e m e n t s . A g a i n , t h e i n f l a t i o n g o a l is s p e c i f i e d b e f o r e t h e m o n e t a r y t a r g e t is set. A l t h o u g h t h e Swiss N a t i o n a l B a n k , u n l i k e t h e B u n d e s b a n k , makes n o m e n t i o n o f " u n a v o i d a b l e p r i c e increases," t h e fact t h a t u n t i l 1985 its m o n e t a r y targets w e r e always fixed at n u m b e r s h i g h e r t h a n 2 % ( a n d h i g h e r t h a n 3% d u r i n g t h e years 1975-78) indicates t h a t i t makes s o m e a l l o w a n c e f o r t h e i n e r t i a o f r e c e n t i n f l a t i o n w h e n s e t t i n g its targets. As i n G e r m a n y , p r i c e stability is d e f i n e d , n o r m a t i v e l y a n d o p e r a t i o n a l l y , as a n i n f l a t i o n rate g r e a t e r t h a n zero. M o r e o v e r , t h e B a n k allows f o r t h e g r a d u a l p u r s u i t o f p r i c e stability b y a c c o m m o d a t i n g o n e - t i m e increases i n t h e p r i c e level. L i k e t h e B u n d e s b a n k , i t bases its t a r g e t d e r i v a t i o n o n estimates o f p o t e n t i a l g r o w t h o f GDP, r a t h e r t h a n o n forecasts o f a c t u a l g r o w t h o f GDP, t h u s d o w n p l a y i n g t h e l i n k b e t w e e n m o n e t a r y p o l i c y a n d cyclical c o n d i t i o n s , at least i n t h e target-setting process. T h e Swiss N a t i o n a l B a n k has always c h o s e n a p o i n t t a r g e t r a t h e r t h a n a target b a n d for m o n e y growth: The decision to abstain from a target band was based o n the belief that, from a psychological p o i n t o f view, missing a target band is worse than missing a point target. A target band suggests that a central bank is able n o t only to establish a reasonable target but also to control the monetary aggregates w i t h i n a narrow margin. The [Swiss National Bank] never intended to give such an impression to the public. (Schiltknecht, 1983, p. 73) U n t i l 1988, m o n e t a r y targets w e r e f o r m u l a t e d i n t e r m s o f t h e average g r o w t h o f S A M B over t h e p r e v i o u s year, w h i l e i n 1989 a n d 1990 t h e B a n k chose t o f o r m u l a t e t h e targets i n t e r m s o f t h e g r o w t h rate over t h e f o u r t h q u a r t e r o f t h e p r e v i o u s year. W h i l e , i n its c h o i c e o f a p o i n t target, t h e

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Swiss N a t i o n a l B a n k is a d m i t t i n g m o r e e x p l i c i t l y t h e p o s s i b i l i t y o f c o n ­ t r o l p r o b l e m s t h a n t h e B u n d e s b a n k does, i t also engages i n extensive e x p l a n a t i o n s o f d e v i a t i o n s f r o m its targets, a n a l o g o u s t o those o f t h e B u n d e s b a n k . T h e advantage o f c h o o s i n g a p o i n t t a r g e t is t h a t i t e l i m i ­ nates t h e d a m a g e t o c r e d i b i l i t y caused b y m i s s i n g a t a r g e t r a n g e . T h e disadvantage is t h a t i t leaves less r o o m f o r m a n e u v e r w h e n d e v i a t i o n s f r o m t h e t a r g e t have t o be e x p l a i n e d . S i m i l a r l y , d e s p i t e t h e i n d e x a t i o n o f Swiss h o u s i n g sector r e n t s , t h e B a n k focuses o n t h e r a t e o f c h a n g e o f t h e h e a d l i n e C P I , w h i c h forces i t to e x p l a i n w h e n that measure o f inflation misrepresents " u n d e r l y i n g " i n f l a t i o n , r a t h e r t h a n t a k i n g t h e a p p r o a c h o f t a r g e t i n g a specially de­ fined p r i c e i n d e x . K e e p i n g t h e r u l e s i m p l e c o m p l i c a t e s e x p l a n a t i o n s a n d p e r h a p s r e d u c e s p o l i c y flexibility, b u t i t also m a k e s t a r g e t misses less d a m a g i n g t o c r e d i b i l i t y . T h i s strategy assumes t h e e x i s t e n c e o f a n e d u c a t e d p u b l i c , o r at least shows t h a t t h e B a n k is t r y i n g t o e d u c a t e t h e public. T h e Swiss N a t i o n a l B a n k has r e p e a t e d l y d e c l a r e d t h a t m a i n t a i n i n g p r i c e stability is t h e p r i m a r y g o a l o f its m o n e t a r y policy. T h e B a n k " i n ­ tended, by means o f a gradual r e d u c t i o n o f m o n e t a r y g r o w t h , to lower i n f l a t i o n , as m e a s u r e d b y t h e C P I , f r o m m o r e t h a n 10 p e r c e n t i n t h e year o f 1973 t o zero. T h e Swiss N a t i o n a l B a n k ' s o p i n i o n t h a t p r i c e level stability constitutes t h e m a i n g o a l o f m o n e t a r y p o l i c y was also l a r g e l y u n d i s p u t e d i n t h e p u b l i c " ( R i c h , 1985, p . 60; t r a n s l a t i o n b y a u t h o r s ) . U n l i k e t h e B u n d e s b a n k ' s charter, t h e Swiss N a t i o n a l B a n k ' s c h a r t e r does n o t l i m i t its m a n d a t e d goals t o p r i c e stability. I n fact, i t i n c l u d e s several p o t e n t i a l l y c o n f l i c t i n g goals. T h e Bank's c o m m i t m e n t t o t h e g o a l o f p r i c e stability is e v i d e n c e d b y its b e h a v i o r a n d b y its c r e d i b i l i t y , r a t h e r t h a n b e i n g r e q u i r e d b y law. I n fact, t h e Swiss p u b l i c g e n e r a l l y has n o t ques­ t i o n e d e i t h e r t h e i n d e p e n d e n c e o f t h e c e n t r a l b a n k o r its c o m m i t m e n t t o p r i c e stability. T h e p r i m a c y o f p r i c e stability also finds e x p r e s s i o n i n t h e B a n k ' s decisions t o a l l o w a m o n e t a r y t a r g e t t o be u n d e r s h o t o r over­ s h o t w h e n a c o n f l i c t arises b e t w e e n a d h e r i n g t o t h e t a r g e t a n d m a i n t a i n ­ i n g p r i c e stability. F o r e x a m p l e , e x c h a n g e rate crises, as i n 1978, are g r a n t e d escape-clause status b y p r e c e d e n t a n d c o m m o n sense, w i t h o u t any e x p l i c i t s t a t e m e n t t o t h a t e f f e c t . 12

13

A c c o r d i n g l y , t h e Swiss N a t i o n a l Bank's o r i g i n a l c h o i c e o f M l , as m e n ­ t i o n e d earlier, was based o n r e c o g n i t i o n o f a "fairly close r e l a t i o n s h i p " b e t w e e n M l g r o w t h a n d i n f l a t i o n . F r o m 1975 t o 1978 i t u s e d t h e m o n ­ etary base as its i n s t r u m e n t t o c o n t r o l t h e g r o w t h o f M l — a p r a c t i c e m a d e possible b y its a b i l i t y t o p r e d i c t w i t h some accuracy t h e m o n e y m u l t i p l i e r ( t h e r a t i o o f M l t o t h e m o n e t a r y base). W h e n t h e B a n k r e t u r n e d t o

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m o n e t a r y t a r g e t i n g after t h e 1978-79 i n t e r l u d e , i t c o n c l u d e d t h a t t h e accuracy o f its m u l t i p l i e r forecasts h a d d e t e r i o r a t e d . I n p a r t i c u l a r , de­ m a n d f o r M l s e e m e d t o be r e a c t i n g s t r o n g l y t o changes i n e x c h a n g e rate e x p e c t a t i o n s . T h e B a n k t h e r e f o r e d e c i d e d t o t a r g e t t h e m o n e t a r y base, f o r these reasons: I t considered the monetary base to be more stable than the aggregate M l . W i t h hindsight, i t is doubtful that this claim was true. But targeting the mon­ etary base turned out to be attractive i n another respect: The demand for base money is less sensitive to changes i n interest rates and therefore less volatile than the demand for M l . (Rich, 1997, p. 119) 14

T h i s c h a n g e i n t a r g e t r e f l e c t e d t h e Bank's c o n c e r n a b o u t its a b i l i t y t o c o n t r o l M l . A c c o r d i n g t o t h e e v i d e n c e available, b o t h aggregates—the m o n e t a r y base a n d M l — l e a d i n f l a t i o n by t w o t o t h r e e years ( R i c h , 1989, p p . 350, 354-5). T h e p e r c e i v e d advantages o f t a r g e t i n g t h e m o n e t a r y base r a t h e r t h a n M l lay i n t h e fact t h a t S w i t z e r l a n d is a s m a l l , o p e n e c o n o m y a n d i n t h e Swiss franc's i m p o r t a n c e as a safe-haven c u r r e n c y . I n theory, t h e Swiss N a t i o n a l B a n k has p e r f e c t c o n t r o l over t h e m o n e t a r y base. I n p r a c t i c e , however, t h e B a n k has r e p e a t e d l y f o u n d i t s e l f f o r c e d t o c o u n t e r a c t l a r g e a n d sustained exchange-rate m o v e m e n t s , usually a p p r e c i a t i o n s o f t h e Swiss franc, t h a t o b l i g e d i t t o accept l a r g e , u n d e s i r e d expansions o f t h e m o n e t a r y base. T h a t was t h e case i n 1978, w h e n t h e B a n k t e m p o r a r i l y a b a n d o n e d m o n e t a r y t a r g e t i n g , a n d a g a i n i n 1987. F o r e i g n e x c h a n g e i n t e r v e n t i o n s , f o r e x a m p l e , have a n i m m e d i a t e i m p a c t o n t h e S A M B , i n c o n t r a s t t o t h e i r m o r e g r a d u a l i n f l u e n c e o n aggregates such as t h e C B M . Consequently they i m m e d i a t e l y force the Bank to present an explana­ t i o n o f w h y m o n e y g r o w t h has d e v i a t e d f r o m target. A n n o u n c i n g a tar­ g e t f o r t h e m o n e t a r y base m a y serve t o c o m m u n i c a t e t h a t m o n e t a r y ex­ pansions necessitated b y excessive fluctuations i n t h e e x c h a n g e rate are t r a n s i t o r y a n d w i l l be reversed i n d u e course. T h e B a n k ' s r e g u l a r t a r g e t a n n o u n c e m e n t s have served as a c o m m u n i ­ c a t i o n device, even t h o u g h n o specific t i m e t a b l e f o r t h e reversal o f tar­ get d e v i a t i o n s is issued, o r even a c o m m i t m e n t t o m e e t i n g t h e t a r g e t o n average i n less t h a n five years. I n fact, since t h e B a n k is very f o r t h r i g h t i n e x p l a i n i n g t h e p r o v i s i o n a l n a t u r e o f its targets a n d t h e possible n e e d f o r d e v i a t i o n s , i t is clear t h a t t h e p r i m a r y p u r p o s e i n t h e s h o r t t e r m o f t h e m o n e t a r y t a r g e t is t o signal p o l i c y i n t e n t i o n s a n d objectives t o t h e p u b ­ l i c . T h i s is i n c o n t r a s t t o t h e i d e a l i z e d v e r s i o n o f a n i n t e r m e d i a t e - t a r g e t ­ i n g r e g i m e w h e r e m e e t i n g t h e t a r g e t i t s e l f is w o r t h t h e e f f o r t because i t moves t h e c e n t r a l b a n k e f f i c i e n t l y t o w a r d its l o n g e r - t e r m goals.

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L i k e t h e B u n d e s b a n k , t h e Swiss N a t i o n a l B a n k is h i g h l y i n d e p e n d e n t . I t is also free o f g o v e r n m e n t a l o v e r s i g h t a n d any legislative r e q u i r e m e n t t o give t e s t i m o n y a b o u t its p e r f o r m a n c e . I t regards p u b l i c s u p p o r t as its source o f l e g i t i m a c y f o r t h e p u r s u i t o f its m o n e t a r y policy. T h e m a i n v e h i c l e f o r its a p p e a l f o r such s u p p o r t is t h e q u a r t e r l y p u b l i c a t i o n Geld, Währung, und Konjunktur ( l i t e r a l t r a n s l a t i o n , Money, Currency, and Busi­ ness Cycle). E a c h issue c o n t a i n s a l e n g t h y , data-intensive, " S u m m a r y o f M o n e t a r y a n d E c o n o m i c D e v e l o p m e n t s , " two t o f o u r t o p i c a l articles, a n d a one-page " C h r o n i c l e o f M o n e t a r y a n d E x c h a n g e Rate Policy" at t h e e n d . T h e D e c e m b e r issue, i n a d d i t i o n , b e g i n s w i t h a b r i e f (one-to-threepage) s t a t e m e n t o f "Swiss M o n e t a r y Policy i n < t h e c o m i n g year>," w h i c h c o n t a i n s some e v a l u a t i o n o f t h e p r e v i o u s year's p e r f o r m a n c e a n d a state­ m e n t o f t h e i n t e n d e d course o f t h e m o n e t a r y aggregate i n t h e c o m i n g year. 15

T h e r e are several differences, however, b e t w e e n t h e a p p r o a c h e s o f t h e Swiss N a t i o n a l B a n k a n d t h e B u n d e s b a n k i n r e p o r t i n g o n m o n e t a r y p o l i c y . T h e Swiss N a t i o n a l B a n k discusses i n t e r n a t i o n a l a n d real-side d e v e l o p m e n t s i n d e t a i l . T h a t p r a c t i c e reflects its use o f m a n y i n f o r m a ­ t i o n variables i n d e c i s i o n - m a k i n g a n d u n d e r l i n e s t h e l i m i t a t i o n s o f its c o n t r o l over o u t c o m e s f o r t h e Swiss e c o n o m y . I t devotes a l m o s t as m u c h space t o " T h e E c o n o m i c D e v e l o p m e n t s i n t h e M o s t I m p o r t a n t I n d u s t r i ­ alized C o u n t r i e s " as t o t h e d o m e s t i c s i t u a t i o n , a n d i t p u t s t h e i n t e r n a ­ t i o n a l articles first. M o r e o v e r , t h r o u g h o u t its discussion o f e c o n o m i c d e v e l o p m e n t s at h o m e a n d a b r o a d , a n d even m o r e so i n t h e a n n u a l s t a t e m e n t a b o u t t h e c o m i n g year's m o n e t a r y policy, i t makes forecasts a b o u t any n u m b e r o f e c o n o m i c variables a n d occasionally contrasts its o w n forecasts w i t h private-sector forecasts. 16

T h e Swiss N a t i o n a l B a n k draws a d i f f e r e n t l i n e o n a c c o u n t a b i l i t y f r o m t h a t o f t h e B u n d e s b a n k . I t makes clear t h a t i n a s m a l l , o p e n , f i n a n c i a l l y innovative economy, the central b a n k cannot be h e l d responsible f o r events a n d c o n d i t i o n s b e y o n d its c o n t r o l , b u t i t takes f u l l r e s p o n s i b i l i t y f o r w h a t i t c a n c o n t r o l . I n its p u b l i c a t i o n s , t h e B a n k r e q u i r e s a l l t o p i c a l articles t o be s i g n e d b y t h e a u t h o r s , a n d m a n y p o l i c y speeches g i v e n b y s e n i o r officials are r e p r i n t e d . I t p u t s itself o n t h e l i n e b y p u b l i s h i n g f o r e ­ casts a n d does n o t associate t h e p u b l i c a t i o n o f its r e p o r t w i t h any l e g a l statute. T h e B a n k e v i d e n t l y wishes t o give t h e i m p r e s s i o n t h a t i t is v o l u n ­ t a r i l y p u t t i n g i t s e l f i n h a r m ' s way, w h i l e at t h e same t i m e r e m i n d i n g t h e p u b l i c j u s t h o w h a r m f u l t h a t way c a n be. B o t h c e n t r a l b a n k s use m o n e t a r y targets as a f r a m e w o r k f o r e x p l a i n ­ i n g t h e i r p o l i c y t o t h e p u b l i c . T h e i r analyses have t o d o w i t h t h e w h o l e economy a n d e x t e n d b e y o n d monetary policy narrowly defined. I n short,

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t h e y d o n o t l i m i t themselves t o d e a l i n g w i t h t h e q u e s t i o n o f w h e t h e r o r n o t a t a r g e t was m e t at t h e p r e s c r i b e d t i m e .

German and Swiss Monetary Policy under Monetary Targeting R a t h e r t h a n r e v i e w t h e e n t i r e h i s t o r y o f G e r m a n a n d Swiss m o n e t a r y t a r g e t i n g , we start b y h i g h l i g h t i n g events i n G e r m a n y t h r o u g h t h e 1970s a n d 1980s t h a t i l l u s t r a t e t h e t h e m e s discussed a b o v e — p a r t i c u l a r l y t h e t r e a t m e n t o f t h e m o n e t a r y targets n o t as r i g i d rules b u t as a f r a m e w o r k f o r p r o v i d i n g s t r u c t u r e a n d t r a n s p a r e n c y f o r m o n e t a r y policy. T h e n , f o r each c o u n t r y , we focus o n events since t h e late 1980s. I n t h e case o f G e r m a n y , t h e m o s t c h a l l e n g i n g e v e n t was m o n e t a r y u n i f i c a t i o n . I n t h a t instance, t h e B u n d e s b a n k s u c c e e d e d i n h a n d l i n g a o n e - t i m e i n f l a t i o n ­ ary s h o c k o f g r e a t m a g n i t u d e , a l o n g w i t h p o l i t i c a l l y sensitive d e v e l o p ­ ments i n the real economy, t h r o u g h flexibility a n d c o m m u n i c a t i o n . D u r i n g this same p e r i o d , S w i t z e r l a n d e x p e r i e n c e d a m a j o r shift i n m o n e y d e m a n d w i t h serious i n f l a t i o n a r y consequences, a l o n g w i t h t h e Swiss N a t i o n a l B a n k ' s shift f r o m a n n u a l targets t o five-year g r o w t h p a t h s f o r S A M B . E x a m i n a t i o n o f these events w i l l reveal h o w t h e t w o c e n t r a l b a n k s c o n d u c t e d t h e i r m o n e y - t a r g e t i n g r e g i m e s d u r i n g t h e 1990s a n d w i l l p r o ­ v i d e a baseline f o r t h e i n f l a t i o n targeters we e x a m i n e i n l a t e r chapters. T h e r e a d e r is a g a i n r e f e r r e d t o Figures 4.1 a n d 4.2, p p . 48 a n d 54 respec­ tively, w h i c h display t h e p a t h s o f i n f l a t i o n , i n t e r e s t rates, n o m i n a l ex­ c h a n g e rates, G D P g r o w t h , u n e m p l o y m e n t , a n d m o n e t a r y g r o w t h i n b o t h countries.

Germany D u r i n g t h e 1970s a n d 1980s t h e B u n d e s b a n k e i t h e r o v e r s h o t o r u n d e r ­ s h o t its a n n u a l m o n e t a r y targets a p p r o x i m a t e l y h a l f t h e t i m e ; i n m o s t b u t n o t a l l cases, i t reversed o v e r s h o o t i n g s . I t also r e s p o n d e d t o m o v e ­ m e n t s i n variables o t h e r t h a n i n f l a t i o n . F r o m t h e b e g i n n i n g o f C B M t a r g e t i n g i n 1975, t h e B u n d e s b a n k was aware o f t h e risk t h a t " c e n t r a l b a n k m o n e y is p r o n e t o d i s t o r t i o n s caused b y special m o v e m e n t s i n cur­ r e n c y i n c i r c u l a t i o n " ( D e u t s c h e B u n d e s b a n k , 1976a, p . 1 1 ) . I n 1977, i t p e r m i t t e d C B M g r o w t h t o e x c e e d t h e t a r g e t i n t h e face o f a n a p p r e c i a t ­ i n g d e u t s c h e m a r k a n d weak e c o n o m i c activity. A t t h a t t i m e , o n l y t w o years after t h e a d o p t i o n o f t h e targets, t h e B u n d e s b a n k e x p l a i n e d t h a t 17

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" t h e r e m a y be p e r i o d s i n w h i c h t h e p u r s u i t o f a n ' i n t e r m e d i a t e t a r g e t variable' . . . cannot be given priority," thereby a c k n o w l e d g i n g the i m ­ p o r t a n c e o f real-side a n d f o r e i g n - e x c h a n g e d e v e l o p m e n t s i n its d e c i s i o n ­ m a k i n g ( D e u t s c h e B u n d e s b a n k , 1978a, p . 2 ) . I n 1981 a n d early 1982, because o f weakness i n t h e d e u t s c h e m a r k , C B M g r e w m u c h m o r e slowly t h a n M 3 . T h a t t r e n d l e d t o large-scale re­ p a t r i a t i o n o f d e u t s c h e m a r k notes a n d a n i n v e r t e d y i e l d c u r v e (shortt e r m i n t e r e s t rates h i g h e r t h a n l o n g - t e r m i n t e r e s t rates) t h a t caused p o r t ­ f o l i o shifts o u t o f c u r r e n c y i n t o h i g h - y i e l d i n g s h o r t - t e r m assets. A c c o r d ­ ingly, t h e m o n e t a r y t a r g e t f o r 1981 o f 4 % t o 7 % was u n d e r s h o t ( F i g u r e 4 . 1 , P a n e l E ) . H o w e v e r , d u r i n g this p e r i o d t h e B u n d e s b a n k was p u r s u ­ i n g a d i s i n f l a t i o n a r y course w i t h some success, so i t d i d n o t act t o b r i n g m o n e y g r o w t h u p to target range. I n 1986 a n d 1987, a reversal o f t h e s i t u a t i o n — n a m e l y , a s t r o n g m a r k c o m b i n e d w i t h historically l o w short-term interest rates—led to C B M g r o w t h o f 7.7% a n d t h e n 8%. T h e B u n d e s b a n k t o l e r a t e d this overshoot­ i n g i n p a r t because o f t h e Plaza A c c o r d , w h i c h gave G e r m a n y some re­ sponsibility f o r stabilizing G-7 exchange rates. T h e p a r t i c u l a r l y b a d miss f o r C B M g r o w t h p r o m p t e d t h e B u n d e s b a n k t o a n n o u n c e a switch i n 1988 t o t h e aggregate M 3 as its target, w i t h t h e f o l l o w i n g c o m m e n t : The expansion o f currency i n circulation is i n itself o f course a significant development which the central bank plainly has to heed. This is, after all, the most l i q u i d f o r m o f money . . . and n o t least the k i n d o f money which the central bank issues itself and which highlights its responsibility for the value of money. O n the other hand, especially at times when the growth rates o f currency i n circulation and deposit money are diverging strongly, there is no reason to stress the weight o f currency i n circulation unduly. (Deutsche Bundesbank, 1988b, March, pp. 18-21) T h e fact t h a t t h e B u n d e s b a n k c h a n g e d t h e t a r g e t v a r i a b l e w h e n C B M g r e w t o o fast, b u t d i d n o t d o so w h e n i t g r e w t o o slowly, c a n b e i n t e r ­ p r e t e d as a n i n d i c a t i o n o f t h e i m p o r t a n c e t h e B u n d e s b a n k ascribes t o m o n e t a r y targets as a m e a n s o f c o m m u n i c a t i n g w i t h t h e p u b l i c . A l l o w ­ i n g t h e t a r g e t v a r i a b l e t o r e p e a t e d l y o v e r s h o o t t h e t a r g e t because o f fac­ tors t o w h i c h t h e B u n d e s b a n k d i d n o t w a n t t o react m i g h t have l e d t o the p u b l i c assumption that the Bundesbank's attitude toward m o n e t a r y control and inflation had changed. C l a r i d a a n d G e r t l e r (1997) have a r g u e d t h a t t h e B u n d e s b a n k has re­ a c t e d a s y m m e t r i c a l l y t o t a r g e t misses, r a i s i n g i n t e r e s t rates i n response t o a n o v e r s h o o t i n g o f t h e t a r g e t b u t c h o o s i n g n o t t o l o w e r i n t e r e s t rates i n response t o a n u n d e r s h o o t i n g . I n any event, t h e s w i t c h i n targets was 18

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n o t a c c o m p a n i e d b y any o t h e r changes i n t h e m o n e t a r y f r a m e w o r k a n d caused l i t t l e c o n c e r n . I n s h o r t , so l o n g as t h e u n d e r l y i n g i n f l a t i o n g o a l was m e t over t h e m e d i u m t e r m , t h e existence o f a m o n e t a r y target, r a t h e r t h a n its precise s p e c i f i c a t i o n , a p p e a r e d t o be sufficient. As we n o t e d above, t h e B u n d e s b a n k has t e n d e d t o p u r s u e d i s i n f l a t i o n g r a d u a l l y i n r e s p o n s e t o i n f l a t i o n a r y shocks. Its r e s p o n s e t o t h e 1979 o i l s u p p l y s h o c k was v e r y g r a d u a l a n d was p u b l i c l y stated t o be so. T h e B u n d e s b a n k set t h e l e v e l o f " u n a v o i d a b l e " i n f l a t i o n f o r 1980 at 4 % , c l e a r l y b e l o w t h e p r e v a i l i n g r a t e b u t above t h e l e v e l o f i n f l a t i o n accept­ a b l e o v e r t h e l o n g e r t e r m . T h e t a r g e t level o f i n f l a t i o n was b r o u g h t d o w n i n stages a n d r e t u r n e d t o t h e l o n g - r u n g o a l o f 2 % o n l y i n 1984. E v e n t h o u g h t h e u n d e r l y i n g i n t e n t was clear, e a c h year's t a r g e t l e v e l o f " u n a v o i d a b l e " i n f l a t i o n (as w e l l as t h e m o n e t a r y t a r g e t a n d i n t e r e s t r a t e p o l i c i e s d e t e r m i n e d b y t h a t level) was set o n l y a year a h e a d , per­ m i t t i n g t h e B u n d e s b a n k f u r t h e r flexibility t o r e s p o n d t o events a n d t o r e t h i n k t h e pace o f d i s i n f l a t i o n . A l t h o u g h w h a t t u r n e d o u t t o b e f o u r years o f i n f l a t i o n r e d u c t i o n is h a r d l y a n i n s t a n c e o f t h e B u n d e s b a n k ' s g o i n g easy o n i n f l a t i o n , i t is a n i l l u s t r a t i o n o f t h e flexibility a n d c o n c e r n f o r real-side e c o n o m i c effects e x h i b i t e d b y G e r m a n m o n e t a r y p o l i c y ­ makers. T h e behavior o f the Bundesbank i n the aftermath o f G e r m a n reunifi­ c a t i o n tells us a great d e a l a b o u t its use o f t h e t a r g e t i n g f r a m e w o r k . D u r ­ i n g t h e t w o years p r i o r t o its e c o n o m i c a n d m o n e t a r y u n i o n w i t h t h e G e r m a n D e m o c r a t i c R e p u b l i c ( G D R ) o n J u l y 1, 1990, t h e F e d e r a l Re­ public o f Germany had experienced real GDP growth o f about 4 % a n d t h e first s i g n i f i c a n t d e c l i n e i n u n e m p l o y m e n t since t h e late 1970s ( P a n e l C o f F i g u r e 4 . 1 ) . A f t e r a p r o l o n g e d p e r i o d o f f a l l i n g i n f l a t i o n a n d his­ t o r i c a l l y l o w i n t e r e s t rates d u r i n g t h e mid-1980s, i n f l a t i o n h a d r i s e n f r o m -1 % at t h e e n d o f 1986 t o s l i g h t l y m o r e t h a n 3% b y t h e e n d o f 1989. T h e B u n d e s b a n k h a d b e g u n t o t i g h t e n its m o n e t a r y p o l i c y i n m i d - 1 9 8 8 , rais­ i n g t h e r e p o rate ( t h e rate at w h i c h t h e B u n d e s b a n k makes r o u t i n e shortt e r m loans t o t h e b a n k i n g system, a n d at this t i m e its effective p o l i c y i n s t r u m e n t ) i n steps f r o m 3.25% i n J u n e 1988 t o 7.75% i n early 1990. T h e first M 3 t a r g e t o f 3% t o 6% was o v e r s h o t i n 1988 b y 1 % , b u t t h e 1989 t a r g e t o f a r o u n d 5% was a l m o s t achieved, w i t h M 3 g r o w i n g at 4 . 7 % . T h a t M 3 g r o w t h rate was c e r t a i n l y n o t h i g h i n view o f t h e p r e v a i l i n g rate of economic growth. In term with than

response t o the u n c e r t a i n t i e s a t t e n d i n g G e r m a n r e u n i f i c a t i o n , l o n g i n t e r e s t rates h a d i n c r e a s e d s h a r p l y f r o m late 1989 t o M a r c h 1990, ten-year b o n d yields r i s i n g f r o m a r o u n d 7% t o a r o u n d 9 % i n less six m o n t h s . C o m b i n e d w i t h a s t r o n g d e u t s c h e m a r k , t h e rise i n l o n g -

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t e r m i n t e r e s t rates e n a b l e d t h e B u n d e s b a n k t o k e e p official i n t e r e s t rates unchanged d u r i n g the months immediately preceding monetary u n i o n . I t k e p t t h e rates u n c h a n g e d i n t h e i m m e d i a t e a f t e r m a t h o f m o n e t a r y u n i o n as w e l l , even t h o u g h t h e effects o f e x p a n s i o n a r y fiscal p o l i c y ac­ c o m p a n y i n g reunification were b e g i n n i n g to p r o p e l G D P g r o w t h to r e c o r d levels. T h e B u n d e s b a n k ' s d e c i s i o n t o k e e p o f f i c i a l i n t e r e s t rates u n c h a n g e d f o r t h e first few m o n t h s f o l l o w i n g m o n e t a r y u n i o n r e f l e c t e d t h e fact t h a t i t was very d i f f i c u l t t o assess t h e i n f l a t i o n a r y p o t e n t i a l o f t h e c o n v e r s i o n o f G D R m a r k s ("ostmarks") i n t o d e u t s c h e m a r k s . T h e B u n d e s b a n k h a d b e e n o p p o s e d t o t h e c o n v e r s i o n rate a g r e e d t o i n t h e treaty o n m o n ­ etary u n i o n ( o n average, a b o u t 1 D M p e r 1.8 ostmarks) a n d h a d b e e n p u b l i c l y o v e r r u l e d o n this p o i n t b y t h e f e d e r a l g o v e r n m e n t . T h e m o n e y stock M 3 h a d i n c r e a s e d a l m o s t 1 5 % i n t h e wake o f m o n e t a r y u n i o n . I n t e r e s t i n g l y , t h e rate o f c o n v e r s i o n set b y t h e treaty t u r n e d o u t t o be a l m o s t exactly " r i g h t . " W h i l e G D P i n t h e f o r m e r G D R was e s t i m a t e d t o be o n l y a r o u n d 7% o f t h a t o f t h e F e d e r a l R e p u b l i c f o l l o w i n g r e u n i f i c a ­ t i o n , vast g o v e r n m e n t transfers t o t h e east o f m o n e y f r o m t h e west w e r e a b s o r b e d w i t h o u t c a u s i n g a m a j o r i n f l a t i o n a r y i m p e t u s (see K ö n i g a n d W i l l e k e , 1 9 9 5 ) . D u r i n g t h e first few m o n t h s , t h e B u n d e s b a n k was p r e o c ­ c u p i e d w i t h assessing t h e p o r t f o l i o shifts i n eastern G e r m a n y i n response t o t h e i n t r o d u c t i o n o f a n e w c u r r e n c y , a n e w financial system, a n d a b r o a d r a n g e o f assets t h a t h a d n o t p r e v i o u s l y e x i s t e d t h e r e . 19

So l o n g as t h e eastern G e r m a n banks w e r e a d j u s t i n g t o t h e i r n e w i n ­ s t i t u t i o n a l s t r u c t u r e , a n d so l o n g as velocity was b e i n g d e s t a b i l i z e d b y p o r t f o l i o shifts, m o n e t a r y i n f o r m a t i o n c o n c e r n i n g eastern G e r m a n y was h a r d t o i n t e r p r e t . Consequently, t h e B u n d e s b a n k , d u r i n g t h e s e c o n d h a l f o f 1990 c a l c u l a t e d m o n e t a r y aggregates separately f o r eastern a n d w e s t e r n G e r m a n y , b a s i n g its c a l c u l a t i o n s o n t h e r e t u r n s o f t h e banks d o m i c i l e d i n t h e respective sectors. A l t h o u g h M 3 g r o w t h i n w e s t e r n Ger­ m a n y accelerated i n late 1990, t h e g r o w t h rate o f 5.6% f o r t h e year was w e l l w i t h i n t h e t a r g e t r a n g e o f 4 % t o 6%. D u r i n g t h e f a l l o f 1990, t h e r e p o rate h a d a p p r o a c h e d t h e L o m b a r d rate, w h i c h m e a n t t h a t banks w e r e i n c r e a s i n g l y u s i n g t h e L o m b a r d facil­ ity f o r t h e i r r e g u l a r l i q u i d i t y needs a n d n o t as t h e e m e r g e n c y facility i t was i n t e n d e d t o be. O n N o v e m b e r 2, 1990, t h e B u n d e s b a n k raised t h e L o m b a r d rate f r o m 8% t o 8.5%, a n d t h e d i s c o u n t rate ( t h e B u n d e s b a n k ' s subsidized l e n d i n g r a t e ) f r o m 6% t o 6.5%. W i t h i n t h e n e x t few weeks, however, banks b i d u p t h e i n t e r e s t rate (Mengentender), a n d t h e r e p o rate rose above t h e L o m b a r d rate, p r o m p t i n g t h e B u n d e s b a n k t o raise t h e L o m b a r d rate t o 9% as o f F e b r u a r y 1, 1 9 9 1 . W i t h these measures,

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t h e B u n d e s b a n k was r e a c t i n g t o b o t h t h e v o l a t i l e G D P g r o w t h rates a n d t h e faster M 3 g r o w t h i n t h e l a t t e r p a r t o f 1990. A l t h o u g h i n f l a t i o n u n t i l t h e n h a d r e m a i n e d fairly steady, i t seems l i k e l y t h a t t h e B u n d e s b a n k was e x p e c t i n g i n f l a t i o n a r y pressures t o d e v e l o p i n t h e n e a r f u t u r e , g i v e n t h e fiscal e x p a n s i o n , t h e o v e r s t r e t c h e d capacities i n w e s t e r n G e r m a n y , a n d the terms o f monetary u n i o n . A t t h e e n d o f 1990, t h e B u n d e s b a n k a n n o u n c e d a t a r g e t r a n g e f o r M 3 g r o w t h o f 4 % t o 6% f o r t h e year 1 9 9 1 , a p p l y i n g a m o n e t a r y t a r g e t f o r t h e first t i m e t o t h e w h o l e c u r r e n c y area. T h e t a r g e t was based o n t h e average a l l - G e r m a n M 3 stock d u r i n g t h e last q u a r t e r o f 1990. Because t h a t stock was l i k e l y t o be affected b y c o n t i n u i n g p o r t f o l i o shifts i n east­ e r n G e r m a n y , t h e t a r g e t was subject t o u n u s u a l l y h i g h u n c e r t a i n t y . N e i ­ t h e r o f t h e basic i n p u t s i n t o t h e q u a n t i t y e q u a t i o n t h a t generates t h e Bundesbank's monetary targets—normative inflation a n d the p o t e n t i a l g r o w t h rate o f t h e G e r m a n e c o n o m y — w a s c h a n g e d . (Since t h e achieve­ m e n t i n the mid-1980s o f effective p r i c e stability i n Germany, the B u n d e s b a n k has s p o k e n o f " n o r m a t i v e p r i c e increases" r a t h e r t h a n " u n ­ a v o i d a b l e i n f l a t i o n " i n response t o t h e h i g h i n f l a t i o n o f t h e 1970s a n d early 1 9 8 0 s . ) 20

Following German unification, the money targets set by the Bundesbank were decidedly ambitious as they left normative inflation, o n which these targets are based, unchanged at 2 percent d u r i n g this period, even though i t was obvious from the outset that this rate could not be achieved i n the target periods concerned. (Issing, 1996, p. 123) T h i s was a s t a t e m e n t o f p o l i c y r a t h e r t h a n a forecast. I t i m p l i e d a be­ l i e f o n the part o f the Bundesbank that the shock o f r e u n i f i c a t i o n h a d n o t f u n d a m e n t a l l y a l t e r e d t h e basic s t r u c t u r e o f t h e G e r m a n e c o n o m y . M o r e o v e r , i t c o m m u n i c a t e d t o t h e p u b l i c t h a t any p r i c e shifts a r i s i n g f r o m t h a t s h o c k s h o u l d be t r e a t e d as a o n e - t i m e event a n d s h o u l d n o t be i n c o r p o r a t e d i n t o inflationary expectations. C l e a r l y this stance r e q u i r e d f a i t h i n t h e p u b l i c ' s a b i l i t y t o c o m p r e ­ h e n d , a n d the Bundesbank's ability to explain, the extraordinary nature o f t h e times. I t is useful t o c o n t r a s t t h i s a d h e r e n c e t o t h e 2 % m e d i u m t e r m i n f l a t i o n g o a l w i t h t h e B u n d e s b a n k ' s response t o t h e 1979 o i l shock, w h e n " u n a v o i d a b l e i n f l a t i o n " was r a t c h e t e d u p t o 4 % a n d b r o u g h t b a c k d o w n o n l y slowly. T h e r e are t w o e x p l a n a t i o n s f o r this d i f f e r e n c e i n p o l i c y response: First, since t h e m o n e t a r y u n i f i c a t i o n shock was a d e m a n d s h o c k r a t h e r t h a n a s u p p l y shock, t h e B u n d e s b a n k was c o r r e c t i n c h o o s i n g n o t t o a c c o m m o d a t e i t ; a n d s e c o n d , after several years o f m o n e t a r y target­ i n g , t h e B u n d e s b a n k ' s h i g h l y t r a n s p a r e n t e x p l a n a t i o n s o f its m o n e t a r y

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policy h a d t r a i n e d the public to discern the difference between one­ t i m e p r i c e - l e v e l increases a n d persistent i n f l a t i o n a r y pressures. I n any event, t h e B u n d e s b a n k was c l e a r l y p e r m i t t i n g its s h o r t - t e r m m o n e t a r y p o l i c y t o miss t h e t a r g e t i n its d e t e r m i n a t i o n t o achieve its l o n g e r - t e r m goal. I n February, 1991 l o n g - t e r m i n t e r e s t rates b e g a n t o f a l l f o r t h e first t i m e since 1988. I n h i n d s i g h t , i t is a p p a r e n t t h a t t h i s was t h e b e g i n n i n g o f a downward t r e n d that c o n t i n u e d u n t i l the bond-market slump i n early 1994. A l t h o u g h t h e h i g h e s t i n f l a t i o n rates w e r e s t i l l t o c o m e , at t h i s p o i n t financial m a r k e t s were a p p a r e n t l y c o n v i n c e d t h a t t h e B u n d e s b a n k w o u l d succeed i n c o n t r o l l i n g , i f n o t r e d u c i n g , i n f l a t i o n i n t h e l o n g r u n . By m a k i n g i t clear t h a t i t w o u l d n o t a c c o m m o d a t e f u r t h e r p r i c e increases i n t h e m e d i u m t e r m , t h e B u n d e s b a n k h a d b o u g h t i t s e l f t h e flexibility i t n e e d e d f o r s h o r t - t e r m easing o f m o n e t a r y p o l i c y w i t h o u t i n v i t i n g m i s i n ­ terpretation. This l i n k between transparency a n d enhanced flexibility d e p e n d s o n t h e c e n t r a l bank's a b i l i t y t o m a k e c r e d i b l e its c o m m i t m e n t t o p r i c e stability, b u t i t also i n d i c a t e s h o w even a c r e d i b l e c e n t r a l b a n k m a y increase t h e t r a n s p a r e n c y o f p o l i c y t h r o u g h i n s t i t u t i o n a l arrange­ ments. U n t i l m i d - A u g u s t 1991, the B u n d e s b a n k left the d i s c o u n t a n d L o m b a r d rates u n c h a n g e d , w h i l e t h e r e p o r a t e s t e a d i l y e d g e d u p t o w a r d t h e L o m b a r d rate o f 9 % . C P I i n f l a t i o n i n w e s t e r n G e r m a n y h a d r e m a i n e d a r o u n d 3% d u r i n g t h e first h a l f o f 1991, w h i l e G D P g r o w t h h a d r e m a i n e d v i g o r o u s . By contrast, M 3 g r o w t h was f a l l i n g , i n p a r t because o f faster t h a n e x p e c t e d p o r t f o l i o shifts i n t o l o n g e r - t e r m assets i n eastern G e r m a n y . These p o r t f o l i o shifts, a l o n g w i t h a s h a r p e r - t h a n - e x p e c t e d d e c l i n e i n t h e p r o d u c t i o n p o t e n t i a l o f eastern Germany, p r o m p t e d t h e B u n d e s b a n k f o r t h e first t i m e ever t o c h a n g e its m o n e t a r y t a r g e t o n t h e occasion o f its m i d y e a r review. I t l o w e r e d t h e t a r g e t f o r 1991 b y 1 % , t o a r a n g e o f 3 % t o 5%. I n t h i s instance, t h e B u n d e s b a n k was able t o i n v o k e t h e i m p l i c i t escape clause b u i l t i n t o its s e m i a n n u a l t a r g e t review. T h a t process, w h i c h requires a clear e x p l a n a t i o n f o r any shift i n targets, e n a b l e d the B u n d e s b a n k t o j u s t i f y its a c t i o n . T h e d i s c i p l i n e o f t h e m o n e t a r y target­ i n g f r a m e w o r k d i s p l a y e d t h e f r a m e w o r k ' s disadvantages as w e l l ; specifi­ cally, i t is d i f f i c u l t t o m e e t s h o r t - r u n m o n e t a r y targets w h e n m o n e y de­ m a n d is u n s t a b l e a n d t h e effect o f m o n e y g r o w t h o n g o a l variables is difficult to predict. O n A u g u s t 16, 1 9 9 1 , as t h e r e p o rate a p p r o a c h e d t h e L o m b a r d rate again, t h e B u n d e s b a n k raised t h e L o m b a r d rate f r o m 9 % t o 9.25% a n d t h e d i s c o u n t rate f r o m 6.5% t o 7.5%. T h e d i s c o u n t rate was raised t o r e d u c e t h e subsidy c h a r a c t e r o f banks' r e d i s c o u n t facilities, w h i c h u n t i l

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t h a t p o i n t t h e B u n d e s b a n k h a d t o l e r a t e d as a m e a n s o f p r o v i d i n g l i q u i d ­ i t y t o eastern G e r m a n banks. D e s p i t e t h e fact t h a t G D P g r o w t h b e g a n t o slacken d u r i n g t h e s e c o n d h a l f o f 1 9 9 1 , M 3 g r o w t h accelerated. T o some e x t e n t , t h a t a c c e l e r a t i o n was a r e s u l t o f t h e b y - t h e n i n v e r t e d y i e l d c u r v e , w h i c h l e d t o a s t r o n g g r o w t h i n t i m e deposits a n d p r o m p t e d banks t o c o u n t e r t h e o u t f l o w f r o m savings deposits b y o f f e r i n g special savings schemes w i t h attractive t e r m s . T h i s was t h e first t i m e t h a t t h e y i e l d curve h a d b e c o m e i n v e r t e d since t h e early 1980s ( a n d t h e first t i m e since t h e B u n d e s b a n k h a d b e e n t a r g e t i n g M 3 ) . I n this s i t u a t i o n , t h e B u n d e s b a n k faced t h e u n u s u a l situ­ a t i o n t h a t increases i n i n t e r e s t rates w e r e l i k e l y t o raise M 3 g r o w t h . T h i s p r o b l e m was a l l t h e m o r e acute since b a n k s ' l e n d i n g t o t h e p r i v a t e sec­ t o r was g r o w i n g r a p i d l y despite t h e h i g h i n t e r e s t rates. T h i s l o a n g r o w t h was p r o b a b l y d u e , t o a large e x t e n t , t o l o a n subsidies by t h e f e d e r a l gov­ e r n m e n t i n c o n n e c t i o n w i t h t h e r e s t r u c t u r i n g o f t h e eastern G e r m a n e c o n o m y a n d h o u s i n g sector. This tendency o f the Bundesbank's i n s t r u m e n t to w o r k i n the "wrong" direction b r o u g h t the u n d e r l y i n g conflict o f monetary targeting to the f o r e : T h e t a r g e t m u s t b e c r i t i c a l l y evaluated c o n s t a n t l y i n r e l a t i o n s h i p t o t h e u l t i m a t e g o a l v a r i a b l e (s). H o w e v e r , i f t h e t a r g e t is cast aside r e g u ­ l a r l y w i t h r e f e r e n c e t o changes i n t h a t r e l a t i o n s h i p o r t o special c i r c u m ­ stances i n d i c a t i n g a r o l e f o r o t h e r i n t e r m e d i a t e variables, i t ceases t o serve as a t a r g e t r a t h e r t h a n solely as a n i n d i c a t o r . Strictly defined, the use o f a money growth target means that the central bank not only treats all unexpected fluctuations i n money as informative i n j u s t this sense, but also, as a quantitative matter, changes its instrument vari­ able i n such a way as to restore money growth to the originally designated path. (Friedman and Kuttner, 1996, p. 94) D e s p i t e t h e a c c e l e r a t i o n i n late 1 9 9 1 , M 3 g r e w b y 5.2% d u r i n g 1 9 9 1 , close t o t h e m i d p o i n t o f t h e o r i g i n a l t a r g e t a n d j u s t s l i g h t l y above t h e revised target. O n D e c e m b e r 2 0 , 1 9 9 1 , t h e B u n d e s b a n k raised t h e L o m b a r d a n d dis­ c o u n t rates b y a n o t h e r 0.5%, t o 9.75% a n d 8%, respectively, t h e i r h i g h ­ est levels since t h e S e c o n d W o r l d W a r ( i f t h e special L o m b a r d rates f r o m t h e early 1970s are d i s r e g a r d e d ) . I n the light o f the sharp monetary expansion, i t was essential to prevent per­ manently higher inflation expectations from arising on account of the adopted wage and fiscal policy stance and the faster pace o f inflation—expectations which would have become ever more difficult and costly to restrain. (Deutsche Bundesbank, 1992a, p. 43)

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T h e r h e t o r i c h e r e deserves close a t t e n t i o n . B o t h g o v e r n m e n t p o l i c i e s a n d u n i o n wage d e m a n d s were b e i n g c i t e d f o r t h e i r i n f l a t i o n a r y effects; t h a t is, t h e i r p u r s u i t o f transfers b e y o n d available resources. A l t h o u g h t h e B u n d e s b a n k h a d n o t b e e n able t o o v e r r i d e C h a n c e l l o r H e l m u t K o h l ' s d e s i r e d e x c h a n g e rate o f ostmarks f o r d e u t s c h e m a r k s , o r his " s o l i d a r i t y " transfers, t h e B u n d e s b a n k D i r e k t o r i u m ( C o u n c i l o f D i r e c t o r s ) m a d e i t clear i n this statement t h a t t h e K o h l g o v e r n m e n t a n d n o t t h e B u n d e s b a n k s h o u l d be h e l d a c c o u n t a b l e f o r t h e i n f l a t i o n a r y pressures those mea­ sures e n g e n d e r e d . T h e B u n d e s b a n k D i r e k t o r i u m was a c c e p t i n g account­ a b i l i t y o n l y f o r l i m i t i n g t h e s e c o n d - r o u n d effects o f those pressures. T h e B u n d e s b a n k was also expressing its c o n c e r n over t h e persistence o f i n f l a t i o n a r y e x p e c t a t i o n s a n d t h e p o t e n t i a l cost o f l o w e r i n g t h e m , t h e r e b y a c k n o w l e d g i n g t h a t even f o r a c r e d i b l e c e n t r a l b a n k t h e costs o f d i s i n f l a t i o n , i n t e r m s o f lost o u t p u t a n d e m p l o y m e n t , m a y be substan­ t i a l . Finally, t h e B u n d e s b a n k ' s emphasis o n t h e u l t i m a t e g o a l — m e d i u m t e r m p r i c e stability a n d i n f l a t i o n e x p e c t a t i o n s — d i d n o t l e a d i t t o cite m e a s u r e s o f p r i v a t e s e c t o r e x p e c t a t i o n s d i r e c t l y , as m a n y i n f l a t i o n targeters b e g a n d o i n g at this t i m e . T h e D e c e m b e r 20 increase i n t h e L o m b a r d rate p r o v e d t o be t h e last. D u r i n g t h e first h a l f o f 1992, t h e r e p o r a t e slowly a p p r o a c h e d t h e L o m b a r d rate. T h e r e p o rate p e a k e d i n A u g u s t at 9.7%, t h e n b e g a n t o subside as t h e B u n d e s b a n k started t o ease m o n e t a r y policy. T h e easing was, f o r t h e m o s t p a r t , i n response t o t h e a p p r e c i a t i o n o f t h e m a r k a n d e m e r g i n g tensions i n t h e E u r o p e a n M o n e t a r y System; i t also c o i n c i d e d w i t h t h e r a p i d s l o w d o w n i n t h e g r o w t h o f G e r m a n GDP. A l t h o u g h t h e m o n e t a r y targets f o r 1992 a n d 1993 w o u l d n o t be m e t , t h e c h a l l e n g e t h a t r e u n i f i c a t i o n h a d p o s e d t o G e r m a n m o n e t a r y p o l i c y was over. Thus i n 1992, for example, when the money stock overshot the target by a large margin, the Bundesbank made i t clear by the interest rate policy mea­ sures i t adopted, that i t took this sharp monetary expansion seriously. The fact that, for a number o f reasons, i t still failed i n the end to meet the target . . . has therefore ultimately had little impact o n the Bundesbank's credibility and its strategy. (Issing, 1996, p. 121) M o n e t a r y p o l i c y t r a n s p a r e n c y was e x p l i c i t l y l i n k e d t o flexibility d u r i n g r e u n i f i c a t i o n , at least a c c o r d i n g t o B u n d e s b a n k C h i e f E c o n o m i s t Issing, a n d t h a t flexibility was e x e r c i s e d t o m i n i m i z e t h e r e a l e c o n o m i c a n d p o l i t i c a l effects o f m a i n t a i n i n g l o n g - t e r m p r i c e stability. Since a b o u t 1992, however, M 3 has c o n t i n u e d t o p r o v e a p r o b l e m a t i c i n t e r m e d i a t e target. T h e B u n d e s b a n k ' s o w n e x p l a n a t i o n s f o r t h e sub­ stantial fluctuations i n M 3 g r o w t h since 1992 ( F i g u r e 4 . 1 , P a n e l E ) sug-

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gest t h a t t h e d e m a n d f o r M 3 behaves m o r e a n d m o r e l i k e t h e d e m a n d f o r a financial asset r a t h e r t h a n t h e d e m a n d f o r a m e d i u m o f e x c h a n g e . T h e B u n d e s b a n k , i n j u s t i f y i n g d e v i a t i o n s f r o m t h e M 3 targets, has be­ g u n t o f e a t u r e r e p o r t s o n " e x t e n d e d m o n e y stock M 3 , " a b r o a d e r aggre­ gate t h a t i n c l u d e s some f o r m s o f m o n e y m a r k e t accounts, b u t i t has g i v e n n o s i g n t h a t i t is ready t o switch t a r g e t aggregates a g a i n (see D e u t s c h e B u n d e s b a n k , 1995b, July, p . 2 8 ) . T h e B u n d e s b a n k has d e s c r i b e d i t s e l f as " f o r t u n a t e " t h a t financial re­ l a t i o n s h i p s i n G e r m a n y have b e e n m o r e stable t h a n i n o t h e r m a j o r e c o n o ­ m i e s t h a t have t a r g e t e d m o n e t a r y aggregates. I t has a t t r i b u t e d t h i s suc­ cess t o t h e e a r l i e r d e r e g u l a t i o n o f financial m a r k e t s i n G e r m a n y a n d t o t h e l a c k o f i n f l a t i o n a r y o r r e g u l a t o r y i n d u c e m e n t s f o r financial firms t o p u r s u e i n n o v a t i o n s . T h e targets c o n t i n u e t o serve as a s t r u c t u r e d f r a m e ­ w o r k b y w h i c h t h e B u n d e s b a n k c a n e x p l a i n its m o n e t a r y policy, even as t h e targets g o u n m e t f o r several years at a t i m e . 2 1

I n 1996, M 3 g r o w t h e x c e e d e d t h e B u n d e s b a n k ' s t a r g e t r a n g e o f 4 % to 7%, w i t h m u c h o f the difference b e i n g a t t r i b u t e d to movements i n n a r r o w m o n e y d u r i n g t h e last q u a r t e r , w h e n m a n y h o u s e h o l d s t o o k p a r t i n t h e p u r c h a s e o f n e w l y issued D e u t s c h e T e l e k o m stock. I t is i m p o r t a n t to r e m e m b e r , however, t h a t 1996 i n f l a t i o n was at its lowest level since G e r m a n y a d o p t e d m o n e t a r y targets ( 1 . 4 % g r o w t h i n C P I ) , a n d t h a t t h e B u n d e s b a n k c u t a l l t h r e e o f its i n s t r u m e n t i n t e r e s t rates t o h i s t o r i c a l lows, even as M 3 g r o w t h e x c e e d e d t h e stated target. I n its D e c e m b e r 1996 Monthly Report, t h e B u n d e s b a n k a n n o u n c e d t h a t i t w o u l d set a t a r g e t o f 5% a n n u a l i z e d g r o w t h f o r M 3 i n b o t h 1997 a n d 1998. Subsequently, one-year targets f o r M 3 g r o w t h w e r e set at 3.5% t o 6.5% f o r 1997 a n d 3 % t o 6% f o r 1998, t h e l a t t e r i n r e s p o n s e t o e x p e c t a t i o n s o f c o n t i n u e d m o d e r a t i o n o f i n f l a t i o n . T h e D e c e m b e r 1996 a n n o u n c e m e n t r e p r e s e n t e d t h e first t i m e s i n c e G e r m a n y a d o p t e d m o n e t a r y t a r g e t i n g i n 1975 t h a t i t h a d a n n o u n c e d a t a r g e t f o r m o r e t h a n o n e year. T h e r e a s o n g i v e n was t o p r o v i d e p o l i c y - m a k e r s w i t h flex­ i b i l i t y i n d e a l i n g w i t h t h e v o l a t i l i t y i n c u r r e n c y m a r k e t s t h a t is e x p e c t e d t o set i n d u r i n g t h e r u n - u p t o t h e E u r o p e a n M o n e t a r y U n i o n ( E M U ) i n 1999. T h a t e v e n t m a k e s these t h e last G e r m a n m o n e t a r y targets. Clearly, f o r these t w o years d o m e s t i c p r i c e s t a b i l i t y was b e i n g b a l a n c e d w i t h o t h e r goals, n o t a b l y t h e e v o l v i n g E x c h a n g e Rate M e c h a n i s m ( E R M ) parities. T h e e n d g a m e n a t u r e o f G e r m a n y ' s m o n e t a r y s i t u a t i o n raises a p o i n t t h a t affects a l l i n f l a t i o n targeters w i t h a fixed-term t a r g e t i n g r e g i m e . W h e n t h e e n d o f t h e t a r g e t i n g r e g i m e is t i e d t o a specific event, s u c h as a n e l e c t i o n o r a treaty, i t is n o t clear h o w m u c h d i s c i p l i n e t h e t a r g e t w i l l

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evoke as t h a t event approaches. A c e n t r a l b a n k c o u l d be less s t r i c t a b o u t t a r g e t a d h e r e n c e i n t h e early years o f t h e p e r i o d , m a k i n g t h e c l a i m t h a t i t w i l l m a k e u p f o r t e m p o r a r y o v e r s h o o t i n g s later. Yet, w h e n this l a t e r t i m e arrives, t h e c o m m i t m e n t t o r e t u r n t h e t a r g e t e d v a r i a b l e t o a level r e q u i r e d u n d e r t h e t a r g e t i n g r e g i m e w i l l i n effect p r e d e t e r m i n e t h e p a t h o f policy. T h e c e n t r a l b a n k is t h e n u n a b l e t o r e s p o n d t o e c o n o m i c events as t h e y u n f o l d unless i t a b a n d o n s t h e target. I n a d d i t i o n , t h e c e n t r a l b a n k m a y n o t be h i g h l y a c c o u n t a b l e f o r its m o n e t a r y p o l i c y i f t h e t a r g e t i n g r e g i m e is u n l i k e l y t o be k e p t i n place. I f t h e c e n t r a l b a n k c a n n o t be h e l d a c c o u n t a b l e , t h e n h o w c a n its t a r g e t c o m m i t m e n t be f u l l y credible? T h i s is n o t t o suggest b y any m e a n s t h a t t h e B u n d e s b a n k w i l l go "soft" o n i n f l a t i o n i n t h e r u n - u p t o E M U , b u t r a t h e r t h a t i t is best i f t a r g e t t i m e h o r i z o n s c a n be c r e d i b l y e x t e n d e d b e f o r e t h e i r e x p i r a t i o n . As we w i l l see i n t h e case studies f o r b o t h C a n a d a a n d t h e U n i t e d K i n g d o m , t h e r e was a n e e d t o reassure t h e p u b l i c t h a t targets w o u l d be m a i n t a i n e d past e l e c t i o n dates ( a n d changes o f p o l i t i ­ cal p o w e r ) .

Switzerland As P a n e l A o f t h e Swiss E c o n o m i c I n d i c a t o r s ( F i g u r e 4.2) shows, t h e Swiss m o n e t a r y strategy k e p t i n f l a t i o n over t h e past t w o decades a r o u n d 3% p e r year o n average. Yet t h e g r a p h also shows t h a t "the S N B [Swiss N a t i o n a l B a n k ] failed to maintain p r i c e stability after i t h a d successfully r e d u c e d i n f l a t i o n " ( R i c h , 1997, p . 115, emphasis i n o r i g i n a l ) . W h i l e t h e first i n f l a t i o n a r y episode u n d e r m o n e t a r y t a r g e t i n g , s p a n n i n g t h e years 1979 t o 1982, m a y be e x p l a i n e d t o a large e x t e n t b y t h e s e c o n d o i l shock, t h e s e c o n d episode, f r o m 1989 t o 1992, c a n n o t be b l a m e d o n o u t s i d e events. I n p a r t i c u l a r , d u r i n g t h e l a t t e r p e r i o d t h e Swiss i n f l a t i o n p e r f o r ­ m a n c e relative t o o t h e r O E C D e c o n o m i e s was far less favorable t h a n i t was d u r i n g t h e f o r m e r p e r i o d . Since t h e events l e a d i n g t o t h e 1989-92 i n f l a t i o n p r o m p t e d t h e Swiss N a t i o n a l B a n k t o switch f r o m m o n e t a r y targets w i t h a one-year h o r i z o n t o m e d i u m - t e r m g r o w t h paths o f five years' d u r a t i o n , t h e m o s t s i g n i f i c a n t c h a n g e i n its f r a m e w o r k over t w e n t y years, we w i l l r e v i e w those events a n d p o i n t o u t t h e i r effect o n t h e Bank's c o n d u c t o f m o n e t a r y policy. T h e r a p i d increase o f i n f l a t i o n d u r i n g 1989 a n d 1990 was t h e conse­ q u e n c e o f a c o m p l e x set o f d e v e l o p m e n t s . T h e first, a n d p r o b a b l y m o s t i m p o r t a n t , o f these arose f r o m t h e v u l n e r a b i l i t y o f t h e Swiss e c o n o m y t o t h e effects o f sustained m o v e m e n t s o f t h e e x c h a n g e rate. I n early 1987,

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t h e Swiss N a t i o n a l B a n k b e c a m e c o n c e r n e d a b o u t t h e s t r e n g t h o f t h e Swiss f r a n c , w h i c h , after r e c o v e r i n g i n 1985 f r o m e a r l i e r weakness, h a d g o n e o n r i s i n g t h r o u g h o u t 1986 at a rate o f a b o u t 1 2 % i n t r a d e - w e i g h t e d t e r m s (see F i g u r e 4.2, P a n e l D ) . So t h e B a n k d e c i d e d t o deviate f r o m t h e m o n e t a r y t a r g e t f o r 1987 a n d a l l o w t h e m o n e t a r y base t o g r o w at a rate h i g h e r t h a n 2 % ( F i g u r e 4.2, P a n e l E ) . T h e r e u p o n r e a l s h o r t - t e r m i n t e r ­ est rates f e l l t o a p p r o x i m a t e l y z e r o % . T h e Swiss franc s h o w e d n o signs o f w e a k e n i n g , however, a n d t h e B a n k m a i n t a i n e d its l o o s e r p o l i c y stance t h r o u g h t h e first t h r e e q u a r t e r s o f 1987. F o l l o w i n g t h e s t o c k - m a r k e t crash i n O c t o b e r 1997, t h e Swiss N a t i o n a l B a n k , l i k e o t h e r c e n t r a l b a n k s , f e l t o b l i g e d t o p r o v i d e t h e b a n k i n g sec­ t o r w i t h a d d e d l i q u i d i t y , e v e n t h o u g h t h a t w o u l d cause a f u r t h e r devia­ t i o n f r o m t h e m o n e t a r y t a r g e t f o r t h e year. O v e r t h e year S A M B g r e w b y 2 . 9 % , n e a r l y a p e r c e n t a g e p o i n t above t h e t a r g e t g r o w t h r a t e . I n D e c e m b e r 1987, w i t h t h e e c o n o m i c c o n s e q u e n c e s o f t h e s t o c k - m a r k e t crash still u n c e r t a i n , a n d amidst widespread p r e d i c t i o n s o f a slowdown i n e c o n o m i c activity, t h e B a n k r a i s e d t h e m o n e t a r y t a r g e t f o r 1988 t o 3 % g r o w t h . R a i s i n g t h e t a r g e t was i n t e n d e d t o s i g n a l t o t h e f o r e i g n e x c h a n g e m a r k e t t h a t t h e c u r r e n t m o n e t a r y stance was n o t l i k e l y t o c h a n g e s o o n , w i t h t h e h o p e o f p r e v e n t i n g t h e Swiss f r a n c f r o m r i s i n g further. C o m b i n e d w i t h the overshooting o f the target for the previous year, t h i s c h a n g e i m p l i e d t h a t o n e f u l l year's w o r t h o f base m o n e y g r o w t h , inconsistent w i t h the l o n g - r u n i n f l a t i o n target, h a d b e e n i n ­ j e c t e d i n t o t h e system. A m i d s t t h i s u n c e r t a i n t y , t h e B a n k also f a c e d t h e p r o s p e c t o f a m a j o r shift i n t h e d e m a n d f o r S A M B , specifically t h a t p o r t i o n h e l d as c o m m e r ­ c i a l b a n k deposits at t h e B a n k . S u c h a shift w o u l d be t h e c o n s e q u e n c e o f t w o i n s t i t u t i o n a l changes i n t h e Swiss financial m a r k e t s . T h e first c h a n g e was t h e i n t r o d u c t i o n o f t h e n e w i n t e r b a n k p a y m e n t system, k n o w n as Swiss I n t e r b a n k C l e a r i n g ( S I C ) . Previously, t h e B a n k h a d a c t e d as a c l e a r i n g h o u s e t h a t p r o d u c e d a n e t s e t t l e m e n t o f t h e c o m m e r c i a l b a n k s ' a c c o u n t s at t h e e n d o f e a c h day. T h e n e w p a y m e n t system r e p l a c e d t h i s system w i t h r e a l - t i m e s e t t l e m e n t , w h i c h r e q u i r e s b a n k s t o t r a n s f e r balances f r o m t h e i r Swiss N a t i o n a l B a n k a c c o u n t at t h e b e g i n n i n g o f each day i n t o a s p e c i a l a c c o u n t i n w h i c h n o o v e r d r a f t is a l l o w e d d u r i n g t h e c o u r s e o f t h e day. T h e B a n k p u b l i c l y a d m i t t e d t h a t i t d i d n o t k n o w w h a t effect t h i s system w o u l d have o n t h e b a n k s ' d e m a n d f o r base m o n e y , because t h e b a n k s first h a d t o g a i n e x p e r i ­ e n c e w i t h t h e system. T h e s e c o n d i n s t i t u t i o n a l c h a n g e was a w i d e - r a n g i n g r e v i s i o n o f t h e c o m m e r c i a l b a n k s ' l i q u i d i t y r e q u i r e m e n t s as o f t h e b e g i n n i n g o f 1988.

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O n e p u r p o s e was t o r e m o v e t h e c o m p e t i t i v e d i s a d v a n t a g e t h e b a n k s faced u n d e r the previous l i q u i d i t y requirements, w h i c h r e q u i r e d t h e m t o h o l d s u b s t a n t i a l l y h i g h e r reserves at t h e Swiss N a t i o n a l B a n k t h a n they actually n e e d e d f o r c l e a r i n g purposes. U n d e r the new r e g u l a t i o n , t h e B a n k d i d n o t e x p e c t t h e reserve r e q u i r e m e n t s u n d e r u s u a l c i r c u m ­ stances t o b e b i n d i n g , even u n d e r t h e a s s u m p t i o n t h a t S I C w o u l d re­ d u c e b a n k s ' d e s i r e d w o r k i n g balances. T h i s m e a n t t h a t t h e b a n k s ' de­ m a n d f o r d e p o s i t s at t h e Swiss N a t i o n a l B a n k w o u l d b e d e t e r m i n e d b y t h e i r o p e r a t i n g needs. T h e s e , however, w e r e i m p o s s i b l e f o r t h e Swiss N a t i o n a l B a n k to predict, given the c o n c u r r e n t i n t r o d u c t i o n o f SIC. T h e Swiss N a t i o n a l B a n k e x p e c t e d t h a t t h e p r e d i c t i v e p r o p e r t i e s o f S A M B g r o w t h f o r i n f l a t i o n w o u l d f o r a w h i l e be s i g n i f i c a n t l y i m p a i r e d . I n fact, i n its a n n o u n c e m e n t o f t h e t a r g e t f o r 1987 (Swiss N a t i o n a l B a n k , 1986c, D e c e m b e r , p p . 207-9), t h e B a n k h a d discussed t h e i m p l i c a t i o n s o f t h e i n t r o d u c t i o n o f SIC i n g e n e r a l t e r m s , saying t h a t i t w o u l d have t o " u n d e r s h o o t its l o n g e r - t e r m m o n e y t a r g e t o f 2 % d u r i n g a c e r t a i n p e r i o d by a possibly substantial m a r g i n " ( p . 208, t r a n s l a t i o n b y a u t h o r s ) . Fur­ t h e r m o r e , t h e B a n k e x p l a i n e d t h a t d u r i n g t h e a d j u s t m e n t o f S A M B de­ m a n d , i t w o u l d pay i n c r e a s e d a t t e n t i o n t o o t h e r i n d i c a t o r s , n o t a b l y M l a n d s h o r t - t e r m i n t e r e s t rates, a l t h o u g h i t w o u l d n o t be a n n o u n c i n g tar­ gets f o r M l g r o w t h . (As a consequence o f t h e n e w l i q u i d i t y r e q u i r e m e n t s , w h i c h w o u l d c o m e i n t o effect o n J a n u a r y 1, 1988, i t was e x p e c t e d t h a t t h e usefulness o f M l as a n i n d i c a t o r o f f u t u r e e c o n o m i c c o n d i t i o n s was i m p a i r e d as w e l l . ) These d e v e l o p m e n t s , a n d t h e Bank's response, showed clearly t h a t t h e Swiss w e r e n o t t a r g e t i n g m o n e y i n any s t r i c t sense. I n fact, w h e n a d d i t i o n a l i n f o r m a t i o n i n d i c a t e d t h a t a d h e r i n g t o t h e m o n ­ etary t a r g e t w o u l d cause t h e i n f l a t i o n objective t o be missed, t h e m o n ­ etary t a r g e t was set aside e n t i r e l y . T h e B a n k ' s e x p l a n a t i o n s w e r e a g a i n consistent w i t h its c o m m i t m e n t t o s i m p l e rules w i t h c o m p l i c a t e d e x p l a n a t i o n s . P r i m a r i l y , t h e B a n k was t r y i n g t o convey t o t h e p u b l i c t h a t a o n e - t i m e rise i n m o n e y g r o w t h a n d prices ( a n d u n c e r t a i n t y ) d i d n o t i n d i c a t e a n a b r o g a t i o n o f t h e u n d e r l y ­ i n g c o m m i t m e n t t o p r i c e stability. T h i s n e e d t o d i s t i n g u i s h b e t w e e n t h e a c c o m m o d a t i o n o f a o n e - t i m e s h o c k a n d a c h a n g e i n goals, i n t h e h o p e o f preventing the shock f r o m t r i g g e r i n g expectations o f inflation a n d wage g r o w t h , is a r e c u r r i n g c h a l l e n g e f o r m o n e t a r y policy. As seen i n t h e case o f G e r m a n r e u n i f i c a t i o n , t r a n s p a r e n c y o f p o l i c y is a n effective t o o l f o r m a k i n g this v i t a l d i s t i n c t i o n . As 1988 b e g a n , t h e r e f o r e , t h e B a n k faced, a l l at o n c e , u n f a v o r a b l e d e v e l o p m e n t s i n t h e e x c h a n g e rate, u n c e r t a i n prospects f o r e c o n o m i c g r o w t h i n t h e n e a r f u t u r e , a n d serious p r o b l e m s w i t h its t a r g e t v a r i a b l e .

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Since, i n the wake o f the stock market crash, a significant economic slow­ down worldwide had been generally expected, the SNB decided to continue its expansive monetary policy—in view o f the strength o f the Swiss franc— d u r i n g 1988. [The Swiss National Bank] therefore increased the growth tar­ get for [SAMB] from 2% to 3% . Because o f the fall i n [SAMB] demand due to the innovations immediately ahead, the SNB expected to undershoot this target. The target therefore was not intended to serve as a guideline for con­ trolling the money stock. Rather, the SNB meant to communicate to the public with this target its i n t e n t i o n to continue the monetary stance o f the previous year. (Rich, 1992, p. 77, translation by authors) T h e u n u s u a l u n c e r t a i n t i e s s u r r o u n d i n g t h a t target s h o u l d have p r o m p t e d t h e B a n k to issue a d e t a i l e d e x p l a n a t i o n o f its plans f o r t h e c o n ­ d u c t o f m o n e t a r y policy d u r i n g the u p c o m i n g year. Yet, by its o w n admis­ sion, its a n n o u n c e m e n t o f t h e m o n e t a r y target f o r 1988 was unusually terse. W h e n the SNB . . . announced its money target for 1988, i t issued a statement that was remarkable for its brevity and vacuity. The statement m e n t i o n e d the prospect o f a shift i n money demand, b u t contained no information whatso­ ever o n the indicators the SNB m i g h t use i n lieu o f the monetary base. The SNB subsequently made up for that mistake and took pains to explain to the public its approach to setting policy. Furthermore, from the end o f 1988 onwards, the Bank's policy announcements became m u c h more substantial. (Rich, 1997, pp. 124-5) Clearly, t h e B a n k r e g r e t t e d its f a i l u r e t o c o m m u n i c a t e a n d b e g a n a g a i n t o f u r n i s h t h e p u b l i c w i t h i n f o r m a t i o n b e y o n d m e r e statements a b o u t w h e t h e r targets w e r e b e i n g missed. As t h e year 1988 u n f o l d e d , i t b e c a m e clear t h a t t h e Swiss N a t i o n a l B a n k h a d guessed w r o n g r e g a r d i n g a l l t h r e e sources o f u n c e r t a i n t y — t h e ex­ c h a n g e rate, prospects f o r e c o n o m i c g r o w t h , a n d p r o b l e m s w i t h its tar­ g e t v a r i a b l e . U n f o r t u n a t e l y f o r t h e B a n k , w h a t h a p p e n e d i n each case w o r k e d t o i n t e n s i f y t h e risk o f i n f l a t i o n . First a n d f o r e m o s t , t h e d e c l i n e i n t h e deposits o f c o m m e r c i a l banks at t h e Swiss N a t i o n a l B a n k was m u c h m o r e severe t h a n t h e B a n k h a d e x p e c t e d . By t h e e n d o f 1988, those deposits w e r e 5 7 % b e l o w t h e i r levels i n D e c e m b e r 1987. A t first, t h e B a n k reacted cautiously t o t h e sharp fall i n deposits, u n a b l e t o t e l l w h e t h e r i t h a d b e e n i n d u c e d solely b y t h e i n s t i t u t i o n a l changes, o r w h e t h e r i t also r e f l e c t e d t h e onset o f t h e p r e d i c t e d e c o n o m i c d o w n t u r n . A r o u n d t h e m i d d l e o f 1988, however, t h e B a n k was c o n v i n c e d , m a i n l y b y a s h a r p f a l l i n s h o r t - t e r m i n t e r e s t rates, t h a t i t h a d t o c o n t r a c t t h e s u p p l y o f l i ­ q u i d i t y m o r e sharply. O v e r a l l , t h e S A M B f e l l b y 3.9% ( c a l c u l a t e d as t h e average o f m o n t h l y g r o w t h rates), u n d e r s h o o t i n g t h e t a r g e t b y 6.9%.

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S e c o n d , t h e w i d e l y p r e d i c t e d s l o w d o w n i n e c o n o m i c activity, b o t h i n Switzerland a n d elsewhere, failed to materialize. Instead, e c o n o m i c g r o w t h i n a l l t h e m a j o r e c o n o m i e s p i c k e d u p significantly. T h e f a l l i n the SAMB masked a brisk growth i n the v o l u m e o f currency i n circula­ t i o n , w h i c h e x p a n d e d b y 4 . 2 % d u r i n g t h e year. W h i l e t h e B a n k at t h e e n d o f 1987 h a d e x p e c t e d Swiss r e a l G D P t o f a l l b y 1 % d u r i n g 1988, i t actually rose b y 3% ( F i g u r e 4.2, P a n e l C ) . T h i r d , a l t h o u g h f r o m mid-1988 o n the Bank t i g h t e n e d policy consid­ erably, Swiss s h o r t - t e r m i n t e r e s t rates w e r e r i s i n g m o r e slowly t h a n Ger­ m a n ones, l e a d i n g t o a s h a r p reversal o f t h e Swiss franc's e a r l i e r rise. T h e B a n k c o n t i n u e d t o t i g h t e n p o l i c y s h a r p l y d u r i n g 1989. By t h a t t i m e , however, i n f l a t i o n a r y pressures h a d b e g u n t o appear, w i t h i n f l a ­ t i o n r i s i n g f r o m 2 % t o 5%. G D P c o n t i n u e d t o grow, p e a k i n g at 4 % b y t h e e n d o f t h e year. S A M B , m e a n w h i l e , r e m a i n e d a n u n r e l i a b l e i n d i c a ­ tor, f a l l i n g b y a n o t h e r 2 % d u r i n g 1989, i n p a r t i n response t o t h e c o n ­ t i n u i n g adjustment o f the commercial banks' liquidity d e m a n d . I n con­ trast t o t h e d e v e l o p m e n t s o f 1988, however, t h e 4 % s h o r t f a l l o f S A M B g r o w t h relative t o t a r g e t i n 1989 d i d n o t r e f l e c t o n l y a t e c h n o l o g y - i n ­ d u c e d fall i n banks' desired balances at t h e Swiss N a t i o n a l B a n k . " [ A ] b o u t h a l f t h e s h o r t f a l l o f a p p r o x i m a t e l y f o u r p e r c e n t a g e p o i n t s . . . was caused by t h e r e n e w e d t i g h t e n i n g o f m o n e t a r y p o l i c y at t h e b e g i n n i n g o f 1989" (Swiss N a t i o n a l B a n k , 1989c, D e c e m b e r , p . 2 9 1 ) . T h e m a i n reason f o r t h a t t i g h t e n i n g was t h e c o n t i n u i n g d e c l i n e o f t h e Swiss f r a n c , p a r t i c u ­ l a r l y relative t o t h e d e u t s c h e m a r k . Since b y t h e e n d o f 1989 t h e Swiss f r a n c still a p p e a r e d v u l n e r a b l e , t h e B a n k d e c i d e d t o a d d a n e x p l i c i t ca­ veat t o t h e a n n o u n c e m e n t o f its m o n e t a r y t a r g e t f o r 1990. The sustained weak trends, since mid-1988, o f the Swiss franc vis-a-vis the Dmark and the other EMS currencies is particularly undesirable from a mon­ etary policy p o i n t o f view. The [Swiss National Bank] will not tolerate ex­ treme exchange rate fluctuations and will accordingly adjust its monetary policy i f developments i n the foreign exchange market warrant this. (Swiss National Bank, 1989c, December, p. 292) I n o t h e r w o r d s , t h e B a n k g r a n t e d i t s e l f a p u b l i c l y d e c l a r e d escape clause f r o m its t a r g e t c o m m i t m e n t . A g a i n , t r a n s p a r e n c y e n h a n c e d flexibility. S t i l l t h e B a n k a n n o u n c e d a t a r g e t o f 2 % S A M B g r o w t h f o r 1990. T h e Swiss c u r r e n c y c o n t i n u e d weak i n t o t h e first m o n t h s o f 1990, forc­ i n g t h e B a n k t o exercise its escape clause. The [Bank] already realized i n the first few months o f 1990 that its exchange rate-oriented monetary policy was not i n line with the growth target, set at 2 percent, for [S^fiVIB] . . . The [Swiss National Bank] was well aware o f the

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dangers inherent i n its exchange rate-oriented monetary policy. I t could not rule out the possibility that an exchange rate-induced curb o n money supply expansion would, i n the m e d i u m term, lead to an unnecessarily strong set­ back i n the Swiss economy. (Swiss National Bank, 1990c, December, p . 272) I n t h e e n d , t h e t a r g e t f o r 1990 was u n d e r s h o t by 4.5%. T h e u n d e r s h o o t i n g o f its targets b y s u c h c o n s i d e r a b l e m a r g i n s f o r t h r e e consecutive years m u s t have b e e n d i s c o n c e r t i n g t o t h e B a n k . T h e passage f r o m R i c h (1992) c i t e d above, t o g e t h e r w i t h t h e caveats a t t a c h e d t o t h e t a r g e t a n n o u n c e m e n t s , reveal t h e B a n k ' s g r o w i n g r e a l i z a t i o n t h a t its m o n e t a r y targets w e r e o f d i m i n i s h i n g u t i l i t y as a m e a n s o f s i g n a l i n g policy direction. O n one h a n d , the target announcements, w h i c h were m e a n t t o c o m m u n i c a t e t h e m o n e t a r y p o l i c y i n t e n d e d over t h e c o m i n g year, w e r e based o n a n e x p e c t a t i o n t h a t t h e r e l a t i o n s h i p b e t w e e n g o a l a n d t a r g e t w o u l d h o l d over a l o n g e r t i m e span t h a n t h e t a r g e t h o r i z o n . O n t h e o t h e r h a n d , as t h a t r e l a t i o n s h i p b e t w e e n S A M B g r o w t h a n d i n ­ flation lost its s h o r t - r u n p r e d i c t i v e power, t h e o u t c o m e s o f S A M B g r o w t h , w h i c h w e r e i n t e n d e d t o i n d i c a t e t o t h e p u b l i c h o w t i g h t o r easy r e c e n t m o n e t a r y p o l i c y h a d b e e n , b e c a m e increasingly u n i n f o r m a t i v e . T h e B a n k t h u s h a d t o f i n d a way t o c o m m u n i c a t e t o t h e p u b l i c its g r o w i n g realiza­ t i o n t h a t , w h i l e l o n g - r u n p r i c e stability r e q u i r e d m o n e t a r y g r o w t h n o t t o e x c e e d 1 % o n average, s h o r t - t e r m d e v i a t i o n s f r o m this average rate o f g r o w t h w o u l d be necessary t o achieve a n d m a i n t a i n p r i c e stability i n any g i v e n year. T h e B a n k was p r o b a b l y l o o k i n g f o r a new, m o r e flexible f r a m e w o r k i n w h i c h t o c o m m u n i c a t e b o t h its i n t e n d e d a n d its r e a l i z e d stance. B e t w e e n t h e e n d o f 1987 a n d t h e e n d o f 1990 S A M B h a d c o n t r a c t e d b y m o r e t h a n 1 6 % (see F i g u r e 4.2, P a n e l F ) . T h e B a n k was c o n v i n c e d t h a t i n 1991 d e m a n d f o r S A M B w o u l d be w e l l b e l o w the level t h a t w o u l d be expected u n d e r m o r e o r d i n a r y cyclical c o n d i t i o n s . T h e very h i g h (by h i s t o r i c a l standards) s h o r t - t e r m n o m i n a l i n t e r e s t rates i n p a r t i c u l a r h a d depressed S A M B d e m a n d . As the B a n k expected to loosen p o l i c y i n t h e n e a r f u t u r e , i t w o u l d be d o i n g so i n t h e face o f S A M B g r o w t h rates that were likely to exceed the m e d i u m - t e r m objective o f 1 % f o r some t i m e . T h a t g r o w t h , m o r e o v e r , w o u l d m e r e l y m a k e u p f o r past c o n t r a c ­ t i o n . T h e B a n k f a c e d t h e same d i l e m m a t h a t G e r m a n y h a d f a c e d i n 1991-92: T h e t a r g e t v a r i a b l e a n d p o l i c y w e r e m o v i n g i n o p p o s i t e d i r e c ­ t i o n s . T h e B a n k ' s h o p e was t o k e e p t h e p u b l i c f r o m i n t e r p r e t i n g t h i s t e m p o r a r y m o n e t a r y g r o w t h as a n o v e r l y s t i m u l a t i v e p o l i c y . I n p a r t i c u ­ lar, t h e B a n k w a n t e d t o a v o i d a r e n e w e d s h a r p d e p r e c i a t i o n o f t h e Swiss franc.

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T h e B a n k ' s response t o this p r o b l e m was t o a n n o u n c e t h e replace­ m e n t o f its a n n u a l m o n e t a r y targets w i t h a m e d i u m - t e r m g r o w t h p a t h f o r t h e S A M B i n D e c e m b e r 1990. Swiss N a t i o n a l B a n k P r e s i d e n t Lusser's r e m a r k s t o t h e Bank's G e n e r a l Assembly i n A p r i l 1991 s h e d some l i g h t o n t h e l o g i c b e h i n d this d e c i s i o n . The effective growth o f [SAMB] will presumably exceed the average [growth rate o f 1 percent] i n some years, and fall short o f i t i n others. I t was signifi­ cantly below the intended average d u r i n g the past two years. I therefore do not exclude the possibility that [SAMB] will increase i n the near future tem­ porarily by more than 1 percent, and only thereafter growth will approach the medium-term growth path . . . The medium-term money target o f 1 % defines the general direction o f monetary policy. I t does not, however, neces­ sarily determine the money growth rate which we will aim for i n 1991 . . . I n particular we are taking the development o f the exchange rate o f the Swiss franc vis-a-vis the most important currencies into account. The deutschemark/ Swiss franc relation is of particular importance. (Lusser, 1991, p. 168, transla­ tion by authors) T h e m e d i u m - t e r m g r o w t h p a t h was t o p r o v i d e t h e f r a m e w o r k i n w h i c h t h e B a n k c o u l d e x p l a i n c u r r e n t actions a n d , m o s t i m p o r t a n t l y , devia­ t i o n s f r o m t h e m e d i u m - t e r m t a r g e t as necessary steps towards m a i n t a i n ­ i n g t h e price-stability g o a l over t i m e . T h e n e e d t o e x p l a i n t h e r e l a t i o n ­ s h i p b e t w e e n t h e c u r r e n t p o s i t i o n a n d t h e m e d i u m - t e r m t a r g e t was t h e d i s c i p l i n e i m p o s e d o n t h e s h o r t - t e r m d i s c r e t i o n o f m o n e t a r y p o l i c y re­ q u i r e d i n a small, o p e n economy. However, t h e a n n o u n c e m e n t o f t h e m e d i u m - t e r m g r o w t h p a t h (Swiss N a t i o n a l B a n k , 1990c, D e c e m b e r , p p . 272-274) left a n u m b e r o f issues u n a d d r e s s e d . W h i l e t h e a n n o u n c e m e n t r e p e a t e d t h e Bank's c o m m i t ­ m e n t t o S A M B as "the m a i n i n d i c a t o r o f Swiss m o n e t a r y p o l i c y " ( p . 2 7 3 ) , i t also stated This aggregate will serve mainly as a medium-term monetary indicator. The [Swiss National Bank] intends to increase the monetary base to approach the medium-term expansion path envisaged. The speed with which i t will move towards this path will depend largely o n exchange rate developments. (Ibid., pp. 273-4) T h e o n l y d e t a i l specified i n t h e a n n o u n c e m e n t was t h e slope o f t h e p a t h — namely, t h a t "a m e d i u m - t e r m m o n e y supply g r o w t h o f a r o u n d 1 p e r c e n t w o u l d be m o r e adequate i n f u t u r e " (Ibid., p . 2 7 4 ) . T h e a n n o u n c e m e n t d i d n o t specify the l e n g t h o f the " m e d i u m t e r m , " the p o s i t i o n o f actual 22

S A M B relative to the p a t h , o r the time h o r i z o n w i t h i n w h i c h the B a n k ex-

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pected to b r i n g SAMB back to the path. I n short, the a n n o u n c e m e n t c o n t a i n e d n o specifics a b o u t t h e d i r e c t i o n o f m o n e t a r y p o l i c y d u r i n g 1 9 9 1 . T h e B a n k " p r e f e r r e d t o s t r a i g h t e n o u t t h e loose e n d s o f t h e n e w strat­ egy b e f o r e c o m m i t t i n g i t s e l f t o a precise d e f i n i t i o n o f t h e m e d i u m - t e r m target" ( R i c h , 1997, p . 1 3 5 ) . T h i s l a g b e t w e e n a n n o u n c e m e n t o f a n e w t a r g e t i n g r e g i m e a n d t h e p r o v i s i o n o f specific details reflects a p a t t e r n seen i n o t h e r i n f l a t i o n - t a r g e t i n g c o u n t r i e s , s u c h as S w e d e n a n d A u s t r a ­ lia. Apparently, central banks i n small, o p e n economies want to make sure t h a t t h e i r s u r r o u n d i n g s are stable b e f o r e t h e y m a k e a f o r m a l c o m ­ m i t m e n t . A f t e r a l l , t h e r e is l i t t l e p o i n t t o a n n o u n c i n g a new, m o r e flex­ i b l e t a r g e t o n l y t o miss i t at t h e outset. As we have seen, t h e Swiss N a t i o n a l B a n k g r a d u a l l y p r o v i d e d t h e miss­ i n g details over t h e n e x t few years. By t h e e n d o f 1994, f o r t h e first t i m e , i t p r o v i d e d a c h a r t s i m i l a r t o P a n e l F o f o u r F i g u r e 4.2. A c c o r d i n g t o t h i s c h a r t , i t appears t h a t since t h e c h a n g e t o m e d i u m - t e r m g r o w t h paths, t h e B a n k has u s e d t h e r o o m f o r m a n e u v e r p r o v i d e d b y t h i s strategy w i t h ­ o u t d e v i a t i n g t o o far f r o m its m e d i u m - t e r m objective. I t is i m p o r t a n t t o p u t the accumulated credibility o f l o w i n f l a t i o n i n postwar Switzerland i n perspective. W h i l e t h e r e c o r d o f p r i o r success a n d t h e l o w l o n g - r u n i n f l a t i o n e x p e c t a t i o n s m a d e this t r a n s i t i o n a l i n t e r r e g n u m possible w i t h ­ o u t a d r a m a t i c rise i n t h e p r i c e level, s u c h c r e d i b i l i t y c o u l d n o t p r e v e n t Swiss m o n e t a r y p o l i c y f r o m r u n n i n g u p against t h e l i m i t a t i o n s o f its c o n ­ t r o l over t h e e c o n o m y . F l e x i b i l i t y was r e q u i r e d a n d was used.

Key Lessons from Germany and Switzerland's Experiences T h e experience o f Germany a n d Switzerland w i t h monetary targeting suggests t w o m a i n lessons t h a t are a p p l i c a b l e t o any t a r g e t i n g r e g i m e i n w h i c h a n i n f l a t i o n g o a l plays a p r o m i n e n t r o l e . First, i t appears t h a t a t a r g e t i n g r e g i m e c a n r e s t r a i n i n f l a t i o n i n t h e l o n g e r r u n , even w h e n t h e r e g i m e p e r m i t s t a r g e t misses i n response t o short-run considerations. I n d e e d , the approaches o f b o t h countries to m o n e t a r y t a r g e t i n g r e p r e s e n t s i g n i f i c a n t d e p a r t u r e s f r o m a rigid p o l i c y r u l e i n t h e classical sense. S e c o n d , a key e l e m e n t o f a successful t a r g e t i n g r e g i m e is a s t r o n g c o m m i t m e n t t o transparency; t h a t is, c l a r i t y o f p o l i c y objectives a n d ap­ p r o a c h c o u p l e d w i t h clear e x p l a n a t i o n s . T h e effective use o f a t a r g e t c a n increase p o l i c y t r a n s p a r e n c y b y s e r v i n g as a v e h i c l e f o r c o m m u n i c a t ­ i n g w i t h the public and p r o m o t i n g understanding o f what the central b a n k is t r y i n g t o achieve.

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As we w i l l see i n t h e c h a p t e r s a h e a d , these key e l e m e n t s o f a success­ ful targeting regime—flexibility a n d transparency—have played an i m ­ p o r t a n t r o l e i n t h e p o l i c i e s o f a l l t h e c o u n t r i e s s t u d i e d i n this b o o k .

New Zealand: Inflation-Targeting Pioneer

I N 1990, N e w Z e a l a n d b e c a m e t h e first c o u n t r y t o a d o p t f o r m a l i n f l a t i o n t a r g e t i n g . T h i s c h a n g e i n t h e c o n d u c t o f m o n e t a r y p o l i c y was p a r t o f a wide-ranging economic reform i n New Zealand, undertaken by the L a b o u r G o v e r n m e n t e l e c t e d i n J u l y 1984. T h e r e f o r m s , a response t o a l o n g p e r i o d o f p o o r p e r f o r m a n c e by the N e w Zealand economy, were r e m a r k a b l y a m b i t i o u s i n scope: T h e L a b o u r G o v e r n m e n t t a c k l e d fiscal, s t r u c t u r a l , a n d t r a d e issues, as w e l l as m o n e t a r y policy, i n t h e b e l i e f t h a t t h e r e f o r m s n e e d e d t o b e m u t u a l l y consistent a n d m u t u a l l y r e i n f o r c i n g i n o r d e r t o succeed. (See B r a s h [ 1 9 9 6 a ] f o r a n overview o f t h e r e f o r m measures.) T h e i n f l a t i o n - t a r g e t i n g c o m p o n e n t o f N e w Zealand's r e f o r m s , l i k e m a n y o t h e r e l e m e n t s o f L a b o u r ' s p o l i c y package, was q u i t e i n n o v a t i v e , a n d s p a r k e d c o n s i d e r a b l e analysis a n d discussion i n t h e academy a n d i n c e n t r a l b a n k i n g circles. As we w i l l see i n this c h a p t e r a n d those t h a t f o l ­ low, t h e N e w Z e a l a n d e x p e r i e n c e i n m a n y ways has b e c o m e a l a b o r a t o r y f r o m w h i c h s u b s e q u e n t a d o p t e r s o f i n f l a t i o n t a r g e t i n g have d r a w n b o t h p o s i t i v e a n d negative lessons.

Key Features of Inflation Targeting in New Zealand •

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Inflation targeting i n New Zealand followed legislation that m a n d a t e d a Policy Targets A g r e e m e n t ( P T A ) b e t w e e n t h e gov­ e r n m e n t a n d the newly i n d e p e n d e n t central bank. U n d e r each P T A , t h e g o v e r n m e n t a n d t h e c e n t r a l b a n k have a g r e e d o n specific n u m e r i c a l targets f o r i n f l a t i o n . I n f l a t i o n t a r g e t i n g was a d o p t e d o n l y a f t e r a disinflation had been nearly completed.

successful

NEW Z E A L A N D : I N F L A T I O N - T A R G E T I N G P I O N E E R

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T h e p r i c e i n d e x o n w h i c h i n f l a t i o n targets are based is de­ s i g n e d t o e x c l u d e t h e first-round effects o f s u p p l y shocks a n d t h u s m e a s u r e " u n d e r l y i n g i n f l a t i o n . " Statistics N e w Z e a l a n d publishes a c o n s u m e r p r i c e i n d e x t h a t excludes t h e f i r s t - r o u n d effects o f interest-rate changes o n t h e cost o f l i v i n g . T h i s i n ­ d e x is f u r t h e r m o d i f i e d b y t h e Reserve B a n k o f N e w Z e a l a n d , w h i c h excludes " s i g n i f i c a n t " first-round i m p a c t s f r o m termsof-trade m o v e m e n t s , changes i n energy a n d c o m m o d i t y prices, changes i n g o v e r n m e n t charges a n d i n d i r e c t taxes, a n d some o t h e r prices as d e t e r m i n e d o n a n ad hoc basis.

•

A l t h o u g h N e w Zealand's i n f l a t i o n - t a r g e t i n g r e g i m e is p e r h a p s t h e m o s t n e a r l y " r u l e - l i k e " o f any, i t still has a l l o w e d t h e cen­ t r a l b a n k c o n s i d e r a b l e flexibility t o r e s p o n d t o fluctuations i n variables o t h e r t h a n i n f l a t i o n , s u c h as e m p l o y m e n t a n d r e a l GDP.

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A c c o u n t a b i l i t y o f t h e c e n t r a l b a n k is a key f e a t u r e o f t h e i n ­ flation-targeting r e g i m e . Legally, t h e G o v e r n o r o f t h e Reserve B a n k m a y be dismissed i f t h e i n f l a t i o n t a r g e t is b r e a c h e d , al­ t h o u g h his o r h e r dismissal is n o t m a n d a t o r y a n d so far this p r o v i s i o n has n o t b e e n i n v o k e d .

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T h e i n f l a t i o n target i n N e w Z e a l a n d is stated as a range, r a t h e r t h a n as a p o i n t target, w i t h t h e m i d p o i n t o f t h e r a n g e above zero. T h e l o n g - t e r m g o a l is also d e f i n e d as a m e a s u r e d i n f l a ­ t i o n rate above zero.

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A d h e r e n c e t o a relatively n a r r o w t a r g e t r a n g e a n d a one-year t i m e h o r i z o n f o r targets has r e s u l t e d i n t w o r e l a t e d p r o b l e m s f o r N e w Zealand's policy-makers: (1) a c o n t r o l p r o b l e m (i.e., d i f f i c u l t y i n k e e p i n g i n f l a t i o n w i t h i n t h e very n a r r o w t a r g e t r a n g e ) ; a n d (2) a n i n s t r u m e n t i n s t a b i l i t y p r o b l e m (i.e., occa­ s i o n a l w i d e swings i n i n t e r e s t rates a n d e x c h a n g e rates, t h e instruments o f monetary policy).

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The Adoption of Inflation Targeting T h e c u r r e n t f r a m e w o r k f o r N e w Z e a l a n d m o n e t a r y p o l i c y was set f o r t h by t h e Reserve B a n k o f N e w Z e a l a n d A c t o f 1989. T h e A c t was i n t r o ­ d u c e d i n t o P a r l i a m e n t b y t h e g o v e r n m e n t o n M a y 4 , 1 9 8 9 , was passed o n

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D e c e m b e r 15, a n d t o o k effect o n F e b r u a r y 1, 1990. I t r e q u i r e s t h e Re­ serve B a n k o f N e w Z e a l a n d ( t h e c e n t r a l b a n k ) "to f o r m u l a t e a n d i m p l e ­ m e n t m o n e t a r y policy d i r e c t e d to the e c o n o m i c objective o f achieving a n d m a i n t a i n i n g s t a b i l i t y i n t h e g e n e r a l level o f p r i c e s " ( S e c t i o n 8 ) . A l t h o u g h i n f l a t i o n t a r g e t i n g was t h e means c h o s e n t o achieve p r i c e stability, t h e A c t i t s e l f does n o t g o b e y o n d s t a t i n g t h e n e e d f o r q u a n t i t a ­ tive p e r f o r m a n c e c r i t e r i a . S e c t i o n 9 o f t h e A c t r e q u i r e s t h e M i n i s t e r o f F i n a n c e a n d t h e G o v e r n o r o f t h e Reserve B a n k t o n e g o t i a t e a n d m a k e p u b l i c a P o l i c y Targets A g r e e m e n t ( P T A ) t h a t sets o u t "specific targets b y w h i c h m o n e t a r y p o l i c y p e r f o r m a n c e , i n r e l a t i o n t o its s t a t u t o r y objec­ tive, c a n b e assessed d u r i n g t h e p e r i o d o f t h e G o v e r n o r ' s t e r m " ( L l o y d , 1992, p . 2 1 1 ) . T h e first P T A , s i g n e d b y t h e M i n i s t e r o f F i n a n c e a n d t h e G o v e r n o r o n M a r c h 2, 1990, s p e c i f i e d n u m e r i c a l targets f o r i n f l a t i o n a n d t h e dates b y w h i c h t h e y w e r e t o be achieved. T h e passage o f t h e A c t was o n e r e s u l t o f t h e g e n e r a l sense o f crisis a b o u t N e w Zealand's e c o n o m i c p e r f o r m a n c e t h a t h a d i n s t i g a t e d t h e L a b o u r g o v e r n m e n t ' s b r o a d package o f r e f o r m s . L i k e m a n y o t h e r o f N e w Zealand's e c o n o m i c policies, m o n e t a r y p o l i c y d i d n o t have a p r o u d r e c o r d i n t h e 1970s a n d 1980s: New Zealand experienced double-digit inflation for most o f the p e r i o d since the first o i l shock. Cumulative inflation ( o n a CPI basis) between 1974 and 1988 (inclusive) was 480 per cent. A brief, b u t temporary, fall i n inflation to below 5 per cent occurred i n the early 1980s, b u t only as the result o f a distortionary wage, price, d i v i d e n d and interest rate freeze. T h r o u g h o u t the p e r i o d , monetary policy faced m u l t i p l e and varying objectives w h i c h were seldom clearly specified, and only rarely consistent w i t h achievement o f inflation reduction. As a result o f this experience, inflation expectations were deeply entrenched i n New Zealand society. (Nicholl and Archer, 1992, p. 316) Following Labour's election and the movement toward policy reform, t h e Reserve B a n k stated t h a t "a firm m o n e t a r y p o l i c y is seen as a n essen­ t i a l p r e r e q u i s i t e f o r lower, m o r e stable i n t e r e s t rates a n d i n f l a t i o n rates over t h e m e d i u m - t e r m " (Reserve B a n k o f N e w Z e a l a n d , 1985a, A u g u s t , p . 4 5 1 ) . However, at first t h e r e was n o focused discussion o f w h a t t h e objectives o f m o n e t a r y p o l i c y s h o u l d be. T h e r e was some i n t e r e s t i n t h e i n t e r m e d i a t e t a r g e t i n g o f m o n e t a r y aggregates, b u t t h a t t o p i c was never p u r s u e d . ( I n r e c e n t years t h e B a n k has o f t e n asserted t h a t n o useful l i n k exists b e t w e e n such aggregates a n d i n f l a t i o n . ) O v e r t h e f o u r years f o l l o w i n g t h e 1984 e l e c t i o n , a consensus g r a d u ­ ally e m e r g e d i n s i d e t h e g o v e r n m e n t , a n d i n t h e Reserve B a n k i n par1

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t i c u l a r , a b o u t t h e p r o p e r objectives o f m o n e t a r y p o l i c y , as w e l l as t h e i n s t i t u t i o n a l f r a m e w o r k n e e d e d t o achieve t h o s e objectives. A k e y ele­ m e n t o f t h i s consensus was t h e n e e d f o r i n c r e a s e d focus o n p r i c e sta­ bility. M u l t i p l e objectives o f m o n e t a r y p o l i c y h a d b e e n s p e c i f i e d i n t h e Re­ serve B a n k A c t o f 1964, w h i c h stated " . . . t h a t t h e [ m o n e t a r y ] p o l i c y s h o u l d be r e l a t e d t o t h e d e s i r a b i l i t y o f p r o m o t i n g t h e h i g h e s t d e g r e e o f p r o d u c t i o n , t r a d e a n d e m p l o y m e n t a n d o f m a i n t a i n i n g a stable i n t e r n a l p r i c e level" (Reserve B a n k o f N e w Z e a l a n d , 1985a, S e p t e m b e r , p . 5 1 2 ) . H o w e v e r , a shift t o w a r d a m o r e f o c u s e d a p p r o a c h was suggested i n a n a r t i c l e i n t h e S e p t e m b e r 1987 issue o f t h e Reserve B a n k ' s Bulletin. T h e a r t i c l e stated ( p . 1 0 4 ) , " T h e o v e r r i d i n g objective o f m o n e t a r y p o l i c y is t o l o w e r t h e rate o f i n f l a t i o n , " a n d t h a t ". . . a n i n i t i a l objective o f g o v e r n ­ m e n t p o l i c y has b e e n t o r e d u c e i n f l a t i o n t o a level c o m p a r a b l e w i t h o u r m a j o r t r a d i n g p a r t n e r s . " L e f t o p e n was t h e q u e s t i o n o f w h a t exactly t h a t level was a n d w h a t t h e objective o f m o n e t a r y p o l i c y w o u l d be o n c e i t h a d b e e n achieved. T h e a r t i c l e c o n c l u d e d that: " T h o u g h t h e d i r e c t i o n o f t h e d e s i r e d m o v e m e n t is clear, t h e t i m e f r a m e over w h i c h this r e d u c t i o n can, o r s h o u l d , be a c h i e v e d is s o m e w h a t less so." {Ibid.) I n s h o r t , t h e g o v e r n m e n t a n d t h e Reserve B a n k w e r e slowly s h i f t i n g t o a g o a l o f p r i c e stability f o r m o n e t a r y policy, h o w e v e r w i t h o u t i n d i c a t i n g precisely h o w they w o u l d g o a b o u t r e a c h i n g t h a t g o a l . T h e n e e d f o r c l a r i f i c a t i o n became a p p a r e n t over t h e f o l l o w i n g m o n t h s . D u r i n g t h e first q u a r t e r o f 1988, . . . accompanying the growing acceptance that m u c h lower rates o f inflation would be achieved, there was an expectation amongst some commentators that policy would be eased once inflation rates o f around 5 percent had been achieved or were i n prospect . . . Official concern at the growing credence given to this view . . . p r o m p t e d a more explicit statement [by the Minister o f Finance] o f the ultimate inflation objective than had previously been for­ mally made . . . that the ultimate goal is to achieve price stability by the early 1990s . . . The Bank shares the Minister's objective. (Redell, 1988, pp. 81-82) A f o o t n o t e says t h a t p r i c e stability is ". . . l i k e l y t o be consistent w i t h a small positive m e a s u r e d i n f l a t i o n rate, i n t h e o r d e r o f 0-2 p e r c e n t . " T h u s , t w o years b e f o r e t h e first i n f l a t i o n targets w e r e a n n o u n c e d , t h e i r final f o r m h a d effectively b e e n a g r e e d o n b y t h e g o v e r n m e n t a n d t h e Reserve B a n k . A p p a r e n t l y N e w Zealand's p o l i c y - m a k e r s r e a l i z e d t h a t some p u b ­ lic c o m m i t m e n t was necessary t o p u t a cap o n i n f l a t i o n e x p e c t a t i o n s . Yet t h e i r s t a t e m e n t was h a r d l y p u b l i c i z e d , a n d t h e c r u c i a l d e t a i l — t h e l i k e l y target range for inflation—was relegated to a footnote.

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T h e r e c o g n i t i o n o f t h e n e e d f o r i n c r e a s e d i n d e p e n d e n c e f o r t h e cen­ t r a l b a n k t h a t h e l p e d t o shape t h e Reserve B a n k A c t o f 1989 seems t o have arisen s o m e w h a t later. A n a r t i c l e p u b l i s h e d i n t h e Bulletin i n 1992 stated: I n order to improve the prospects for monetary policy to remain—and be seen to remain—on the track to low inflation, and thereby help reduce the costs o f disinflation, attention turned to possible institutional arrangements which would improve monetary policy credibility. D u r i n g 1986, the Government i n i ­ tiated consideration o f ways o f allowing the Reserve Bank to operate m o n ­ etary policy more autonomously . . . Nevertheless, [even i f independence wasn't seen as the whole answer,] i t was at least suggestive that a more au­ tonomous central bank would be helpful, even i f neither necessary nor suffi­ cient by itself for achieving and maintaining low inflation. (Lloyd, 1992, p. 208) A l t h o u g h the l i n k between the a u t o n o m y o f the central bank a n d the p e r f o r m a n c e o f t h e e c o n o m y at l a r g e was o n l y b e g i n n i n g t o b e e x p l o r e d i n a c a d e m i c circles, t h e g o v e r n m e n t clearly f e l t t h a t t h e p u b l i c ' s u n c e r ­ t a i n t y a b o u t m o n e t a r y p o l i c y was a m a j o r t h r e a t t o p r i c e stability. M o r e ­ over, t h e B a n k , at least at first, b e l i e v e d t h a t a c h a n g e i n i n s t i t u t i o n a l a r r a n g e m e n t s m i g h t b r i n g a b o u t a decrease i n t h e r e a l e c o n o m i c costs o f disinflation. Lack o f central bank autonomy and uncertainty about monetary policy w e r e i n fact closely l i n k e d i n t h e t h i n k i n g o f t h e Bank's l e a d e r s h i p . T h e B a n k has a r g u e d t h a t t h e costs o f i n f l a t i o n r e s u l t m a i n l y f r o m u n c e r ­ tainty about future inflation, and that to m i n i m i z e that uncertainty the c e n t r a l b a n k m u s t be c h a r g e d w i t h , a n d h e l d responsible for, a c h i e v i n g p r i c e stability. T o t h a t e n d , m o n e t a r y p o l i c y m u s t be b o t h clearly f o r m u ­ l a t e d a n d c r e d i b l e ; o t h e r w i s e , t h e r e is n o t h i n g t o p r e v e n t private-sector c o n t r a c t s f r o m b e i n g c o n c l u d e d o n t h e basis o f i n f l a t i o n e x p e c t a t i o n s t h a t are i n c o n s i s t e n t w i t h t h e objective o f p r i c e stability. " T h e B a n k m u s t e n s u r e t h a t a c r e d i b l e n o n - a c c o m m o d a t i v e stance is consistently m a i n ­ t a i n e d t o i n f l u e n c e e x p e c t a t i o n s a n d wage claims" ( R e d e l l , 1988, p . 8 3 ) . Price stability was c o n s i d e r e d p r e f e r a b l e t o a positive, stable i n f l a t i o n rate, since i t was " . . . seen as c o n s i d e r a b l y m o r e socially a n d p o l i t i c a l l y c r e d i b l e over t h e l o n g e r t e r m " t h a n t h e l a t t e r ( R e d e l l , 1988, p . 8 2 ) . A u t o n o m y f o r t h e c e n t r a l b a n k , t o g e t h e r w i t h a focus o n p r i c e stabil­ ity, was also a r g u e d t o p r o m o t e c r e d i b i l i t y , transparency, a n d a c c o u n t ­ ability. A c e n t r a l b a n k w o u l d c e r t a i n l y be m o r e c r e d i b l e i f i t w e r e b o t h free t o set t h e i n s t r u m e n t s o f p o l i c y a n d also h e l d responsible solely f o r m a i n t a i n i n g p r i c e stability, w i t h n o i n c e n t i v e t o p u r s u e o t h e r goals. Trans­ p a r e n c y a n d a c c o u n t a b i l i t y w o u l d also be served by t h e s h a r p e n e d f o 2

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cus: " M u l t i p l e objectives . . . t e n d t o r e d u c e t h e t r a n s p a r e n c y o f m o n ­ etary policy, a n d also, t h e r e f o r e , [ t o ] w e a k e n t h e a c c o u n t a b i l i t y o f b o t h t h e c e n t r a l b a n k , a n d t h e G o v e r n m e n t . G i v e n m u l t i p l e objectives, fail­ u r e t o achieve o n e objective c a n t o o easily be e x p l a i n e d by r e f e r e n c e t o a n o t h e r o b j e c t i v e " ( L l o y d , 1992, p . 2 0 9 ) . T h e n e w emphasis o n a c c o u n t ­ a b i l i t y was r e f l e c t e d i n t h e much-discussed p r o v i s i o n o f t h e A c t t h a t per­ m i t s ( a l t h o u g h i t does n o t r e q u i r e ) t h e f i r i n g o f t h e Bank's G o v e r n o r i f t h e goals o f t h e Policy Targets A g r e e m e n t are n o t m e t . A t t h e t i m e o f t h e s i g n i n g o f t h e first P T A , i n M a r c h 1990, t h e Reserve B a n k h a d succeeded i n b r i n g i n g so-called " u n d e r l y i n g " i n f l a t i o n d o w n f r o m a l m o s t 1 7 % at t h e b e g i n n i n g o f 1985 t o t h e v i c i n i t y o f 5 % — " a l ­ t h o u g h a n u m b e r o f o n e - o f f factors m e a n t t h a t o n l y l i m i t e d progress [ o n d i s i n f l a t i o n ] was m a d e " d u r i n g 1989 (Reserve B a n k o f N e w Z e a l a n d , 1990a, M a r c h , p . 6 ) . I n this e f f o r t t h e B a n k was b a c k e d b y t h e L a b o u r g o v e r n m e n t , w h i c h h a d r e t u r n e d t o p o w e r i n A u g u s t 1987. T h u s t h e d e c i s i o n to a n n o u n c e i n f l a t i o n targets o c c u r r e d after m o s t o f the d i s i n f l a t i o n ( a n d its recessionary consequences) h a d already t a k e n place. As we w i l l also see i n t h e case o f Canada, t h e a n n o u n c e m e n t was t i m e d less to p r o m o t e d i s i n f l a t i o n t h a n t o f o r e s t a l l a rise i n i n f l a t i o n a r y expec­ tations o n c e m o n e t a r y p o l i c y b e g a n t o ease. T h e Reserve B a n k r e s p o n d e d t o t h e possible revival o f i n f l a t i o n d u r ­ i n g t h e s u m m e r o f 1989 w i t h a s l i g h t f i r m i n g o f policy, r a i s i n g s h o r t - t e r m i n t e r e s t rates f r o m 1 3 % t o 1 4 % . T h e B a n k ' s forecast, based o n d a t a t h r o u g h t h e first q u a r t e r o f 1990, i n d i c a t e d t h a t u n d e r l y i n g i n f l a t i o n w o u l d stay a r o u n d 5% f o r t h e rest o f t h e year a n d t h e n f a l l t o 1 % b y t h e e n d o f 1992. A c c o r d i n g t o t h a t p r o j e c t i o n , t h e i n f l a t i o n targets l a i d d o w n i n t h e first P T A , 3% t o 5% by D e c e m b e r 1990, w o u l d b e a c h i e v e d . D u r ­ i n g 1989 " . . . t h e e c o n o m y m o v e d o n l y slowly o u t o f t h e recession expe­ rienced since late 1987," b u t Reserve B a n k G o v e r n o r D o n Brash r e m a i n e d ". . . c o n f i d e n t t h a t t h e recovery is u n d e r w a y , a n d t h a t w h a t e v e r pressure m a y be necessary t o ensure c o n t i n u e d progress towards t h e G o v e r n m e n t ' s m o n e t a r y p o l i c y objectives w i l l n o t stifle t h e r e c o v e r y . . . " (Reserve B a n k o f N e w Z e a l a n d , 1990b, p p . 6-7). T h e possibility o f a recession was t a k e n seriously; t h e a n n o u n c e m e n t o f t h e targets a l o n e was n o t h e l d t o be e n o u g h t o c h a n g e e c o n o m i c behavior. It was quite clear from the outset that the mere enactment o f the legislation would not be enough to establish monetary policy c r e d i b i l i t y . . . There d i d not seem to be a large 'announcement effect' o n the passing o f the legislation. Ultimately, credibility is derived from results —and particularly from results i n relation to publicly advertised intentions. (Nicholl and Archer, 1992, p. 319)

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As o f 1990, t h e o p e r a t i o n a l f r a m e w o r k f o r t h e n e w r e g i m e a n d , m o r e i m p o r t a n t l y , t h e p e r f o r m a n c e o f N e w Zealand's m o n e t a r y p o l i c y u n d e r a r e g i m e o f i n f l a t i o n t a r g e t i n g , r e m a i n e d t o be d e t e r m i n e d .

The Operational Framework M o s t o f t h e o p e r a t i o n a l aspects o f N e w Zealand's i n f l a t i o n - t a r g e t i n g f r a m e w o r k are g o v e r n e d b y t h e P o l i c y Targets A g r e e m e n t s , w h i c h c o n ­ stitute t h e o n l y legal i m p l e m e n t a t i o n o f t h e Reserve B a n k o f N e w Z e a l a n d A c t o f 1989. T h e r e f o r m e r s w e r e faced w i t h t w o u n k n o w n s : first, w h e t h e r d o m e s t i c i n s t i t u t i o n a l c h a n g e a l o n e c o u l d d o m u c h t o take a s m a l l , natural-resource-based, o p e n e c o n o m y t o w a r d m a c r o e c o n o m i c stabil­ ity; a n d , second, w h e t h e r i t w o u l d b e possible t o e n l i s t a n d m a i n t a i n p u b l i c s u p p o r t f o r c o u n t e r - i n f l a t i o n a r y p o l i c i e s , s h o u l d these p o l i c i e s w o r k less w e l l at t h e outset t h a n was h o p e d . T o p r e p a r e t o d e a l w i t h those challenges, N e w Zealand's g o v e r n m e n t a n d c e n t r a l b a n k a d o p t e d f o r m a l , l e g a l m e a n s o f e n s u r i n g flexibility i n its n e w f r a m e w o r k f o r m o n ­ etary policy. T h e s e d e s i g n choices have m a d e i t possible f o r t h e Reserve B a n k t o i m p l e m e n t changes i n t a r g e t values a n d t i m e h o r i z o n s w h e n s u c h changes a p p e a r e d necessary, t h o u g h p e r h a p s at some sacrifice o f transparency a n d credibility. I n i t i a l l y , t h e g o a l o f p r i c e stability was d e f i n e d as a n a n n u a l rate o f i n f l a t i o n b e t w e e n zero a n d 2 % . T h e t a r g e t was i n t e n d e d t o b e a t r u e r a n g e , w i t h b o t h t h e floor a n d t h e c e i l i n g t o be t a k e n seriously, b u t w i t h n o special emphasis o n t h e m i d p o i n t . F o r e x a m p l e , i n S e p t e m b e r 1 9 9 1 , p o l i c y was eased t o a v o i d u n d e r s h o o t i n g t h e r a n g e , t h e i d e a b e i n g t o strengthen the public's p e r c e p t i o n that the bands o f the range were " h a r d " ( N i c h o l l a n d A r c h e r , 1992, p . 3 2 1 ) . H i t t i n g t h e 0 % t o 2 % t a r g e t was a n e x t r e m e l y a m b i t i o u s g o a l , g i v e n t h e narrowness o f t h e r a n g e a n d t h e fact t h a t t h e c e n t e r o f t h e r a n g e was so close t o zero. I n p r a c t i c e , t h e a c t u a l i n f l a t i o n rate has r e m a i n e d n e a r t h e t o p o f t h e r a n g e f o r m u c h o f t h e t i m e since targets w e r e a d o p t e d , a n d t h e p u b l i c has t e n d e d t o focus o n the 2% ceiling o f the target range, rather t h a n o n the 1 % m i d p o i n t o r t h e 0 % floor. U n l i k e S w i t z e r l a n d , a s m a l l , o p e n e c o n o m y t h a t chose n o t t o a d o p t a t a r g e t r a n g e i n o r d e r t o a v o i d c o n v e y i n g t h e i m p r e s s i o n t h a t its c o n t r o l o f i n f l a t i o n is precise, i n N e w Z e a l a n d t h e c e n t r a l b a n k i n i t i a l l y t r i e d t o d o w n p l a y t h e l i k e l i h o o d o f c o n t r o l p r o b l e m s . However, t h e r e a l i t y o f t h e i m p e r f e c t c o n t r o l l a b i l i t y o f i n f l a t i o n c o u l d n o t be a v o i d e d , a n d at t h e e n d o f 1996 t h e b a n d was w i d e n e d , f r o m 0 % t o 2 % t o 0 % t o 3 % .

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T h e r e has b e e n some a m b i g u i t y left i n t h e p o l i c y f r a m e w o r k a b o u t t h e c h o i c e o f p r i c e i n d e x f o r d e f i n i n g t h e i n f l a t i o n target. I n i t i a l l y , t h e d e c i s i o n was t o d e f i n e t h e i n f l a t i o n t a r g e t i n t e r m s o f t h e A l l G r o u p s , o r "headline", CPI because i t is the most widely known and the best understood index. . . . The above-zero rate o f inflation specified [as the target] reflects index number problems, the survey methodology, and the difficulty o f adjusting for new goods or for improvements i n quality. Effectively, a j u d g m e n t has been made that 1% CPI inflation is consistent with stability i n the general level o f prices. (Nicholl and Archer, 1992, p. 317) H o w e v e r , t h e first P T A a d m i t t e d t h a t t h e h e a d l i n e C P I "is n o t a n e n t i r e l y suitable measure o f [ t h e prices o f goods a n d services c u r r e n t l y c o n s u m e d by h o u s e h o l d s ] since i t also i n c o r p o r a t e s prices a n d s e r v i c i n g costs o f i n v e s t m e n t - r e l a t e d e x p e n d i t u r e s , " m o s t n o t a b l y prices o f e x i s t i n g d w e l l ­ ings. A n o t h e r p r o b l e m n o t e d at t h e t i m e was t h a t increases i n i n t e r e s t rates s h o w u p d i r e c t l y as increases i n t h e cost o f l i v i n g , as m e a s u r e d b y t h e all-items C P I , so t h a t a p o l i c y t i g h t e n i n g creates a n essentially s p u r i ­ ous rise i n m e a s u r e d i n f l a t i o n . S t i l l , t h e P T A c o n c l u d e d t h a t "the C P I w i l l , f o r p r a c t i c a l purposes, b e t h e m e a s u r e u s e d i n s e t t i n g t h e targets" ( S e c t i o n 2 ) . I n t h e " U n d e r l y i n g I n f l a t i o n " s e c t i o n o f its A u g u s t 1991 Monetary Policy Statement, t h e B a n k stated t h a t h e a d l i n e C P I "is t h e basic y a r d s t i c k against w h i c h t h e B a n k s h o u l d be assessed" (Reserve B a n k o f N e w Z e a l a n d , 1991c, A u g u s t , p . 1 7 ) . 3

D e s p i t e t h e o f f i c i a l r o l e o f t h e h e a d l i n e C P I , however, t h e Reserve B a n k has, i n p r a c t i c e , p a i d g r e a t e r a t t e n t i o n t o its m e a s u r e o f " u n d e r l y ­ i n g " o r "core" i n f l a t i o n ; t h a t is, i n f l a t i o n e x c l u d i n g relatively t e m p o r a r y i n f l u e n c e s o n t h e p r i c e level. As w i l l be seen i n t h e chapters t o c o m e , w h i l e every i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k has m a d e use o f s u c h a mea­ sure i n o n e way o r a n o t h e r , n o single d e f i n i t i o n o f u n d e r l y i n g i n f l a t i o n has b e e n u n i v e r s a l l y a d o p t e d . T h i s d i f f e r e n c e arises because t h e o p t i m a l d e f i n i t i o n o f u n d e r l y i n g i n f l a t i o n d e p e n d s t o some e x t e n t o n t h e struc­ t u r e o f t h e p a r t i c u l a r e c o n o m y a n d t h e types o f e c o n o m i c shocks t h a t i t faces. N o t i n g t h e i m p o r t a n c e o f h e a d l i n e C P I as a "yardstick" i n t h e q u o ­ t a t i o n c i t e d above, t h e Monetary Policy Statement w e n t o n t o m e n t i o n t h e Bank's emphasis i n t h e r e c e n t past o n c o n t r o l l i n g u n d e r l y i n g i n f l a t i o n . It then continued: Unfortunately, because the nature o f such shocks [transitory shocks to the price level] cannot be fully specified i n advance, and because the impact o f shocks can often n o t be measured precisely, i t is not possible to specify a

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single, comprehensive definition o f "underlying inflation." To some extent, interpretation o f the impact and significance o f the shocks is a matter o f j u d g m e n t , and hence requires clear explanations by the Bank to support any numerical estimates. (Reserve Bank o f New Zealand, 1991c, August, p. 19) I n other words, the measure o f u n d e r l y i n g inflation developed by the Reserve B a n k ( a n d w h i c h has b e e n r e p o r t e d r e g u l a r l y a l o n g s i d e h e a d ­ l i n e i n f l a t i o n b y t h e N e w Z e a l a n d press) is s o m e w h a t ad hoc i n its c o n ­ s t r u c t i o n . T h e i m p l i e d scope f o r j u d g m e n t i n t h e t a r g e t d e f i n i t i o n is u n i q u e t o t h e Reserve B a n k o f N e w Z e a l a n d a m o n g t h e c e n t r a l b a n k s t h a t we study i n this b o o k . O p e r a t i o n a l l y , t h e first-round effect o f i n t e r ­ est-rate changes o n prices is a u t o m a t i c a l l y e x c l u d e d i n a series p u b l i s h e d b y Statistics N e w Z e a l a n d ; t o this series, t h e B a n k makes a d d i t i o n a l ad­ j u s t m e n t s t h a t i t feels are w a r r a n t e d . T h e o v e r a l l effects o f these adjust­ m e n t s are n o t i n c o n s e q u e n t i a l ; t h e h e a d l i n e a n d u n d e r l y i n g i n f l a t i o n series have d i v e r g e d b y as m u c h as 2 p e r c e n t a g e p o i n t s a n d have occa­ sionally m o v e d i n opposite directions. T h e use o f u n d e r l y i n g i n f l a t i o n i n t h e t a r g e t i n g p r o c e d u r e is for­ m a l l y r e c o g n i z e d b y t h e P o l i c y Targets A g r e e m e n t s . E a c h o f t h e PTAs has i n c l u d e d a list o f shocks i n r e s p o n s e t o w h i c h t h e B a n k is r e q u i r e d to "generally r e a c t . . . i n a m a n n e r w h i c h prevents general i n f l a t i o n a r y pressures [ f r o m ] e m e r g i n g " ( S e c t i o n 3 ) . I n o t h e r w o r d s , t h e PTAs have escape clauses t h a t a l l o w t h e Reserve B a n k t o a c c o m m o d a t e first-round effects o f c e r t a i n shocks o n p r i c e s , b u t t h a t r e q u i r e p o l i c y t o t r y t o p r e v e n t these t r a n s i t o r y p r i c e c h a n g e s f r o m b e i n g i n c o r p o r a t e d i n t o wage- a n d price-setters' e x p e c t a t i o n s a n d h e n c e i n t o t r e n d i n f l a t i o n ( " s e c o n d - r o u n d effects"). T h e " c o v e r e d " shocks l i s t e d i n t h e PTAs i n ­ clude: 4

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A m o v e m e n t i n i n t e r e s t rates t h a t causes a s i g n i f i c a n t diver­ gence between the change i n the C P I a n d the change i n the C P I e x c l u d i n g t h e i n t e r e s t rates c o m p o n e n t . T h i s clause, w h i c h appears i n t h e t h i r d P T A , r e p l a c e d a n e a r l i e r clause t h a t specified a s i g n i f i c a n t d i v e r g e n c e b e t w e e n t h e C P I a n d a p r i c e i n d e x t r e a t i n g h o u s i n g costs o n a n i n t e r n a t i o n a l l y c o m ­ p a r a b l e basis.

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S i g n i f i c a n t changes i n t h e t e r m s o f t r a d e ( a r i s i n g f r o m a n increase o r a decrease i n e i t h e r i m p o r t o r e x p o r t p r i c e s ) .

•

A n increase o r a decrease i n t h e r a t e o f t h e goods-and-services t a x ( G S T ) , o r a s i g n i f i c a n t c h a n g e i n o t h e r i n d i r e c t taxes.

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A n e c o n o m i c crisis, i n d u c e d b y factors s u c h as a n a t u r a l d i ­ saster o r a m a j o r livestock e p i d e m i c , t h a t is e x p e c t e d t o have a s i g n i f i c a n t i m p a c t o n t h e p r i c e level. Changes i n g o v e r n m e n t o r l o c a l - a u t h o r i t y tax levies t h a t sig­ n i f i c a n t l y affect t h e p r i c e level.

As we have n o t e d , t h e B a n k has consistently e x c l u d e d f r o m its mea­ sure o f u n d e r l y i n g i n f l a t i o n t h e effect o f interest-rate changes o n m o r t ­ gage a n d c r e d i t charges ( r e l y i n g o n a p r i c e series f r o m Statistics N e w Z e a l a n d ) . I t has also e x c l u d e d t h e d i r e c t effects o f changes i n i n d i r e c t taxes a n d i n g o v e r n m e n t a n d l o c a l a u t h o r i t y levies w h e n t h e i m p a c t o f such changes o n t h e C P I was j u d g e d t o be s i g n i f i c a n t ( d e f i n e d as a n i m p a c t o f at least 0.25% i n any t w e l v e - m o n t h p e r i o d ) . O f course, this d e f i n i t i o n o f significance r e q u i r e s some decisions a b o u t m o d e l i n g tax effects, a n d t h e B a n k has c h o s e n o n l y t o r e s p o n d t o those t a x changes t h a t were c l e a r l y d r i v e n b y p o l i c y decisions. T h e natural-disaster escape clause has so far n o t b e e n i n v o k e d . T h e terms-of-trade escape clause, however, has b e e n a p p l i e d f o r e x t e n d e d p e r i o d s i n t h e d i s c r e t i o n a r y m a n n e r a l l o w e d f o r i n t h e PTAs: Twice, i n 1990-91 a n d i n 1994, o i l p r i c e changes w e r e e x c l u d e d f r o m t h e c a l c u l a t i o n o f u n d e r l y i n g i n f l a t i o n , a n d t i m b e r prices w e r e e x c l u d e d t h r o u g h o u t 1993-94. 5

A n i m p o r t a n t d r a w b a c k o f u s i n g adjustments i n t h e t a r g e t d e f i n i t i o n to d e t e r m i n e w h i c h shocks p o l i c y s h o u l d offset a n d w h i c h i t s h o u l d ac­ c o m m o d a t e , as o p p o s e d t o e x p l a i n i n g d i r e c t l y t o t h e p u b l i c w h y specific p o l i c y actions are b e i n g t a k e n o r n o t t a k e n , is t h a t i t m a y r e d u c e t h e t r a n s p a r e n c y a n d c r e d i b i l i t y o f policy. I t is t h e B a n k itself, after a l l , t h a t decides w h e t h e r a g i v e n s h o c k has a " s i g n i f i c a n t " i m p a c t o n t h e p r i c e level. Since outsiders, say i n financial m a r k e t s , c a n n o t r e p r o d u c e t h e B a n k ' s j u d g m e n t a l estimates o f u n d e r l y i n g i n f l a t i o n , a n i m p o r t a n t p a r t o f t h e p o l i c y d e c i s i o n process b e c o m e s o b s c u r e d . P o t e n t i a l l y , this prac­ tice u n d e r m i n e s t h e p e r c e i v e d i m p a r t i a l i t y o f t h e e n t i r e m e c h a n i s m . T h i s p r o b l e m seems less l i k e l y t o arise w h e n t h e d i s c r e t i o n t h a t is exer­ cised is o p e n l y discussed a n d e x p l a i n e d , t h o u g h o f course c r i t i c i s m s o f p a r t i c u l a r p o l i c y decisions w i l l r e m a i n . T h e r e are o t h e r c o n c e r n s as w e l l : T h e fact t h a t u n d e r l y i n g i n f l a t i o n is n o t d e f i n e d as a c o n t i n u o u s series, b u t r a t h e r as a series whose c o m p o s i ­ t i o n changes at i r r e g u l a r i n t e r v a l s , has l e d t o some c o n f u s i o n . M o r e o v e r , t h e t i m i n g o f t h e PTAs themselves—and t h e r e f o r e o f t h e a n n o u n c e m e n t o f t h e i n f l a t i o n target, h o w e v e r d e f i n e d — i s a r b i t r a r y . F o r e x a m p l e , t h e first P T A lasted o n l y six m o n t h s , b u t t h e m o s t r e c e n t is t o last i n d e f i 6

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nitely. F u r t h e r , g i v e n t h e r e c e n t shift t o o p e n - e n d e d targets, t h e PTAs are n o t t i e d t o e i t h e r the e l e c t o r a l cycle o r t o t h e c u r r e n t p a r l i a m e n t a r y ma­ j o r i t y . N o r are they i n s u l a t e d f r o m changes i n the e l e c t o r a l cycle o r i n t h e m a k e - u p o f P a r l i a m e n t . A n e w g o v e r n m e n t c o u l d renegotiate w i t h t h e B a n k i f i t so desired. We w i l l discuss a n actual episode o f this type below. O n t h e o t h e r h a n d , a t t e n t i o n t o some type o f u n d e r l y i n g i n f l a t i o n series i n s h o r t - r u n p o l i c y - m a k i n g appears p a r t i c u l a r l y useful f o r a s m a l l , o p e n e c o n o m y l i k e t h a t i n N e w Z e a l a n d ( a s s u m i n g t h e j u d g m e n t a l as­ pects o f t h e series d e f i n i t i o n are n o t excessive). W i t h o u t t h e terms-oft r a d e p r o v i s i o n i n t h e PTAs ( w h i c h p e r m i t s e x c l u s i o n o f t h e first-round effects o f exchange-rate changes o n p r i c e s ) , f o r e x a m p l e , i t is h a r d t o see h o w m o n e t a r y p o l i c y c o u l d l i m i t v a r i a t i o n s i n i n f l a t i o n t o a n a r r o w r a n g e w i t h o u t c a u s i n g severe d i s r u p t i o n i n r e a l e c o n o m i c activity. T h e s e escape clauses are m e a n t t o b a l a n c e t h e Reserve Bank's i n f l a t i o n g o a l w i t h o t h e r goals, p a r t i c u l a r l y s h o r t - r u n s t a b i l i z a t i o n o f r e a l o u t p u t a n d e m p l o y m e n t , i n t h e face o f s u p p l y shocks: [As a] detailed examination of what has been written about the caveats makes clear, the fundamental rationale for the caveats is that, i n certain specified circumstances, the Reserve Bank should be paying attention to consequences for variables such as output and employment rather than concentrating singlemindedly o n the inflation rate. (Bryant, 1996, p. 24) Officially, t h e A c t o f 1989 d i d n o t m a n d a t e objectives o t h e r t h a n p r i c e stability, a n d i t o n l y a d m i t t e d s u p p l y shocks e x p l i c i t l y as a j u s t i f i c a t i o n f o r d e v i a t i n g f r o m t h e price-stability g o a l . Five reasons w e r e g i v e n f o r t h i s n a r r o w focus: First, m o n e t a r y p o l i c y affects i n f l a t i o n o n l y i n t h e l o n g r u n . S e c o n d , because m o n e t a r y p o l i c y is o n l y o n e i n s t r u m e n t , i t c a n d e a l w i t h o n l y o n e g o a l at a t i m e . T h i r d , m u l t i p l e objectives a l l o w p o l i c y t o c h a n g e i n ways t h a t m a y a p p e a r a r b i t r a r y , t h e r e b y l o w e r i n g c r e d i b i l i t y a n d r a i s i n g i n f l a t i o n a r y expectations. F o u r t h , t o r e q u i r e t h e Reserve B a n k to c o o p e r a t e w i t h g o v e r n m e n t agencies o n objectives such as e m p l o y ­ m e n t s t a b i l i z a t i o n w o u l d c o m p r o m i s e its a u t o n o m y . F i f t h , m u l t i p l e o b ­ j e c t i v e s r e d u c e t r a n s p a r e n c y a n d a c c o u n t a b i l i t y , because p o o r p e r f o r ­ m a n c e o n , say, t h e p r i c e s t a b i l i t y f r o n t m i g h t be a t t r i b u t e d t o t h e o b l i g a ­ tion to p u r s u e o t h e r goals (e.g., see L l o y d , 1 9 9 2 ) . A g a i n , t h e e x p l i c i t escape clauses w e r e t h e o n l y e x c e p t i o n s t o t h e single-goal p h i l o s o p h y . H o w e v e r , t h e y have h a d t h e effect o f i n c r e a s i n g s h o r t - r u n p o l i c y flexibil­ ity a n d a l l o w i n g m o n e t a r y p o l i c y t o a c c o m m o d a t e o t h e r goals besides l o n g - r u n p r i c e stability. W h e n e v e r a n i n f l a t i o n g o a l b e l o w c u r r e n t i n f l a t i o n levels is t o be a c h i e v e d w i t h i n a specified t i m e h o r i z o n , t h e r e q u i r e d d i s i n f l a t i o n a r y

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t r a j e c t o r y i m p l i e s a j u d g m e n t a b o u t w h a t r e a l e c o n o m i c costs are ac­ ceptable t o achieve t h e r e d u c t i o n i n i n f l a t i o n . T h i s is, o f course, i n h e r ­ e n t l y a p o l i t i c a l d e c i s i o n , w h i c h is w h y t h e c h o i c e i n N e w Z e a l a n d was n o t left solely t o t h e Reserve B a n k , b u t was e m b o d i e d i n t h e PTAs. B o t h t h e first a n d t h e s e c o n d PTAs envisaged a g r a d u a l t r a n s i t i o n t o p r i c e stability over t h e t h r e e years f o l l o w i n g t h e i r s i g n i n g , a n d b o t h c a l l e d o n t h e B a n k t o " p u b l i s h a p r o j e c t e d p a t h f o r i n f l a t i o n f o r each o f t h e years u n t i l p r i c e stability is a c h i e v e d " ( S e c t i o n 5 b ) . The initial Policy Targets Agreement signed i n March 1990 called for achieve­ ment o f 0-2% inflation by December 1992 and maintenance o f price stability thereafter. Partly as a result o f a view that the output and employment costs of the speed o f adjustment implicit i n this time frame were too high, the new government elected i n October 1990 deferred the target date by one year. (Nicholl and Archer 1992, p. 317) 7

Clearly, t h e Reserve B a n k o f N e w Z e a l a n d u n d e r t h e 1989 A c t was d e s i g n e d t o o p e r a t e as a relatively " r u l e - o r i e n t e d " c e n t r a l b a n k . N o t i c e t h e c o n t r a s t b e t w e e n t h e PTA-based f r a m e w o r k i n N e w Z e a l a n d a n d t h e policy framework i n Germany: Rather t h a n seeking an agreement w i t h t h e g o v e r n m e n t , t h e B u n d e s b a n k takes t h e f u l l r e s p o n s i b i l i t y f o r deter­ m i n i n g t h e speed o f any necessary d i s i n f l a t i o n , t h e n j u s t i f i e s t h e p r o ­ jected disinflation path directly to the public. I n t h e t i m e since t h e first P o l i c y T a r g e t s A g r e e m e n t was s i g n e d , t h e Reserve B a n k has t a k e n p a i n s t o e m p h a s i z e t h a t t h e l i n k b e t w e e n t h e r e a l e c o n o m y a n d m o n e t a r y p o l i c y s t i l l exists i n t h e s h o r t r u n , a n d t h a t d e t e r m i n i n g t h e s p e e d o f d i s i n f l a t i o n is t h e g o v e r n m e n t ' s c h o i c e ( a n d n o t t h e B a n k ' s ) . I n t h e w o r d s o f t h e Reserve B a n k ' s o w n leadership: 8

I t should be emphasized, however, that the single price stability objective embodied i n the Act does n o t mean that monetary policy is divorced from consideration o f the real economy. A t the technical level, the state o f the real economy is an i m p o r t a n t component o f any assessment o f the strength o f inflationary pressures. More importantly, inflation/real economy trade-offs may need to be made o n occasion, particularly i n the context o f a decision about the pace o f disinflation. . . . The main trade-offs are essentially politi­ cal ones, and i t is appropriate that they be made clearly at the political level. The framework allows trade-offs i n areas such as the pace o f disinflation, or the width o f target inflation ranges, to be reflected i n the PTA with the Gov­ ernor. The override provision can also be used, i f required, to reflect a policy trade-off. (Lloyd 1992, p. 210) 9

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I n J u n e 1997, t h e Reserve B a n k c h a n g e d t w o aspects o f t h e way i n w h i c h i t expresses its i n t e n d e d stance o f m o n e t a r y policy. T h e first c h a n g e was s u p p o s e d t o clarify t h e n e t effect o n f u t u r e i n f l a t i o n o f changes i n t h e e x c h a n g e rate, t a k i n g m o n e t a r y p o l i c y as g i v e n . As discussed i n t h e t h i r d s e c t i o n o f this chapter, t h e Reserve B a n k h a d always a c c o r d e d ex­ c h a n g e rate m o v e m e n t s a p r o m i n e n t place i n its discussions, a n d h a d r e s p o n d e d t o e x c h a n g e rate f l u c t u a t i o n s t o some e x t e n t b y a d j u s t i n g d o m e s t i c m o n e y - m a r k e t i n t e r e s t rates. T h i s was a b i t c o n f u s i n g , h o w ­ ever, because as l o n g as t h e Reserve B a n k h a d n o t s p e c i f i e d t h e d e g r e e t o w h i c h i t v i e w e d changes i n s h o r t - t e r m i n t e r e s t rates a n d t h e e x c h a n g e rate as substitutes, i t was u n c l e a r w h e t h e r t h e e x c h a n g e rate e n t e r e d p o l i c y decisions as a d e t e r m i n a n t o f f u t u r e i n f l a t i o n o r as a g o a l u n t o itself. Since b o t h i n t e r e s t rates a n d e x c h a n g e rates d o affect f u t u r e i n f l a ­ t i o n , a n d t h e f o r m e r c a n d i r e c t l y i n f l u e n c e t h e l a t t e r as w e l l , t h e a c t u a l i m p a c t o f any m o n e t a r y p o l i c y m o v e r e q u i r e s t a k i n g exchange-rate feed­ back i n t o account. I n response, b e g i n n i n g i n late 1996 t h e Reserve B a n k c o n s t r u c t e d a n d e x p l a i n e d i n several p u b l i c a t i o n s t h e use o f a m o n e t a r y c o n d i t i o n s i n d e x ( M C I ) as a m e a n s t o assess t h e o v e r a l l stance o f m o n e t a r y p o l i c y . As w i l l be seen i n C h a p t e r 6, t h e B a n k o f C a n a d a was t h e first t o d e v e l o p this i n d i c a t o r o f m o n e t a r y p o l i c y stance, a n d t h e Reserve B a n k f o l l o w e d its l e a d . I n N e w Z e a l a n d , t h e M C I is c o n s t r u c t e d as a 1:2 w e i g h t e d aver­ age o f t h e t r a d e - w e i g h t e d e x c h a n g e rate a n d t h e 90-day i n t e r e s t rate. T h i s w e i g h t i n g reflects t h e relative i m p a c t o f a m o v e i n e x c h a n g e rates o n i n f l a t i o n versus a m o v e i n i n t e r e s t rates (i.e., a 2 % rise i n t h e ex­ c h a n g e rate is e s t i m a t e d t o have t h e same effect o n f u t u r e i n f l a t i o n as a 100 basis p o i n t , o r o n e p e r c e n t a g e p o i n t , rise i n t h e i n t e r e s t r a t e ) . T h i s r a t i o underscores h o w i m p o r t a n t t h e exchange rate is t o t h e N e w Z e a l a n d e c o n o m y , since o t h e r c o u n t r i e s w h i c h have c r e a t e d s u c h i n d i c e s have f o u n d t h a t i t takes 3 o r 4 times as m u c h m o v e m e n t i n e x c h a n g e rates t o be e q u i v a l e n t t o a 1 % rise i n i n t e r e s t rates. Since J u n e 1997, t h e Reserve B a n k has p u b l i s h e d a forecast o f this M C I t o i n d i c a t e t h e p a t h o f m o n ­ etary p o l i c y f o r t h e n e x t t h r e e years i f c o n d i t i o n s r e m a i n u n c h a n g e d . T h e second change i n t h e expression o f p o l i c y h a d t o d o w i t h t h e Re­ serve Bank's m e d i u m - t e r m p r o j e c t i o n s f o r i n f l a t i o n . B e f o r e 1997, these h a d b e e n d e r i v e d u n d e r t h e a s s u m p t i o n o f a n u n c h a n g e d 90-day i n t e r e s t rate ( w h i c h h a d served as t h e defacto i n s t r u m e n t o f m o n e t a r y p o l i c y ) , as w e l l as changes i n t h e trade-weighted exchange rate i n l i n e w i t h t h e ( p r o ­ j e c t e d ) d i f f e r e n t i a l b e t w e e n i n f l a t i o n rates i n N e w Z e a l a n d a n d those o f its m a i n t r a d i n g p a r t n e r s . Occasionally, t h e i n f l a t i o n forecast d e r i v e d u n d e r these assumptions d i d n o t c o i n c i d e w i t h t h e m i d p o i n t o f t h e t a r g e t 10

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range, m e a n i n g t h a t the assumptions o n m o n e t a r y c o n d i t i o n s u n d e r w h i c h t h e forecast was d e r i v e d were i n c o m p a t i b l e w i t h t h e target, a n d w o u l d t h e r e f o r e have t o be c h a n g e d . I n o r d e r t o a v o i d this inconsistency be­ t w e e n t h e Reserve Bank's actual b e h a v i o r a n d t h a t assumed i n its i n f l a t i o n p r o j e c t i o n , since J u n e 1997, t h e p r o j e c t i o n has b e e n g e n e r a t e d u n d e r t h e a s s u m p t i o n t h a t d u r i n g t h e forecast h o r i z o n , t h e Reserve B a n k w i l l adjust m o n e t a r y c o n d i t i o n s (as d e f i n e d by t h e M C I ) such t h a t t h e i n f l a t i o n p r o ­ j e c t i o n converges o n t h e target m i d p o i n t b y t h e e n d o f t h e h o r i z o n . Beyond considerations o f o u t p u t a n d e m p l o y m e n t stabilization, the Reserve B a n k acknowledges t h a t f i n a n c i a l stability is also a n a p p r o p r i a t e s h o r t - r u n objective o f m o n e t a r y p o l i c y . " T h e B a n k n o w has effective i n d e p e n d e n c e t o i m p l e m e n t m o n e t a r y p o l i c y i n p u r s u i t o f its s t a t u t o r y objective, w i t h o u t l i m i t a t i o n s o n t h e t e c h n i q u e e x c e p t t h a t t h e choices m a d e m u s t 'have r e g a r d t o t h e efficiency a n d soundness o f t h e f i n a n c i a l system'" ( N i c h o l l a n d A r c h e r , 1992, p . 3 1 6 ) . 11

I n short, N e w Zealand—although probably the most extreme o f all t h e i n f l a t i o n - t a r g e t i n g c o u n t r i e s i n its use o f f o r m a l i n s t i t u t i o n a l c o n ­ straints o n m o n e t a r y p o l i c y — i s n o t as c o n s t r a i n e d o r as s i n g l e - m i n d e d i n its p u r s u i t o f p r i c e stability as some w o u l d have i t . 1 2

N e v e r since targets w e r e a d o p t e d has t h e Reserve B a n k assigned t h e status o f i n t e r m e d i a t e t a r g e t t o any v a r i a b l e e x c e p t t h e i n f l a t i o n t a r g e t itself. I n t h i s respect N e w Z e a l a n d d e v i a t e d s i g n i f i c a n t l y f r o m t h e prac­ tice o f G e r m a n y a n d S w i t z e r l a n d , w h o at least i n t h e i r r h e t o r i c have used m o n e y - g r o w t h t a r g e t i n g as a n i n t e r m e d i a t e step t o a c h i e v i n g t h e i r i n f l a ­ t i o n goals (see C h a p t e r 4 ) . T h e reasons f o r n o t e m p l o y i n g a n i n t e r m e d i ­ ate t a r g e t are l a r g e l y p r a c t i c a l ones: The j u d g m e n t to date has been that a target specified i n terms o f the final inflation objective (suitably defined) is preferable to an intermediate mon­ etary aggregate target, mainly because empirical work had n o t been able to identify any particular money aggregate which demonstrated a sufficiently close relationship with n o m i n a l income growth and inflation. (Lloyd, 1992, p. 213) R e f l e c t i n g t h i s j u d g m e n t , t h e Reserve B a n k has consistently assigned l o w w e i g h t t o m o n e y ( a n d c r e d i t ) aggregates even as i n f o r m a t i o n variables (variables useful i n j u d g i n g t h e state o f t h e e c o n o m y b u t n o t u s e d as targets perse). I n a t t e m p t i n g t o assess t h e state o f t h e e c o n o m y , t h e B a n k , a c c o r d i n g t o its p u b l i c statements, has i n s t e a d p a i d t h e m o s t a t t e n t i o n t o t h e t r a d e - w e i g h t e d e x c h a n g e rate a n d t h e level a n d slope o f t h e y i e l d curve (the relationship between b o n d maturities a n d b o n d yields), a m o n g o t h e r variables:

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I n b u i l d i n g its forecasts o f inflation pressures, the Bank has, over the last year or so, taken increasing account o f the role o f interest rates. Over the years, a better sense has emerged o f the strength o f the interest rate effect o n demand, and hence inflation. . . . Short-term interest rate developments are now playing a greater role i n the implementation o f policy between formal forecast reviews, alongside the p r o m i n e n t role played by the exchange rate. (Reserve Bank o f New Zealand, 1995c, December, p. 8) As we n o t e d , t h e Reserve B a n k has r e c e n t l y m a d e extensive use o f its m o n e t a r y conditions i n d e x . T h e yield curve (the relationship between i n t e r e s t rates a n d b o n d m a t u r i t i e s ) has also b e e n i m p o r t a n t i n t h e Bank's analyses. T h e B a n k seems t o use t h e y i e l d curve as a m e a n s o f assessing t h e stance o r effect o f m o n e t a r y policy, w i t h a n i n v e r t e d y i e l d c u r v e sig­ n a l i n g t i g h t e r policy, r a t h e r t h a n as a way o f i n f e r r i n g a n i m p l i c i t , mar­ ket-based i n f l a t i o n forecast. I n J u n e 1987, w e l l before t h e t a r g e t - a d o p t i o n a n n o u n c e m e n t , t h e B a n k s t a r t e d t o c o n d u c t q u a r t e r l y surveys o f t h e e x p e c t a t i o n s o f businesses a n d h o u s e h o l d s c o n c e r n i n g a n u m b e r o f e c o n o m i c variables, i n c l u d i n g i n f l a t i o n , a n d i t has r e g u l a r l y r e p o r t e d o n t h e i n f l a t i o n e x p e c t a t i o n s re­ p o r t e d i n these a n d o t h e r surveys. Since t h e n , t h e Reserve B a n k has i n v e s t e d a great d e a l o f e f f o r t i n a survey t h a t covers t e n m a c r o e c o n o m i c variables a n d draws t h e m a j o r i t y o f its r e s p o n d e n t s f r o m t h e financial a n d business sectors. Q u e s t i o n s a n d responses f r o m t h e survey are p u b ­ l i s h e d i n t h e B a n k ' s Bulletin. T h e B a n k a t t e m p t s t o m e a s u r e u n c e r t a i n t y a b o u t f u t u r e i n f l a t i o n ( w h i c h i t does b y m e a s u r i n g t h e d i s p e r s i o n o f re­ p o r t e d i n f l a t i o n e x p e c t a t i o n s ) , as w e l l as t h e m e a n level o f e x p e c t e d i n ­ flation (Fischer a n d O r r , 1994, p . 1 6 2 ) . A l l t h e i n f l a t i o n - r e l a t e d d a t a i t e m s a n d forecasts are a s s e m b l e d a n d are m a d e available t o t h e p u b l i c . S e c t i o n 15 o f t h e Reserve B a n k o f N e w Z e a l a n d A c t o f 1989 r e q u i r e s t h e B a n k t o p r o d u c e , at least every six m o n t h s , a p o l i c y s t a t e m e n t t h a t ( 1 ) reviews t h e m o n e t a r y p o l i c y o f t h e p r e c e d i n g six m o n t h s a n d ( 2 ) o u t l i n e s h o w m o n e t a r y p o l i c y is t o b e i m p l e m e n t e d o v e r t h e n e x t six m o n t h s , i n a m a n n e r c o n s i s t e n t w i t h t h e B a n k ' s stated i n f l a t i o n o b j e c t i v e . T h e s e Monetary Policy Statements are s u b m i t t e d t o P a r l i a m e n t a n d m a y be discussed b y a p a r l i a m e n t a r y select c o m m i t t e e . They must review the implementation o f monetary policy over the p e r i o d since the last Statement, and detail the policies and means by which mon­ etary policy will be directed towards price stability i n the coming periods. The reasons for adopting the specified policies must also be given. The an­ nual report provides a vehicle for accountability and m o n i t o r i n g o f the Bank

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as a whole (not just i n terms o f monetary policy). This is also tabled i n Parlia­ ment. The Governor a n d / o r Deputy Governors are questioned by the Parlia­ mentary Select Committee for Finance and Expenditure o n b o t h the M o n ­ etary Policy Statements and the annual reports. (Lloyd, 1992, p . 214) I n a d d i t i o n t o t h e Annual Report, t h e Reserve B a n k p u b l i s h e s t h e Re­ serve Bank of New Zealand Bulletin, w h i c h contains t o p i c a l articles, r e p r i n t e d speeches, a n d official statements. Since t h e Reserve B a n k o f N e w Z e a l a n d A c t o f 1989, m o s t o f t h e articles i n t h e Bulletin have b e e n s i g n e d , a prac­ tice t h a t encourages g r e a t e r a c c o u n t a b i l i t y a n d m o r e o p e n discussion. However, o n e m a j o r l i m i t a t i o n o n t h e f l o w o f i n f o r m a t i o n is t h a t i n f l a ­ t i o n d a t a are c o l l e c t e d a n d r e p o r t e d o n a q u a r t e r l y basis r a t h e r t h a n o n a m o n t h l y basis. I t is n o t clear w h e t h e r this u n u s u a l ( f r o m a n i n t e r n a ­ t i o n a l perspective) p r a c t i c e reflects i n h e r e n t d a t a l i m i t a t i o n s i n t h e N e w Z e a l a n d c o n t e x t o r w h e t h e r i t has t h e t a c t i c a l p u r p o s e o f de-emphasiz­ i n g s h o r t - t e r m "noise" i n t h e i n f l a t i o n rate ( a n d t h e c o n s e q u e n t reac­ t i o n s by t h e financial m a r k e t s ) . T h e r e has b e e n some t e n d e n c y to r e g a r d t h e Reserve Bank's legal sta­ tus a n d degree o f i n d e p e n d e n c e as similar t o those o f t h e B u n d e s b a n k o r the Federal Reserve System. Actually, the Reserve B a n k o f N e w Z e a l a n d a n d its g o v e r n o r face a m u c h d i f f e r e n t s i t u a t i o n t h a n d o those o t h e r cen­ t r a l banks. " T h i s is n o t i n d e p e n d e n c e as t h e B u n d e s b a n k w o u l d u n d e r ­ stand i t , since t h e target is t o be set by t h e g o v e r n m e n t a n d t h e B a n k is responsible t o t h e g o v e r n m e n t f o r a c h i e v i n g i t . T h e B a n k is a n agent, n o t a p r i n c i p a l " (Easton, 1994, p . 8 6 ) . P u t a n o t h e r way, w h i l e t h e G e r m a n a n d t h e N e w Z e a l a n d c e n t r a l banks share a similar goal, s i m i l a r l y d e f i n e d , t h e B u n d e s b a n k is a t r u s t e d ( a n d o n l y i n f o r m a l l y o r v o l u n t a r i l y accountable) i n s t i t u t i o n . T h e Reserve B a n k o f N e w Z e a l a n d , however, is a n agency o f t h e g o v e r n m e n t a n d is h e l d r e g u l a r l y t o account. T h i s difference i n insti­ t u t i o n a l design is neatly c a p t u r e d by D e b e l l e a n d Fischer's (1994) distinc­ t i o n b e t w e e n "goal i n d e p e n d e n c e " (enjoyed by t h e B u n d e s b a n k ) a n d " i n ­ s t r u m e n t i n d e p e n d e n c e " ( t h e l o t o f t h e Reserve B a n k ) . P h i l o s o p h i c a l as m u c h as p r a c t i c a l reasons u n d e r l a y this design choice: The New Zealand reforms were motivated partly by orthodox economics and the desire to apply its precepts to government. However, they were also influ­ enced by the political "New Right," which, o n philosophical grounds, sought a smaller role for the public sector than perhaps could bejustified from con­ ventional economic theory alone. (Easton 1994, p. 78) I n a d d i t i o n , t i g h t e r c o n s t r a i n t s o n t h e Reserve B a n k m a y have b e e n t h o u g h t necessary because o f t h e p o o r p e r f o r m a n c e o f N e w Zealand's

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m o n e t a r y p o l i c y i n t h e past a n d t h e w e a k e r p u b l i c s u p p o r t f o r l o w i n f l a ­ t i o n . T h e i m p l i c a t i o n f o r N e w Z e a l a n d m o n e t a r y p o l i c y i n p r a c t i c e is t h a t t h e r e is relatively l i t t l e exercise o f d i s c r e t i o n i n t h e s h o r t r u n b y t h e B a n k , e x c e p t as a l l o w e d by t h e caveats i n t h e PTAs. M o r e o v e r , even t h a t l i m i t e d d i s c r e t i o n m u s t be f o l l o w e d after t h e fact by f o r m a l c o m m u n i c a ­ t i o n s w i t h t h e g o v e r n m e n t . A c c o r d i n g l y , a l t h o u g h those c o m m u n i c a t i o n s are p u b l i s h e d i n t h e Monetary Policy Statement, a n d are also c o n v e y e d t o t h e p u b l i c i n a n active c o m m u n i c a t i o n p r o g r a m b y t h e B a n k , t h e rela­ tive r o l e p l a y e d b y d i r e c t c o m m u n i c a t i o n w i t h t h e p u b l i c is c o n s i d e r a b l y less i n N e w Z e a l a n d t h a n i n c o u n t r i e s i n w h i c h t h e c e n t r a l b a n k has greater discretion. I n N e w Zealand, the support o f the g o v e r n m e n t f o r t h e Reserve B a n k ' s decisions, r a t h e r t h a n t h e Reserve Bank's e x p l a n a ­ t i o n s t o t h e p u b l i c , is t h e p r i n c i p a l source o f p o l i c y flexibility.

New Zealand Monetary Policy under Inflation Targeting I n this section we s u m m a r i z e t h e h i s t o r y o f N e w Zealand's m o n e t a r y p o l i c y i n t h e 1990s. W e have d r a w n h e a v i l y t h e Bank's Monetary Policy Statement, t h e OECD Economic Reports, a n d v a r i o u s newspaper accounts. F i g u r e 5.1 is a g r a p h i c a l s u m m a r y o f r e c e n t m a c r o e c o n o m i c d e v e l o p ­ m e n t s i n N e w Z e a l a n d . Panels A - D o f t h e figure show t h e p a t h s o f i n f l a ­ t i o n , i n t e r e s t rates, G D P g r o w t h , u n e m p l o y m e n t , a n d t h e e x c h a n g e rate b o t h b e f o r e a n d after t h e c o m m e n c e m e n t o f i n f l a t i o n t a r g e t i n g . I t is useful t o view t h e p e r i o d since N e w Zealand's a d o p t i o n o f i n f l a t i o n tar­ g e t i n g as b e i n g m a d e u p o f t h r e e p r i n c i p a l episodes. T h e first episode, f r o m t a r g e t a d o p t i o n i n M a r c h 1990 t o M a r c h 1992, was a p e r i o d o f d i s i n f l a t i o n a n d w e a k r e a l e c o n o m i c p e r f o r m a n c e . I t was characterized by a d r o p i n i n f l a t i o n to w i t h i n the 0% to 2 % range, inter­ est rates t h a t w e r e i n i t i a l l y h i g h b u t l a t e r f e l l rapidly, a g r a d u a l d e p r e c i a ­ t i o n i n t h e e x c h a n g e rate, negative G D P g r o w t h , a n d r i s i n g u n e m p l o y ­ ment. T h e s e c o n d episode, f r o m t h e s e c o n d q u a r t e r o f 1992 t h r o u g h t h e first q u a r t e r o f 1994, was o n e o f recovery. I n f l a t i o n fluctuated w i t h i n t h e u p p e r h a l f o f t h e 0 t o 2 % r a n g e , i n t e r e s t rates c o n t i n u e d t o f a l l , t h e e x c h a n g e rate a p p r e c i a t e d , G D P g r o w t h rose sharply, a n d u n e m p l o y ­ m e n t d e c l i n e d at a m o d e r a t e pace. T h e t h i r d episode, s p a n n i n g t h e years 1994 t o 1997, w i l l engage m o s t o f o u r a t t e n t i o n here. These years saw the greatest challenges t h a t the Re­ serve B a n k h a d faced since t h e a d o p t i o n o f i n f l a t i o n targets. T h e p e r i o d f o l l o w i n g t h e second q u a r t e r o f 1994 was o n e o f rising i n f l a t i o n a n d i n t e r -

1984

1986

1988 1 9 9 0

1992

1996

Rate

1994

1998

Inflation a n d Targets

C. G D P G r o w t h a n d U n e m p l o y m e n t

1982

Underlying a n d Headline

1984

1986 D. N o m i n a l

1982

1990

1992

Rate

1996

Rates

1994

Interest

Effective Exchange

1988

B. D i s c o u n t a n d L o n g — T e r m

Figure 5.1 New Zealand economic indicators. Sources: A ) Reserve Bank o f New Zealand; B) International Financial Statistics of the International Monetary Fund; C) Reserve Bank of New Zealand, Main economic indicators o f the Organisation for Economic Cooperation and Development; D) Bank for International Settle­ ments database.

A.

1998

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est rates, c o n t i n u e d a p p r e c i a t i o n o f the exchange rate, sustained G D P g r o w t h , a n d rapidly falling u n e m p l o y m e n t . D u r i n g that p e r i o d , the i n f l a t i o n target was b r e a c h e d twice briefly a n d was reset as the result o f a n e l e c t i o n . T h e first episode begins w i t h t h e first Policy Targets A g r e e m e n t , s i g n e d o n M a r c h 2, 1990. T h i s P T A s t i p u l a t e d t h a t p r i c e stability, d e f i n e d as a n n u a l i n f l a t i o n w i t h i n t h e 0 t o 2 % r a n g e , was t o be a c h i e v e d b y t h e year e n d i n g D e c e m b e r 1992. T h e P T A also r e q u i r e d t h a t each Monetary Policy Statementreleased by the B a n k s h o u l d contain a projected p a t h for infla­ t i o n over t h e f o l l o w i n g five years. T h e first M o n e t a r y Policy S t a t e m e n t , released i n A p r i l 1990, specified t h a t a 3% t o 5% target r a n g e be a c h i e v e d by D e c e m b e r 1990, a 1.5% t o 3.5% r a n g e by D e c e m b e r 1 9 9 1 , a n d a 0 t o 2 % r a n g e b y D e c e m b e r 1992 a n d thereafter. A t t h e t i m e t h e P T A was s i g n e d , t h e B a n k was e x p e c t i n g t h e e c o n o m y t o c o n t i n u e its g r a d u a l r e c o v e r y f r o m t h e 1988 recession. T h e D e c e m b e r 1989 figure f o r u n d e r ­ l y i n g i n f l a t i o n , e x c l u d i n g t h e effects o f t h e 2.5% increase i n t h e g o o d s a n d services tax ( G S T ) effective J u l y 1, 1989, h a d b e e n 5.3%, a n d t h e B a n k saw n o n e e d t o c h a n g e s h o r t - t e r m i n t e r e s t rates i n o r d e r t o achieve t h e D e c e m b e r 1990 r a n g e . Two m a j o r surprises p r e s e n t e d themselves over t h e p e r i o d t h r o u g h January 1991: the o i l price shock that followed the I r a q i invasion o f Ku­ w a i t , a n d t h e u n e x p e c t e d c o n t i n u e d weakness o f t h e N e w Z e a l a n d e c o n o m y . I n A u g u s t 1990, t h e B a n k t i g h t e n e d m o n e t a r y p o l i c y some­ w h a t i n response t o w h a t i t c a l l e d t h e "fiscal slippage" e v i d e n t i n t h e b u d g e t released i n July. I n O c t o b e r , i t a n n o u n c e d t h a t t h e t a r g e t r a n g e to b e a c h i e v e d b y D e c e m b e r 1990 w o u l d a p p l y t o C P I i n f l a t i o n e x c l u d ­ i n g o i l prices. T h e B a n k t h e n u s e d t h a t a d j u s t m e n t as a n o c c a s i o n t o a n n o u n c e t h a t targets i n t h e f u t u r e w o u l d a p p l y t o " u n d e r l y i n g " i n f l a ­ t i o n . As i t t u r n e d o u t , i n f l a t i o n i n c l u d i n g o i l prices over t h e year t o D e ­ c e m b e r 1990 was 4 . 9 % — i n s i d e t h e o r i g i n a l t a r g e t r a n g e . By t h e n , h o w ­ ever, t h e t a r g e t r a n g e h a d b e e n c h a n g e d t o 1.5% t o 3.5%. F o l l o w i n g its v i c t o r y b y a l a r g e m a r g i n i n t h e g e n e r a l e l e c t i o n o n O c ­ t o b e r 2 9 , 1 9 9 0 , t h e conservative N a t i o n a l G o v e r n m e n t s i g n e d a n e w P T A w i t h t h e B a n k o n D e c e m b e r 19. T h e n e w a g r e e m e n t e x t e n d e d t h e p l a n n e d d i s i n f l a t i o n process b y o n e year. As we have n o t e d , t h i s e x t e n ­ s i o n r e f l e c t e d t h e g o v e r n m e n t ' s b e l i e f t h a t r a p i d d i s i n f l a t i o n h a d already p r o v e d t o o costly t o t h e r e a l e c o n o m y . T h i s view was w i d e l y h e l d at t h e t i m e , a n d p r o m i n e n t figures i n t h e d o m e s t i c financial sector w e r e o u t ­ s p o k e n i n c h a r a c t e r i z i n g t h e 0 % t o 2 % i n f l a t i o n t a r g e t r a n g e as a d a n ­ g e r o u s "obsession." Nevertheless, b e f o r e t h e e l e c t i o n , b o t h t h e L a b o u r Party a n d t h e N a t i o n a l Party h a d u r g e d t h a t t h e i n f l a t i o n targets be m a i n ­ t a i n e d at t h e i r o r i g i n a l l e v e l . These events are i n d i c a t i v e o f some o f t h e 13

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ways i n w h i c h a n i n f l a t i o n t a r g e t c a n be m a n i p u l a t e d w i t h o u t c h a n g i n g the p r i m a r y target definition; i n particular, the t i m e h o r i z o n allowed f o r a c h i e v i n g t h e t a r g e t c a n be a c r i t i c a l d e t e r m i n a n t o f h o w t i g h t l y t h e tar­ get constrains policy. T h e F e b r u a r y 1991 Monetary Policy Statement set u p a n e w p a t h t o w a r d p r i c e stability by specifying t a r g e t ranges f o r i n f l a t i o n o f 2.5% t o 4 . 5 % b y D e c e m b e r 1 9 9 1 , 1.5% t o 3.5% b y D e c e m b e r 1992, a n d 0 t o 2 % by D e ­ c e m b e r 1 9 9 3 . 9 T h e targets f o r D e c e m b e r 1991 a n d D e c e m b e r 1992, a l o n g w i t h t h e t a r g e t f o r D e c e m b e r 1990 l a i d d o w n i n t h e first PTA, are s h o w n as v e r t i c a l bars i n P a n e l A o f F i g u r e 5 . 1 . T h e t a r g e t f r o m D e c e m b e r 1993 o n w a r d is s h o w n b y t h e s o l i d h o r i z o n t a l l i n e f o r its u p p e r b o u n d a n d t h e d o t t e d h o r i z o n t a l l i n e f o r its m i d p o i n t . ) M e a n w h i l e , s t a r t i n g i n m i d - N o ­ v e m b e r 1990, t h e B a n k h a d b e g u n t o a l l o w t h e ninety-day b a n k b i l l rate f a l l substantially i n response t o l o w e r - t h a n - e x p e c t e d i n f l a t i o n a r y pres­ sures. T h e d e c l i n e i n i n f l a t i o n a r y pressure was a t t r i b u t e d t o t h e rela­ tively m o d e s t effects o f t h e o i l p r i c e increases, sluggish d o m e s t i c g r o w t h , a n d w h a t was seen as t h e n e w g o v e r n m e n t ' s s u p p o r t o f t h e g o a l o f p r i c e stability. B y m i d - J a n u a r y 1 9 9 1 , t h e ninety-day b a n k b i l l rate h a d f a l l e n t o u n d e r 11.5%, d o w n f r o m 14.6% i n A u g u s t 1990. 15

By A u g u s t 1 9 9 1 , t h e B a n k h a d expressed its surprise over t h e speed at w h i c h i n f l a t i o n was f a l l i n g . G r o w t h i n wage settlements was low, u n i t la­ b o r costs w e r e essentially u n c h a n g e d , t h e e x c h a n g e rate was stable, a n d i m p o r t prices w e r e flat, r e f l e c t i n g t h e o n g o i n g recession i n several m a ­ j o r e c o n o m i e s . W h e r e a s i n its F e b r u a r y 1991 Monetary Policy Statement t h e B a n k h a d e x p e c t e d h e a d l i n e i n f l a t i o n t o be s l i g h t l y above t h e m i d ­ p o i n t o f t h e 2.5% t o 4 . 5 % r a n g e b y t h e n e x t D e c e m b e r , i n t h e q u a r t e r t o J u n e t h e i n f l a t i o n rate was already d o w n t o 2 . 8 % , a n d t h e Bank's fore­ cast f o r t h e year u p t o D e c e m b e r 1991 was 2 % . L i k e w i s e , u n d e r l y i n g i n f l a t i o n ( w i t h m o r t g a g e i n t e r e s t rates, o i l prices, a n d i n d i r e c t taxes a n d g o v e r n m e n t charges r e m o v e d ) was d o w n t o 2.6% b y J u n e a n d was ex­ p e c t e d t o f a l l b e l o w 2.5% b y t h e e n d o f t h e year. T h e B a n k stated t h a t "this o u t c o m e w i l l r e f l e c t t h e f i r m p o l i c y stance m a i n t a i n e d t h r o u g h o u t [ 1 9 9 0 ] , a n d some i m p r e c i s i o n i n t h e process o f c o n t r o l l i n g i n f l a t i o n " (Reserve B a n k o f N e w Z e a l a n d , 1991c, A u g u s t , p . 4 3 ) . By late September, t h e B a n k started t o ease m o n e t a r y p o l i c y sharply " w h e n i t b e c a m e clear t h a t , i n t h e absence o f t h i s a c t i o n , u n d e r l y i n g i n f l a t i o n f o r 1992 was l i k e l y t o f a l l b e l o w t h e 1.5 t o 3.5% i n d i c a t i v e r a n g e " (Reserve B a n k o f N e w Z e a l a n d , 1992c, February, p p . 5-6). I n o r d e r t o emphasize t h a t i t was c o m m i t t e d t o t h e b o t t o m as w e l l as t h e t o p o f its t a r g e t r a n g e , t h e Reserve B a n k a l l o w e d t h e ninety-day b a n k b i l l rate t o f a l l t o 8.8% over t h e n e x t t h r e e m o n t h s a n d t h e e x c h a n g e rate t o d e p r e -

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ciate sharply. B y O c t o b e r , as t h e N e w Z e a l a n d d o l l a r r e a c h e d its lowest level i n five years against t h e c u r r e n c i e s o f its t r a d i n g p a r t n e r s , t h e B a n k a n d the P r i m e Minister were f o r c e d to try to persuade the p u b l i c that the depreciation w o u l d n o t i m p e r i l the achievement o f future inflation targets (see, f o r e x a m p l e Reuters Financial Service [ 1 9 9 1 ] ) . I n D e c e m b e r 1 9 9 1 , h e a d l i n e a n d u n d e r l y i n g i n f l a t i o n w e r e d o w n t o 1 % a n d 1.7%, respectively, r o u g h l y 1 % b e l o w t h e A u g u s t forecasts. " T h e c o n t r a c t i o n i n t h e d o m e s t i c e c o n o m y ( w h i c h i t s e l f was m o r e m a r k e d t h a n a n t i c i ­ p a t e d ) i m p a c t e d o n i n f l a t i o n a r y pressures t o a g r e a t e r e x t e n t t h a n h a d b e e n e x p e c t e d " (Reserve B a n k o f N e w Z e a l a n d , 1992c, F e b r u a r y , p . 10). Also, w o r l d prices h a d b e e n lower a n d the exchange rate h a d h e l d f i r m f o r l o n g e r t h a n h a d b e e n e x p e c t e d . M o s t l y as a r e s u l t o f t h e exchange-rate d e p r e c i a t i o n , the B a n k expected u n d e r l y i n g i n f l a t i o n t o p e a k at a r o u n d 3% b y e a r l y 1993 a n d t h e n t o f a l l b a c k t o 1.2% b y t h e e n d o f t h a t year. T h e J u n e 1992 Monetary Policy Statement, h e r a l d i n g t h e b e g i n n i n g o f t h e s e c o n d episode, stated t h a t "the B a n k is n o w f o c u s i n g o n e n s u r i n g t h a t p r i c e stability is c o n s o l i d a t e d , r a t h e r t h a n o n still t r y i n g t o achieve s i g n i f i c a n t r e d u c t i o n s i n i n f l a t i o n " (Reserve B a n k o f N e w Z e a l a n d , 1992c, J u n e , p . 1 3 ) . F r o m M a r c h 1991 t o M a r c h 1992, h e a d l i n e i n f l a t i o n a n d u n d e r l y i n g i n f l a t i o n h a d f a l l e n t o 0.8% a n d 1.3% respectively. W i t h t h e d o m e s t i c e c o n o m y b e g i n n i n g t o recover, t h e B a n k saw its task n o w as t o m a i n t a i n p r i c e stability i n a n e n v i r o n m e n t o f m o d e r a t e g r o w t h . T h e c o n ­ t i n u e d favorable o u t l o o k f o r i n f l a t i o n a n d t h e r e d u c t i o n i n i n f l a t i o n ex­ p e c t a t i o n s , as d o c u m e n t e d b y t h e Bank's surveys, h a d e n a b l e d t h e B a n k t o ease p o l i c y f u r t h e r , a l l o w i n g t h e ninety-day b a n k b i l l rate t o f a l l t o 6.6%. T h e Bank's forecasts f o r u n d e r l y i n g i n f l a t i o n f o r t h e e n d o f 1992 a n d f o r 1993 w e r e n o w at 2 % a n d 1 % , respectively, r e f l e c t i n g p r i m a r i l y d o w n w a r d revisions i n e x p e c t e d u n i t l a b o r costs a n d i m p o r t prices. T h e t u r n i n g p o i n t i n t h e e x c h a n g e rate, i n J a n u a r y 1993, was f o r e s h a d o w e d by t h e Bank's assessment t h a t "over t h e l o n g e r r u n . . . i f t h e i n f l a t i o n rates o f o u r t r a d i n g p a r t n e r s . . . r e m a i n h i g h e r t h a n t h a t i n N e w Z e a l a n d , some a p p r e c i a t i o n o f t h e n o m i n a l e x c h a n g e rate w o u l d be e n t i r e l y c o n ­ sistent w i t h t h e m a i n t e n a n c e o f p r i c e stability" (Reserve B a n k o f N e w Z e a l a n d , 1992c, J u n e , p . 3 5 ) . 1 6

U n r e s t i n t h e c u r r e n c y m a r k e t f o l l o w i n g t h e release o f t h e D e c e m b e r 1992 M o n e t a r y P o l i c y S t a t e m e n t p r o m p t e d t h e B a n k t o increase t h e n i n e t y - d a y b a n k b i l l rate f r o m 6.4% t o 7.8%. A p a r t f r o m t h a t b r i e f i n c i ­ d e n t , however, t h e p e r i o d f r o m m i d - 1 9 9 2 t o t h e e n d o f 1993 was a rela­ tively p l a c i d o n e . T h e d o m e s t i c e c o n o m y c o n t i n u e d its r e c o v e r y w i t h o u t any n o t a b l e i n f l a t i o n a r y pressures, a n d t h e ninety-day b a n k b i l l rate f e l l

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b e l o w 5% i n D e c e m b e r 1993. I n f l a t i o n e x p e c t a t i o n s r e m a i n e d l a r g e l y u n c h a n g e d , a n d t h e Bank's i n f l a t i o n forecasts o n e a n d t w o years a h e a d r e m a i n e d comfortably w i t h i n the 0 to 2 % range. D o n a l d Brash h a d been r e a p p o i n t e d G o v e r n o r o f t h e Reserve B a n k o n D e c e m b e r 16, 1992, re­ flecting t h e Reserve Bank's p o l i t i c a l s t r e n g t h , w h i l e t h e N a t i o n a l Party b a r e l y s u r v i v e d t h e n e x t e l e c t i o n w i t h a one-seat m a j o r i t y i n P a r l i a m e n t . A t t h e e n d o f 1992, a n e w P T A s i g n e d b y t h e B a n k a n d t h e N a t i o n a l Party specified t h a t t h e Reserve B a n k m u s t m a i n t a i n u n d e r l y i n g i n f l a t i o n w i t h i n t h e already-achieved 0 to 2 % r a n g e . As t h e t h i r d p e r i o d i n o u r h i s t o r y o f r e c e n t N e w Z e a l a n d m o n e t a r y policy began, c o n t i n u i n g domestic expansion a n d appreciation o f the e x c h a n g e rate h a d shifted t h e risk o f f u t u r e i n f l a t i o n f r o m e x t e r n a l t o domestic sources. W i t h h i n d s i g h t , i t is clear t h a t i n f l a t i o n a r y pressures started t o develop i n early 1994. I n D e c e m b e r 1993, t h e B a n k h a d n o t i c e d signs t h a t t h e recovery m i g h t be s t r o n g e r t h a n a n t i c i p a t e d b u t still consid­ e r e d i t " p r e m a t u r e " t o t i g h t e n policy. Its forecasts o f u n d e r l y i n g i n f l a t i o n by t h e e n d o f 1994 a n d 1995 were at 0.8% a n d 1.8%, respectively. A r e c u r r i n g t o p i c i n t h e Monetary Policy Statement after early 1994 was t h e Bank's u n c e r t a i n t y a b o u t t h e level o f g r o w t h t h a t t h e e c o n o m y c o u l d sustain w i t h o u t i n d u c i n g i n f l a t i o n . T h e s t r u c t u r a l r e f o r m s i n i t i a t e d since 1985, p r i m a r i l y t h e l i b e r a l i z a t i o n o f t h e e c o n o m y a n d t h e o p e n i n g u p o f m a r k e t s t o i n t e r n a t i o n a l c o m p e t i t i o n , a l o n g w i t h changes i n t h e wages e t t i n g process, w e r e p r e s u m e d t o have m a d e i t m o r e d i f f i c u l t f o r p r i c e a n d wage i n f l a t i o n t o d e v e l o p . C o u p l e d w i t h w h a t s e e m e d t o be a n i n ­ crease i n t h e c r e d i b i l i t y o f t h e m o n e t a r y - p o l i c y f r a m e w o r k , t h e r e f o r m s m i g h t c o n c e i v a b l y have p e r m i t t e d h i g h e r n o n - i n f l a t i o n a r y g r o w t h i n the economy. Estimating the non-inflationary rate o f g r o w t h p r o v e d to b e d i f f i c u l t , however, as i t has i n m a n y o t h e r c o u n t r i e s i n r e c e n t years. I n l i n e w i t h t h e o p t i m i s t i c view o f N e w Zealand's g r o w t h p o t e n t i a l , t h e B a n k p e r m i t t e d t h e average ninety-day b a n k b i l l r a t e t o d r o p f r o m 5.5% i n t h e D e c e m b e r 1993 q u a r t e r t o 4 . 9 % i n t h e M a r c h 1994 q u a r t e r . M e a n w h i l e , however, i t was d e t e r m i n e d t h a t r e a l G D P h a d g r o w n 5% d u r i n g 1993. O v e r t h e s e c o n d q u a r t e r o f 1994, m o n e t a r y p o l i c y reversed course a n d started t o t i g h t e n i n t h e face o f t h e u n e x p e c t e d s t r e n g t h o f t h e e c o n o m y ; t h e average ninety-day b a n k b i l l rate rose t o 6.2% t h r o u g h J u n e . By this p o i n t , r e a l G D P was g r o w i n g at a n a n n u a l rate o f 6% w i t h a l l sectors e x p a n d i n g r a p i d l y , m o s t n o t a b l y t h e c o n s t r u c t i o n sector. D e ­ spite s t r o n g i n v e s t m e n t over t h e p r e c e d i n g years, capacity u t i l i z a t i o n h a d b e e n o n a n u p w a r d p a t h since late 1 9 9 1 , a n d e m p l o y m e n t h a d g r o w n at a n a n n u a l rate o f 4 % since t h e b e g i n n i n g o f t h e year. B y m i d y e a r 1994, economists b e g a n t o w o r r y t h a t a b r e a c h o f t h e t a r g e t r a n g e b y h e a d l i n e

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C P I m i g h t raise t h e p u b l i c ' s i n f l a t i o n e x p e c t a t i o n s , even i f u n d e r l y i n g C P I i n f l a t i o n r e m a i n e d o n target. F r o m J u n e t o D e c e m b e r , t h e b i l l rate rose f r o m 5.5% t o 9.5% as m o n ­ etary p o l i c y c o n t i n u e d t o t i g h t e n . T h e y i e l d curve's slope t u r n e d nega­ tive o n c e a g a i n a n d t h e e x c h a n g e rate a p p r e c i a t e d b y 4 . 5 % o v e r 1994. A t this p o i n t , t h e Bank's assessment was " t h a t t h e e c o n o m i c u p t u r n m a y have p e a k e d , a n d t h a t g r o w t h m a y b e g i n t o m o d e r a t e over t h e c o m i n g year" (Reserve B a n k o f N e w Z e a l a n d , 1994c, D e c e m b e r , p . 1 5 ) . H o w ­ ever, t h e Bank's forecast o f u n d e r l y i n g i n f l a t i o n over t h e n e x t t w o years c a m e v e r y close t o t h e 2 % c e i l i n g , w i t h u n d e r l y i n g i n f l a t i o n e x p e c t e d t o stay i n t h e v i c i n i t y o f 1.8% t h r o u g h o u t 1995. H e a d l i n e i n f l a t i o n was ex­ p e c t e d t o p e a k at 4 . 2 % i n t h e s e c o n d q u a r t e r o f t h e year, m a i n l y as a c o n s e q u e n c e o f r i s i n g m o r t g a g e rates. A n u m b e r o f p r i v a t e forecasts dis­ a g r e e d w i t h those o f t h e B a n k , p r e d i c t i n g a t a r g e t b r e a c h i n m i d - 1 9 9 5 . R e p o r t e r s asked F i n a n c e M i n i s t e r W i l l i a m B i r c h w h e t h e r G o v e r n o r B r a s h w o u l d b e dismissed i f t h e t a r g e t was b r e a c h e d . H i s response was t h a t t h e Reserve Bank's forecasts d i d n o t offer any g r o u n d s f o r b e l i e v i n g t h a t t h e t a r g e t w o u l d n o t be m e t . 1 7

I n t h e event, t h e Reserve Bank's forecast f o r b o t h G D P g r o w t h a n d i n f l a t i o n i n 1995 p r o v e d t o have b e e n t o o low. I n May, t h e B a n k revised its forecast t o p r e d i c t t h a t u n d e r l y i n g i n f l a t i o n w o u l d e x c e e d t h e 2 % t a r g e t c e i l i n g i n t h e s e c o n d q u a r t e r o f 1995. I n fact, u n d e r l y i n g i n f l a t i o n rose above t h e 0 t o 2 % r a n g e , p e a k i n g at 2.2% i n t h e s e c o n d q u a r t e r o f 1995. H e a d l i n e i n f l a t i o n rose even m o r e sharply, t o 4 . 6 % , a l t h o u g h b o t h measures r e m a i n e d s h o r t o f t h e h i g h e s t private-sector forecasts. B u t " M r . B r a s h said t h e B a n k r e m a i n e d c o n f i d e n t t h e u n d e r l y i n g i n f l a t i o n rate w o u l d f a l l b a c k d u r i n g t h e t h i r d q u a r t e r o f t h i s year, a n d t h e r e f o r e p l a n n e d t o take n o a c t i o n o n a ' t e m p o r a r y ' b r e a c h " (Tait, 1 9 9 5 ) . Gover­ n o r B r a s h m a d e i t clear t h a t t h e o v e r s h o o t i n g w o u l d n o t be reversed so l o n g as t h e r e a p p e a r e d t o b e n o c h a n g e i n t h e i n f l a t i o n t r e n d , a n d t h a t he d i d n o t anticipate public expectations o f inflation to respond u n d u l y to a " t e m p o r a r y " d e v i a t i o n . T h e r e a f t e r h e a d l i n e i n f l a t i o n f e l l rapidly, as t h e rise i n m o r t g a g e rates s t e m m i n g f r o m t h e m o n e t a r y t i g h t e n i n g d u r i n g 1994 ceased t o have a n effect o n t h e C P I c a l c u l a t i o n . U n d e r l y i n g i n f l a t i o n f e l l t o o n l y 2 % i n t h e year t o S e p t e m b e r 1995. A l t h o u g h i n J u n e 1994 t h e B a n k h a d s t i l l b e e n e x p e c t i n g u n d e r l y i n g i n f l a t i o n t o r e t u r n t o 1.2% b y J u n e 1996, its D e ­ c e m b e r 1995 forecast f o r t h e year t o S e p t e m b e r 1996 was 1.7%. A m a j o r f a c t o r b e h i n d t h e rise i n u n d e r l y i n g i n f l a t i o n was t h e c o n t i n u i n g b o o m i n t h e c o n s t r u c t i o n sector, p a r t i c u l a r l y i n t h e A u c k l a n d area, w h e r e c o n ­ s t r u c t i o n costs rose b y 11.8% o v e r t h e year t o M a r c h 1995.

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T h i s c o n c e n t r a t i o n o f i n f l a t i o n a r y pressures i n t h e n o n t r a d e d sector m a d e t h e Bank's m o n e t a r y p o l i c y less effective i n s l o w i n g prices t h a n i t h a d b e e n i n t h e past, because t h e e x c h a n g e rate c h a n n e l o f m o n e t a r y t r a n s m i s s i o n has w e a k e r a n d m o r e i n d i r e c t effects o n t h a t sector. L a r g e l y f o r this reason, k e e p i n g i n f l a t i o n w i t h i n t h e t i g h t t a r g e t r a n g e r e q u i r e d a s h a r p rise i n n o m i n a l i n t e r e s t rates t o m o r e t h a n 9 % , a n d a n associ­ ated, u n u s u a l l y large, a p p r e c i a t i o n o f t h e N e w Z e a l a n d d o l l a r . T h e m o v e ­ m e n t o f b o t h t h e i n t e r e s t rate a n d t h e e x c h a n g e rate shows w h a t can happen w h e n a small, o p e n economy runs an i n d e p e n d e n t monetary p o l i c y w h i l e its e c o n o m i c cycle is o u t o f phase w i t h t h e m a j o r w o r l d econo­ mies. I t also shows t h e p o t e n t i a l f o r instrument instability ( o s c i l l a t i o n s i n t h e variables c o n t r o l l e d b y m o n e t a r y p o l i c y ) , w i t h its a t t e n d a n t e c o n o m i c d i s l o c a t i o n s . Nevertheless, w h a t N e w Z e a l a n d observers saw was t h a t t h e c o u n t r y h a d , f o r t h e first t i m e i n decades, g o n e t h r o u g h a p e r i o d o f s t r o n g g r o w t h w i t h o u t h a v i n g t o face a balance-of-payments o r i n f l a t i o n crisis at t h e e n d o f i t . 18

G o v e r n o r B r a s h d i d take " f u l l r e s p o n s i b i l i t y " f o r t h e Bank's n o t hav­ i n g acted sooner t o stem i n f l a t i o n a r y pressures, t h e r e b y a l l o w i n g t h e tar­ get t o be b r e a c h e d . C i t i n g t h e " t e m p o r a r y " n a t u r e o f t h e b r e a c h , however, he said t h a t h e w o u l d n o t resign, a n d Finance M i n i s t e r B i r c h b a c k e d h i m ( H a l l , 1995). T h u s i t became clear t h a t t h e dismissal o f t h e Reserve B a n k G o v e r n o r f o r a b r e a c h o f t h e target was n o t t o be a u t o m a t i c , b u t was t o be left t o the j u d g m e n t o f t h e B o a r d a n d t h e Finance Minister. I n this respect N e w Zealand's f r a m e w o r k differs f r o m r e c e n t proposals f o r a n " o p t i m a l c e n t r a l b a n k i n g contract," as the N e w Z e a l a n d f r a m e w o r k has b e e n de­ scribed, w h i c h w o u l d n o t have a l l o w e d G o v e r n o r Brash t o escape p e n a l t y f o r e x c e e d i n g t h e n u m e r i c a l target set i n t h e p o l i c y agreement. By O c t o b e r 1995 i n f l a t i o n h a d subsided, b u t G o v e r n o r B r a s h was chas­ t e n e d b y t h e p r a c t i c a l p r o b l e m s o f k e e p i n g i n f l a t i o n w i t h i n a t i g h t l y speci­ fied r a n g e , g i v e n t h e d i f f i c u l t i e s o f f o r e c a s t i n g a n d t h e p o t e n t i a l f o r i n ­ s t r u m e n t instability. T h e gap b e t w e e n h o w finely t h e Reserve B a n k c a n c o n t r o l i n f l a t i o n a n d t h e n a r r o w r a n g e t o w h i c h i t was c o m m i t t e d be­ came a n i m p o r t a n t p o l i t i c a l t h e m e f o r t h e n e x t year. I n d e e d , m o n e t a r y p o l i c y i n g e n e r a l b e c a m e a lively p o l i t i c a l issue i n t h e r u n - u p t o t h e Oc­ t o b e r 1996 elections. M u c h o f t h e debate c e n t e r e d o n w h e t h e r t h e tar­ get r a n g e s h o u l d be w i d e n e d , a l t h o u g h some m i n o r parties suggested a l t e r i n g t h e m i d p o i n t o f t h e r a n g e as w e l l . I n D e c e m b e r 1995, t h e Reserve B a n k t i g h t e n e d p o l i c y a g a i n . M o s t observers c h a r a c t e r i z e d this m o v e as a r e a c t i o n t o t h e N a t i o n a l Party's a n n o u n c e m e n t o f tax cuts, t o take effect r i g h t b e f o r e t h e e l e c t i o n s n i n e m o n t h s later. F i n a n c e M i n i s t e r B i r c h d e n i e d t h e i m p l i c a t i o n t h a t t h e

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Reserve B a n k e x p e c t e d t h e tax cuts t o be i n f l a t i o n a r y , s t a t i n g t h a t t h e size a n d n a t u r e o f t h e tax cuts h a d b e e n discussed w i t h t h e Reserve B a n k before b e i n g presented to Parliament (Birch, 1996). I n any event, t h e issue i n t h e p o p u l a r m i n d h a d m o v e d f r o m l o w i n f l a ­ t i o n t o h i g h r e a l i n t e r e s t rates. B y F e b r u a r y 1996, G o v e r n o r B r a s h f e l t i t necessary t o o p e n a speech t o t h e A u c k l a n d M a n u f a c t u r e r s ' A s s o c i a t i o n w i t h the following remarks: Over recent weeks there have been a number o f media reports o f people calling for the abolition o f the Reserve Bank, or the repeal o f the Reserve Bank Act, with the claim that the Bank is an anachronism i n New Zealand's free-market economy, that its operations result i n New Zealanders having to pay interest rates which are among the highest i n the w o r l d i n real terms, and that these interest rates are pushing up the exchange rate to the huge detriment o f exporters and those competing with imports. There are varia­ tions around this theme, depending u p o n who is m o u n t i n g the case, but I t h i n k that I accurately reflect the general case. (Brash, 1996b) W h i l e G o v e r n o r Brash's policies h a d c h e c k e d t h e i n f l a t i o n a r y t r e n d w e l l e n o u g h to j u s t i f y t h e g o v e r n m e n t ' s s u p p o r t , t h e d i f f e r e n t i a l effects o f h i g h s h o r t - t e r m i n t e r e s t rates o n t r a d e d a n d n o n t r a d e d goods ( h i g h i n t e r e s t rates h u r t exports a n d i m p o r t - c o m p e t i n g p r o d u c t s m o r e t h a n t h e n o n t r a d e d goods sector by s t r e n g t h e n i n g the exchange rate) exacerbated t h e p u b l i c ' s disaffection. S i m p l y m e e t i n g t h e P T A c o n t r a c t was n o t e n o u g h w h e n t h e P T A itself came u n d e r fire, a n d even t h o u g h r e w r i t i n g i t was t h e p o l i t i c i a n s ' responsibility a n d n o t t h e Bank's, t h e B a n k b e g a n t o suffer t h e consequences o f t h e u n p o p u l a r i t y o f its policies. O n A p r i l 19, 1996, t h e B o a r d o f t h e Reserve B a n k sent a l e t t e r t o F i n a n c e M i n i s t e r B i r c h . Several t h i n g s h a d b e c o m e clear: T h e t a r g e t c e i l i n g w o u l d be b r e a c h e d a g a i n b y m i d y e a r . H e a d l i n e i n f l a t i o n w o u l d rise, a n d u n d e r l y i n g i n f l a t i o n w o u l d rise a g a i n , t h o u g h o n l y t e m p o r a r i l y . A l s o , t h e issue o f d i s m i s s i n g t h e G o v e r n o r w o u l d have t o b e d e a l t w i t h o n c e m o r e , even t h o u g h a g a i n n o o n e f e l t t h a t p o l i c y was t o o loose o r t h a t i n f l a t i o n e x p e c t a t i o n s w e r e r i s i n g . H o w e v e r , t h e fact t h a t t h e Re­ serve B a n k was r u n n i n g i n t o a c o n t r o l p r o b l e m f o r t h e s e c o n d t i m e i n a year p o i n t e d o u t t h e difficulties associated w i t h t h e t h i r d PTA. T h e Board's l e t t e r s u p p o r t e d G o v e r n o r Brash's p e r f o r m a n c e — c a r e f u l l y b a s i n g t h e argument o n the t r e n d o f u n d e r l y i n g inflation—and r e c o m m e n d e d that h e c o n t i n u e i n his p o s i t i o n . I n May, however, t h e N e w Z e a l a n d First Party—a p o p u l i s t p a r t y t h a t was likely, i n t h e N o v e m b e r e l e c t i o n s , t o b e c o m e a c o a l i t i o n m e m b e r f o r t h e first t i m e — a d v o c a t e d t h a t goals f o r u n e m p l o y m e n t a n d g r o w t h 19

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be a d d e d t o m o n e t a r y policy. I n view o f t h e l i k e l i h o o d o f a n i n f l a t i o n b l i p a n d t h e p o l i t i c a l u n c e r t a i n t y s u r r o u n d i n g m o n e t a r y policy, l o n g t e r m b o n d yields rose; t h e s p r e a d b e t w e e n ten-year b o n d rates i n N e w Z e a l a n d a n d t h e U n i t e d States r e a c h e d 200 basis p o i n t s , t h e h i g h e s t level since 1992. I n response, t h e L a b o u r Party m a d e a p r o p o s a l o f its o w n : t o w i d e n t h e i n f l a t i o n b a n d t o - 1 % t o 3%. I n J u n e 1996, t h e Reserve B a n k r e p o r t e d t h a t u n d e r l y i n g i n f l a t i o n h a d i n fact b r e a c h e d t h e target c e i l i n g o f 2 % i n t h e first q u a r t e r a n d fore­ cast t h a t i t w o u l d r e a c h 2.6% i n t h e t h i r d quarter. W h e n historically h i g h real i n t e r e s t rates a p p e a r e d t o be i n s u f f i c i e n t t o m a i n t a i n i n f l a t i o n w i t h i n t h e t a r g e t r a n g e consistently, t h e feasibility o f t h e t a r g e t r a n g e was ques­ t i o n e d m o r e widely. Private-sector e c o n o m i s t s b e g a n t o j o i n t h e o p p o s i ­ t i o n parties i n a d v o c a t i n g a w i d e n i n g o f t h e range, p r e d i c t i n g t h a t infla­ t i o n w o u l d r e m a i n above 2 % t h r o u g h M a r c h 1997. T h e Reserve B a n k , a m o n g others, feared t h a t w i d e n i n g t h e r a n g e m i g h t be i n t e r p r e t e d as a w e a k e n i n g o f a n t i - i n f l a t i o n a r y resolve, w h i c h w o u l d have h a r m f u l effects o n c r e d i b i l i t y a n d i n f l a t i o n e x p e c t a t i o n s . As we n o t e d above, however, even G o v e r n o r Brash h a d c o m e t o realize t h a t t h e c o n t r o l p r o b l e m s posed by a 0 t o 2 % target r a n g e were perhaps t o o great t o be h a n d l e d . Dr. Brash acknowledged that i t would be tempting to say that the 0 to 2 per­ cent target range was both too low and too narrow. B u t . . . " I don't think i t is self-evident at all that a wider target would help the real economy," Dr. Brash said. " O n the contrary there are some real risks i n d o i n g that." The dangers were that widening the range would itself raise inflationary expectations, and that the Reserve Bank itself would be slower to react to inflationary pres­ sures. The width o f the target band is only one o f the features o f the present monetary policy framework to be questioned o f late. (Fallow, 1996) O n l y successful targeters o f l o n g s t a n d i n g , s u c h as G e r m a n y a n d Swit­ z e r l a n d , have s e e m e d able t o c o p e w i t h f r e q u e n t misses o f t h e t a r g e t ranges w i t h o u t c h a n g i n g t h e i r ranges. T h e premises o f t h e Reserve B a n k o f N e w Z e a l a n d A c t o f 1989, t h e i n t e r p r e t a t i o n o f i n f l a t i o n t a r g e t i n g as r e q u i r i n g i n f l a t i o n to be tightly c o n t r o l l e d quarter to quarter, a n d the i n h e r e n t l i m i t a t i o n s o n w h a t N e w Zealand's m o n e t a r y p o l i c i e s c o u l d a c c o m p l i s h , c r e a t e d pressure f o r a m o r e activist m o n e t a r y p o l i c y i n N e w Z e a l a n d t h a n was o r i g i n a l l y i n t e n d e d . F u r t h e r , t h e s t r i n g e n t r e q u i r e m e n t s o f i n f l a t i o n c o n t r o l caused h a r m t o t h e r e a l e c o n o m y , n o t a b l y t h e ex­ p o r t sector, whose c o m p e t i t i v e n e s s was h a r m e d b y h i g h i n t e r e s t rates a n d a p p r e c i a t i o n o f t h e e x c h a n g e rate. O n O c t o b e r 12, 1996, N e w Z e a l a n d h e l d its first m i x e d - m e m b e r p r o ­ p o r t i o n a l r e p r e s e n t a t i o n elections f o r n a t i o n a l P a r l i a m e n t . T h e o u t c o m e

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was (as e x p e c t e d ) i n d e c i s i v e , w i t h n o o n e p a r t y g e t t i n g m o r e t h a n 5 0 % o f t h e v o t e . T h e N e w Z e a l a n d F i r s t Party, w h i c h clearly h e l d t h e balance i n f o r m i n g a c o a l i t i o n , n e g o t i a t e d w i t h b o t h t h e L a b o u r Party a n d t h e N a t i o n a l Party. O n O c t o b e r 18, N a t i o n a l Party ( a n d c a r e t a k e r ) F i n a n c e M i n i s t e r B i r c h p u b l i c l y i n d i c a t e d t h a t t h e i n f l a t i o n t a r g e t (its w i d t h a n d its average level) was o n t h e table i n n e g o t i a t i o n s w i t h t h e N e w Z e a l a n d First Party. T h e O c t o b e r 16 data release s h o w e d u n d e r l y i n g i n f l a t i o n re­ m a i n i n g above t a r g e t at 2.3% ( h e a d l i n e i n f l a t i o n was 2 . 4 % ) , b u t b e l o w some p r i v a t e forecasts, w h i c h w e r e as h i g h as 2 . 7 % . I n t h e w o r d s o f o n e N e w Z e a l a n d business c o l u m n i s t w a t c h i n g t h e n e g o t i a t i o n s , " T h e mes­ sage: [ d e s p i t e b e i n g g e n e r a l l y successful,] p r e s e n t Reserve B a n k i n f l a ­ t i o n targets are n o t c r e d i b l e . T h e y c o u l d be c h a n g e d at any t i m e , de­ p e n d i n g o n t h e w h i m s o f w h o e v e r wants m o s t t o d r i v e a b o u t i n a m i n i s ­ t e r i a l L T D . W e are b a c k t o p o l i t i c i z e d m o n e t a r y p o l i c y " ( C o o t e , 1 9 9 6 ) . Meanwhile, the B a n k f o u n d itself o n the horns o f a familiar d i l e m m a . As c a p i t a l flowed b a c k i n t o N e w Z e a l a n d after t h e e l e c t i o n , t h e N e w Z e a l a n d d o l l a r h a d r i s e n t o a n eight-year h i g h against t h e y e n a n d t h e U . S . d o l l a r . T h e B a n k a g a i n was c o n f r o n t e d w i t h d i f f i c u l t choices. D e ­ spite t h e ab ove-tar get i n f l a t i o n rate a n d t h e n e e d t o r e i n i n i n f l a t i o n a r y pressures o n t h e n o n t r a d e d goods s e c t o r — a n d because o f t h e m e d i u m t e r m t r e n d o f u n d e r l y i n g inflation a n d the highly unfavorable circum­ stances f o r t h e traded-goods s e c t o r — t h e r e was g o o d reason n o t t o raise i n t e r e s t rates f u r t h e r . " U n f o r t u n a t e l y , i n o r d e r t o k e e p o v e r a l l m o n e t a r y c o n d i t i o n s consistent w i t h m a i n t a i n i n g p r i c e stability, i t appears we have t o accept r a t h e r less i n t e r e s t rate pressure t h a n m i g h t be i d e a l , a n d r a t h e r m o r e e x c h a n g e pressure t h a n m i g h t b e i d e a l , " stated t h e B a n k o n O c t o ­ b e r 24 ( H a l l , 1996a). I n o t h e r w o r d s , t h e B a n k was a d m i t t i n g t h a t t h e c o n t r o l p r o b l e m o f h i t t i n g the r e q u i r e d n a r r o w target range h a d f o r c e d i t i n t o s h o r t - r u n p o l i c y trade-offs t h a t i t d i d n o t w a n t , g i v e n t h e p o l i t i c a l c o n s t r a i n t s o f t h e t i g h t target. Finally, o n D e c e m b e r 10, a p a r l i a m e n t a r y c o a l i t i o n b e t w e e n t h e N a ­ t i o n a l Party a n d the N e w Zealand First Party was agreed t o f o r a three-year t e r m . T h e i r first substantive a n n o u n c e m e n t was t h a t the i n f l a t i o n target w o u l d be m o d i f i e d . T h e n e w Policy Targets A g r e e m e n t , signed by the N a ­ t i o n a l Party's F i n a n c e M i n i s t e r B i r c h a n d G o v e r n o r Brash t h a t same day, w i d e n e d t h e target r a n g e f r o m 0 % t o 2 % t o 0 % t o 3%. T h e shift u n d e r ­ lines t h e u n a v o i d a b l y p o l i t i c a l n a t u r e o f a c e n t r a l bank's a c c o u n t a b i l i t y u n d e r any d e m o c r a t i c system: T h e goals by w h i c h m o n e t a r y p o l i c y is evalu­ ated, a n d , i n the N e w Z e a l a n d case, the d e c i s i o n o f w h e t h e r t o exercise t h e o p t i o n t o dismiss the G o v e r n o r f o r n o t a t t a i n i n g t h e goal, reflect t h e preferences o f the officials w h o h a p p e n t o be i n office at t h e m o m e n t .

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O n D e c e m b e r 18, G o v e r n o r B r a s h d e s c r i b e d t h e w i d e n i n g o f t h e i n ­ flation t a r g e t r a n g e as a m o d e s t change: "We p r e v i o u s l y a i m e d at i n f l a ­ t i o n o f 1 p e r cent. I t is n o w 1.5 p e r cent" ( H a l l , 1 9 9 6 b ) . W h i l e G o v e r n o r Brash a d m i t t e d t h a t this c h a n g e w o u l d a l l o w some easing o f policy, h e stated t h a t i t was already j u s t i f i e d by i n f l a t i o n forecasts: "to t h e e x t e n t t h a t i n c r e a s e d i n f l a t i o n a r y e x p e c t a t i o n s l e a d t o h i g h e r prices, h i g h e r wage settlements a n d so o n , t h e n e w i n f l a t i o n t a r g e t gives m u c h less scope f o r a n easing . . . t h a n m i g h t perhaps be assumed" (Tait, 1 9 9 6 ) . T o t h e e x t e n t possible, t h e Reserve B a n k was i n t e n t o n l i m i t i n g any d a m a g e to its c r e d i b i l i t y f r o m t h e m o d i f i c a t i o n o f t h e target. I n a n address g i v e n a m o n t h l a t e r (Brash, 1 9 9 7 ) , G o v e r n o r B r a s h s u m ­ marized the m e a n i n g o f the new PTA, i n c l u d i n g the a m e n d e d inflation target. H e e m p h a s i z e d t h a t " p r i c e stability r e m a i n s t h e single objective o f m o n e t a r y p o l i c y a n d constitutes t h e best way i n w h i c h t h e Reserve B a n k can c o n t r i b u t e t o N e w Zealand's e c o n o m i c d e v e l o p m e n t . " H e n o t e d t h a t t h e c u r r e n t state o f k n o w l e d g e i n m o n e t a r y e c o n o m i c s left u n r e ­ solved t h e debate b e t w e e n those w h o advocate a "low, positive i n f l a t i o n " a n d those w h o a r g u e f o r zero i n f l a t i o n . T h e G o v e r n o r c o n t i n u e d , it is at this stage quite inappropriate to be dogmatic, and i n my own view a target which involves doing our utmost to keep measured inflation between 0 and 3 percent is certainly consistent with the intention o f the legislation within which monetary policy is operated. . . . Indeed, irrespective o f where the mid-point o f the target range should be, there may be some advantage i n having a slightly wider inflation target than the original 0 to 2 percent target. A number o f observers have suggested that a target with a width o f only 2 percentage points requires an excessive degree o f activism o n the part o f the central b a n k . . . . The tension is between, o n the one hand, choosing a target range which effectively anchors inflation expectations at a low level but which is so narrow that i t provokes excessive policy activism and risks loss o f cred­ ibility by being frequently exceeded; and on the other, a target range which does a less effective j o b o f anchoring inflation expectations, but which re­ quires less policy activism and protects credibility by being rarely breached. (Brash, 1997)

Key Lessons from New Zealand's Experience A f t e r e i g h t years o f i n f l a t i o n t a r g e t i n g , t h e e x p e r i e n c e o f t h e Reserve B a n k o f N e w Z e a l a n d p r o v i d e s several i m p o r t a n t lessons. First, i t sug­ gests t h a t t h e c h a l l e n g e o f b r i n g i n g d o w n t r e n d i n f l a t i o n a n d m a i n t a i n -

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i n g l o w i n f l a t i o n e x p e c t a t i o n s is r e l a t i v e l y easy c o m p a r e d w i t h t h a t o f t i g h t l y c o n t r o l l i n g t h e course o f i n f l a t i o n w i t h i n a n a r r o w r a n g e , espe­ cially f o r a s m a l l , o p e n e c o n o m y . I n p a r t i c u l a r , i t i n d i c a t e s t h a t s t r i c t adherence to a n a r r o w inflation target range may lead to movements i n p o l i c y i n s t r u m e n t s t h a t are g r e a t e r t h a n t h e c e n t r a l b a n k w o u l d l i k e , o p e n i n g the possibility o f i n s t r u m e n t instability a n d perhaps macroeco­ n o m i c i n s t a b i l i t y as w e l l . S e c o n d , t h e Reserve B a n k has f o u n d t h a t excessive r e s t r i c t i o n s o n t h e exercise o f its d i s c r e t i o n a n d t h e m a n n e r i n w h i c h i t e x p l a i n s p o l i c y — even i f i n t h e n a m e o f a c c o u n t a b i l i t y — m a y create instances i n w h i c h c r e d i b i l i t y c o u l d b e d a m a g e d , even w h e n u n d e r l y i n g i n f l a t i o n is c o n ­ t r o l l e d . T h i s p r o b l e m is d u e n o t o n l y t o i n f l e x i b i l i t y o f policy, b u t also t o t h e focus o f t h e N e w Z e a l a n d p o l i c y f r a m e w o r k o n t h e f o r m a l a c c o u n t ­ a b i l i t y o f t h e B a n k d i r e c t l y t o t h e g o v e r n m e n t . W e shall see t h a t c r e d i b i l ­ i t y a n d flexibility are e n h a n c e d i n p r a c t i c e w h e n t h e c e n t r a l b a n k also a t t e m p t s t o establish a c c o u n t a b i l i t y d i r e c t l y t o t h e p u b l i c , b y i n c r e a s i n g t h e t r a n s p a r e n c y o f m o n e t a r y p o l i c y a n d by m a k i n g t h e e f f o r t t o c o m ­ m u n i c a t e t h e r a t i o n a l e a n d objectives o f its p o l i c y f r a m e w o r k . T h e s e c a u t i o n a r y notes d o n o t negate t h e fact t h a t i n f l a t i o n t a r g e t i n g i n N e w Z e a l a n d has, o n t h e w h o l e , b e e n h i g h l y successful. T h i s c o u n t r y , w h i c h was p r o n e t o h i g h , v o l a t i l e i n f l a t i o n b e f o r e t h e i n f l a t i o n - t a r g e t i n g r e g i m e was a d o p t e d , has e m e r g e d as a c o u n t r y w i t h l o w a n d stable i n f l a ­ t i o n . M o r e o v e r , this has b e e n a c c o m p l i s h e d as p a r t o f a n o v e r a l l package o f r e f o r m s w h i c h has p r o m o t e d a n d s u s t a i n e d s u b s t a n t i a l e c o n o m i c growth and modernization.

Canada: Inflation Targets as Tools of Communication

CANADA a d o p t e d i n f l a t i o n t a r g e t i n g i n 1 9 9 1 , o n e year after N e w Z e a l a n d . As i n N e w Z e a l a n d , t h e c h a n g e i n p o l i c y a p p r o a c h was t h e r e s u l t o f dis­ satisfaction a m o n g p o l i c y - m a k e r s w i t h t h e p e r f o r m a n c e o f t h e e c o n o m y , p a r t i c u l a r l y o n t h e i n f l a t i o n f r o n t . U n l i k e t h e case o f N e w Z e a l a n d , h o w ­ ever, i n f l a t i o n t a r g e t i n g i n C a n a d a d i d n o t e m e r g e f r o m a legislative m a n d a t e , b u t was d e v e l o p e d g r a d u a l l y a n d s o m e w h a t i n f o r m a l l y . H o w ­ ever, over t i m e t h e n e w r e g i m e has t a k e n o n a n o f f i c i a l quality, w i t h t h e i n f l a t i o n t a r g e t b e i n g j o i n t l y d e t e r m i n e d a n d a n n o u n c e d by t h e g o v e r n ­ m e n t Qnrl f h p i - e n t r c i l V V J n \

Key Features of Inflation Targeting in Canada •

I n f l a t i o n t a r g e t i n g i n C a n a d a was n o t t h e r e s u l t o f f o r m a l leg­ i s l a t i o n . H o w e v e r , as i n N e w Z e a l a n d , t h e i n f l a t i o n t a r g e t i n C a n a d a is j o i n t l y d e t e r m i n e d a n d a n n o u n c e d by b o t h t h e gov­ e r n m e n t a n d t h e c e n t r a l b a n k . T h e B a n k o f C a n a d a is t h e e n t i t y responsible f o r m e e t i n g t h e i n f l a t i o n targets, a l t h o u g h t h e r e are n o e x p l i c i t sanctions f o r t a r g e t misses.

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As i n N e w Z e a l a n d , i n f l a t i o n t a r g e t i n g was a d o p t e d i n C a n a d a after substantial progress i n r e d u c i n g t h e i n f l a t i o n rate was already e v i d e n t , so t h a t success i n a c h i e v i n g t h e i n i t i a l targets a p p e a r e d likely. T h e l i k e l i h o o d o f i n i t i a l success was also i n ­ creased b y t h e fact t h a t t h e h o r i z o n f o r t h e first targets was set at 22 m o n t h s f r o m t a r g e t a d o p t i o n .

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T h e C P I i n f l a t i o n rate, as m e a s u r e d b y Statistics Canada, has b e e n t h e o f f i c i a l p r i m a r y t a r g e t variable i n C a n a d a because o f its " h e a d l i n e " quality. H o w e v e r , a c o r e i n f l a t i o n rate t h a t excludes e n e r g y a n d f o o d prices has also b e e n u s e d e x t e n ­ sively i n assessing w h e t h e r t h e t r e n d i n f l a t i o n rate is o n t r a c k for the m e d i u m t e r m .

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T h e i n f l a t i o n t a r g e t is stated as a r a n g e r a t h e r t h a n as a p o i n t target, w i t h as m u c h e m p h a s i s p l a c e d o n t h e floor o f t h e r a n g e as o n t h e c e i l i n g . T h e m i d p o i n t o f t h e i n f l a t i o n t a r g e t r a n g e , 2 % , is above z e r o , as i n a l l t h e o t h e r cases we e x a m ­ i n e . M e d i u m - t e r m i n f l a t i o n goals have b e e n set t o c o n v e r g e g r a d u a l l y t o t h e l o n g - t e r m g o a l . E a c h o f these p r o v i s i o n s represents a c o m p r o m i s e b e t w e e n a n exclusive focus o n p r i c e stability a n d c o n c e r n f o r short-term o u t p u t a n d e m p l o y m e n t goals.

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T h e C a n a d i a n i n f l a t i o n - t a r g e t i n g r e g i m e is q u i t e flexible i n p r a c t i c e , w i t h r e a l o u t p u t g r o w t h a n d fluctuations t a k e n i n t o c o n s i d e r a t i o n i n t h e c o n d u c t o f m o n e t a r y policy. I n d e e d , i n Canada, t h e i n f l a t i o n target is v i e w e d as a way t o h e l p d a m p e n cyclical fluctuations i n e c o n o m i c activity.

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A c c o u n t a b i l i t y is a c e n t r a l f e a t u r e o f t h e i n f l a t i o n - t a r g e t i n g r e g i m e i n C a n a d a , b u t t h e c e n t r a l b a n k is m o r e a c c o u n t a b l e t o t h e p u b l i c at large t h a n t o t h e g o v e r n m e n t . I n d e e d , a cen­ t r a l a n d i n c r e a s i n g l y i m p o r t a n t feature o f Canada's f r a m e ­ w o r k is a s t r o n g c o m m i t m e n t t o transparency a n d t o t h e c o m ­ m u n i c a t i o n o f m o n e t a r y - p o l i c y strategy t o t h e p u b l i c .

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I n i m p l e m e n t i n g the inflation-targeting regime, the central b a n k uses a so-called " m o n e t a r y c o n d i t i o n s i n d e x , " a w e i g h t e d average o f t h e e x c h a n g e rate a n d t h e s h o r t - t e r m i n t e r e s t rate, as b o t h a n i n f o r m a t i o n a l v a r i a b l e a n d a s h o r t - r u n target.

The Adoption of Inflation Targeting T h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g i n C a n a d a f o l l o w e d a three-year c a m ­ p a i g n b y t h e B a n k o f C a n a d a t o p r o m o t e p r i c e stability as t h e l o n g - t e r m objective o f m o n e t a r y policy. T h a t c a m p a i g n , b e g i n n i n g w i t h then-Gov­ e r n o r J o h n Crow's H a n s o n L e c t u r e at t h e U n i v e r s i t y o f A l b e r t a i n J a n u ­ ary 1988, " T h e W o r k o f C a n a d i a n M o n e t a r y Policy" ( C r o w , 1 9 8 8 ) , h a d s p e l l e d o u t t h e reasons f o r t h e B a n k o f Canada's d i s i n f l a t i o n a r y p o l i c y o f t h e late 1980s a n d early 1990s. I t h a d n o t , however, b e e n e q u a l l y clear a b o u t w h a t a price-stability g o a l w o u l d m e a n i n p r a c t i c e , e i t h e r i n t e r m s o f specific i n f l a t i o n targets o r t h e t i m e f r a m e f o r a c h i e v i n g those targets (Thiessen, 1995a; F r e e d m a n , 1994a a n d 1 9 9 5 ) .

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O n F e b r u a r y 26, 1 9 9 1 , f o r m a l targets " f o r r e d u c i n g i n f l a t i o n a n d es­ t a b l i s h i n g p r i c e stability i n Canada" t h r o u g h 1995 w e r e a n n o u n c e d . T h e a n n o u n c e m e n t was m a d e j o i n t l y b y t h e M i n i s t e r o f F i n a n c e , M i c h a e l W i l s o n , o f t h e r u l i n g Conservative Party, a n d t h e G o v e r n o r o f t h e B a n k o f Canada, J o h n C r o w . T o m a x i m i z e p u b l i c i t y a n d t o u n d e r s c o r e t h e g o v e r n m e n t ' s s u p p o r t o f t h e g o a l o f p r i c e stability, t h e a n n o u n c e m e n t was m a d e o n t h e same day t h e g o v e r n m e n t released its b u d g e t . I n M a r c h , t h e B a n k issued its Annual Report, 1990, w h i c h f e a t u r e d r e m a r k s b y Gov­ e r n o r C r o w o n t h e a p p r o p r i a t e n e s s o f p r i c e stability as a g o a l f o r m o n ­ etary p o l i c y a n d i n c l u d e d a n a r t i c l e t i t l e d " T h e Benefits o f Price Stabil­ ity" ( B a n k o f Canada, 1990a). T h e i n i t i a t i o n o f t h e c o m m i t m e n t t o i n f l a ­ t i o n t a r g e t i n g h a d b e e n carefully p l a n n e d t o a t t r a c t p u b l i c a t t e n t i o n a n d to b u i l d public support. I t is i n t e r e s t i n g t h a t t h e r e h a d b e e n n o advance n o t i c e t o t h e p u b l i c o f t h e p o l i c y shift t o i n f l a t i o n t a r g e t i n g by s e n i o r B a n k o f C a n a d a o f f i ­ cials. T h e Annual Report, 1990 c o n t a i n e d a o n e - p a r a g r a p h m e n t i o n o f t h e a d o p t i o n o f i n f l a t i o n targets t a c k e d o n t o t h e e n d o f G o v e r n o r Crow's a n n u a l statement, b u t n o r e f e r e n c e t o targets e a r l i e r i n t h e piece. N o r was t h e r e any crisis t h a t m i g h t have p r o m p t e d t h e a b r u p t shift i n p o l i c y (such as t h e collapse o f a n exchange-rate p e g , o r t h e s u d d e n b r e a k d o w n o f the relationship between an intermediate target a n d the goal vari­ a b l e ) . G o v e r n o r C r o w h a d b e e n a p p o i n t e d t o his p o s i t i o n f o u r years earlier, a n d t h e Conservative G o v e r n m e n t h a d b e e n r e e l e c t e d i n late 1988, so n e i t h e r c o u l d a c h a n g e i n p o l i c y - m a k e r s e x p l a i n t h e shift. B e f o r e t h e a n n o u n c e m e n t o f specific i n f l a t i o n targets, t h e Bank's re­ p e a t e d d e c l a r a t i o n o f t h e price-stability g o a l b y i t s e l f a p p e a r e d t o have m a d e l i t t l e headway against t h e " m o m e n t u m " i n i n f l a t i o n e x p e c t a t i o n s t h a t h a d b u i l t u p (Thiessen, 1991; F r e e d m a n , 1994a). I n fact, i n t h e "Back­ g r o u n d N o t e " released at t h e t i m e o f t h e a d o p t i o n o f t h e targets, m e n ­ t i o n is m a d e o f t h e " u n d u l y pessimistic" o u t l o o k f o r i n f l a t i o n i n a n u m ­ b e r o f q u a r t e r s ( B a n k o f Canada, 1991b, M a r c h , p . 1 1 ) . Evidently, i n f l a ­ t i o n targets w e r e t h e tactic c h o s e n t o r e d u c e i n f l a t i o n e x p e c t a t i o n s a n d to b r i n g the declared goal o f Canadian monetary policy to f r u i t i o n . T h e B a n k o f C a n a d a a p p a r e n t l y d e c i d e d t h a t F e b r u a r y 1991 was a g o o d t i m e t o f o r m a l i z e its c o m m i t m e n t t o p r i c e stability. A p r o p i t i o u s f a c t o r was t h a t year-over-year C P I i n f l a t i o n h a d d r o p p e d t o 4 . 2 % i n t h e f o u r t h q u a r t e r o f 1990 (versus a h i g h o f 5.5% i n early 1 9 8 9 ) , a n d "the pressures f r o m excess d e m a n d t h a t w e r e p u s h i n g u p prices f r o m 1987 t h r o u g h 1989 f i n a l l y eased d u r i n g 1990" (Thiessen, 1 9 9 1 , p . 1 8 ) . I n d e e d , e c o n o m i c g r o w t h was at a cyclical t r o u g h . Because t h e C a n a d i a n e c o n o m y h a d s l o w e d — a n d , t h o u g h i t was n o t r e a l i z e d at t h e t i m e , h a d e n t e r e d a

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d e e p recession i n 1 9 9 0 — u n d e r l y i n g d i s i n f l a t i o n a r y pressures w e r e al­ r e a d y b e c o m i n g m a n i f e s t at t h e t i m e t h e targets were i n t r o d u c e d . T h e s e c o n d i t i o n s m a d e i t m o r e l i k e l y t h a t i n i t i a l i n f l a t i o n targets c o u l d be m e t . A negative d e v e l o p m e n t m o t i v a t i n g t a r g e t a d o p t i o n was t h e large r i s k p r e m i u m s t h a t w e r e b e i n g b u i l t i n t o l o n g - t e r m C a n a d i a n i n t e r e s t rates. These p r e m i u m s r e f l e c t e d a variety o f d i s q u i e t i n g factors, i n c l u d i n g r a p i d g r o w t h o f government a n d external debt, political uncertainty, a n d cred­ i b i l i t y p r o b l e m s f o r m o n e t a r y p o l i c y after t w o decades o f i n f l a t i o n . A r ­ r e s t i n g this i n c r e a s i n g u n c e r t a i n t y t h r o u g h whatever devices w e r e avail­ able was a n i m p o r t a n t c o n c e r n o f p o l i c y - m a k e r s . T h e r e w e r e also w o r r i e s a b o u t f u t u r e shocks t o t h e p r i c e level, i n c l u d ­ i n g t h e p o s s i b i l i t y o f o i l - p r i c e increases. O f i m m e d i a t e c o n c e r n was a n e w g o o d s a n d services tax ( G S T ) — a n i n d i r e c t tax s i m i l a r t o a valuea d d e d tax, o r V A T — w h i c h was t o take effect at t h e start o f 1991 a n d was e x p e c t e d t o have a n i m p a c t o n t h e t o t a l h e a d l i n e C P I o f 1.25 p e r c e n t a g e p o i n t s . A f a i l u r e o f m o n e t a r y p o l i c y t o k e e p t h e f i r s t - r o u n d effects o f t h e increase i n t h e i n d i r e c t tax f r o m t r i g g e r i n g a n e w wage-price s p i r a l w o u l d only c o n f i r m the public's conviction that inflation w o u l d continue. T h e c u r r e n t G o v e r n o r o f t h e B a n k o f Canada, G o r d o n T h i e s s e n , has d e s c r i b e d F e b r u a r y 1991 as a p e r i o d o f p u b l i c u n c e r t a i n t y a b o u t i n f l a ­ t i o n , d e s p i t e t h e e a r l i e r d e c l a r a t i o n o f t h e price-stability g o a l ( T h i e s s e n 1 9 9 1 , 1995a). D e p u t y G o v e r n o r Charles F r e e d m a n (1994a) also stated t h a t o n e o f t h e Bank's p r i m a r y s h o r t - r u n c o n c e r n s was t o p r e v e n t a n u p w a r d s p i r a l i n i n f l a t i o n e x p e c t a t i o n s i n t h e face o f these shocks. T h e B a n k w e n t f u r t h e r a n d seized t h e o p p o r t u n i t y t o d i s t i n g u i s h b e t w e e n t h e t e m p o r a r y shocks a n d t h e i n t e n d e d p a t h o f i n f l a t i o n as a n i n s t r u c ­ t i o n a l p r e c e d e n t f o r its t a r g e t i n g f r a m e w o r k . As t h e a n n o u n c e m e n t ex­ p l a i n e d : "These targets are d e s i g n e d t o p r o v i d e a clear i n d i c a t i o n o f t h e d o w n w a r d p a t h f o r i n f l a t i o n over t h e m e d i u m t e r m " ( B a n k o f C a n a d a , 1991b, M a r c h , p . 5 ) . T o u n d e r s c o r e this i n t e n t i o n , t h e B a n k r e f e r r e d t o t h e targets as " i n f l a t i o n - r e d u c t i o n targets," u n t i l t h e target r a n g e s t o p p e d d r o p p i n g i n 1995 a n d t h e targets b e c a m e " i n f l a t i o n - c o n t r o l targets." (We have already seen semantic d i s t i n c t i o n s o f this type d r a w n i n t h e case o f Germany, where the Bundesbank used the phrase "unavoidable rate o f p r i c e increase" d u r i n g t h e d i s i n f l a t i o n phase a n d t h e n s w i t c h e d t o "nor­ mative rate o f p r i c e increase.") O f course, t h e targets chosen were t h o u g h t by t h e B a n k t o be a t t a i n a b l e , t h e l o g i c b e i n g t h a t i f d e c l a r a t i o n s o f t h e price-stability g o a l were n o t e n o u g h , t h e n f a i l u r e t o achieve specific p r o m ­ ised r e d u c t i o n s i n i n f l a t i o n w o u l d c e r t a i n l y be d e t r i m e n t a l t o t h e c r e d ­ ibility o f policy a n d the h o p e o f eventually e l i m i n a t i n g i n f l a t i o n (Freed­ m a n , 1995).

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T h e B a n k set the first target f o r twenty-two m o n t h s after t h e a n n o u n c e ­ m e n t o f t a r g e t a d o p t i o n , f o r t h e stated r e a s o n t h a t six-to-eight-quarter lags b e f o r e t h e effect o f m o n e t a r y p o l i c y b e c a m e a p p a r e n t m a d e any e a r l i e r t a r g e t infeasible. C a n a d a m a y have g o n e t h r o u g h a p e r i o d o f sig­ n i f i c a n t i n f l a t i o n u n c e r t a i n t y as a r e s u l t o f t h a t d e c i s i o n . I n t h e event, i n f l a t i o n actually undershot t h e t a r g e t r a n g e u n t i l early 1993. I t appears, t h o u g h , t h a t t h e p u b l i c d i d n o t r e g a r d t h e i n f l a t i o n t a r g e t as c r e d i b l e u n t i l later, as we w i l l d o c u m e n t u s i n g d a t a o n i n f l a t i o n e x p e c t a t i o n s i n C h a p t e r 10. I n contrast, N e w Zealand's a n d t h e U n i t e d K i n g d o m ' s tar­ get ranges t o o k effect i m m e d i a t e l y u p o n a d o p t i o n , a n d those c o u n t r i e s e x p e r i e n c e d l i t t l e p r o b l e m w i t h t a r g e t misses u n t i l s u b s e q u e n t cyclical upswings. T h e B a n k o f Canada's r a t i o n a l e f o r its i n f l a t i o n - t a r g e t i n g a p p r o a c h — a n d f o r its g o a l o f p r i c e stability, r a t h e r t h a n j u s t l o w i n f l a t i o n — w a s w h a t c o u l d be t e r m e d a sluggishness, as w e l l as a n e n t r e n c h e d u p w a r d bias, i n t h e p u b l i c ' s i n f l a t i o n e x p e c t a t i o n s . As a r t i c u l a t e d b y G o v e r n o r C r o w (1988) i n his H a n s o n L e c t u r e , " I n m y view, t h e n o t i o n o f a h i g h , yet stable, r a t e o f i n f l a t i o n is s i m p l y u n r e a l i s t i c . " O f f e r i n g t h e h y p o t h e t i c a l e x a m p l e o f a c e n t r a l b a n k t o l e r a t i n g 4 % i n f l a t i o n , t h e G o v e r n o r asserted t h a t a p u b l i c t h a t sees t h e c e n t r a l b a n k as u n w i l l i n g t o r e d u c e i n f l a t i o n f r o m t h a t level w o u l d v i e w any s h o c k t h a t m o v e d i n f l a t i o n u p (say t o 5 % ) as u n l i k e l y t o be reversed, a n d t h e r e f o r e l i k e l y t o be b u i l t i n t o i n f l a t i o n e x p e c t a t i o n s . I n f l a t i o n e x p e c t a t i o n s get a n e n t r e n c h e d bias u p w a r d , this a r g u m e n t goes, w h e n t h e r e is n o clear n o m i n a l a n c h o r t o k e e p t h e g o a l o f p r i c e stability i n view. T h e e n t r e n c h e d u p w a r d bias o f these e x p e c t a t i o n s is c i t e d r e p e a t e d l y as a n e m p i r i c a l r e a l i t y o f t h e C a n a d i a n e c o n o m y . F o r e x p e c t a t i o n s t o c h a n g e , G o v e r n o r C r o w a r g u e d , t h e c e n t r a l b a n k m u s t d e m o n s t r a t e its w i l l i n g n e s s t o pay t h e costs o f d i s i n f l a t i o n : " B u t as l o w e r i n f l a t i o n is achieved, as p e o p l e are less c o n d i t i o n e d b y fears o f i n f l a t i o n , r e d u c i n g i n f l a t i o n a n d p r e v e n t i n g its r e s u r g e n c e b e c o m e s less d i f f i c u l t " ( C r o w , 1989, p . 2 3 ) . W h i l e Crow's views h e l p t o e x p l a i n w h y t h e a n n o u n c e d targets " p r o v i d e [ a p a t h ] f o r gradual b u t progressive r e d u c t i o n s o f i n f l a ­ t i o n u n t i l p r i c e s t a b i l i t y is r e a c h e d " ( B a n k o f C a n a d a , 1991b, M a r c h , p . 5, e m p h a s i s a d d e d ) , this begs t h e q u e s t i o n o f w h y f o r t h r e e years t h e B a n k s i m p l y d e c l a r e d its c o m m i t m e n t t o p r i c e s t a b i l i t y w i t h o u t n a m i n g a n e x p l i c i t n o m i n a l a n c h o r . I t is l i k e l y t h a t t h e B a n k was w a i t i n g u n t i l t h e e l e c t e d g o v e r n m e n t was ready t o s u p p o r t f u l l y its c o m m i t m e n t t o p r i c e s t a b i l i t y (see, f o r e x a m p l e , L a i d l e r a n d R o b s o n [ 1 9 9 3 ] ) . I t is also possible t h a t t h e B a n k s i m p l y w e n t t h r o u g h a p r o l o n g e d de­ c i s i o n - m a k i n g process t h a t c u l m i n a t e d i n t h e o p p o r t u n i t y t o take advan1

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tage o f t h e e c o n o m i c s i t u a t i o n o f F e b r u a r y 1 9 9 1 . T h e H a n s o n L e c t u r e i t s e l f was i g n o r e d i n t h e Annual Report, 1988, t h o u g h i t was e v e n t u a l l y c i t e d r e p e a t e d l y i n B a n k o f C a n a d a statements a n d was f o l l o w e d u p b y " T h e Benefits o f Price Stability" i n t h e Annual Report, 1990. A n a p p r e c i a ­ t i o n f o r t h e possible benefits o f t a r g e t i n g e m e r g e d after a n even g r e a t e r lag: I n 1989, G o v e r n o r C r o w stated i n a speech r e p r i n t e d i n t h e Bank of Canada Review, " I n m y e x p e r i e n c e , i f [ a n i n f l a t i o n ] t a r g e t is suggested i t is a l m o s t i n v a r i a b l y w h a t e v e r t h e rate o f i n f l a t i o n h a p p e n s t o be at t h e t i m e . Some target!" (Crow, 1989, p . 2 2 ) . 3

I n any event, the decision t o a d o p t i n f l a t i o n - r e d u c t i o n targets was m a d e t o "buttress" t h e B a n k o f Canada's c o m m i t m e n t t o p r i c e stability a n d t o resolve u n c e r t a i n t i e s a b o u t i t ( F r e e d m a n , 1994a). " T h e targets [ w e r e ] n o t m e a n t t o s i g n a l a shift i n m o n e t a r y policy. . . . A l l we [ w e r e ] d o i n g [was] m a k i n g clear t o t h e p u b l i c t h e rate o f progress i n r e d u c i n g i n f l a ­ t i o n t h a t m o n e t a r y p o l i c y [was] a i m i n g f o r " (Thiessen, 1 9 9 1 , p . 1 9 ) . T h e B a n k o f C a n a d a d i d n o t suggest t h a t t h e a n n o u n c e m e n t o f targets b y itself w o u l d b r i n g an i m m e d i a t e payoff i n lower inflation expectations; rather, i t saw t h e benefits a c c r u i n g over a l o n g p e r i o d o f t i m e . A c h i e v i n g those targets over t h e m e d i u m t e r m w o u l d e v e n t u a l l y s t r e n g t h e n p u b l i c c o n f i d e n c e i n m o n e t a r y policy, i t was t h o u g h t , a n d i n f l a t i o n c o n t r o l w o u l d be s u p p o r t e d by t h e i n c r e a s e d t r a n s p a r e n c y a n d a c c o u n t a b i l i t y t h a t t h e targets w o u l d b r i n g t o t h e c o n d u c t o f m o n e t a r y policy.

The Operational Framework W h e n t h e C a n a d i a n i n f l a t i o n - t a r g e t i n g scheme was a n n o u n c e d i n Feb­ r u a r y 1 9 9 1 , i t was i n t h e f o r m o f a t i m e t a b l e f o r r e d u c i n g i n f l a t i o n , de­ fined by t h r e e c o m m i t m e n t s f o r i n f l a t i o n levels at l a t e r dates. ( I n fact, as m e n t i o n e d earlier, B a n k o f C a n a d a officials o r i g i n a l l y r e f e r r e d t o t h e targets as " i n f l a t i o n - r e d u c t i o n targets.") T h e first t a r g e t r a n g e t o o k a m i d p o i n t o f 3% year-over-year i n f l a t i o n ( d e f i n e d as t h e c h a n g e i n t h e C P I ) b y t h e e n d o f 1992, twenty-two m o n t h s after a d o p t i o n . T h e s e c o n d t a r g e t was a m i d p o i n t o f 2.5% i n f l a t i o n b y t h e e n d o f J u n e 1994, a n d t h e t h i r d was a m i d p o i n t o f 2 % i n f l a t i o n e i g h t e e n m o n t h s after t h a t . T h e B a n k stated at t h e o u t s e t t h a t p r i c e stability i n v o l v e d a rate o f i n f l a t i o n b e l o w 2 % : " A g o o d deal o f w o r k has already b e e n d o n e i n Canada o n w h a t stability i n t h e b r o a d level o f prices means o p e r a t i o n a l l y . T h i s w o r k suggests a rate o f increase i n c o n s u m e r prices t h a t is c l e a r l y b e l o w 2 p e r c e n t " ( B a n k o f Canada, 1991b, M a r c h , p . 5 ) . T h e r e was n o m e n ­ t i o n , however, o f t a r g e t i n g zero m e a s u r e d i n f l a t i o n o r a c o n s t a n t p r i c e

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level. T h e B a n k w a n t e d t o see f u r t h e r research b e f o r e c o m m i t t i n g t o a precise o p e r a t i o n a l d e f i n i t i o n o f p r i c e stability. F r o m t h e outset o f tar­ g e t i n g , t h e B a n k m a d e a n u m b e r o f statements i n d i c a t i n g t h a t t h e cor­ r e c t n u m b e r f o r p r i c e stability w o u l d be d e f i n e d at a l a t e r date, a n d t h a t t h e r e w o u l d be f u r t h e r r e d u c t i o n s i n t h e t a r g e t u n t i l p r i c e stability h a d b e e n achieved. I t is i n t e r e s t i n g t h a t , since l a t e r studies b y t h e B a n k w o u l d estimate t h e u p w a r d bias i n i n f l a t i o n m e a s u r e m e n t o f t h e C a n a d i a n C P I t o be at m o s t 0.5% p e r year ( B a n k o f Canada, 1995c, May, p . 4, f o o t n o t e 1 ) , m o r e t h a n m e a s u r e m e n t e r r o r a l o n e m u s t u n d e r l i e Canada's r e l u c ­ tance t o d a t e t o r e d u c e t h e m i d p o i n t o f its t a r g e t i n f l a t i o n r a n g e b e l o w 2 % p e r year. O n t h e a p p o i n t m e n t o f G o v e r n o r T h i e s s e n i n D e c e m b e r 1993, t h e n e w L i b e r a l G o v e r n m e n t a n d t h e B a n k e x t e n d e d t h e 1 % t o 3% i n f l a t i o n t a r g e t f r o m t h e e n d o f 1995 t o t h e e n d o f 1998. T h e s e t t i n g o f a n opera­ t i o n a l d e f i n i t i o n o f p r i c e stability was a g a i n p u t o f f u n t i l m o r e e x p e r i ­ ence was g a i n e d a b o u t t h e p e r f o r m a n c e o f t h e e c o n o m y at l o w rates o f i n f l a t i o n . T h e B a n k specified a g a i n t h a t i t was n o t t r e a t i n g t h e c u r r e n t targets as t h e e q u i v a l e n t o f p r i c e stability: There were two reasons for the extension—(i) given that i t has been a long time since Canada has had such low rates o f inflation, i t would be helpful to have more experience i n operating under such conditions before an appro­ priate longer-term objective is determined; (ii) some time is needed to en­ able Canadians to adjust to the improved inflation outlook. (Freedman, 1995, p. 2 4 ) 4

I n s e t t i n g its targets, t h e B a n k a t t e m p t e d t o o r i e n t b o t h its o w n p o l i c i e s a n d the expectations o f the p u b l i c toward a m e d i u m - t e r m h o r i z o n o f o n e t o t h r e e years. I t accepted, however, t h a t p u b l i c e x p e c t a t i o n s a n d t h e i r i m p l i c a t i o n s f o r e c o n o m i c b e h a v i o r ( s u c h as p a t t e r n s o f wage-set­ t i n g ) w o u l d n o t be c o m p l e t e l y a l t e r e d even after a n u m b e r o f years o f targeting. T h e m e d i u m - t e r m o r i e n t a t i o n also i n f o r m e d t h e Bank's c h o i c e o f tar­ get v a r i a b l e . T h e rate o f c h a n g e i n t h e C P I was c h o s e n as t h e p r i m a r y target because o f its " h e a d l i n e " q u a l i t y ; i t is t h e m o s t c o m m o n l y used a n d u n d e r s t o o d p r i c e m e a s u r e i n Canada. I n a d d i t i o n , t h e C P I comes o u t m o n t h l y , w i t h i n f r e q u e n t delays a n d w i t h o u t revisions ( o n e a l t e r n a ­ tive p r i c e i n d e x , t h e G D P deflator, is f r e q u e n t l y revised i n C a n a d a ) . Be­ cause t h e h e a d l i n e C P I i n c l u d e s f o o d a n d energy prices, however, i t tends t o b e v o l a t i l e . Consequently, t o a v o i d f o r c e d responses t o s h o r t - r u n fluc­ t u a t i o n s , t h e B a n k also uses a n d r e p o r t s "core C P I " ( w h i c h e x c l u d e s changes i n prices o f f o o d a n d e n e r g y ) , asserting t h a t c o r e C P I i n f l a t i o n

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a n d headline CPI inflation move together i n the medium-to-long t e r m . " H o w we w i l l react [ t o a c h a n g e i n i n f l a t i o n ] w i l l d e p e n d o n w h e t h e r o r n o t a c h a n g e i n m e a s u r e d i n f l a t i o n is associated w i t h a shift i n t h e m o ­ m e n t u m , o r u n d e r l y i n g t r e n d , o f i n f l a t i o n " (Thiessen, 1994b, p . 8 1 ) . T h e r e is n o f i x e d p r o c e d u r e b y w h i c h t h e B a n k is h e l d a c c o u n t a b l e f o r p e r f o r m a n c e o n e i t h e r o f t h e t w o C P I i n d i c e s over a s p e c i f i e d t i m e f r a m e , b u t r e p e a t e d d e v i a t i o n s f r o m t h e p a t h set by t h e targets w o u l d c e r t a i n l y be o b v i o u s t o t h e g o v e r n m e n t a n d t o t h e p u b l i c . F u r t h e r , t h e B a n k makes a s t r o n g e f f o r t t o c o m m u n i c a t e t o t h e p u b l i c its r e a d i n g o f t h e e c o n o m y a n d t h e r a t i o n a l e f o r its decisions. I t e x p l a i n s t h e e x t e n t t o w h i c h t h e changes i n t h e C P I r e f l e c t e i t h e r p u r e l y t r a n s i t o r y factors o r p e r s i s t e n t i n f l a t i o n a r y pressures. T h e B a n k is s c r u p u l o u s a b o u t convey­ i n g this message clearly, since its o f f i c i a l target, h e a d l i n e C P I i n f l a t i o n , m a y b e sensitive t o t e m p o r a r y f a c t o r s . I t takes o u t t h e first-round effects o f i n d i r e c t taxes w h e n d e t e r m i n i n g w h e t h e r a c u r r e n t o r f u t u r e c h a n g e i n i n f l a t i o n exceeds t h e t a r g e t r a n g e i n a m a n n e r t h a t j u s t i f i e s a p o l i c y r e s p o n s e . T h i s p r a c t i c e o f d i s t i n g u i s h i n g b e t w e e n t h e first-round a n d s e c o n d - r o u n d p r i c e effects o f shocks is consistent w i t h t h e B a n k ' s behav­ i n g i n a p r e e m p t i v e m a n n e r against i n f l a t i o n a r y i m p u l s e s . 5

6

7

D e p u t y G o v e r n o r C h a r l e s F r e e d m a n ' s discussion o f p r i c e d e v e l o p ­ m e n t s i n 1994 i n d i c a t e s t h e B a n k ' s a t t e n t i o n t o special factors i n s e t t i n g policy a n d i n c o m m u n i c a t i n g w i t h the public: I n particular, although the 12 m o n t h rate of increase i n the total CPI t h r o u g h m u c h o f 1994 was virtually zero, the Bank focused o n the fact that the reduc­ tion i n excise taxes o n cigarettes i n early 1994 accounted for a decline o f 1.3 per cent i n the total CPI. Operationally, therefore, the emphasis has been placed o n the CPI excluding food, energy and the effect o f indirect taxes, which has been posting a rate of increase between 1 /i and 1 A per cent. A t mid-1994, the date o f the second milestone, the rate o f increase o f total CPI was at 0.0 per cent while that o f the CPI excluding food, energy and the effect o f indirect taxes was at 1.8 per cent, near the bottom o f the band. (Freedman, 1995, pp. 24-25) x

3

T h e i n f l a t i o n targets are set i n terms o f ranges: As i n i t i a l l y a n n o u n c e d , i n f l a t i o n w o u l d be p e r m i t t e d t o range f r o m 1 % above t o 1 % b e l o w each o f these targets. T h e n , b e g i n n i n g i n D e c e m b e r 1995, i t w o u l d be p e r m i t t e d to r a n g e b e t w e e n 1 % a n d 3%. I n p r i n c i p l e , t h e objective t o be t a r g e t e d was t h e m i d p o i n t o f t h e range. I n practice, t h e B a n k never aggressively s o u g h t t o m o v e i n f l a t i o n f r o m t h e o u t e r bands t o w a r d t h e m i d p o i n t s , even w h e n actual i n f l a t i o n l i n g e r e d at o r b e l o w t h e target floor f o r a n e x t e n d e d p e r i o d . I n fact, " i n t h e revised targets m o r e emphasis is p l a c e d o n t h e

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b a n d s t h a n o n t h e m i d p o i n t s " ( F r e e d m a n , 1 9 9 5 ) . T h e use o f a t a r g e t r a n g e is e x p l i c i t l y i n t e n d e d t o a l l o w f o r c o n t r o l p r o b l e m s . T h e B a n k does r e c o g n i z e t h a t a b a n d o f 2 % w i d t h is n a r r o w e r t h a n w h a t research has s h o w n t o be necessary t o a c c o m m o d a t e c o n t r o l e r r o r a n d u n e x p e c t e d shocks; b u t i t also feels t h a t t o o w i d e a b a n d w o u l d s e n d t h e w r o n g mes­ sage t o t h e p u b l i c ( F r e e d m a n , 1994a). T h e B a n k also b e l i e v e d t h a t t h e b a n d w o u l d p r o v i d e sufficient f l e x i b i l ­ ity f o r m o n e t a r y p o l i c y t o deal w i t h supply shocks, b e y o n d those already t a k e n care o f by t h e e x c l u s i o n o f f o o d a n d energy prices f r o m core infla­ t i o n a n d ad hoc adjustments t o e x c l u d e t h e first-round effects o f changes i n i n d i r e c t taxes. N o e x p l i c i t escape clauses were set u p f o r t h e B a n k t o i n v o k e s h o u l d u n u s u a l l y large o r u n a n t i c i p a t e d shocks arise; t h e response t o such e x t r a o r d i n a r y shocks was left, i m p l i c i d y , t o t h e Bank's d i s c r e t i o n . 8

9

N o t e h o w loosely d e f i n e d this t a r g e t d e f i n i t i o n appears w h e n c o m ­ p a r e d t o t h e Reserve B a n k o f N e w Zealand's h i g h l y s p e c i f i e d list o f ex­ c e p t i o n s , w h i c h i n t u r n m u s t be a p p r o v e d b y t h e e l e c t e d g o v e r n m e n t . I n t h e a c t u a l c o n d u c t o f policy, however, t h e B a n k o f Canada's d e f i n i t i o n o f the i n f l a t i o n target implies an approach very similar to that o f N e w Z e a l a n d , r e f l e c t i n g t h e fact t h a t b o t h are " s m a l l " ( i n a n e c o n o m i c sense), o p e n e c o n o m i e s l a r g e l y d e p e n d e n t o n e x p o r t s o f n a t u r a l resources. D e f i n i n g t h e t a r g e t i n f l a t i o n rate i n t h e way t h a t C a n a d a d i d has sev­ e r a l i m p l i c a t i o n s : First, i t c o m m i t s m o n e t a r y p o l i c y i n C a n a d a t o revers­ i n g shifts i n t h e t r e n d i n f l a t i o n rate w h i l e a l l o w i n g p r i c e - l e v e l shifts i n t h e face o f s u p p l y shocks; i t is n o t a f r a m e w o r k consistent w i t h p r i c e level t a r g e t i n g . S e c o n d , i t grants t h e B a n k o f C a n a d a t h e f r e e d o m t o act w i t h r e f e r e n c e t o t h e t a r g e t b a n d s i n w h a t e v e r way i t c a n j u s t i f y t o t h e p u b l i c ; i t does n o t specify b e f o r e h a n d t h e c i r c u m s t a n c e s u n d e r w h i c h t h e B a n k s h o u l d deviate f r o m its target. A n o t h e r aspect o f t h e B a n k o f Canada's p o l i c y f r a m e w o r k is t h a t i t lends a c o u n t e r c y c l i c a l t e n d e n c y t o m o n e t a r y policy, i n t h a t t h e B a n k m u s t r e s p o n d t o aggregate d e m a n d - d r i v e n p r i c e increases ana decreases t h a t w o u l d take i n f l a t i o n o u t o f t h e t a r g e t r a n g e . W h i l e c o m m o n t o a l l i n f l a t i o n - t a r g e t i n g r e g i m e s t h a t p u t a f l o o r as w e l l as a c e i l i n g o n i n f l a ­ t i o n goals, this f e a t u r e has b e c o m e m o r e p r o m i n e n t a n d e x p l i c i t i n t h e Canadian framework: 10

Some people fear that, by focusing monetary policy tightly o n inflation con­ trol, the monetary authorities may be neglecting economic activity and em­ ployment. N o t h i n g could be further from the t r u t h . By keeping inflation w i t h i n a target range, monetary policy acts as a stabilizer for the economy. When weakening demand threatens to p u l l inflation below the target range, it will be countered by monetary easing. (Thiessen, 1996b, p. 2)

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The l i n k between developments i n the real economy a n d movements i n prices is n o t d e n i e d b y t h e B a n k o f Canada, despite its o f f i c i a l focus o n i n f l a t i o n goals. G o v e r n o r T h i e s s e n , i n fact, has o f f e r e d a n e x p l a n a ­ t i o n f o r i n f l a t i o n d i s t i n c t f r o m e x p l a n a t i o n s t h a t relate solely t o m o n ­ etary factors: Upward pressure on inflation comes about when excessive spending demands i n the economy, which are not adequately resisted by monetary policy, persis­ tently exceed the capacity o f the economy to produce the goods and services that are being sought. (Thiessen, 1995b, p. 66) C o n c e r n about the trade-off between o u t p u t a n d inflation explains the g r a d u a l way t h e B a n k m o v e d f r o m a n e x p e c t e d i n f l a t i o n rate o f 5% at t h e e n d o f 1991 t o a 2 % t a r g e t b y t h e e n d o f 1995. F r e e d m a n (1994a) n o t e d that a typical Phillips-curve equation, a u g m e n t e d to allow for the effects o f s u p p l y shocks, was b r o a d l y able t o t r a c k t h e d e c l i n e i n i n f l a t i o n i n Canada, suggesting t h a t t h e r e was n o n e e d t o r e s o r t t o e x p l a n a t i o n s i n v o l v i n g c r e d i b i l i t y a n d changes i n e x p e c t a t i o n s t o e x p l a i n t h e pace o f d i s i n f l a t i o n . H o w e v e r , despite t h e c o n t i n u i n g " o u t p u t g a p " (i.e., a s h o r t ­ f a l l o f o u t p u t relative t o its p o t e n t i a l ) , since t h a t t i m e i n f l a t i o n has n o t f a l l e n f u r t h e r , as such e q u a t i o n s w o u l d p r e d i c t . O n e reason m i g h t b e t h a t t h e Bank's t a r g e t is n o w sufficiently c r e d i b l e t h a t t h e p u b l i c ' s i n f l a ­ t i o n e x p e c t a t i o n s have b e c o m e q u i t e firm at a b o u t 2 % . I n any event, t h e B a n k r e p e a t e d l y h o l d s o u t t h e h o p e i n p u b l i c state­ m e n t s t h a t as t h e e x p e c t a t i o n s o f p r i v a t e i n d i v i d u a l s a n d firms a d a p t t o t h e n e w r e g i m e , t h e cost a n d t i m e necessary t o achieve a n d m a i n t a i n i n f l a t i o n goals w i l l d r o p . I t is fair t o ask, however, h o w l o n g C a n a d a ( o r any o t h e r c o u n t r y ) must pursue credible disinflationary, a n d t h e n c o u n t e r i n f l a t i o n a r y , p o l i c i e s b e f o r e results c a n be e x p e c t e d . Clearly, i n t h e case o f Canada, m o r e t h a n f o u r years o f i n f l a t i o n t a r g e t i n g , p r e c e d e d by at least t h r e e years o f t i g h t e n i n g m o n e t a r y c o n d i t i o n s , were n o t e n o u g h to r e d u c e s i g n i f i c a n t l y t h e costs o f d i s i n f l a t i o n . A c c o r d i n g l y , t h e B a n k o f Canada's j u s t i f i c a t i o n f o r t h e p u r s u i t o f i n ­ flation targets, a n d f r o m t h e r e p r i c e stability, does n o t rest solely o n t h e a r g u m e n t t h a t q u a n t i t a t i v e goals c a n h e l p i m p r o v e c r e d i b i l i t y ; t h e r e is also t h e view t h a t l o w e r i n f l a t i o n w i l l i m p r o v e t h e f u n c t i o n i n g o f t h e r e a l e c o n o m y w i t h i n a reasonably s h o r t span o f time. " I n o t h e r w o r d s , o u r objective is p r i c e stability, b u t as a m e a n s t o t h e e n d o f g o o d e c o n o m i c p e r f o r m a n c e r a t h e r t h a n as a n e n d i n i t s e l f (Thiessen 1994a, p . 85) . I t is i n t e r e s t i n g , t h o u g h , t h a t G o v e r n o r T h i e s s e n has also e x t o l l e d trans­ p a r e n c y i n m o n e t a r y policy—as f o s t e r e d b y i n f l a t i o n targeting—as hav­ i n g i m p o r t a n t e c o n o m i c benefits i n its o w n r i g h t . 1 1

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First, [the central bank] can try to reduce the uncertainty o f the public and of financial markets about its responses to the various shocks. I t can do this by making clear the longer-run goal o f monetary policy, the shorter-term operational targets at which i t is aiming i n taking policy actions, and its own interpretation o f economic developments. Moreover, by committing itself to a longer-term goal and sticking to it, as well as by lessening uncertainty about its own responses to shocks, the central bank may be able to lessen the effect of shocks o n private sector behavior. (Thiessen, 1995a, p. 42) N o o t h e r i n f l a t i o n - t a r g e t i n g c e n t r a l b a n k has so e x p l i c i t l y m a d e a v i r t u e o f t r a n s p a r e n c y f o r its b e n e f i t t o t h e e c o n o m y as w e l l as f o r its r o l e i n r e d u c i n g i n f l a t i o n , a l t h o u g h a l l have m a d e efforts i n t h a t d i r e c t i o n . N o t e t h a t t h e benefits Thiessen lists h e r e can stem f r o m any sustainable longerr u n g o a l o f a c e n t r a l b a n k w i t h a consistent o p e r a t i o n a l f r a m e w o r k ; h e makes n o e x p l i c i t m e n t i o n o f e i t h e r p r i c e stability o r i n f l a t i o n . Clearly, t h e B a n k o f C a n a d a feels that, w i t h i n such a f r a m e w o r k , i t c a n r e s p o n d effectively t o s h o r t - r u n d e v e l o p m e n t s w i t h o u t h a v i n g t o c o m p r o m i s e its longer-run goals. 14

F r o m 1982, w h e n M l was d r o p p e d as t h e B a n k o f Canada's i n t e r m e ­ diate target, u n t i l 1 9 9 1 , w h e n i n f l a t i o n - r e d u c t i o n targets were an­ n o u n c e d , the B a n k h a d b e e n searching f o r a substitute a m o n g the vari­ ous b r o a d e r m o n e t a r y a n d c r e d i t aggregates, a l t h o u g h " [ t h e y h a d ] n o t f o u n d t h e b e h a v i o r o f any o n e o f t h e m s u f f i c i e n t l y r e l i a b l e t o s h o u l d e r t h e b u r d e n o f a c t i n g as a f o r m a l t a r g e t f o r m o n e t a r y p o l i c y " ( C r o w , 1990, p . 3 6 ) . T h e m o v e t o t a r g e t i n g d i r e c t l y a g o a l o f p o l i c y ( o r its f o r e c a s t ) , r a t h e r t h a n a n i n t e r m e d i a t e v a r i a b l e ( s u c h as t h e m o n e y stock) r e p r e s e n t e d a s i g n i f i c a n t p a r a d i g m shift f o r t h e B a n k o f C a n a d a . A n i m p l i c a t i o n o f t h i s c h a n g e was t h a t t h e B a n k w o u l d have t o b r o a d e n its i n f o r m a t i o n - g a t h e r i n g t o i n c l u d e any v a r i a b l e c o n t a i n i n g i n f o r m a ­ t i o n a b o u t f u t u r e i n f l a t i o n , a n d i t has since selected a w i d e r a n g e o f i n f o r m a t i o n variables . T h e o r y was o f o n l y m o d e r a t e h e l p i n selecting t h e i n f o r m a t i o n vari­ ables. " I n o u r view, u n d e r l y i n g i n f l a t i o n is affected p r i m a r i l y by t h e level o f slack i n t h e e c o n o m y a n d b y t h e e x p e c t e d rate o f i n f l a t i o n , " stated G o v e r n o r Thiessen (1995a, p . 4 9 ) . N e i t h e r slack n o r e x p e c t a t i o n is a f a c t o r t h a t c a n be observed d i r e c t l y ; t h e y c a n be assessed o n l y i n refer­ ence t o a variety o f variables. I n p r a c t i c e , the Bank o f Canada has focused closely o n estimates o f excess demand or supply (or "gaps") i n goods and labor markets as key inputs i n t o the infla­ tionary process. I t also follows closely such variables as the rate o f expansion of money (especially the broader aggregate M2+ . . . ) , the growth o f credit,

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the rate o f increase o f total spending and wage settlements as guides to policy action. (Freedman, 1995) T h e Bank's M a y 1995 Monetary Policy Report, e s t a b l i s h i n g t h e f o r m a t f o r those t h a t f o l l o w e d , discussed p r o d u c t a n d l a b o r m a r k e t s , i n f l a t i o n e x p e c t a t i o n s , c o m m o d i t y prices, a n d t h e C a n a d i a n d o l l a r e x c h a n g e rate i n t h e s e c t i o n "Factors at W o r k o n I n f l a t i o n . " M o n e t a r y aggregates are n o t m e n t i o n e d u n t i l l a t e r i n t h e Report, as t h e last o f " o t h e r i n d i c a t o r s " l i s t e d i n t h e " O u t l o o k " s e c t i o n . F o r measures o f i n f l a t i o n e x p e c t a t i o n s , t h e B a n k considers results f r o m t h e q u a r t e r l y survey o f t h e C o n f e r e n c e B o a r d o f Canada, t h e forecasts l i s t e d i n Consensus Forecasts, as w e l l as t h e d i f f e r e n t i a l b e t w e e n t h e r e t u r n s o n thirty-year c o n v e n t i o n a l n o m i n a l b o n d s a n d r e a l i n d e x e d b o n d s , b u t i t does n o t c o n d u c t its o w n surveys o f expectations. 15

T o a i d i n assessing t h e e c o n o m i c s i t u a t i o n , t h e B a n k o f C a n a d a i n ­ t r o d u c e d t h e c o n c e p t o f a m o n e t a r y c o n d i t i o n s i n d e x ( M C I ) as a s h o r t r u n o p e r a t i o n a l t a r g e t . ( N e w Z e a l a n d has a d o p t e d a s i m i l a r i n d e x ; see C h a p t e r 5.) A c h a n g e i n t h e M C I is d e f i n e d as t h e w e i g h t e d s u m o f c h a n g e s i n t h e n i n e t y - d a y c o m m e r c i a l p a p e r i n t e r e s t rate a n d t h e t r a d e w e i g h t e d exchange rate (for t r a d i n g partners i n the G r o u p o f T e n ) , w h e r e t h e w e i g h t s are t h r e e t o o n e . T h e t h r e e - t o - o n e w e i g h t i n g o f i n ­ terest rates t o e x c h a n g e rates c a m e o u t o f B a n k estimates o f t h e six-toe i g h t - q u a r t e r t o t a l effect o f c h a n g e s o f e a c h v a r i a b l e o n a g g r e g a t e de­ m a n d . T h e M C I was a r b i t r a r i l y b a s e d at 100 i n J a n u a r y 1987 a n d t h e n c o m p u t e d b a c k w a r d a n d f o r w a r d f r o m t h a t p o i n t ; because t h e v a l u e o f t h e M C I at a p o i n t i n t i m e is a r b i t r a r y , t h e B a n k c o r r e c t l y stresses t h a t s h o r t - r u n changes i n t h e M C I are m o r e m e a n i n g f u l t h a n t h e levels t h e m ­ selves. 16

T h e m a i n p u r p o s e o f t h e M C I is t o r e m i n d t h e B a n k a n d t h e p u b l i c t h a t t h e r e are t w o key m o n e t a r y - p o l i c y c h a n n e l s o f effect o n aggregate d e m a n d i n an o p e n economy, the channel operating t h r o u g h interest rates a n d t h e o n e o p e r a t i n g t h r o u g h e x c h a n g e rates. T h e M C I is a "shortr u n o p e r a t i o n a l t a r g e t . . . m o s t u s e f u l over a one- t o t w o - q u a r t e r h o r i ­ z o n " ( B a n k o f Canada, 1996c, N o v e m b e r , p . 2 1 ) . T h e M C I does n o t c o n ­ s t i t u t e a n o m i n a l a n c h o r i n itself, n o r does i t i m p l y a c o m m i t m e n t t o i n t e r v e n e t o a l t e r e x c h a n g e rates: " B e t w e e n q u a r t e r l y staff p r o j e c t i o n s , the M C I provides the Bank w i t h a continuous r e m i n d e r that exchange rate changes m u s t be c o n s i d e r e d w h e n m a k i n g decisions a b o u t i n t e r e s t rate adjustments" ( B a n k o f Canada, 1996c, N o v e m b e r , p . 2 1 ) . U n d e r l i n ­ i n g its essentially tactical r o l e i n o p e r a t i o n s , t h e M C I is c o n s i d e r e d o n l y b r i e f l y i n t h e s e m i a n n u a l Monetary Policy Report.

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T h e B a n k o f Canada's Annual Report, 1994mm t o t a l l y r e d e s i g n e d f r o m t h e 1993 e d i t i o n t o p r o m o t e openness a n d transparency. T h e first i t e m discussed u n d e r t h e h e a d i n g o f m o n e t a r y p o l i c y was t h e p l a n n e d i n t r o ­ d u c t i o n o f t h e Monetary Policy Report. A c c o r d i n g t o t h e Bank's o w n de­ scription: The new Monetary Policy Report will be designed to b r i n g increased trans­ parency and accountability to monetary policy. I t will measure our perfor­ mance i n terms o f the Bank's targets for controlling inflation and will exam­ ine how current economic circumstances and monetary conditions i n Canada are likely to affect future inflation. (Bank o f Canada, 1995a, p. 7) N o l o n g e r densely p r i n t e d a n d f o r m a l i n a p p e a r a n c e , t h e Annual Re­ port, 1994 ( a n d a l l those p u b l i s h e d since) was p r i n t e d i n large type, w i t h lots o f w h i t e space a n d n u m e r o u s p i c t u r e s a n d g r a p h s . T h e w r i t i n g be­ came l i g h t e r i n t o n e , a n d t h e Report b e c a m e m o r e w i d e l y d i s t r i b u t e d . As we discuss f u r t h e r i n t h e n e x t s e c t i o n , these changes m a y be seen as p a r t o f t h e Bank's efforts at p u b l i c o u t r e a c h a n d e d u c a t i o n , goals t h a t g a i n e d g r e a t e r a t t e n t i o n after G o r d o n Thiessen succeeded J o h n C r o w as Gover­ n o r . A n o t h e r f a c t o r i n t h e n e w d e s i g n m a y have b e e n t h e s w i t c h i n 1995 f r o m " i n f l a t i o n - r e d u c t i o n " t o " i n f l a t i o n - c o n t r o l " targets, t h a t is, i n f l a t i o n was n o w t o be stabilized r a t h e r t h a n r e d u c e d . 17

I n t h e i n t r o d u c t i o n t o t h e Annual Report, G o v e r n o r Thiessen spoke directly to the reader i n an i n f o r m a l manner: I n carrying out the responsibilities o f the Bank, our objective is to promote the economic and financial welfare o f Canada. I hope this description o f those activities w i l l increase the public's understanding o f how the Bank has fulfilled its responsibilities. Communicating what the Bank is up to and why is i m p o r t a n t i f we are going to maintain the confidence o f Canadians. This year we have changed the Bank's Annual Report. . . . This new style o f annual report is designed to provide more information o n what the Bank does, thereby providing a better account o f our actions. (Bank o f Canada, 1995a, p. 5) T h i s d e c i s i o n was p a r t o f a conscious e f f o r t t o increase t h e t r a n s p a r e n c y o f p o l i c y f o r t h e g e n e r a l p u b l i c . W h e n i n f l a t i o n targets w e r e o r i g i n a l l y a d o p t e d , t h e B a n k h a d stated: The Bank o f Canada will be reporting regularly o n progress relative to the inflation-reduction targets and on its monetary policy actions i n speeches, i n the extracts from the minutes o f meetings o f the Board o f Directors o f the Bank o f Canada and o f course i n the Bank o f Canada's A n n u a l Report to the

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Minister o f Finance. I n addition, an analysis o f inflation developments rela­ tive to the targets will be published periodically i n the Bank of Canada Review. (Bank o f Canada, 1991b, September, p. 15) T h e Review s w i t c h e d f r o m m o n t h l y t o q u a r t e r l y p u b l i c a t i o n i n 1993, h o w ­ ever, a n d t h e e x p e r i e n c e o f o t h e r i n f l a t i o n - t a r g e t i n g c o u n t r i e s , p a r t i c u ­ l a r l y t h e U n i t e d K i n g d o m , d e m o n s t r a t e d t h e usefulness o f a separate p u b l i c a t i o n i n e l i c i t i n g a n d focusing p u b l i c discussion o f m o n e t a r y policy. F o r C a n a d a , this separate p u b l i c a t i o n was t o be t h e Monetary Policy Report. T h e s e m i a n n u a l Monetary Policy Report v a r i e d s l i g h t l y i n s t r u c t u r e i n t h e first issues, b u t a l l e d i t i o n s i n c l u d e d some discussion o f r e c e n t devel­ o p m e n t s i n i n f l a t i o n , progress i n a c h i e v i n g t h e i n f l a t i o n - c o n t r o l targets, a n d t h e o u t l o o k f o r i n f l a t i o n . T h e B a n k describes t h e a i m o f t h e Mon­ etary Policy Report as follows: 18

This report reflects the framework used by the Bank i n its conduct o f policy. This framework includes: (I) a clear policy objective; ( I I ) a medium-term perspective (given the l o n g lags for the full impact o f monetary policy ac­ tions o n the economy) ; and ( I I I ) a recognition that monetary policy works t h r o u g h b o t h interest rates and the exchange rate. (Bank o f Canada, 1995c, May, p. 3) T h e Monetary Policy Report is d e s i g n e d t o be i n t e l l i g i b l e t o t h e layper­ son, w i t h " t e c h n i c a l boxes" e x p l a i n i n g various c o n c e p t s a n d p r o c e d u r e s ( s i m i l a r t o t h e p e d a g o g i c a l efforts i n t h e U n i t e d K i n g d o m ' s Inflation Re­ port) . T h e f o r m a t is o p e n , a n d s u m m a r y b u l l e t p o i n t s are u s e d i n t h e m a r g i n s . E a c h issue c o n t a i n s fewer t h a n t h i r t y pages, c o n s i s t i n g l a r g e l y o f charts. T h e Report is available o n t h e I n t e r n e t o r b y c a l l i n g a toll-free n u m b e r , a n d a four-page s u m m a r y is p r o v i d e d f o r those w h o d o n o t w i s h to r e a d t h e e n t i r e d o c u m e n t . O v e r a l l , t h e Report represents a m a j o r shift i n t o n e a n d i n target a u d i e n c e f r o m t h e r e p o r t i n g efforts u n d e r t a k e n i n t h e early years o f i n f l a t i o n t a r g e t i n g i n Canada, w h e n t h e discussion o f i n f l a t i o n was c o u c h e d i n t e c h n i c a l l a n g u a g e a n d was b u n d l e d t o g e t h e r w i t h o t h e r topics i n B a n k p u b l i c a t i o n s . A b o u t t h e same t i m e , changes w e r e b e i n g m a d e i n t h e i n t e r n a l orga­ n i z a t i o n o f t h e B a n k o f C a n a d a . M o s t p r o m i n e n t l y (as s u m m a r i z e d i n t h e A n n u a l R e p o r t , 1 9 9 4 ) , "the B o a r d o f D i r e c t o r s established a n e w senior decision-making authority w i t h i n the Bank called the ' G o v e r n i n g C o u n c i l . ' T h e C o u n c i l , w h i c h [ t h e G o v e r n o r c h a i r s ] , is c o m p o s e d o f the Senior Deputy Governor a n d the f o u r Deputy Governors. A major d e c e n t r a l i z a t i o n o f d e c i s i o n - m a k i n g is b e i n g i m p l e m e n t e d i n t h e wake

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o f t h e C o u n c i l ' s e s t a b l i s h m e n t " ( B a n k o f C a n a d a , 1995a, p . 8 ) . Since this c h a n g e , a l l issues o f t h e Monetary Policy Reporthave c a r r i e d t h e n o t e " T h i s is a r e p o r t o f t h e G o v e r n i n g C o u n c i l o f t h e B a n k o f Canada," f o l l o w e d b y t h e n a m e s o f t h e six m e m b e r s . T h i s m o v e m e n t t o c o l l e c t i v e responsi­ b i l i t y m a y have b e e n t o some e x t e n t a r e a c t i o n t o G o v e r n o r Crow's t e n ­ d e n c y t o b e c o m e p e r s o n a l l y i d e n t i f i e d w i t h t h e Bank's p o l i c y d u r i n g t h e early 1990s. T h e B a n k o f C a n a d a r e m a i n s a relatively i n d e p e n d e n t c e n t r a l b a n k . I n l i n e w i t h its r e s p o n s i b i l i t y f o r t h e c o n d u c t o f m o n e t a r y policy, i t has full operational independence i n the setting o f monetary-policy instru­ ments. For example, the B a n k alone determines the setting o f policyc o n t r o l l e d s h o r t - t e r m i n t e r e s t rates. Nevertheless, t h e B a n k is subject t o t h e " d o c t r i n e o f d u a l responsibility," w h i c h puts u l t i m a t e r e s p o n s i b i l i t y for monetary policy i n the hands o f the Minister o f Finance. T h e Minis­ ter can make the Governor follow a particular policy ( o r move interest rates at a specific t i m e ) b y issuing a p u b l i c d i r e c t i v e , w i t h w h i c h t h e Gov­ e r n o r a n d the Bank must comply. 19

20

N o c o n f l i c t b e t w e e n t h e M i n i s t e r a n d t h e B a n k has ever o c c u r r e d , however. Because t h e issuance o f a p u b l i c d i r e c t i v e w o u l d i m p l y t h a t t h e M i n i s t e r h a d lost c o n f i d e n c e i n t h e G o v e r n o r ' s a b i l i t y t o c a r r y o u t t h e g o v e r n m e n t ' s m o n e t a r y policy, such a d i r e c t i v e w o u l d l i k e l y be f o l l o w e d b y t h e G o v e r n o r ' s r e s i g n a t i o n — a n a c t i o n t h a t w o u l d have serious reper­ cussions f o r t h e g o v e r n m e n t . S u c h a d i r e c t i v e w o u l d be u s e d o n l y i n e x t r a o r d i n a r y circumstances, n o t as a r o u t i n e m e a s u r e b y t h e g o v e r n ­ m e n t t o i n f l u e n c e t h e c o n d u c t o f m o n e t a r y policy. I n d e e d , i t m i g h t be a r g u e d t h a t t h e very existence o f t h e d i r e c t i v e p o w e r has s t r e n g t h e n e d t h e i n d e p e n d e n c e o f t h e B a n k o f Canada, as c o m p a r e d w i t h a system i n w h i c h t h e p r o c e d u r e s f o r r e s o l v i n g p o l i c y conflicts are n o t s p e l l e d o u t so e x p l i c i t l y . I n g e n e r a l , r e l a t i o n s b e t w e e n t h e F i n a n c e M i n i s t r y a n d t h e B a n k have b e e n q u i t e close. T h e M i n i s t e r a n d t h e G o v e r n o r m e e t a l m o s t w e e k l y ( t h o u g h n o t o n a r e q u i r e d sched­ u l e ) , a n d t h e D e p u t y M i n i s t e r o f F i n a n c e h o l d s a n o n - v o t i n g seat o n t h e Bank's B o a r d o f D i r e c t o r s . T h e r e are a n u m b e r o f o t h e r less f o r m a l c o n ­ tacts as w e l l . T h e Bank's i n f l a t i o n - t a r g e t i n g f r a m e w o r k has b e e n e x c e e d i n g l y flex­ i b l e a n d has u n d e r g o n e c o n s t a n t r e f i n e m e n t , w i t h a m a r k e d t r e n d t o ­ w a r d g r e a t e r t r a n s p a r e n c y over t i m e . T h e targets have c h a n g e d f r o m " i n f l a t i o n r e d u c t i o n " t o " i n f l a t i o n c o n t r o l " at a r o u n d 2 % C P I i n f l a t i o n , a l t h o u g h w i t h n o c o m m i t m e n t t o a specific l o n g - r u n d e f i n i t i o n o f p r i c e stability. M o r e o v e r , t h e B a n k has assumed a d d e d r e p o r t i n g o b l i g a t i o n s (such as t h e Monetary Policy Report) a n d a d o p t e d new, m o r e t r a n s p a r e n t 2 1

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o p e r a t i o n a l tactics ( f o r e x a m p l e , t h e a d o p t i o n o f t h e M C I a n d t h e m i d 1994 m o v e t o t a r g e t m o r e e x p l i c i t l y t h e o v e r n i g h t i n t e r e s t rate w i t h i n a r a n g e o f 50 basis p o i n t s ) . A t t h e same t i m e , assessment o f i n f l a t i o n per­ f o r m a n c e a n d forecasts o f i n f l a t i o n have always b e e n n u a n c e d b y refer­ ence t o d e v e l o p m e n t s i n t h e c o r e C P I , i n d i r e c t taxes, a n d e x c h a n g e rates, l e a v i n g t h e c r i t e r i a f o r j u d g i n g success s o m e w h a t i m p l i c i t . O v e r a l l , be­ cause o f Canada's u n i q u e i n s t i t u t i o n a l a r r a n g e m e n t s , as w e l l as t h e B a n k o f Canada's efforts at c o m m u n i c a t i o n , t h e B a n k has b e c o m e m o r e ac­ countable to the public a n d the financial markets rather t h a n directly to t h e g o v e r n m e n t . I n t h i s respect, Canada's f r a m e w o r k is m u c h closer t o that o f Switzerland a n d Germany t h a n to that o f New Zealand.

Canadian Monetary Policy under Inflation Targeting W e n o w s u m m a r i z e t h e m a i n events i n C a n a d i a n m o n e t a r y p o l i c y since t h e a n n o u n c e m e n t o f i n f l a t i o n targets i n F e b r u a r y 1 9 9 1 . O u r s u m m a r y is based o n accounts i n t h e Bank's Annual Report a n d s e m i a n n u a l Mon­ etary Policy Report (since 1 9 9 5 ) , speeches a n d articles p r i n t e d i n t h e B a n k o f C a n a d a Review, some a c a d e m i c studies, t h e OECD Economic Report, a n d v a r i o u s n e w s p a p e r accounts. F i g u r e 6.1 shows t h e r e c e n t h i s t o r i e s o f i n f l a t i o n , i n t e r e s t rates, t h e n o m i n a l effective e x c h a n g e rate ( h e n c e f o r t h t h e e x c h a n g e r a t e ) , G D P g r o w t h , a n d u n e m p l o y m e n t i n Canada. S o m e o f t h e sternest challenges faced b y t h e B a n k o f C a n a d a d u r i n g this p e r i o d w e r e p o l i t i c a l , r a t h e r t h a n e c o n o m i c . I n g e n e r a l , t h e target­ i n g f r a m e w o r k f o r m o n e t a r y p o l i c y has r e c e i v e d s u p p o r t f r o m t h e p u b l i c a n d has b e e n e n d o r s e d b y t h e t w o g o v e r n m e n t s i n p o w e r since i t was first a d o p t e d . H o w e v e r , critics a r g u e d t h a t t h e Bank's success i n r e d u c ­ i n g i n f l a t i o n a n d m a i n t a i n i n g i t at a l o w level h a d b e e n a c h i e v e d o n l y at a n u n a c c e p t a b l y h i g h cost i n u n e m p l o y m e n t . As i n W e s t e r n E u r o p e , w h i c h has h a d s i m i l a r u n e m p l o y m e n t p r o b l e m s , i t is b y n o m e a n s clear t h a t t h e level o f u n e m p l o y m e n t r e a c h e d i n C a n a d a was p r i m a r i l y d u e t o m o n e t a r y policy. O f course, a l l c e n t r a l b a n k s t h a t have a d o p t e d i n f l a t i o n t a r g e t i n g have r e c e i v e d c r i t i c i s m f r o m c e r t a i n quarters. B u t critics o f t h e B a n k o f C a n a d a have b e e n p a r t i c u l a r l y v o c a l i n o b j e c t i n g t o t h e B a n k ' s s u p p o s e d exclusive focus o n i n f l a t i o n c o n t r o l a n d t o t h e l o w level o f its t a r g e t r a n g e . T h i s e x p e r i e n c e contrasts w i t h t h a t o f N e w Z e a l a n d , w h e r e t h e r e was basic a g r e e m e n t t h a t t h e m o n e t a r y r e f o r m s , i n c l u d i n g t h e a d o p t i o n o f i n f l a t i o n targets, w e r e b e n e f i c i a l , b u t t h e c o n t r o l p r o b l e m s o f t h e c e n t r a l b a n k i n m e e t i n g a t i g h t i n f l a t i o n t a r g e t b a n d n e a r zero w e r e t h e focus o f a t t e n t i o n . T h e C a n a d i a n e x p e r i e n c e also contrasts w i t h

Figure 6.1. Canadian economic indicators. Sources: A ) Bank for International Settlements database, Bank of Canada; B) Bank for International Settlements database; C) Main economic indicators of the Organisation for Economic Cooperation and Development; D) Bank for International Settlements database.

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t h a t o f t h e U n i t e d K i n g d o m , w h e r e t h e c e n t r a l b a n k , because o f its l a c k o f i n d e p e n d e n c e , d i d n o t c o n t r o l t h e setting o f t h e m o n e t a r y - p o l i c y i n ­ struments a n d so was n o t a n obvious target f o r p u b l i c c r i t i c i s m . I n d e e d , as we argue i n t h e n e x t chapter, t h e m a i n challenge i n B r i t a i n arose f r o m t h e separation between those a c c o u n t a b l e f o r forecasting a n d assessing infla­ t i o n p e r f o r m a n c e a n d those responsible f o r setting m o n e t a r y policy. W e focus h e r e o n t h r e e c r i t i c a l j u n c t u r e s f o r t h e C a n a d i a n i n f l a t i o n t a r g e t i n g f r a m e w o r k . T h e first came i n 1991 at t h e t i m e o f t h e a d o p t i o n o f targets, w h e n forces b e y o n d t h e B a n k o f Canada's c o n t r o l — i n par­ t i c u l a r d e v e l o p m e n t s i n w o r l d o i l m a r k e t s a n d C a n a d i a n d o m e s t i c tax p o l i c y — c r e a t e d i n f l a t i o n a r y i m p u l s e s . T h e s e c o n d c a m e i n late 1993, w h e n t h e L i b e r a l Party w o n i n a f e d e r a l e l e c t i o n w i t h a c a m p a i g n plat­ f o r m t h a t d e c r i e d t h e i n c u m b e n t Conservative Party's " s i n g l e - m i n d e d fight against i n f l a t i o n . " T h e t h i r d i m p o r t a n t event o c c u r r e d i n m i d 1996, w h e n t h e p r e s i d e n t o f t h e C a n a d i a n E c o n o m i c A s s o c i a t i o n ( a n d a p r o m i n e n t critic o f the B a n k o f Canada) voiced concerns about w h a t he p e r c e i v e d t o be t h e excessive tightness o f m o n e t a r y p o l i c y i n t h e face o f h i g h and rising unemployment. 22

I n a l l t h r e e instances, t h e B a n k o f C a n a d a r e s p o n d e d b y e n g a g i n g i n substantive p u b l i c discourse a n d by r e d o u b l i n g its efforts t o i m p r o v e trans­ p a r e n c y a n d c o m m u n i c a t i o n w i t h t h e p u b l i c . I n t h e e n d , t h e B a n k suc­ c e e d e d i n d e f e n d i n g its p o l i c i e s w i t h o u t a l t e r i n g its basic c o m m i t m e n t t o p r i c e stability. T h e fact t h a t t h e B a n k w o n over a s u f f i c i e n t n u m b e r o f wage- a n d price-setters i n t h e first instance, t h e L i b e r a l G o v e r n m e n t i n the second, a n d the general p u b l i c i n the t h i r d , demonstrates the poten­ t i a l o f i n f l a t i o n t a r g e t s — a n d o f t h e associated t r a n s p a r e n c y a n d a c c o u n t ­ a b i l i t y — t o foster serious a n d i n f o r m e d discussion o f m o n e t a r y policy. W i t h t h e B a n k o f Canada's c o m p e t e n c e a n d r e s p o n s i b i l i t i e s c l e a r l y de­ f i n e d a n d t r a c k e d , t h e B a n k c o u l d j u s t i f y its policies w i t h i n a clear struc­ t u r e . M e a n w h i l e , critics w h o a r g u e d f o r d i f f e r e n t p o l i c i e s w e r e o b l i g e d t o base t h e i r case solely o n its e c o n o m i c m e r i t s . T h e first m a j o r c h a l l e n g e t o Canada's m o n e t a r y p o l i c y after t h e an­ n o u n c e m e n t o f i n f l a t i o n targets o n F e b r u a r y 26, 1 9 9 1 , was h o w t o c o p e w i t h u p w a r d pressures o n i n f l a t i o n t h a t w e r e b e g i n n i n g t o e m e r g e at t h e t i m e . T o c o m p l i c a t e matters, as we n o t e d earlier, t h e f e d e r a l g o v e r n m e n t h a d j u s t i n t r o d u c e d a goods a n d services tax ( G S T ) , a c c o m p a n i e d b y increases i n o t h e r i n d i r e c t taxes b y b o t h t h e f e d e r a l a n d p r o v i n c i a l gov­ e r n m e n t s . T h e B a n k t o o k t h e l i n e t h a t t h e p r i c e increases caused b y t h e n e w taxes w e r e i d e n t i f i a b l e , o n e - t i m e adjustments t h a t w o u l d n o t have t o be offset b y m o n e t a r y policy, so long as t h e p r i v a t e sector d i d n o t pass t h e m o n t h r o u g h a r o u n d o f p r i c e a n d wage hikes. T h e B a n k h a d l i t t l e

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i n c e n t i v e t o raise i n t e r e s t rates; i n fact, i t h a d b e e n t r y i n g t o ease m o n ­ etary c o n d i t i o n s since t h e s p r i n g o f 1990. F u r t h e r , r e a l G D P g r o w t h f o r 1991 was e x p e c t e d t o b e weak. T h e B a n k used t h e targets as a m e a n s o f c o m m u n i c a t i n g t o t h e p u b l i c t h a t t h e o n e - t i m e p r i c e increases s h o u l d n o t b e i n c o r p o r a t e d i n t o f u t u r e i n f l a t i o n o r i n f l a t i o n e x p e c t a t i o n s , k e e p i n g t h e t h r e a t o f a rise i n i n t e r ­ est rates i n t h e b a c k g r o u n d . L o o k i n g back, G o v e r n o r C r o w stated i n t h e Annual Report, 1991: The fact that the economy was able to absorb the GST and the other indirect tax changes without provoking an inflationary spiral—a process o f wages chasing prices, prices increasing further as a result, and so on—has been especially welcome. Certainly, the Bank o f Canada has sought to make abso­ lutely clear that monetary policy would n o t finance such a destructive pro­ cess. The way that the price effects o f the GST have been successfully ab­ sorbed has become even more widely recognized with the recent publication of the January 1992 CPI numbers. (Bank o f Canada, 1992a, p . 9) I n d e e d , because o f t h e t i g h t m o n e t a r y c o n d i t i o n s already established a n d t h e sluggishness o f t h e e c o n o m y , t h e B a n k was able t o ease n o m i n a l s h o r t - t e r m i n t e r e s t rates b y 6.5 p e r c e n t a g e p o i n t s b e t w e e n t h e s p r i n g o f 1990 a n d F e b r u a r y 1992, a l a r g e r d r o p t h a n t h e c o n t e m p o r a n e o u s d r o p i n inflation. T h e Bank's o w n analysis o f t h e e c o n o m i c s i t u a t i o n at t h e e n d o f 1991 a t t r i b u t e d m o s t o f t h e sluggishness i n t h e C a n a d i a n e c o n o m y t o t h e glo­ b a l s l o w d o w n (caused i n t u r n l a r g e l y b y d e b t o v e r h a n g i n t h e rest o f t h e G r o u p o f Seven) a n d t o l o w prices f o r C a n a d i a n e x p o r t s ( B a n k o f Canada, 1992a). I n J a n u a r y 1992, t h e B a n k a n n o u n c e d t h a t i n f l a t i o n h a d c o m e i n u n d e r its e x p e c t e d r a t e o f 5 % . T h e results w e r e e x p r e s s e d i n t e r m s o f c o r e C P I ( t h a t is, w i t h f o o d a n d e n e r g y p r i c e s e x c l u d e d ) r a t h e r t h a n i n terms o f h e a d l i n e C P I , a l t h o u g h b o t h were well b e l o w target level, h a v i n g r i s e n o n l y 2 . 6 % a n d 3 . 8 % , respectively, over 1 9 9 1 . By F e b r u a r y 1992, i n f l a t i o n h a d already d r o p p e d b e l o w t h e t a r g e t level o f 2 % t o 4 % f o r year-end 1992, w i t h c o r e C P I 2.8% h i g h e r t h a n a year earlier, despite a depreciating Canadian dollar. T h e a n n o u n c e m e n t i n M a y 1991 i n t r o d u c i n g i n f l a t i o n - i n d e x e d (real-return) bonds, w i t h payments o f interest a n d p r i n c i p a l l i n k e d t o t h e C P I , s e r v e d as a f u r t h e r i n d i c a t i o n t h a t t h e a u t h o r i t i e s i n t e n d e d to avoid inflationary policies i n the future. T h e i n t r o d u c t i o n o f the n e w b o n d s was seen, as i n t e n d e d , as a n a d d i t i o n a l i n c e n t i v e f o r t h e government a n d the Bank o f Canada to meet the a n n o u n c e d infla­ t i o n targets. 2 3

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By O c t o b e r 1 9 9 1 , B a n k o f C a n a d a researchers suggested t h a t C a n a d a h a d already p a i d m o s t o f t h e cost o f b r i n g i n g d o w n i n f l a t i o n , as mea­ s u r e d b y "sacrifice-ratio" c a l c u l a t i o n s ( C o z i e r a n d W i l k i n s o n , 1 9 9 1 ) . Some economists i m m e d i a t e l y v o i c e d t h e i r c o n c e r n , i n letters t o t h e press, t h a t t h e B a n k ' s estimates o f t h e sacrifice r a t i o w e r e low, possibly b y as m u c h as 50 p e r c e n t . F u r t h e r , they a r g u e d t h a t t h e u n e m p l o y m e n t caused b y t i g h t m o n e t a r y p o l i c i e s was l i k e l y t o be persistent, because o f t h e a t r o ­ p h y o f skills a n d loss o f m o t i v a t i o n a m o n g t h e u n e m p l o y e d . T h e i r p o l i c y r e c o m m e n d a t i o n was a n easing o f m o n e t a r y p o l i c y t o p r e v e n t t h i s o u t ­ c o m e . Significantly, t h e B a n k , i n its response, d i d n o t d e n y t h a t t h e d i s i n f l a t i o n t h a t h a d b e g u n b e f o r e t a r g e t a d o p t i o n h a d i n v o l v e d a cost i n t e r m s o f o u t p u t a n d e m p l o y m e n t — i n fact, i t was t h e release o f t h e B a n k ' s research o n sacrifice ratios t h a t p r o m p t e d this discussion. Never­ theless, v a r i o u s officials d i d h o l d o u t t h e h o p e t h a t as i n f l a t i o n expecta­ t i o n s adjusted u n d e r t h e targets, t h e cost o f f u t u r e d i s i n f l a t i o n w o u l d diminish. 25

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So t h e d e b a t e was a b o u t t h e i n t e n s i t y o f t h e Bank's p u r s u i t o f l o w i n f l a t i o n , r a t h e r t h a n a b o u t t h e t a r g e t i n g f r a m e w o r k per se, a n d t h e c o n ­ troversy w o u l d go o n f o r some t i m e t o c o m e . T h e existence o f t h e i n f l a ­ t i o n targets d i d h e l p t o k e e p t h e d e b a t e at t h e level o f g e n e r a l p r i n c i p l e s i n s t e a d o f a l l o w i n g i t t o d w e l l o n specific p o l i c y actions o r o n t h e c o m p e ­ tence o f policy-making. M u c h o f t h e discussion d u r i n g 1991 h a d t o d o w i t h t h e r e l a t i o n s h i p b e t w e e n t h e Bank's i n d e p e n d e n c e a n d its i n f l a t i o n - t a r g e t i n g f r a m e w o r k . I n t h e Conservative G o v e r n m e n t ' s proposals f o r federal r e f o r m p u b l i s h e d i n September, t h e m a i n r e c o m m e n d a t i o n s r e g a r d i n g t h e B a n k o f C a n a d a w e r e t o s i m p l i f y t h e Bank's l e g a l m a n d a t e ( r e p l a c i n g t h e B a n k ' s m u l ­ t i p l e goals w i t h a focus o n p r i c e stability) a n d t o m a k e t h e a p p o i n t m e n t o f t h e G o v e r n o r subject t o c o n f i r m a t i o n b y t h e Senate. T h e M a n l e y C o m ­ m i t t e e i n t h e H o u s e o f C o m m o n s h e l d h e a r i n g s o n those r e c o m m e n ­ d a t i o n s i n late 1 9 9 1 . T h e B a n k leadership a n d others testified that a mandate f o r the B a n k t o focus o n p r i c e s t a b i l i t y w o u l d increase t h e B a n k ' s a c c o u n t a b i l i t y , whereas u n d e r t h e e x i s t i n g vague m a n d a t e i t was possible t o d e f e n d al­ m o s t any policy. T h e M a n l e y C o m m i t t e e c o n c l u d e d , however, t h a t "the p r o b l e m w i t h a m a n d a t e n a r r o w l y f o c u s e d o n p r i c e stability is t h a t i t w o u l d t e n d t o e n h a n c e t h e Bank's a c c o u n t a b i l i t y b y r e d u c i n g u n d u l y t h e Bank's area o f r e s p o n s i b i l i t y " ( P a r a g r a p h 8 8 ) . I n t h e e n d , t h e C o m ­ m i t t e e d e c i d e d , " T h e e l e c t e d g o v e r n m e n t m u s t r e m a i n u l t i m a t e l y ac­ countable f o r the monetary policy followed" (Paragraph 168). T h u s the system o f d u a l responsibility a n d t h e o l d legal m a n d a t e were m a i n t a i n e d . 2 8

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By S e p t e m b e r 1992, t h e C a n a d i a n d o l l a r h a d f a l l e n t o 79 U . S . cents f r o m 89 U . S . cents a year earlier, a n d m u c h o f t h e B a n k ' s a t t e n t i o n was d e v o t e d t o t r y i n g t o slow d o w n a n d s m o o t h o u t this d o w n w a r d t r e n d , as w e l l as t h e o n g o i n g d e c l i n e i n i n t e r e s t rates. T h e e c o n o m y c o n t i n u e d t o stagnate, b u t w i t h o u t f a l l i n g i n t o recession. T h e Annual Report, 1992noted t h a t t h e C a n a d i a n recovery was m u c h slower t h a n t h e n o r m o f p r e v i o u s business cycles. H e a d l i n e i n f l a t i o n d i d m e e t t h e target, r e a d i n g 2 . 1 % i n D e c e m b e r , w h i l e t h e 1.7% c o r e i n f l a t i o n was b e l o w t h e t a r g e t r a n g e o f 2 % t o 4 % . C o r e i n f l a t i o n w o u l d r e m a i n b e t w e e n 1.3% a n d 2 % u n t i l late 1993. T h e s e c o n d c r i t i c a l j u n c t u r e f o r t h e B a n k o f Canada's t a r g e t i n g f r a m e ­ w o r k came i n t h e s u m m e r o f 1993, b e f o r e t h e N o v e m b e r p a r l i a m e n t a r y election. Given the u n p o p u l a r i t y o f the r u l i n g majority, a n d the rising rate o f u n e m p l o y m e n t , P r i m e M i n i s t e r B r i a n M u l r o n e y ' s Progressive Conservative Party s e e m e d d o o m e d t o defeat ( a l t h o u g h n o o n e at t h e t i m e foresaw t h e m a g n i t u d e o f t h a t d e f e a t ) . T h e L i b e r a l Party i n c l u d e d i n its c a m p a i g n p l a t f o r m a c r i t i c i s m o f t h e Conservative Party's "singlem i n d e d fight against i n f l a t i o n . " A l t h o u g h t h e attack f o c u s e d at first o n t h e Conservative Party's m o n e t a r y - p o l i c y goals, i t s p a r k e d d e b a t e over w h e t h e r G o v e r n o r C r o w s h o u l d be a p p o i n t e d t o a s e c o n d seven-year t e r m w h e n t h e L i b e r a l Party t o o k office. Some private-sector e c o n o m i s t s w a r n e d t h e L i b e r a l Party leaders t h r o u g h t h e press t h a t , i f C r o w was n o t r e a p p o i n t e d , s o m e o t h e r m e a s u r e w o u l d have t o b e t a k e n t o reassure financial markets o f t h e n e w g o v e r n m e n t ' s c o m m i t m e n t t o l o w i n f l a t i o n . 3 0

31

I n O c t o b e r 1993, p r e c e d i n g t h e L i b e r a l Party's victory, D e p u t y Gover­ n o r F r e e d m a n stated i n a speech at a n a c a d e m i c c o n f e r e n c e o n m o n ­ etary p o l i c y : W i t h the unexpected sluggishness o f the economy, the rate o f inflation fell faster and further than initially anticipated, and this despite the fact that monetary conditions were easing for most o f the p e r i o d between the an­ nouncement o f the targets and the first target date, the end o f 1992. . . . [Although inflation was 2.1 percent at the end o f 1992, versus a lower band of 2 percent,] it would be inappropriate to push up the rate o f inflation once it had reached the lower band o f the target range, given that the longer-term goal was price stability. (Freedman, 1994a) 32

T h i s s t a t e m e n t u n d e r l i n e d t h e Bank's u n w i l l i n g n e s s t o engage i n "finet u n i n g " t h e e c o n o m y , as w e l l as its readiness t o a d m i t forecast e r r o r s a n d t o r e c o g n i z e t h e l i m i t a t i o n s o f its c o n t r o l over i n f l a t i o n . O n t h e o t h e r h a n d , the statement reaffirmed that the boundaries o f the target range w e r e t o be t a k e n m o r e seriously t h a n t h e m i d p o i n t a n d gave t h e i m p r e s -

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s i o n t h a t , even t h e n , i n f l a t i o n t h a t t u r n e d o u t t o be l o w e r t h a n t h e m i d ­ p o i n t o f t h e r a n g e w o u l d be a c c e p t e d . As we saw i n t h e case o f N e w Z e a l a n d , a n emphasis o n t h e "hardness" o f t h e t a r g e t r a n g e m a y m a k e i t m o r e d i f f i c u l t t o e x p l a i n d e v i a t i o n s f r o m t h e r a n g e t o t h e p u b l i c , be­ cause t h e c e n t r a l b a n k has already specified e x p l i c i t l y t h e e x t e n t o f flex­ ibility r e q u i r e d . T h e p u b l i c can only conclude that the deviation f r o m t h e r a n g e reflects e i t h e r i n c o m p e t e n c e o r a n active d e c i s i o n b y t h e cen­ t r a l b a n k t o v i o l a t e its c o m m i t m e n t . 33

M o r e o v e r , a willingness t o tolerate i n f l a t i o n rates b e l o w t h e target w h e n i n f l a t i o n is already very l o w risks e c o n o m i c d i f f i c u l t i e s , because o f t h e p o s s i b i l i t y t h a t t h e o u t p u t - i n f l a t i o n t r a d e o f f is m o r e adverse at very l o w levels o f i n f l a t i o n . M o r e r e c e n t statements b y t h e B a n k o f Canada, per­ haps i n r e a c t i o n t o t h e e c o n o m i c a n d p o l i t i c a l e x p e r i e n c e s m e n t i o n e d h e r e , emphasize t h e advantages o f h a v i n g a n effective floor f o r i n f l a t i o n , as w e l l as a c e i l i n g . S u c h a floor, i f t a k e n seriously, c a n h e l p t o stabilize o u t p u t fluctuations a r i s i n g f r o m changes i n aggregate d e m a n d . O n D e c e m b e r 22, 1993, t h e n e w L i b e r a l Party g o v e r n m e n t a n d t h e B a n k m a d e a j o i n t a n n o u n c e m e n t t h a t t h e 1 % to 3% i n f l a t i o n b a n d t h a t was t o be r e a c h e d by year-end 1995 w o u l d be e x t e n d e d t h r o u g h 1998. A g a i n , the B a n k was careful t o i n d i c a t e t h a t this target r e p r e s e n t e d a m e ­ d i u m - t e r m g o a l , n o t the a c h i e v e m e n t o f u l t i m a t e p r i c e stability, h o w e v e r d e f i n e d . T h e n e w L i b e r a l g o v e r n m e n t saw t h e n e e d t o e x t e n d t h e target h o r i z o n because t h e change i n t h e P a r l i a m e n t a r y m a j o r i t y h a d raised fears a b o u t its c o m m i t m e n t t o t h e target r e g i m e . W h i l e t h e g o v e r n m e n t c o u l d n o t g u a r a n t e e t h e survival o f t h a t c o m m i t m e n t b e y o n d t h e d u r a t i o n o f its o w n m a j o r i t y i n the H o u s e o f C o m m o n s , i t c o u l d at least a t t e m p t t o create a n e x p e c t a t i o n t h a t t h e r e g i m e w o u l d last f o r t h e i n d e f i n i t e f u t u r e . As we m e n t i o n e d , t h e L i b e r a l Party g o v e r n m e n t e l e c t e d i n O c t o b e r 1993 h a d c a m p a i g n e d against t h e " s i n g l e - m i n d e d p u r s u i t " o f l o w i n f l a ­ t i o n . J o h n C r o w chose n o t t o b e c o n s i d e r e d f o r a s e c o n d t e r m as Gover­ nor, a n d D e p u t y G o v e r n o r G o r d o n Thiessen was a p p o i n t e d as his suc­ cessor, f o r a seven-year t e r m b e g i n n i n g F e b r u a r y 1, 1994. I t was o n t h e o c c a s i o n o f G o v e r n o r Thiessen's a p p o i n t m e n t t h a t t h e 1 % t o 3% t a r g e t r a n g e was e x t e n d e d t h r e e m o r e years i n t o t h e f u t u r e . E m p l o y m e n t g r o w t h finally p i c k e d u p i n 1994, l a r g e l y i n response t o a revival o f t h e e x p o r t t r a d e . E x p o r t s w e r e h e l p e d b y a d e c l i n i n g Cana­ d i a n d o l l a r , p a r t i c u l a r l y against t h e U . S . d o l l a r ; t h e C a n a d i a n d o l l a r h a d b e e n d e p r e c i a t i n g f o r t w o years b e f o r e t h e 1993 e l e c t i o n a n d h a d o n l y t e m p o r a r i l y s t r e n g t h e n e d o n t h e L i b e r a l majority's r e a f f i r m a t i o n o f t h e i n f l a t i o n targets. However, i n t e r e s t rates h a d r i s e n , r e f l e c t i n g b o t h U . S . rate increases a n d also c o n c e r n s over t h e C a n a d i a n fiscal s i t u a t i o n a n d 3 4

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t h e p o l i t i c a l p o w e r o f separatists i n Q u e b e c . I n t h e Bank's Annual Report, 1993 (released i n M a r c h 1 9 9 4 ) , J o h n Crow, i n his last o f f i c i a l act as Gov­ e r n o r , c a l l e d f o r t h e r e d u c t i o n o f g o v e r n m e n t d e b t i n o r d e r t o take pres­ sure o f f i n t e r e s t rates a n d e x c h a n g e rates. G o v e r n o r T h i e s s e n w o u l d m a k e s i m i l a r statements a b o u t fiscal p o l i c y i n t h e years t h a t f o l l o w e d , a l b e i t m o r e o b l i q u e l y at first. I n g e n e r a l , i n f l a ­ t i o n - t a r g e t i n g c e n t r a l banks, even i n d e p e n d e n t ones, have a d i f f i c u l t t i m e t r y i n g to decide w h a t to say p u b l i c l y a b o u t t h e i r g o v e r n m e n t ' s fiscal policy. T h e issue is n o t r e a l l y avoidable: E v e n a s i m p l e i n f l a t i o n forecast, o r a n assessment o f past m o n e t a r y p o l i c y a n d i n f l a t i o n p e r f o r m a n c e , entails some a t t i t u d e o n t h e c e n t r a l b a n k ' s p a r t t o w a r d t h e g o v e r n m e n t ' s fiscal stance a n d its l i k e l y effects. Yet a c e n t r a l b a n k t h a t appears t o b e s h i f t i n g responsibility for economic outcomes o n t o the other macroeconomic p o l i c y lever, o r t h a t takes a n ( a c t u a l o r p e r c e i v e d ) i d e o l o g i c a l s t a n d o n b u d g e t a r y politics, c o u l d w e l l u n d e r m i n e its o w n p o l i t i c a l legitimacy. L i k e all t h e c e n t r a l banks we c o n s i d e r i n this b o o k , t h e B a n k o f C a n a d a t e n d e d t o l i m i t its discussion o f fiscal matters t o statements a b o u t t h e fiscal stance broadly, its effect o n t h e e x c h a n g e rate risk p r e m i u m s o n i n t e r e s t rates, a n d g e n e r a l e n c o m i u m s t o t h e i d e a l o f l o n g - r u n fiscal balance. O v e r 1994, c o r e C P I i n f l a t i o n adjusted f o r t h e effects o f changes i n i n d i r e c t taxes h a d fluctuated b e t w e e n 1.5% a n d 2 % , w e l l w i t h i n t h e tar­ get b a n d . H e a d l i n e C P I i n f l a t i o n , as w e l l as c o r e i n f l a t i o n adjusted f o r t h e tax changes, h a d d r o p p e d t o as l o w as zero because o f a r e d u c t i o n i n the excise tax o n tobacco i n early 1994. A g a i n , t h e B a n k m a d e j u d i c i o u s use o f core versus h e a d l i n e C P I t o d i s t i n g u i s h one-time p r i c e shifts f r o m t r e n d i n f l a t i o n . By so d o i n g , i t largely a v o i d e d c o n f u s i o n a n d m i n i m i z e d t h e pass-through o f first-round effects t o wage a n d p r i c e i n f l a t i o n . I n d e e d , i n F e b r u a r y 1995 h e a d l i n e C P I j u m p e d f r o m zero t o 1.8% after t h e firstr o u n d effects o f t h e tax r e d u c t i o n o n tobacco h a d b e e n d r o p p e d f r o m t h e calculations. Since t h e B a n k h a d already stressed t h e o n e - t i m e n a t u r e o f the earlier p r i c e d r o p ( a n d t h e stability o f core i n f l a t i o n ) , i t felt n o n e e d t o react t o this p r i c e rise w h e n i t o c c u r r e d (see, f o r e x a m p l e , B a n k o f Canada [1995c, M a y ] ) . M e e t i n g t h e a n n o u n c e d t a r g e t ( a n d t h e r e f o r e m a i n t a i n i n g a positive i n f l a t i o n rate r a t h e r t h a n d r i v i n g i n f l a t i o n even closer t o z e r o ) b o l s t e r e d t h e Bank's s t a n d i n g b y d e m o n s t r a t i n g its c o m p e t e n c e a n d its reason­ ableness i n its p u r s u i t o f p r i c e stability. I n t h e Annual Report, 1994, Gov­ e r n o r T h i e s s e n spoke o f t h e t h i r d successive year o f " m a i n t e n a n c e o f a l o w level o f i n f l a t i o n . . . after t w o decades o f h i g h a n d u n p r e d i c t a b l e i n f l a t i o n " a n d r e m a r k e d o n "the progress t h a t has b e e n m a d e towards p r i c e stability" ( B a n k o f Canada, 1995a, p . 5 ) .

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W h e n t h e first Monetary Policy Report was issued i n M a y 1995, t h e B a n k stated i n t h e four-page s u m m a r y t h a t "core i n f l a t i o n has b e e n consis­ t e n t l y w i t h i n t h e Bank's i n f l a t i o n - c o n t r o l targets b a n d since early 1993." Year-over-year c o r e i n f l a t i o n h a d r i s e n t o 2.7% by t h a t m o n t h (its h i g h ­ est level since t h e e n d o f 1991) b u t h a d t h e n d e c l i n e d , w h i l e h e a d l i n e i n f l a t i o n h a d p e a k e d at 2 . 9 % . A f t e r l o w e r i n g i n t e r e s t rates o n t h r e e oc­ casions d u r i n g t h e s u m m e r o f 1994, t h e B a n k t i g h t e n e d t o w a r d t h e e n d o f t h e year. First, i t raised t h e o v e r n i g h t i n t e r e s t rate i n N o v e m b e r a n d early D e c e m b e r 1994, i n response t o r i s i n g U.S. rates a n d e v i d e n c e o f a d o m e s t i c e x p a n s i o n . Later, i n J a n u a r y a n d F e b r u a r y 1995, i t raised rates five times i n a n e f f o r t t o stabilize financial m a r k e t s i n t h e face o f a r a p i d d e p r e c i a t i o n o f t h e C a n a d i a n d o l l a r t h a t f o l l o w e d t h e g e n e r a l crisis o f c o n f i d e n c e associated w i t h t h e M e x i c a n d e v a l u a t i o n . By M a r c h 1995, m o n e t a r y c o n d i t i o n s as m e a s u r e d b y t h e M C I w e r e 2 % t i g h t e r , reflect­ i n g a r e b o u n d i n t h e C a n a d i a n d o l l a r . D e m a n d f o r e x p o r t s was e x p e c t e d t o r e m a i n s t r o n g t h r o u g h t h e e n d o f t h e year, w h i l e d o m e s t i c aggregate d e m a n d d e c l i n e d i n response t o t h e h i g h e r i n t e r e s t rates a n d g o v e r n ­ m e n t fiscal r e s t r a i n t . T h e C a n a d i a n e c o n o m y h a d g r o w n m o r e s t r o n g l y t h a n e x p e c t e d i n 1994, at a rate o f 5.6%. I n f l a t i o n r e m a i n e d i n t h e u p p e r h a l f o f t h e 1 % t o 3% t a r g e t b a n d t h r o u g h O c t o b e r , l a r g e l y because t h e C a n a d i a n d o l l a r h a d r e v e r s e d course a n d b e g u n t o d e p r e c i a t e a g a i n . T h e B a n k a c c e p t e d t h a t fact a n d t u r n e d t o o t h e r c o n c e r n s . " T h r o u g h o u t t h e rest o f t h e s e c o n d quar­ t e r [ 1 9 9 5 ] , i t b e c a m e i n c r e a s i n g l y a p p a r e n t t h a t t h e e c o n o m y was n o t e x p a n d i n g as e x p e c t e d a n d t h a t a n easing o f m o n e t a r y c o n d i t i o n s was w a r r a n t e d " ( B a n k o f Canada, 1995c, N o v e m b e r , p . 4 ) . A p p a r e n t l y t h e B a n k was w i l l i n g t o a d m i t h a v i n g m a d e a f o r e c a s t i n g e r r o r a n d t o l i n k its m o n e t a r y - p o l i c y decisions t o r e a l e c o n o m i c d e v e l o p m e n t s so l o n g as t h e i n f l a t i o n t a r g e t was m e t . I t c a n b e a r g u e d t h a t t h e B a n k was able t o d o so o n l y after h a v i n g i n v e s t e d i n c r e d i b i l i t y - b u i l d i n g d i s i n f l a t i o n a n d i n e d u ­ cating the p u b l i c to u n d e r s t a n d that a g o o d m o n e t a r y policy must be a f o r w a r d - l o o k i n g policy. T h e B a n k c u t i n t e r e s t rates 25 basis p o i n t s i n early M a y a n d t h e n l o w ­ e r e d i n t e r e s t rates twice i n J u n e , w h i l e t h e C a n a d i a n d o l l a r was d e p r e c i ­ a t i n g . I t t h e n c u t rates twice a g a i n , i n J u l y a n d i n A u g u s t , w h i l e t h e d o l l a r was a p p r e c i a t i n g . T h e B a n k e x p e c t e d i n f l a t i o n t o r e m a i n h i g h w i t h i n t h e t a r g e t b a n d u n t i l 1996, w h e n " a d d e d d o w n w a r d pressure c o m i n g f r o m g r e a t e r - t h a n - e x p e c t e d excess slack i n t h e e c o n o m y " w o u l d b r i n g i t i n t o t h e l o w e r h a l f o f t h e b a n d ( B a n k o f Canada, 1995c, N o v e m b e r , p . 4 ) . I n t e r e s t rates w e r e c u t o n O c t o b e r 3 1 , 1 9 9 5 , t h e day after t h e Q u e b e c r e f e r e n d u m o n sovereignty f a i l e d t o pass; i n D e c e m b e r , h e a d l i n e i n f l a 35

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t i o n d e c l i n e d t o 1.7%, h e a d i n g i n t o t h e l o w e r h a l f o f t h e t a r g e t b a n d a n d p r o m p t i n g a n o t h e r c u t i n t h e o v e r n i g h t i n t e r e s t rate. W h e n output remained further below potential than the Bank had forecast t h r o u g h t h e first t w o q u a r t e r s o f 1996, m o n e t a r y easing c o n t i n ­ u e d . T h e o v e r n i g h t rate was c u t o n J a n u a r y 25 a n d a g a i n o n J a n u a r y 3 1 , f o l l o w i n g a r e d u c t i o n i n t h e U . S . f e d e r a l f u n d s rate. Rates w e r e c u t o n c e a g a i n i n M a r c h , a n d o n c e i n A p r i l . Since O c t o b e r 1995, t h e M C I h a d d e c l i n e d t h e e q u i v a l e n t o f 200 basis p o i n t s t o its lowest level since 1994 ( B a n k o f Canada, 1995c, N o v e m b e r , p . 4 3 ) . H o w e v e r , i n f l a t i o n expecta­ tions appeared to be unaffected by the loosening o f policy a n d r e m a i n e d at h i s t o r i c a l lows; f o r e x a m p l e , t h e C a n a d i a n C o n f e r e n c e B o a r d Survey of Forecasters a n d Consensus Forecasts b o t h d i s p l a y e d d o w n w a r d t r e n d s i n two-year-ahead i n f l a t i o n e x p e c t a t i o n s , f r o m a r o u n d 4 % i n t h e first h a l f o f 1990 t o 2 % i n t h e s e c o n d h a l f o f 1995. T h e d i f f e r e n t i a l b e t w e e n Cana­ d i a n "real b o n d s " a n d thirty-year c o n v e n t i o n a l b o n d s was 3.25%, o n p a r w i t h t h e smallest d i f f e r e n t i a l r e c o r d e d since t h e b o n d s w e r e first issued i n 1991. M o s t significantly, t h e C a n a d i a n - U . S . s h o r t - t e r m interest-rate differ­ e n t i a l t u r n e d negative ( w i t h C a n a d i a n rates d i p p i n g b e l o w those o f t h e U . S . ) , w h i l e t h e C a n a d i a n d o l l a r r e m a i n e d firm, r a i s i n g h o p e s at t h e B a n k t h a t Canada's i n f l a t i o n - t a r g e t i n g r e g i m e h a d b e c o m e such a source o f c o u n t e r i n f l a t i o n a r y c r e d i b i l i t y t h a t t h e i n t e r e s t rates i n t h e t w o c o u n ­ tries m i g h t be d e c o u p l i n g . T h e positive news o n i n f l a t i o n a n d i n f l a t i o n e x p e c t a t i o n s gave t h e B a n k some scope t o increase its a t t e n t i o n t o t h e needs o f t h e r e a l e c o n o m y . T h e B a n k k e p t this c h a n g e o f emphasis w i t h i n t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k b y b e g i n n i n g t o e m p h a s i z e h o w seri­ ously i t takes t h e floor o n its i n f l a t i o n target, as w e l l as t h e c e i l i n g ; a n d b y p o i n t i n g o u t t h e p o t e n t i a l l y s t a b i l i z i n g effect o n r e a l o u t p u t o f k e e p i n g i n f l a t i o n f r o m d r o p p i n g t o o low, as w e l l as r i s i n g t o o h i g h . T h e t h i r d critical j u n c t u r e for Canadian monetary policy occurred i n t h e s u m m e r o f 1996. T h i s t i m e , t h e p r o b l e m was t h e c o n t i n u i n g stagna­ t i o n o f C a n a d i a n G D P a n d e m p l o y m e n t . C r i t i c i s m s o f t h e Bank's p o l i ­ cies w e r e d e l i v e r e d by P i e r r e F o r t i n , t h e n e w l y e l e c t e d p r e s i d e n t o f t h e C a n a d i a n E c o n o m i c s A s s o c i a t i o n . O n J u n e 1, 1996, F o r t i n d e l i v e r e d a p r e s i d e n t i a l address t i t l e d " T h e G r e a t C a n a d i a n S l u m p " ( F o r t i n , 1996a) to the annual m e e t i n g o f the Association. H e characterized Canadian e c o n o m i c p e r f o r m a n c e since 1990 as 3 7

a l o n g slide i n economic activity and e m p l o y m e n t . . . [with the] accompany­ i n g employment and output losses still accumulating, but . . . they surpass the losses experienced by other industrial countries since 1990. The last de-

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cade o f this century will arguably be remembered as the decade of The Great Canadian Slump. (Ibid., p. 761) A f t e r c o n s i d e r i n g a n d d i s m i s s i n g a n u m b e r o f possible s t r u c t u r a l ex­ p l a n a t i o n s f o r Canada's e c o n o m i c p e r f o r m a n c e , F o r t í n a r g u e d t h a t t h e d e p r e s s i o n o f d o m e s t i c d e m a n d was l a r g e l y a t t r i b u t a b l e t o interest-sen­ sitive c o n s u m e r d u r a b l e s a n d business fixed-investment d e m a n d . " T h i s gives us t h e c l u e t o t h e t r u e cause o f t h e great s l u m p o f t h e 1990s: o l d f a s h i o n e d m o n e t a r y a n d fiscal c o n t r a c t i o n . I argue t h a t m o n e t a r y p o l i c y has b e e n t h e leader, a n d t h a t fiscal p o l i c y was induced b y t h e m o n e t a r y c o n t r a c t i o n " (Ibid., p . 7 7 0 ) . I n S e c t i o n I V o f his address, " M o n e t a r y Policy a n d t h e S l u m p , " F o r t í n c i t e d B a n k o f C a n a d a statements a f f i r m i n g its c o n t r o l over s h o r t - t e r m i n t e r e s t rates a n d t h e n p o s e d a q u e s t i o n : The only serious question is why the Bank o f Canada has kept the shortt e r m real interest rate differential w i t h the U n i t e d States so large for so l o n g i n the 1990s. The answer to this question has two parts: first, since 1989 the central bank has focused exclusively o n the goal o f zero inflation; second, contrary to expectations, achieving this objective has forced i t to impose permanently higher unemployment t h r o u g h higher interest rates. (Ibid., pp. 774-5) E l a b o r a t i n g o n t h e first p a r t o f his answer, F o r t í n e m p h a s i z e d t h e B a n k ' s exclusive focus o n i n f l a t i o n , its " r e l i g i o u s " zeal i n d o i n g so, a n d its excessive i n d e p e n d e n c e f r o m p o p u l a r preferences a n d p o l i t i c a l c o n ­ t r o l ( p p . 7 7 5 - 7 7 ) . H e b a s e d t h e s e c o n d p a r t o f h i s answer o n t h e a r g u ­ m e n t o f Akerlof, Dickens, a n d Perry (1996), that low inflation inhibits r e a l wage a d j u s t m e n t w h e n ( w h e t h e r f o r reasons o f "fairness" o r s i m p l e m o n e y i l l u s i o n ) w o r k e r s s t r o n g l y resist n o m i n a l wage cuts (see C h a p ­ t e r 2 ) . A p p l y i n g t h e a r g u m e n t t o t h e C a n a d i a n c o n t e x t , F o r t í n sug­ gested t h a t 3 8

the zero constraint [ o n n o m i n a l wage change] can take a large macroeco­ nomic bite when the median wage change itself is around zero, as was ob­ served over 1992-4.... But i f inflation is to fall to a very low level, such as the 1.4 per cent o f 1992-6 i n Canada, and is to stay there, the p r o p o r t i o n of wage earners that are pushed against the wall o f resistance to wage cuts must i n ­ crease sharply. The long-run marginal unemployment cost o f lower inflation i n this range is not zero, but is positive and increasing. (Ibid., p. 779) H e w e n t o n t o say t h a t t h e B a n k o f C a n a d a has m i s j u d g e d t h e o u t p u t i n f l a t i o n t r a d e o f f at l o w i n f l a t i o n rates a n d "has d i s p l a y e d a s t r o n g de-

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f l a t i o n a r y bias t h a t has n o t r e f l e c t e d t h e t r u e state o f k n o w l e d g e o n t h e benefits o f zero i n f l a t i o n , t h e t r u e preferences o f t h e C a n a d i a n p o p u l a ­ t i o n , a n d t h e s p i r i t a n d l e t t e r o f t h e B a n k o f C a n a d a A c t , w h i c h reflects those preferences by a s k i n g f o r a reasonable balance b e t w e e n t h e i n f l a ­ t i o n a n d u n e m p l o y m e n t objectives" (Ibid., p . 7 8 1 ) . F o r t i n a c k n o w l e d g e d t h a t "the B a n k o f C a n a d a has m a d e every e f f o r t at e x p l a i n i n g this strategy t h r o u g h p u b l i c speeches, appearances i n Par­ l i a m e n t , research papers, Annual Reports, a n d , m o r e recently, Monetary Policy Reports. B u t i t is also t r u e t h a t these a t t e m p t s have m o r e o f t e n b e e n exercises i n advocacy o f a c o n t r o v e r s i a l a n d e x t r e m e p o l i c y o r i e n t a t i o n t h a n g e n u i n e d i a l o g u e w i t h t h e p u b l i c " (Ibid., p . 7 8 1 ) . H i s t w o p r i m a r y p o l i c y r e c o m m e n d a t i o n s were t o m a k e t h e B a n k o f C a n a d a m o r e l i k e t h e U.S. F e d e r a l Reserve System (as h e d e s c r i b e d i t ) , w i t h five g o v e r n o r s h o l d i n g staggered terms, a n d t o raise t h e m i d p o i n t o f t h e i n f l a t i o n tar­ get by 1 % , t o 3%. I n t h e press discussion t h a t e n s u e d ( i n f o r m e d by F o r t i n ' s o w n s u m ­ m a r y o f his a r g u m e n t s f o r mass r e a d e r s h i p ) , t h e p e r m a n e n t costs a n d t h e t r a n s i t i o n a l costs o f a c h i e v i n g l o w i n f l a t i o n w e r e r e p e a t e d l y c o n ­ f u s e d . T h e Canadian-U.S. i n t e r e s t rate d i f f e r e n t i a l h a d d r o p p e d a l o n g w i t h i n t e r e s t rates elsewhere, suggesting t h a t t h e B a n k o f C a n a d a h a d p r o v e d successful i n c o n t a i n i n g i n f l a t i o n . M o r e o v e r , i t appears t h a t t h e B a n k o f C a n a d a h a d eased m o n e t a r y c o n d i t i o n s because o f t h e risk t h a t t h e slack i n t h e r e a l e c o n o m y m i g h t cause i n f l a t i o n t o d r o p b e l o w t h e target r a n g e . W h e t h e r t h e C a n a d i a n e c o n o m y h a d b o r n e t o o g r e a t a cost i n lost o u t p u t d u r i n g t h e t r a n s i t i o n process t h a n c a n be j u s t i f i e d by t h e benefits o f l o w e r i n f l a t i o n — despite t h e B a n k o f Canada's a c k n o w l ­ e d g m e n t s o f t h e cost o f d i s i n f l a t i o n a n d conscious g r a d u a l i s m d o c u ­ m e n t e d above—is a n issue t h a t c e r t a i n l y m e r i t s discussion, a l t h o u g h i n t h e e n d t h e c o n c l u s i o n m a y d e p e n d o n difflcult-to-resolve debates a b o u t t h e l o n g - r u n benefits o f l o w i n f l a t i o n . A t t h e t i m e , however, w i t h t h e r e c o r d o f t h e C a n a d i a n i n f l a t i o n - t a r ­ g e t i n g f r a m e w o r k ' s goals, actions, a n d results available f o r a l l t o see, dis­ cussion was l i m i t e d t o t h e costs a n d benefits o f l o w i n f l a t i o n a n d d i d n o t t o u c h o n ideology or competence. Consequently, participants were o b l i g e d t o take a s t a n d (as F o r t i n d i d ) o n t h e p r o p e r g o a l o f m o n e t a r y policy. T h e B a n k r e s p o n d e d b y r e p e a t i n g its r a t i o n a l e f o r t h e e x i s t i n g 1 % t o 3% i n f l a t i o n target. I n a speech t o t h e E c o l e des H a u t e s Etudes C o m m e r c i a l e s i n M o n t r e a l o n O c t o b e r 9, 1996, G o v e r n o r T h i e s s e n p u t t h e debate i n j u s t those t e r m s w h i l e addressing F o r t i n ' s a r g u m e n t ( w i t h ­ o u t m e n t i o n i n g h i m by n a m e ) : 39

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A distinction should be made here between reducing inflation and maintain­ ing i t at a low level. Reducing inflation requires a downward adjustment i n inflation expectations and may entail transition costs, which is n o t the case w i t h simply maintaining low inflation. I t is generally agreed that the gains achieved by reducing inflation exceed transition costs when inflation is h i g h . Where opinions are more divided is o n the question o f how far inflation should be reduced. Some fear that i f inflation falls below a certain threshold, the economy will be deprived o f a lubricant I must say that this argument assumes a degree o f money illusion that I find difficult to reconcile with the observed behavior o f wages i n inflationary periods. . . . Recent experience will provide us with more useful information i n [the wage behavior d u r i n g periods o f slow wage g r o w t h ] . We have therefore undertaken new research on this question. . . . Since this research is just getting under way, I will con­ fine myself here to r e p o r t i n g that our preliminary examination o f the major wage agreements concluded between 1992 and 1994 does not l e n d evident support to the thesis o f inflation as lubricant. (Thiessen, 1996b, p. 3) G o v e r n o r Thiessen's r e m a r k s p r o m p t t h r e e observations: First, t h e costs o f d i s i n f l a t i o n are o n c e a g a i n f o r t h r i g h t l y a c k n o w l e d g e d ; s e c o n d , t h e a r g u m e n t f o r i n f l a t i o n r e d u c t i o n is m a d e o n t h e basis o f e m p i r i c a l claims, w i t h t h e B a n k a s s u m i n g t h e b u r d e n o f h a v i n g t o p r o v i d e sup­ p o r t i n g ( o r o p p o s i n g ) research; a n d t h i r d , t h e discussion is c e n t e r e d o n t h e a p p r o p r i a t e level o f i n f l a t i o n t o t a r g e t a n d t h e pace at w h i c h t h a t level s h o u l d be r e a c h e d , n o t o n w h a t t h e goals o f m o n e t a r y p o l i c y s h o u l d b e . L a t e r i n his r e m a r k s , T h i e s s e n a t t r i b u t e d t h e s t a l l i n g o f t h e e x p a n ­ s i o n i n 1995 t o i n c r e a s e d interest-rate r i s k p r e m i u m s , a r i s i n g f r o m i n t e r ­ n a t i o n a l m a r k e t fluctuations a n d p o l i t i c a l u n c e r t a i n t i e s a b o u t Canada. " I n s u c h a c o n t e x t [ o f h i g h i n t e r e s t r a t e s ] , t h e benefits o f l o w i n f l a t i o n w e r e slow t o be f e l t " (Ibid., p . 7 ) . R e f e r r i n g t o t h e easing o f m o n e t a r y c o n d i t i o n s since t h a t t i m e a n d t h e d e c l i n e i n t h e Canadian-U.S. interestrate d i f f e r e n t i a l , h e stated, " I t shows t h a t k e e p i n g i n f l a t i o n d o w n is a low-interest-rate p o l i c y a n d n o t , as some critics have o f t e n c l a i m e d , a high-interest-rate p o l i c y " ( I b i d . ) . A m o n t h later, T h i e s s e n gave a s p e e c h t i t l e d "Does C a n a d a N e e d M o r e I n f l a t i o n t o Grease t h e W h e e l s o f t h e E c o n o m y ? , " i n w h i c h h e r e s p o n d e d even m o r e d i r e c t l y t o t h e F o r t i n a r g u m e n t . H e b e g a n b y alluding to 40

some ideas you have probably heard about recently. . . . The suggestion is that the Bank, with its focus o n b r i n g i n g inflation down, is largely respon­ sible for Canada's sluggish pace o f economic expansion and stubbornly h i g h unemployment i n the 1990s. . . . Moreover, i n this view, a monetary policy

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that emphasizes price stability will somehow always be too tight to allow the economy to achieve its full potential i n the future. (Thiessen 1996a, p. 63) H e t h e n asserted t h a t w h a t h a d slowed t h e C a n a d i a n e c o n o m y i n t h e early 1990s was t h e c o m b i n a t i o n o f e x t e r n a l l y i n d u c e d h i g h i n t e r e s t rates a n d w i d e s p r e a d s t r u c t u r a l c h a n g e ( i n response t o g l o b a l i z a t i o n a n d tech­ n o l o g i c a l i n n o v a t i o n s ) , a n d t h a t t h e e c o n o m y was p o i s e d t o p i c k u p over t h e l o n g t e r m . N e x t t h e G o v e r n o r m a d e e x p l i c i t his v i e w o f t h e r e l a t i o n ­ ship between m a i n t a i n i n g low inflation a n d economic g r o w t h : I n fact, when the Bank takes actions to h o l d inflation inside the target range of 1 to 3 per cent, monetary policy operates as an important stabilizer that helps to maintain sustainable growth i n the economy. W h e n economic activ­ ity is expanding at an unsustainable pace . . . the Bank will tighten monetary conditions to cool things off. But the Bank will respond with equal concern, by relaxing monetary conditions when the economy is sluggish and there is a risk that the trend o f inflation will fall below the target range. (Ibid., p. 67) H a v i n g stressed t h e d i s t i n c t i o n b e t w e e n d i s i n f l a t i n g a n d m a i n t a i n i n g l o w i n f l a t i o n , T h i e s s e n t h e n r e i t e r a t e d his b e l i e f t h a t t h e process o f wage s e t t i n g i n a l o w - i n f l a t i o n e n v i r o n m e n t w o u l d be flexible e n o u g h t o a l l o w f o r occasional wage r e d u c t i o n s i n i n d u s t r i e s t h a t r e q u i r e d i t . H e t h u s r e s p o n d e d t o t h e view t h a t zero i n f l a t i o n w o u l d be costly t o t h e e c o n o m y because o f d o w n w a r d n o m i n a l wage r i g i d i t y . 41

T h e p u r p o s e o f o u r e x t e n d e d t r e a t m e n t o f this t h i r d c r i t i c a l j u n c t u r e i n C a n a d i a n m o n e t a r y p o l i c y since t h e a d o p t i o n o f i n f l a t i o n targets is n o t t o s u p p o r t o n e side o f t h e a r g u m e n t o r t h e other, b u t r a t h e r t o e m ­ phasize t h e f o r m t h e a r g u m e n t t o o k . T h e existence o f t h e i n f l a t i o n - t a r ­ g e t i n g f r a m e w o r k c h a n n e l e d d e b a t e i n t o a substantive discussion a b o u t a p p r o p r i a t e t a r g e t levels, w i t h a l l sides h a v i n g t o d e c l a r e t h e i r assump­ t i o n s a n d estimates o f costs a n d benefits w h i l e w o r k i n g f r o m t h e r e c o r d o f what the goal h a d been and h o w well i t h a d been met. I t is i n t e r e s t i n g t h a t , a l t h o u g h F o r t i n ' s a r g u m e n t p r o v i d e d a m e a n s o f a t t a c k i n g t h e B a n k ' s p o l i c i e s t h a t was p o t e n t i a l l y far b e t t e r g r o u n d e d t h a n t h e a r g u m e n t s u s e d i n t h e 1993 elections, t h e r u n - u p t o t h e 1997 elections d i d n o t i n c l u d e c r i t i c i s m o f t h e B a n k o f C a n a d a as a m a j o r issue. W h a t this d i f f e r e n c e i n d i c a t e s m o s t o f a l l is t h a t t h e f a i l u r e o f p o ­ l i t i c a l a c c o u n t a b i l i t y c l a i m e d by F o r t i n i n " T h e G r e a t C a n a d i a n S l u m p " address d i d n o t exist. A key e l e m e n t o f t h i s a c c o u n t a b i l i t y was t h e sus­ t a i n e d e f f o r t by t h e B a n k t o c o m m u n i c a t e its p o l i c i e s a n d t h e i r r a t i o n a l e t o t h e p u b l i c . I n d e e d , t h e B a n k w o n s u p p o r t t h r o u g h its response, its responsiveness, a n d its r e c o r d .

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Key Lessons from the Canadian Experience T h r e e observations based o n t h e C a n a d i a n e x p e r i e n c e are w o r t h stress­ i n g . First, t h e B a n k o f C a n a d a has b e e n successful b o t h i n k e e p i n g i n f l a ­ t i o n l o w a n d i n p r e v e n t i n g o n e - t i m e shocks t o t h e p r i c e level ( i n c l u d i n g s u p p l y shocks, i n d i r e c t tax changes, a n d c u r r e n c y d e p r e c i a t i o n ) f r o m f e e d i n g i n t o t h e t r e n d i n f l a t i o n rate. T h i s success was m a d e possible b o t h b y t h e c o o p e r a t i o n o f t h e B a n k w i t h t h e M i n i s t r y o f F i n a n c e a n d by t h e g r e a t emphasis o n a c c o u n t a b i l i t y t o t h e p u b l i c . I n d e e d , i t is l i k e l y t h a t t h e Bank's efforts t o increase t h e t r a n s p a r e n c y o f its p o l i c i e s h e l p e d t h e p u b l i c t o d i s t i n g u i s h b e t w e e n o n e - t i m e shocks t o t h e p r i c e l e v e l a n d m o v e m e n t s i n t r e n d i n f l a t i o n , r e d u c i n g t h e risk o f "pass-through" o f o n e ­ t i m e shocks. S e c o n d , i n f l a t i o n t a r g e t i n g has w o r k e d t o k e e p i n f l a t i o n l o w a n d stable i n C a n a d a even t h o u g h t h e i n f l a t i o n - t a r g e t i n g r e g i m e is actually q u i t e flexible ( f o r e x a m p l e , t a r g e t misses d o n o t i m p l y any a u t o m a t i c sanc­ t i o n s against t h e B a n k ) . T h a t flexibility has a l l o w e d t h e B a n k o f C a n a d a some r o o m t o deviate f r o m t h e i n f l a t i o n targets w h e n u n f o r e s e e n shocks t o t h e e c o n o m y occur. A g a i n , t h e c o m m i t m e n t t o c o m m u n i c a t i o n a n d t r a n s p a r e n c y has h e l p e d t o p e r m i t this flexibility. Finally, i n f l a t i o n t a r g e t i n g i n C a n a d a has p r o b a b l y d a m p e n e d r a t h e r t h a n a m p l i f i e d t h e business cycle, because t h e floor o f t h e t a r g e t r a n g e has b e e n t a k e n as seriously as t h e c e i l i n g . I n d e e d , at times, t h e B a n k o f C a n a d a has b e e n able t o j u s t i f y easing o f m o n e t a r y c o n d i t i o n s i n t h e face o f a weak e c o n o m y by a p p e a l i n g t o t h e i n f l a t i o n targets, w i t h t h e c o n f i d e n c e t h a t this easing w o u l d n o t l e a d t o e x p e c t a t i o n s o f h i g h e r i n f l a t i o n i n t h e f u t u r e . Because o f t h e flexibility o f t h e t a r g e t i n g f r a m e ­ w o r k , a n d t h e a t t e n t i o n t o t h e floor o f t h e target r a n g e as w e l l as t h e c e i l i n g , i n f l a t i o n t a r g e t i n g has n o t o b l i g e d t h e B a n k t o foreswear a l l re­ sponsibility for stabilization o f the real economy.

7 United Kingdom: The Central Bank as Counterinflationary Conscience T H E U n i t e d K i n g d o m followed Canada i n a d o p t i n g inflation targeting, b u t u n d e r q u i t e d i f f e r e n t circumstances. C a n a d a c a m e t o i n f l a t i o n tar­ g e t i n g gradually, t h r o u g h a process o f e x p e r i m e n t a t i o n a n d discussion. I n contrast, B r i t i s h a d o p t i o n o f t h e i n f l a t i o n - t a r g e t i n g a p p r o a c h was p r o ­ v o k e d b y a crisis, n a m e l y t h e f o r e i g n - e x c h a n g e crisis o f S e p t e m b e r 1992, w h i c h r e s u l t e d i n t h e floating a n d d e p r e c i a t i o n o f t h e p o u n d . I n f l a t i o n t a r g e t i n g was a d o p t e d i n B r i t a i n largely as a m e a n s o f r e s t o r i n g t h e c r e d ­ i b i l i t y o f m o n e t a r y p o l i c y lost i n t h e speculative crisis a n d t o p r o v i d e a n alternative n o m i n a l anchor. T h e i n s t i t u t i o n a l a r r a n g e m e n t s i n t h e U n i t e d K i n g d o m w e r e also sig­ n i f i c a n t l y d i f f e r e n t f r o m those i n Canada, w h i c h h a d i m p o r t a n t effects o n the o p e r a t i o n o f the new policy regime. U n l i k e the relatively inde­ p e n d e n t B a n k o f Canada, t h e B a n k o f E n g l a n d d i d n o t have u n i l a t e r a l a u t h o r i t y t o m a n i p u l a t e t h e i n s t r u m e n t s o f m o n e t a r y policy. T o a signifi­ c a n t e x t e n t , t h e B a n k e x e r t e d its i n f l u e n c e over p o l i c y t h r o u g h its analy­ ses a n d its p u b l i c e x h o r t a t i o n s ; i n d o i n g so, i t f u n c t i o n e d as t h e g o v e r n m e n t ' s " c o u n t e r i n f l a t i o n a r y conscience." O u r analysis o f this case suggests t h a t t h e system o f d i v i d e d responsibility, i n w h i c h t h e C h a n c e l ­ l o r o f the Exchequer c o n t r o l l e d the instruments o f policy b u t the Bank o f E n g l a n d h a d p r i m a r y r e s p o n s i b i l i t y f o r assessing t h e o u t l o o k f o r i n f l a ­ t i o n , h a d a substantial i n f l u e n c e o n t h e effectiveness o f m o n e t a r y p o l i c y i n B r i t a i n b e t w e e n t h e i n t r o d u c t i o n o f targets i n O c t o b e r 1992 a n d t h e g r a n t i n g o f i n d e p e n d e n c e t o t h e B a n k o f E n g l a n d i n M a y 1997.

Key Features of Inflation Targeting in the United Kingdom •

T h e U n i t e d K i n g d o m a d o p t e d i n f l a t i o n targets i n t h e after­ m a t h o f a f o r e i g n e x c h a n g e rate crisis, i n o r d e r t o s t r e n g t h e n t h e c r e d i b i l i t y o f m o n e t a r y p o l i c y a n d restore a n o m i n a l an­ chor. L i k e t h e o t h e r c o u n t r i e s e x a m i n e d i n this study, t h e U n i t e d K i n g d o m ' s a d o p t i o n o f targets also f o l l o w e d a p e r i o d o f successful d i s i n f l a t i o n , w h i c h m a d e h i t t i n g t h e i n i t i a l tar­ gets relatively easy.

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M o n e t a r y p o l i c y i n t h e U n i t e d K i n g d o m u n d e r i n f l a t i o n tar­ g e t i n g r e m a i n s r e l a t i v e l y flexible, a n a p p r o a c h m o r e a k i n t o that o f Canada or Germany than to that o f New Zealand, w h e r e t h e c e n t r a l b a n k has s o m e w h a t less d i s c r e t i o n i n t h e short r u n . I n particular, monetary policy i n the U n i t e d King­ d o m has r e s p o n d e d t o fluctuations i n o u t p u t a n d e m p l o y ­ ment.

•

T h e i n f l a t i o n target i n t h e U n i t e d K i n g d o m is d e f i n e d i n t e r m s o f the annual change i n the retail price i n d e x e x c l u d i n g m o r t ­ gage i n t e r e s t p a y m e n t s , o r R P I X . A t t e n t i o n is also p a i d t o t h e p r i c e i n d e x RPIY, w h i c h is R P I X less t h e first-round effects o f i n d i r e c t taxes. B o t h R P I X a n d R P I Y i n c l u d e f o o d a n d e n e r g y prices, so t h a t t h e t a r g e t i n d e x has i n p r a c t i c e b e e n a c o m ­ p r o m i s e b e t w e e n h e a d l i n e i n f l a t i o n a n d a m e a s u r e o f "core" o r " u n d e r l y i n g " i n f l a t i o n . T h e agency r e p o n s i b l e f o r p r o d u c ­ i n g these t w o i n d e x e s ( t h e O f f i c e f o r N a t i o n a l Statistics) dif­ fers f r o m t h e agency t h a t assesses w h e t h e r t h e t a r g e t has b e e n met (the Bank o f England).

•

I n i t i a l l y , t h e U n i t e d K i n g d o m set a t a r g e t r a n g e f o r i n f l a t i o n . Since M a y 1997 t h e t a r g e t has b e e n expressed as a p o i n t , b u t w i t h " t h r e s h o l d s " o n e i t h e r side. I f i n f l a t i o n breaches a t a r g e t t h r e s h o l d , t h e B a n k o f E n g l a n d is r e q u i r e d t o p r o v i d e a for­ mal explanation to the government.

•

Before the Bank o f E n g l a n d achieved independence follow­ i n g t h e M a y 1997 e l e c t i o n , i t h a d l i t t l e i n d e p e n d e n t c o n t r o l over t h e i n s t r u m e n t s o f m o n e t a r y p o l i c y ; c o n t r o l was exer­ cised i n s t e a d b y t h e C h a n c e l l o r o f t h e E x c h e q u e r . U n d e r t h e pre-1997 t a r g e t i n g r e g i m e , t h e activities o f t h e B a n k w e r e sub­ stantially l i m i t e d t o f o r e c a s t i n g i n f l a t i o n a n d assessing past i n f l a t i o n p e r f o r m a n c e . R a t h e r t h a n b e i n g a f u l l y active p o l i c y ­ maker, t o a c o n s i d e r a b l e d e g r e e t h e B a n k f u n c t i o n e d as t h e C h a n c e l l o r ' s " c o u n t e r i n f l a t i o n a r y conscience."

•

I n p a r t because o f its weak p o s i t i o n b e f o r e M a y 1997, t h e B a n k f o c u s e d its i n f l a t i o n - t a r g e t i n g efforts o n c o m m u n i c a t i n g t o t h e p u b l i c its m o n e t a r y - p o l i c y strategy a n d its c o m m i t m e n t to p r i c e stability. I n d o i n g so, i t r e l i e d heavily o n p u b l i c a t i o n s s u c h as t h e Inflation Report, a n i n n o v a t i o n t h a t has b e e n e m u ­ lated by o t h e r inflation-targeting countries.

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The Adoption of Inflation Targeting T h e Chancellor o f the Exchequer, N o r m a n L a m o n t , a n n o u n c e d an i n ­ flation t a r g e t f o r t h e U n i t e d K i n g d o m at a Conservative Party confer­ ence o n O c t o b e r 8 , 1 9 9 2 . T h r e e weeks later, at his a n n u a l M a n s i o n H o u s e Speech t o t h e C i t y ( L a m o n t , 1 9 9 2 ) , t h e C h a n c e l l o r " i n v i t e d " t h e Gover­ n o r o f t h e B a n k o f E n g l a n d t o p u b l i s h a q u a r t e r l y Inflation Report t h a t w o u l d d e t a i l t h e progress b e i n g m a d e i n a c h i e v i n g t h a t target, a n i n v i t a ­ t i o n t h e G o v e r n o r accepted. 1

T h e a d o p t i o n o f a t a r g e t was i n r e a c t i o n t o t h e e x i t o f s t e r l i n g f r o m t h e E u r o p e a n E x c h a n g e Rate M e c h a n i s m ( E R M ) t h r e e weeks earlier, f o l l o w i n g a series o f speculative attacks. ( B l a c k Wednesday, as t h e day o f t h e exchange-rate crisis was k n o w n , h a d seen t h e p o u n d d e v a l u e d b y m o r e t h a n 1 0 % . ) T h e C h a n c e l l o r ' s p u r p o s e was t o reestablish t h e c r e d ­ i b i l i t y o f t h e g o v e r n m e n t ' s c o m m i t m e n t t o p r i c e stability, w h i c h h a d ap­ p a r e n t l y g r o w n s t r o n g e r d u r i n g t h e p o u n d ' s t w o years i n t h e E R M , as m e a s u r e d b y interest-rate d i f f e r e n t i a l s w i t h G e r m a n y a n d spreads i n t h e U.K. yield curve. Unfortunately, the U n i t e d K i n g d o m h a d a history o f a d o p t i n g a n d t h e n a b a n d o n i n g a series o f m o n e t a r y r e g i m e s d u r i n g t h e p o s t - B r e t t o n W o o d s p e r i o d ; h e n c e t h e r e a p p e a r e d t o be c o n s i d e r a b l e p o t e n t i a l f o r d a m a g e t o t h e c r e d i b i l i t y o f B r i t i s h m o n e t a r y policy. Prior to the Chancellor's announcement, there h a d been n o public discussion b y e i t h e r t h e Treasury o r t h e B a n k o f E n g l a n d a b o u t s e t t i n g i n f l a t i o n targets. So l o n g as t h e p o u n d was p a r t o f t h e E R M , o f course, s u c h t a l k w o u l d have b e e n i r r e l e v a n t , because m a i n t e n a n c e o f t h e p a r i t y c o m m i t t e d the U n i t e d K i n g d o m to m a t c h i n g the Bundesbank's interest rates a n d i n f l a t i o n p e r f o r m a n c e . As t h e exchange-rate crisis a p p r o a c h e d , m o r e o v e r , i t w o u l d have b e e n d a n g e r o u s t o reveal t h e existence o f a fallback p l a n . Accordingly, the a n n o u n c e m e n t o f an i n f l a t i o n target o f 1 % t o 4 % p e r year i n O c t o b e r 1992, u n a c c o m p a n i e d b y any e x p l a n a t i o n o f h o w t h a t t a r g e t was t o be m o n i t o r e d a n d a c h i e v e d , h a d a c e r t a i n a m o u n t o f s h o c k value. Perhaps p l u n g i n g a h e a d i n t h i s a b r u p t f a s h i o n was seen as a m e a n s o f u n d e r l i n i n g t h e c o m m i t m e n t . T h e C h a n c e l l o r a n n o u n c e d t h e n e w p o l i c y at a p a r t i s a n , t h o u g h p u b ­ lic, f o r u m , a n d he c o m m i t t e d the n a t i o n to the target only " t h r o u g h the e n d o f t h e p r e s e n t p a r l i a m e n t , " t h a t is, M a y 1997. I n o t h e r w o r d s , this n e w p o l i c y was o n e o f t h e r u l i n g Conservative m a j o r i t y a n d c o u l d n o t be g u a r a n t e e d t o survive b e y o n d t h e life o f t h a t majority. I t was i m p l i e d , o f course, t h a t i f t h e p o l i c y p r o v e d successful, i t m i g h t w i n s u p p o r t f r o m t h e p u b l i c a n d f r o m o p p o s i t i o n parties a n d t h u s be c o n t i n u e d b e y o n d the t e r m o f the c u r r e n t government.

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T h e t i m i n g o f t h e t a r g e t a d o p t i o n was auspicious. T h e U . K . e c o n o m y was j u s t b e g i n n i n g t o r e b o u n d after f a l t e r i n g t h r o u g h 1990, 1 9 9 1 , a n d t h e first h a l f o f 1992. Since t h e e x i t f r o m t h e E R M h a d b e e n a c c o m p a ­ n i e d b y a 1 % c u t i n i n t e r e s t rates, as w e l l as b y t h e c u r r e n c y d e v a l u a t i o n , t h e r e was n o n e e d f o r any f u r t h e r s h o r t - t e r m s t i m u l u s . M o r e o v e r , t h e d r o p i n i n t e r e s t rates l o w e r e d t h e i n t e r e s t o n f l e x i b l e - r a t e m o r t g a g e s , w h i c h make u p almost a fifth o f the headline RPI (retail price i n d e x ) , a l i g h t n i n g r o d f o r press coverage. T h e d i r e c t i n f l a t i o n a r y effect o f t h e d e v a l u a t i o n was b e l i e v e d b y b o t h p r i v a t e a n d p u b l i c forecasters t o be 12 t o 18 m o n t h s d o w n t h e r o a d . Finally, u n e m p l o y m e n t was still r i s i n g at t h e t i m e , p u t t i n g d o w n w a r d pressure o n wage settlements, a n d t h e C h a n ­ c e l l o r was c o m m i t t e d t o b u d g e t cuts whose m a j o r t a r g e t w o u l d be p u b ­ lic-sector pay. I n short, t h e U n i t e d K i n g d o m a d o p t e d i n f l a t i o n targets at a t i m e w h e n i t was m o s t l i k e l y t o m e e t t h e m , at least f o r t h e first c o u p l e o f years. T h e t i m i n g o f a n d m o t i v a t i o n f o r t a r g e t a d o p t i o n w e r e i n m a n y ways analo­ gous t o t h a t o f N e w Z e a l a n d a n d Canada. As i n b o t h those cases, t h e p r i m a r y c o n c e r n was t o l o c k i n p r e v i o u s r e d u c t i o n s i n i n f l a t i o n i n t h e face o f a o n e - t i m e p r i c e - l e v e l rise ( h e r e , f r o m t h e d e v a l u a t i o n ) . F o l l o w ­ i n g t h e d r a m a t i c crisis a n d t h e c u r r e n c y d e v a l u a t i o n , o f course, t h e U n i t e d K i n g d o m ' s s i t u a t i o n was m o r e u r g e n t t h a n t h e s i t u a t i o n faced b y those e a r l i e r i n f l a t i o n targeters. To understand the arguments u n d e r l y i n g the U n i t e d Kingdom's new m o n e t a r y f r a m e w o r k , i t is useful t o e x a m i n e t h e i r o r i g i n s i n t h e e x p e r i ­ ence o f U . K . m o n e t a r y p o l i c y since t h e Conservative Party came t o p o w e r i n 1979. T h e p r e v i o u s L a b o u r g o v e r n m e n t h a d b e g u n p u b l i s h i n g m o n ­ etary targets i n J u l y 1976, i n a c c o r d a n c e w i t h a n I M F s u p p o r t a r r a n g e ­ m e n t . Its c o m m i t m e n t t o those targets, however, was d o u b t f u l at best, as suggested b y its r e l i a n c e o n i n c o m e s p o l i c i e s (wage-price c o n t r o l s ) t o c o n s t r a i n i n f l a t i o n , a n d o n taxes o n h i g h - i n t e r e s t b a n k deposits ( t h e "cor­ set") t o r e d u c e t h e g r o w t h o f M 3 , its t a r g e t aggregate. T h e i n c o m e s p o l i ­ cies c o l l a p s e d i n t h e " w i n t e r o f d i s c o n t e n t " o f 1978-79. O n t a k i n g office, t h e Conservative g o v e r n m e n t was faced w i t h i n f l a t i o n t h a t was r i s i n g rap­ i d l y f r o m levels already above 1 0 % . I n a d d i t i o n , t h e p u b l i c sector bor­ r o w i n g r e q u i r e m e n t ( P S B R ) , at 5% o f GDP, was h i g h already at t h e o n ­ set o f t h e 1980-81 recession. F r o m t h e b e g i n n i n g o f t h e T h a t c h e r m a j o r i t i e s , t h e g o v e r n m e n t was aware o f t h e u r g e n t n e e d t o restore c r e d i b i l i t y t o e c o n o m i c policy. I n t h e g o v e r n m e n t ' s first b u d g e t , p r e s e n t e d i n M a r c h 1980, t h e C h a n c e l ­ lor, Sir Geoffrey H o w e , a n n o u n c e d t h e M e d i u m - T e r m F i n a n c i a l Strategy

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( M T F S ) , a five-year p l a n o f a n n u a l targets f o r M 3 g r o w t h ( M 3 is a b r o a d m e a s u r e o f t h e m o n e y stock) a n d f o r t h e p u b l i c sector b o r r o w i n g re­ q u i r e m e n t . A g r a d u a l r e d u c t i o n i n t h e b o r r o w i n g r e q u i r e m e n t was seen as a p r e r e q u i s i t e f o r g i v i n g c r e d e n c e t o t h e d e c e l e r a t i o n i n M 3 g r o w t h , w h i c h , i t was h o p e d , w o u l d l e a d t o d i s i n f l a t i o n . T h e g o v e r n m e n t suc­ ceeded, b y m e a n s o f v e r y t i g h t m o n e t a r y p o l i c y t h r o u g h o u t 1980 a n d 1 9 8 1 , i n r e d u c i n g h e a d l i n e i n f l a t i o n f r o m 2 2 % i n early 1980 t o b e l o w 4 % i n m i d - 1 9 8 3 . Nevertheless, t h e first t w o targets f o r M 3 w e r e o v e r s h o t by w i d e m a r g i n s . T h e u n e x p e c t e d l y h i g h rate o f M 3 g r o w t h r e s u l t e d f r o m a set o f measures a n n o u n c e d as p a r t o f t h e M e d i u m - T e r m F i n a n c i a l Strategy, measures t h a t a b o l i s h e d t h e corset a n d a l l o w e d banks t o engage i n m o r t ­ gage l e n d i n g . Those r u l e changes l e d to fierce c o m p e t i t i o n b e t w e e n banks a n d b u i l d i n g societies ( a n a l o g o u s t o savings a n d loans i n t h e U n i t e d States) f o r deposits. T h e g o v e r n m e n t was aware t h a t t h e h i g h rates o f M 3 g r o w t h were g i v i n g false signals a b o u t t h e tightness o f m o n e t a r y policy, as i n d i c a t e d ( f o r e x a m p l e ) b y t h e d e c l i n e i n t h e g r o w t h rate o f t h e m o n ­ etary base (MO) f r o m a b o u t 1 2 % i n early 1980 t o - 2 % i n early 1982. Faced w i t h t h e d i l e m m a o f e i t h e r c o n t i n u i n g t o o v e r s h o o t t h e M 3 targets, h a v i n g t o reset t h e targets, o r c h a n g i n g t h e t a r g e t aggregate, any o f w h i c h m i g h t damage the credibility o f the whole M e d i u m - T e r m Fi­ n a n c i a l Strategy, t h e g o v e r n m e n t o p t e d t o reset t h e targets. T h i s e p i ­ sode e x e m p l i f i e s a p a t t e r n t h a t w o u l d r e c u r i n t h e U n i t e d K i n g d o m over t h e n e x t 12 years, n a m e l y t h e t e n d e n c y f o r c o n f l i c t t o arise b e t w e e n ad­ h e r e n c e t o t h e a n n o u n c e d i n t e r m e d i a t e t a r g e t o f t h e day a n d t h e m a i n ­ t e n a n c e o f p r i c e stability. As we s h a l l see, t h e i n f l a t i o n - t a r g e t i n g r e g i m e , by o f f e r i n g a m e d i u m - t e r m g o a l f o r p o l i c y r a t h e r t h a n a n i n t e r m e d i a t e target, p r o v i d e d a clearer f r a m e w o r k w i t h i n w h i c h a d e g r e e o f flexibility i n p o l i c y c o u l d be e m p l o y e d a n d e x p l a i n e d . T h e g o v e r n m e n t h a d f o r m a l l y a n n o u n c e d t h a t targets f o r M 3 g r o w t h w o u l d be i n place u n t i l 1986. As a n i m m e d i a t e c o n s e q u e n c e o f this e p i ­ sode, however, t h e targets f o r M 3 were g r a d u a l l y de-emphasized, a n d g r o w t h i n t h e n a r r o w e r aggregate MO came t o be c o n s i d e r e d t h e m o s t i m p o r t a n t i n d i c a t o r o f t h e stance o f m o n e t a r y policy. I n t h e 1984, 1985, a n d 1986 budgets, targets f o r b o t h MO a n d M 3 w e r e a n n o u n c e d ; t h e r e ­ after, f o r MO only. M o r e i m p o r t a n t l y , m o n e t a r y p o l i c y - m a k e r s m a d e ef­ forts t o qualify t h e c o m m i t m e n t t o m o n e t a r y targets t o a v o i d p o t e n t i a l d a m a g e s h o u l d t h e m o n e t a r y aggregates a g a i n issue w r o n g signals. I n a s p e e c h g i v e n i n O c t o b e r 1984, t h e G o v e r n o r o f t h e B a n k o f E n g l a n d , R o b i n L e i g h - P e m b e r t o n stated:

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Because o f the variability i n short-run monetary relationships, monetary tar­ gets have to be operated pragmatically. The course o f the monetary target aggregates o f itself thus provides only a first a p p r o x i m a t i o n to the overall assessment o f monetary conditions, and to the appropriate policy reaction . . . I t is n o t i n any sense to d i m i n i s h the importance o f such targets—they provide a c o n t i n u i n g and essential constraint against purely discretionary policy: they give policy its backbone. The existence o f targets places the onus o n the authorities to explain why they are i g n o r i n g the signals given by diverging money growth, or why they are m a k i n g course corrections by changing target indicators or target ranges. (Leigh-Pemberton, 1984, p. 476) M o n e t a r y targets, i t appears, served at t h i s p o i n t p r i m a r i l y t o e n h a n c e the accountability o f the government's c o m m i t m e n t to price stability b y p r o v i d i n g a m e a n s o f c o m m u n i c a t i o n . I n t h e absence o f a p r i m a r y m o n e t a r y o b j e c t i v e , however, l e t a l o n e a n e x p l i c i t m e d i u m - t e r m g o a l , t h e r e was n o baseline against w h i c h t o evaluate t h e p e r f o r m a n c e o f policy. By t h e n i t was r e c o g n i z e d t h a t , i f t h e a u t h o r i t i e s chose t o miss t h e targets repeatedly, w h i l e at t h e same t i m e n o t specifying t h e u l t i m a t e p o l i c y goals, t h e c l a r i t y a n d t r a n s p a r e n c y o f m o n e t a r y p o l i c y w o u l d be g r e a t l y d i m i n i s h e d . O n e p o s s i b i l i t y was t o choose a t a r g e t o t h e r t h a n m o n e y g r o w t h . I n t h e same speech, u n d e r t h e h e a d i n g " A l t e r n a t i v e Tar­ gets," G o v e r n o r L e i g h - P e m b e r t o n discussed n o m i n a l - G D P t a r g e t i n g a n d exchange-rate t a r g e t i n g as a l t e r n a t i v e strategies. H e n o t e d t h a t n o m i ­ n a l - G D P t a r g e t i n g w o u l d n o t o n l y suffer f r o m t h e delay w i t h w h i c h G D P d a t a b e c o m e available, b u t w o u l d also r e q u i r e p o l i c y t o act i n a p u b l i c l y f o r w a r d - l o o k i n g m a n n e r ( w h i c h t h e G o v e r n o r i m p l i e d was i m p r a c t i c a l ) . He went on: Unfortunately forecasts have a somewhat dubious status; indeed cynics see them as potentially offering undue scope for wishful thinking. So, reliance on forecasts could be thought to undermine the role o f the intermediate target as a constraint o n the authorities and a protection against systemati­ cally inflationary policies. (Leigh-Pemberton, 1984, p. 476) T h e c o n t r a s t w i t h c u r r e n t t h i n k i n g o n t h e r o l e o f forecasts a n d f o r w a r d l o o k i n g m o n e t a r y policy, especially i n l i g h t o f t h e B a n k o f E n g l a n d ' s views, is s t r i k i n g . T h e p r o b l e m s associated w i t h c o m m u n i c a t i n g a p o l i c y based o n t h e Bank's forecasts w e r e at this stage seen as m o r e severe t h a n t h e risk t h a t t h e m o n e y - i n c o m e r e l a t i o n s h i p , o n w h i c h t h e m o n e y - g r o w t h targets w e r e based, m i g h t b e c o m e u n s t a b l e . I n s h o r t , t h e r e was m o r e

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fear o f g i v i n g t h e i m p r e s s i o n o f excessive p o l i t i c a l c o n t r o l o f p o l i c y t h a n o f revealing l i m i t e d ability to c o n t r o l economic outcomes. M o n e t a r y targets w e r e f u r t h e r de-emphasized i n t h e s p r i n g o f 1987, w h e n Chancellor Lawson embarked o n a policy o f "shadowing the D M " by k e e p i n g s t e r l i n g i n a n a r r o w b a n d at a r o u n d 3.00 d e u t s c h e m a r k s p e r p o u n d . A t t h e t i m e t h e U n i t e d K i n g d o m was i n t h e m i d s t o f a b o o m , w i t h G D P g r o w i n g at 5.3% a n d 4 . 8 % d u r i n g 1986 a n d 1987, respectively. H e a d l i n e i n f l a t i o n was, however, still s u b d u e d , at 3.4% a n d 4 . 1 % , re­ spectively, i n those t w o years. B r o a d m o n e y was g r o w i n g r a p i d l y : M 3 at 1 8 % a n d 2 3 % , a n d M 4 at 1 5 % a n d 1 8 % i n 1986 a n d 1987, respectively. B u t t h e n a r r o w aggregate MO, t h e p r e f e r r e d i n d i c a t o r a n d t a r g e t v a r i ­ able, f a i l e d t o give any early i n d i c a t i o n o f t h e i n f l a t i o n a r y pressures t h a t w o u l d d e v e l o p d u r i n g 1988 a n d 1989. D u r i n g 1986, MO g r e w at 5.2% a n d d u r i n g 1987 at 4 . 3 % , w e l l i n s i d e t h e a n n o u n c e d t a r g e t ranges. T h e B a n k ' s i n s t r u m e n t i n t e r e s t rate, t h e b a n k l e n d i n g rate, was c u t f r o m 9 % t o 7.5% b e t w e e n D e c e m b e r 1987 a n d M a y 1988. A l t h o u g h these cuts p r o b a b l y w o u l d n o t have o c c u r r e d w i t h o u t t h e exchange-rate target, i t is q u e s t i o n a b l e w h e t h e r m o n e t a r y p o l i c y w o u l d have tightened b e f o r e t h e s p r i n g o f 1988 u n d e r strict a d h e r e n c e t o t h e MO t a r g e t either. T h e n , w i t h i n f l a t i o n a r y pressures b e c o m i n g r a p i d l y a p p a r e n t , m o n ­ etary p o l i c y t i g h t e n e d sharply. T h e base rate d o u b l e d over t h e 16 m o n t h s f r o m J u n e 1988 t o O c t o b e r 1989, f r o m 7.5% t o 1 5 % , w h e r e i t r e m a i n e d f o r t h e f o l l o w i n g 12 m o n t h s . H o w e v e r , i t was t o o late t o p r e v e n t h e a d l i n e i n f l a t i o n f r o m r i s i n g t o a p e a k o f 10.9% i n S e p t e m b e r 1990. B y t h a t t i m e t h e U n i t e d K i n g d o m was i n d e e p recession, w i t h r e a l G D P f a l l i n g b y 2 % d u r i n g 1990. M o n e t a r y targets, w h i c h h a d failed t o p r e v e n t a n o t h e r b o o m bust cycle, w e r e a b a n d o n e d i n a l l b u t f o r m w h e n o n O c t o b e r 8, 1990, t h e U n i t e d K i n g d o m j o i n e d t h e E u r o p e a n E x c h a n g e Rate M e c h a n i s m (ERM). T h e E R M was s u p p o s e d t o d e l i v e r w h a t m o n e t a r y targets h a d f a i l e d t o p r o v i d e , namely, c r e d i b i l i t y a n d p r e d i c t a b i l i t y f o r B r i t i s h m o n e t a r y policy. T h e r e appears n e v e r t o have b e e n any q u e s t i o n , however, t h a t E R M m e m b e r s h i p w o u l d be s u b o r d i n a t e t o t h e a c h i e v e m e n t o f d o m e s t i c p r i c e stability, s h o u l d t h e t w o c o m e i n t o c o n f l i c t . I n a speech d e l i v e r e d o n t h e day o f s t e r l i n g ' s j o i n i n g t h e E R M , G o v e r n o r L e i g h - P e m b e r t o n said, "Per­ haps t h e key p o i n t is t h a t , by p u t t i n g a n effective floor o n sterling's ex­ c h a n g e rate, we have i n t r o d u c e d a n e x t r a d i s c i p l i n e — a d i s c i p l i n e f o r p o l i c y - m a k e r s a n d f o r b o t h sides o f i n d u s t r y a n d c o m m e r c e . . . . [ T ] h e E R M is not a panacea. Its benefits w i l l have t o be w o r k e d for, m o s t o f a l l by m a i n t a i n i n g a firm anti-inflation policy." ( L e i g h - P e m b e r t o n 1990, p . 483, emphasis i n t h e o r i g i n a l )

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T h e p r i o r i t y o f d o m e s t i c p r i c e stability as t h e objective o f m o n e t a r y p o l i c y was stated even m o r e f o r c e f u l l y i n t h e G o v e r n o r ' s M a n s i o n H o u s e speech o n O c t o b e r 3 1 , 1 9 9 1 : The commitment o f the authorities to maintaining the value o f the currency is an essential ingredient o f a stable policy. A n d this makes i t vital that we have a credible medium-term nominal framework. The way i n which this n o m i n a l framework is expressed i n terms o f intermediate targets will vary w i t h circumstances. I n times o f substantial innovation i n financial markets monetary aggregates may not provide a clear picture; and i t may then be more helpful to express our objective i n terms o f some other variable, such as n o m i n a l GDP or the exchange rate. But, i n any event, o f m u c h greater importance is the credibility o f the policy stance itself—the belief that the authorities will not take gambles with inflation. Inflationary expectations— and inflation itself—should then converge o n the ultimate goal o f price sta­ bility. (Leigh-Pemberton, 1991, p. 496) I n c o n t r a s t t o t h e G o v e r n o r ' s 1984 speech, t h e l a n g u a g e o f this speech clearly p u t t h e focus o f p o l i c y o n i n f l a t i o n expectations, a n d a c c o r d i n g l y o n a wide range o f i n f o r m a t i o n , o n l o o k i n g forward, a n d o n the me­ d i u m t e r m . T o some e x t e n t this c h a n g e m a y have r e f l e c t e d t h e d i f f u s i o n o f developments i n macroeconomics d u r i n g the intervening p e r i o d . For example, i n the academic literature, "rational expectations" models o f i n f l a t i o n , w h i c h e m p h a s i z e f o r w a r d - l o o k i n g behavior, h a d r e p l a c e d a m o r e mechanistic monetarism. I n S e p t e m b e r 1992 the f o r e i g n - e x c h a n g e crisis f o r c e d t h e g o v e r n m e n t t o choose b e t w e e n a t t e m p t i n g a p r o l o n g e d a n d expensive defense o f t h e e x c h a n g e rate a n d l e a v i n g t h e E R M ; t h e g o v e r n m e n t o p t e d f o r t h e l a t t e r despite t h e p o t e n t i a l d a m a g e t o c r e d i b i l i t y . T h e u n w i l l i n g n e s s o f t h e U . K . m o n e t a r y p o l i c y - m a k e r s t o raise i n t e r e s t rates t o d e f e n d t h e c u r r e n c y b e y o n d B l a c k Wednesday suggests t h a t t h e i r c o m m i t m e n t t o t h e E R M was n o t very s t r o n g . T h u s , t h e U n i t e d K i n g d o m ' s a d o p t i o n o f a n i n f l a t i o n t a r g e t i n 1992 i n c o r p o r a t e d t w o e l e m e n t s o f c o n t i n u i t y a n d o n e o f c h a n g e w i t h respect to t h e p e r i o d o f E R M m e m b e r s h i p . First, a c h i e v i n g p r i c e s t a b i l i t y re­ m a i n e d a key objective o f m o n e t a r y policy. However, t h e explicitness w i t h w h i c h t h a t g o a l was stated, a n d its p r i m a c y a m o n g p o l i c y goals, h a d i n c r e a s e d d u r i n g t h e 1990s. By t h e t i m e t h e p o u n d e x i t e d t h e E R M , t h e g o v e r n m e n t h a d m a d e clear t h a t i t w i s h e d t o be released n o t f r o m p o l i c y discipline, b u t f r o m the problems arising f r o m asynchronous G e r m a n a n d B r i t i s h business cycles. S e c o n d , t o achieve t h a t objective, c r e d i b i l i t y w i t h t h e p u b l i c h a d t o be f o s t e r e d t h r o u g h i m p r o v e d m e a n s o f c o m m u ­ n i c a t i n g t h e i n t e n t i o n s a n d p e r f o r m a n c e o f m o n e t a r y policy.

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T h e m a i n e l e m e n t o f c h a n g e f o r t h e U n i t e d K i n g d o m , h a v i n g aban­ d o n e d b o t h m o n e t a r y a n d exchange-rate targets, was t h e strategic d e c i ­ sion n o t t o e m p l o y any i n t e r m e d i a t e target variable i n t h e setting o f policy. I n fact, C h a n c e l l o r L a m o n t , i n his speech a n n o u n c i n g t h e i n f l a t i o n - t a r ­ g e t i n g policy, m a d e clear t h a t m o n e y - g r o w t h a n d exchange-rate mea­ sures w o u l d be m o n i t o r e d b u t w o u l d n o t d e t e r m i n e p o l i c y . A speech d e l i v e r e d by G o v e r n o r L e i g h - P e m b e r t o n , o n N o v e m b e r 1 1 , 1992, m a d e t h e p o i n t again: 2

Experience leads us to believe that monetary policy cannot be conducted with reference to a single target variable. The overriding objective o f mon­ etary policy is price stability. Therefore policy must be conducted w i t h refer­ ence to our expectations o f future inflation . . . Consequently, policymakers should make use o f every possible variable, with the importance attached to any given variable at any p o i n t i n time dependent o n its value as a guide to prospective inflation. (Leigh-Pemberton, 1992, p. 447) T h u s , t a r g e t i n g i n f l a t i o n d i r e c t l y was seen as t h e o n l y p r a c t i c a l way t o achieve t h e g o a l . T h i s c o n c l u s i o n , however, left o p e n t h e q u e s t i o n o f h o w t o m a k e t h e n e w p o l i c y c r e d i b l e , especially after t h e e x i t f r o m t h e r e s t r a i n t o f t h e E R M . T h e G o v e r n o r c o n t i n u e d : " B u t i n s u c h a n eclectic f r a m e w o r k i t is possible f o r t h e u n d e r l y i n g r a t i o n a l e o f p o l i c y t o b e lost i n a w e l t e r o f statistical c o n f u s i o n . T h a t is w h y we have o p t e d f o r a p o l i c y o f openness" {Ibid.). T h e b e l i e f t h a t sustained efforts t o c o m m u n i c a t e w i t h t h e p u b l i c — a n d n o t j u s t t h e a n n o u n c e m e n t o f a goal—are r e q u i r e d f o r p o l i c y c r e d ­ i b i l i t y , is at t h e c o r e o f t h e U n i t e d K i n g d o m ' s i n f l a t i o n - t a r g e t i n g frame­ w o r k . Nevertheless, w h i l e t h e f r a m e w o r k e m p h a s i z e d a c c o u n t a b i l i t y , i t d i d n o t f o r f e i t flexibility, even i n p r i n c i p l e . T h e i d e a t h a t m o n e t a r y p o l i c y m u s t r e t a i n some flexibility t o d e a l w i t h m a c r o e c o n o m i c events as t h e y o c c u r p r o b a b l y r e f l e c t e d less a deep-seated c o n v i c t i o n t h a n t h e r e a l i t y that, u l t i m a t e l y , t h e r e s p o n s i b i l i t y f o r m o n e t a r y p o l i c y - m a k i n g rests w i t h t h e e l e c t e d g o v e r n m e n t . As we n o t e d i n o u r discussion o f N e w Z e a l a n d , t h e e x t e n t t o w h i c h i n f l a t i o n t a r g e t i n g is t r e a t e d as a r u l e is best seen as a design choice. 3

The Operational Framework T h e t a r g e t v a r i a b l e i n t h e U n i t e d K i n g d o m is t h e a n n u a l c h a n g e i n t h e retail price i n d e x e x c l u d i n g mortgage interest payments ( R P I X ) . R P I X i n f l a t i o n was t o r e m a i n i n a r a n g e o f 1 % t o 4 % at least u n t i l t h e n e x t

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e l e c t i o n , w i t h t h e e x p e c t a t i o n t h a t i t w o u l d have settled i n t h e l o w e r h a l f o f t h a t r a n g e b y t h a t t i m e ( t h a t is, i t w o u l d be 2.5% o r less). T h e l o n g t e r m i n t e n d e d average f o r R P I X i n f l a t i o n is 2.5% o r less. R P I X is m e a n t to c a p t u r e u n d e r l y i n g i n f l a t i o n a n d is usually r e p o r t e d a l o n g w i t h RPIY, w h i c h is R P I X a l t e r e d t o e x c l u d e t h e first-round effect o f i n d i r e c t taxes. T h e effects o f c o m m o d i t y p r i c e shocks, i n c l u d i n g o i l shocks, are i n c l u d e d i n t h e target; thus, t h e t a r g e t e d i n f l a t i o n m e a s u r e is closer t o h e a d l i n e i n f l a t i o n t h a n i n t h e N e w Z e a l a n d a n d C a n a d i a n cases. As we have seen, i n a l l i n f l a t i o n targets o t h e r t h a n h e a d l i n e i n f l a t i o n , t h e r e is s o m e trade­ o f f b e t w e e n t r a n s p a r e n c y (because h e a d l i n e C P I is w h a t p e o p l e are ac­ c u s t o m e d t o ) a n d flexibility (because v a r i o u s types o f p r i c e changes are e x c l u d e d f r o m t h e d e f i n i t i o n o f t h e target, p e r m i t t i n g some d i s c r e t i o n r e g a r d i n g t o w h i c h types o f shocks t h e c e n t r a l b a n k m u s t r e s p o n d ) . 4

R P I X has p r o v e d t o be a n effective measure, w i t h t h e financial press a n d t h e p u b l i c a d a p t i n g t o i t over t i m e . T h e r e was some c o n s i d e r a t i o n o f a s w i t c h t o R P I Y i n 1995, b u t t h a t tactic was d e c i d e d t o be t o o risky, as t h e p u b l i c m i g h t feel t h a t targets ( a n d t h e shocks t h a t m o n e t a r y p o l i c y was c o m m i t t e d t o offset) w e r e b e i n g c h a n g e d t o o o f t e n . I n d e e d , t o dis­ c o u r a g e t h e p e r c e p t i o n o f excessive m a n i p u l a t i o n , t h e O f f i c e f o r N a ­ t i o n a l Statistics, a n agency separate f r o m t h e B a n k , was m a d e r e s p o n ­ sible f o r c a l c u l a t i n g t h e v a r i o u s i n f l a t i o n series. T h e use o f a t a r g e t r a n g e , set b y t h e C h a n c e l l o r , was i n t e r p r e t e d b y m a n y as a way o f s e t t i n g a clear l i m i t o n t h e a m o u n t o f d i s c r e t i o n a r y p o l i c y t h a t w o u l d be p e r m i t t e d . L a t e r i n t e r p r e t a t i o n s b y t h e B a n k a n d t h e U . K . Treasury, however, i n d i c a t e d t h a t t h e b a n d was n e v e r i n t e n d e d as a t a r g e t r a n g e strictly s p e a k i n g , b u t was r a t h e r a n a d m i s s i o n o f i m p e r ­ fect c o n t r o l o f i n f l a t i o n . H o w e v e r , as o f this w r i t i n g , t h e o f f i c i a l p o s i t i o n o f t h e Treasury a n d t h e B a n k is t h a t t h e r e is n o l o n g e r a t a r g e t r a n g e , b u t a p o i n t t a r g e t o f 2.5% t o be m e t i n t o t h e i n d e f i n i t e f u t u r e . T h i s c h a n g e was first m a d e e x p l i c i t i n C h a n c e l l o r K e n n e t h Clarke's M a n s i o n H o u s e Speech t o t h e C i t y o n J u n e 14, 1995. I n reality, t h e e n d p o i n t o f s u c h a t i m e h o r i z o n is l i k e l y t o c o r r e s p o n d t o t h e l i f e t i m e o f any p a r l i a ­ m e n t a r y m a j o r i t y , as i t d i d i n N e w Z e a l a n d w h e n t h a t c o u n t r y c h a n g e d its t a r g e t r a n g e after t h e O c t o b e r 1996 e l e c t i o n . U n l i k e N e w Z e a l a n d , however, t h e U n i t e d K i n g d o m n o w makes n o e x p l i c i t c o m m i t m e n t t o r e m a i n w i t h i n a r a n g e . A r g u a b l y t h e U n i t e d K i n g d o m ' s p o i n t t a r g e t al­ lows s o m e flexibility t o p o l i c y b y p e r m i t t i n g some s h o r t - r u n d e v i a t i o n s f r o m t a r g e t w i t h o u t c a u s i n g t h e p u b l i c t o focus u n d u l y o n w h e t h e r t h e o f f i c i a l t a r g e t r a n g e has b e e n b r e a c h e d . 5

6

A n o t h e r issue i n h e r e n t i n t h e U n i t e d K i n g d o m ' s t a r g e t i n g f r a m e w o r k was w h e t h e r t h e e n d p o i n t o f t h e t a r g e t p e r i o d s h o u l d be t i e d t o a spe-

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cific event: i n this case, t h e e n d o f t h e P a r l i a m e n t t h e n s i t t i n g . Unless t h e c o m m i t m e n t t o i n f l a t i o n t a r g e t i n g is o p e n - e n d e d , t h e r e is u n c e r ­ t a i n t y a b o u t w h e t h e r t h e t a r g e t i n g r e g i m e w i l l c o n t i n u e t o exist b e y o n d t h e l o n g e s t t a r g e t h o r i z o n . As a r e s u l t , d o u b t s m a y arise a b o u t t h e c o u n t r y ' s w i l l t o m e e t t h e targets as t h e e n d o f t h e p e r i o d a p p r o a c h e s a n d as pressures increase t o l e t bygones be bygones. As we n o t e d i n o u r discussion o f G e r m a n m o n e t a r y targets i n t h e r u n - u p t o E u r o p e a n M o n ­ etary U n i o n ( E M U ) , such d o u b t s are l i k e l y t o arise f o r any t a r g e t i n g f r a m e w o r k t h a t is n o t r e n e w e d far a h e a d o f its a n n o u n c e d ( o r p o l i t i c a l l y d e t e r m i n e d ) e n d p o i n t . H o w e v e r , j u s t as t h e L i b e r a l m a j o r i t y i n C a n a d a e x t e n d e d t h e 1995 targets t o 1998 s h o r t l y after t a k i n g office i n 1993, t h e B r i t i s h L a b o u r Party m a d e clear t h a t i t w o u l d e x t e n d t h e i n f l a t i o n t a r g e t o f 2.5% o r less f o r t h e d u r a t i o n o f its t e n u r e i n office, s h o u l d i t w i n t h e e l e c t i o n i n M a y 1997. T h i s early c o m m i t m e n t h e l p e d t o r e m o v e a p o t e n ­ t i a l source o f u n c e r t a i n t y a n d s t r e n g t h e n e d t h e c r e d i b i l i t y o f p o l i c y . I n contrast, i n t h e N e w Z e a l a n d e l e c t i o n s o f O c t o b e r 1996, t h e r e was n o way t o separate t h e t i m e h o r i z o n o f t h e targets f r o m t h e p o l i t i c a l p r o ­ cess. 7

A c t u a l l y , t h e r e a l t a r g e t o f t h e B a n k o f E n g l a n d ' s p o l i c y is n o t c u r r e n t R P I X i n f l a t i o n b u t t h e expectation o f R P I X i n f l a t i o n . Success i n m e e t i n g t h e t a r g e t is j u d g e d b y w h e t h e r t h e Bank's o w n i n f l a t i o n forecast over t h e s u c c e e d i n g t w o years falls w i t h i n t h e i n t e n d e d r a n g e . T h i s way o f assessing success is consistent w i t h t h e f o r w a r d - l o o k i n g perspective i n ­ h e r e n t i n i n f l a t i o n t a r g e t i n g , a n d w i t h t h e b e l i e f t h a t i t takes a b o u t t w o years f o r m o n e t a r y p o l i c y t o i n f l u e n c e i n f l a t i o n . I n d e e d , at t h e t i m e o f t h e C h a n c e l l o r ' s i n i t i a l a n n o u n c e m e n t o f t h e a d o p t i o n o f targets, h e was c r i t i c i z e d by m a r k e t observers f o r f o c u s i n g o n R P I X i n f l a t i o n per se, r a t h e r t h a n its e x p e c t a t i o n . F r o m t h e first Inflation Report o n w a r d , t h e B a n k has r e p o r t e d p r i ­ vate-sector i n f l a t i o n forecasts, i n a d d i t i o n t o its o w n i n f l a t i o n forecasts. I n r e c e n t issues o f t h e Inflation Report, t h e B a n k has also p a i d close a t t e n t i o n t o t h e v a r i a n c e a m o n g forecasts, a m e a s u r e o f i n f l a t i o n u n ­ c e r t a i n t y . I n its e m p h a s i s o n v a r i a b i l i t y a n d u n c e r t a i n t y , t h e B a n k has c o m m u n i c a t e d t o t h e press a n d t h e p u b l i c t h a t a f o r w a r d - l o o k i n g m o n ­ e t a r y p o l i c y m u s t b a l a n c e risks r a t h e r t h a n p r e t e n d t o exercise t i g h t control. T h e B a n k o f E n g l a n d appears t o be w o r k i n g f r o m a s t a n d a r d p o l i c y feedback f r a m e w o r k i n l i n e w i t h t h e C h a n c e l l o r ' s a n d t h e G o v e r n o r ' s i n i t i a l speeches—that is, o n e i n w h i c h m a n y pieces o f i n f o r m a t i o n are g a t h e r e d a n d w e i g h e d . MO a n d M 4 ( n a r r o w a n d b r o a d m o n e y ) figures m u s t be r e p o r t e d , w i t h " m o n i t o r i n g ranges" a n n o u n c e d f o r t h e m . H O W 8

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ever, t h e r e is a n e x p l i c i t u n d e r s t a n d i n g t h a t w h e n i n f o r m a t i o n o b t a i n e d f r o m m o n e t a r y aggregates is i n c o n f l i c t w i t h R P I X forecasts, t h e R P I X forecasts w i l l be accepted. E x c h a n g e rates a n d h o u s i n g prices have o f t e n b e e n c i t e d as i n d i c a t o r s t o be used i n p o l i c y decisions, b u t t h e r e has b e e n n o e x p l i c i t r a n k i n g o f t h e usefulness o f such a l t e r n a t i v e i n d i c a t o r s . T h e B a n k acknowledges t h a t its l a c k o f success w i t h m o n e y a n d e x c h a n g e r a t e - t a r g e t i n g has m a d e i t h e s i t a n t t o rely o n any o n e i n d i c a t o r o r rela­ tionship. T h e stated g o a l o f t h e U n i t e d K i n g d o m ' s i n f l a t i o n targets is p r i c e sta­ bility, " n a m e l y t h a t t h e rate o f i n f l a t i o n a n t i c i p a t e d by e c o n o m i c agents is u n i m p o r t a n t t o savings, i n v e s t m e n t , a n d o t h e r e c o n o m i c decisions" ( L e i g h - P e m b e r t o n , 1992, p . 4 4 6 ) . As i n m a n y o t h e r c o u n t r i e s , a t a r g e t o f zero i n f l a t i o n was dismissed as u n d u l y restrictive g i v e n t h e f a i l u r e o f stan­ d a r d p r i c e indexes t o c a p t u r e fully t h e e x t e n t o f q u a l i t y c h a n g e ( a l t h o u g h t h e B a n k o f E n g l a n d p o i n t s o u t t h a t R P I X is rebased far m o r e f r e q u e n t l y t h a n i n m a n y o t h e r c o u n t r i e s , so t h e r e w o u l d be less s u b s t i t u t i o n bias f o r t h e U n i t e d K i n g d o m ' s p r i c e i n d e x ) . Consequently, as we have n o t e d , p r i c e stability is o p e r a t i o n a l l y d e f i n e d as g r o w t h i n R P I X o f 2.5% p e r year o r less. T h e c h o i c e o f this figure was p r i m a r i l y a p r a g m a t i c d e c i s i o n , w i t h t h e l i k e l i h o o d t h a t i f t h e 2.5% g o a l was a c h i e v e d a n d m a i n t a i n e d , a l o w e r g o a l , say o f 2 % , w o u l d t h e n be set. N o c o n s i d e r a t i o n o f o t h e r goals, such as exchange-rate stability o r s m o o t h i n g o f t h e business cycle, is ex­ plicitly acknowledged w i t h i n the targeting framework. L i k e every o t h e r c e n t r a l b a n k , however, t h e B a n k o f E n g l a n d r e m a i n s c o m m i t t e d i n fact t o t r a d i n g o f f d i s i n f l a t i o n w h e n necessary against its real-side costs a n d its effects o n t h e financial system. T h i s r e a l i t y is best i l l u s t r a t e d by excerpts f r o m G o v e r n o r Leigh-Pemberton's N o v e m b e r 1992 speech, " T h e Case f o r Price Stability," r e p r i n t e d i n t h e B a n k o f E n g l a n d ' s Quarterly Bulletin. I n t h a t speech t h e G o v e r n o r states, " T h e o v e r r i d i n g objective o f m o n e t a r y p o l i c y is p r i c e stability" ( p . 4 4 7 ) . I n t h e p r e c e d i n g p a r a g r a p h , however, t h e G o v e r n o r e x p l a i n s w h y o t h e r factors h a d b e e n p e r m i t t e d t o o v e r r i d e t h a t objective a n d p r o m p t e d the p o u n d ' s e x i t f r o m the E R M : I t [the ERM] certainly offered a very visible sign o f our commitment to price stability . . . [ b u t ] there was a real risk o f these disinflationary forces d o i n g quite unnecessary damage to the real economy. Although we would have achieved price stability very quickly—indeed there is reason to believe we m i g h t have reached that position d u r i n g 1993—there was a real danger that the deflation which was already apparent i n certain sectors o f the economy (notably asset markets) would have become much more widespread. I t was

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not necessary to compress the transition phase to price stability into such a short time span and could well have been counterproductive i n the longer term. (Ibid.) 9

T h e t r a d e o f f b e t w e e n p r i c e stability a n d o t h e r objectives is a p p a r e n t even w h e n t h e choices are less stark t h a n i n t h e p e r i o d p r i o r t o t h e 1992 crisis. W h y else w o u l d t h e a c h i e v e m e n t o f p r i c e stability be p u r s u e d g r a d u ­ ally, as o u t l i n e d b y t h e B a n k a n d t h e C h a n c e l l o r f o r t h e p a t h f r o m t h e S e p t e m b e r 1992 R P I X rate o f 3.6%? Clearly, a gap exists b e t w e e n t h e claims a n d r e a l i t y o f i n f l a t i o n as a sole g o a l even u n d e r i n f l a t i o n target­ i n g . I n v a r i o u s speeches i n r e c e n t years, G o v e r n o r E d d i e G e o r g e has stressed t h a t t h e B a n k aims t o stabilize t h e business cycle ( a n d t h e r e b y at least p a r t i a l l y t o i n d u c e e x c h a n g e rate stability) w i t h i n t h e t a r g e t c o n ­ straint. 1 0

O n l y t h r e e weeks after t h e d e c i s i o n t o a d o p t i n f l a t i o n t a r g e t i n g , C h a n ­ cellor L a m o n t and the Bank o f England worked out their j o i n t imple­ m e n t a t i o n o f t h e policy. T h e B a n k w o u l d p r o d u c e its o w n i n f l a t i o n f o r e ­ cast each quarter, b e g i n n i n g w i t h F e b r u a r y 1993, a n d t h a t forecast w o u l d be t h e m a i n y a r d s t i c k used t o m e a s u r e success o r f a i l u r e . As m e n t i o n e d above, t h e r o l e o f t h i s forecast i n a c c o u n t a b i l i t y f o r p o l i c y b e c o m e s q u i t e c o m p l i c a t e d . O n e c o m p l i c a t i o n arises w h e n t h e g o v e r n m e n t ' s interestrate decisions are i n c o n s i s t e n t w i t h t h e i m p l i c a t i o n s o f t h e B a n k ' s f o r e ­ casts. Nevertheless, t h e speed w i t h w h i c h t h e c o m m i t m e n t t o p u b l i s h i n f l a t i o n forecasts was u n d e r t a k e n u n d e r l i n e s j u s t h o w c e n t r a l c o m m u ­ n i c a t i o n efforts are t o t h e o p e r a t i o n o f t h e U n i t e d K i n g d o m ' s i n f l a t i o n targets—and h o w t h e a n n o u n c e m e n t o f t h e targets themselves was never t h o u g h t t o be e n o u g h o n its o w n . I n t r a c k i n g progress t o w a r d t h e i n f l a t i o n target, t h e B a n k o f E n g l a n d , i n its Inflation Report, details past p e r f o r m a n c e o f t h e U . K . economy, c o m ­ pares actual i n f l a t i o n outcomes ( b o t h R P I X a n d its c o m p o n e n t s ) w i t h p r i o r forecasts b y t h e B a n k , i d e n t i f i e s t h e factors t h a t are p r e s e n t i n g t h e great­ est d a n g e r t o p r i c e stability, a n d forecasts t h e l i k e l i h o o d t h a t i n f l a t i o n w i l l i n two years' time be w i t h i n t h e target range. I n t h e w o r d s o f G o v e r n o r L e i g h - P e m b e r t o n (1992, p . 4 4 7 ) , " O u r a i m w i l l be t o p r o d u c e a w h o l l y objective a n d c o m p r e h e n s i v e analysis o f i n f l a t i o n a r y trends a n d pressures, w h i c h w i l l p u t t h e Bank's professional c o m p e t e n c e o n t h e l i n e . " F r o m t h e t h i r d issue ( A u g u s t 1993) o n w a r d , t h e Inflation Report has f o l l o w e d a sixp a r t f o r m a t c o v e r i n g i n f l a t i o n , m o n e y a n d interest rates, d e m a n d a n d sup­ ply, the l a b o r m a r k e t , p r i c i n g behavior, a n d prospects f o r i n f l a t i o n . I n ad­ d i t i o n , the Quarterly Bulletin publishes policy speeches a n d relevant research, w i t h t h e a u t h o r s o f t h e research articles r e g u l a r l y i d e n t i f i e d .

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T h e c l a r i t y w i t h w h i c h t h e B a n k p r e s e n t e d its views, a n d t h e n e e d f o r t h e C h a n c e l l o r t o r e a c t e x p l i c i t l y t o those views, w e r e m e a n t t o serve as a c h e c k o n t h e g o v e r n m e n t ' s m o n e t a r y p o l i c y stance b e t w e e n e l e c t i o n s . F o l l o w i n g t h e issuance o f t h e t h i r d Inflation Report in A u g u s t 1993, i t was d e c i d e d t h a t t h e B a n k w o u l d s e n d t h e Report t o t h e Treasury o n l y after its c o n t e n t s h a d b e e n finalized a n d p r i n t e d . T h u s , t h e Treasury w o u l d have n o c h a n c e t o e d i t o r even suggest changes. T h i s a r r a n g e m e n t i n d i ­ c a t e d t h e g o v e r n m e n t ' s acceptance o f t h e Bank's d i s t i n c t v o i c e . T h e Inflation Report is best seen i n t h e c o n t e x t o f t h e Bank's t r a d i ­ t i o n a l r o l e as adviser t o t h e C h a n c e l l o r o n m o n e t a r y policy. E v e n after t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g , t h e B a n k c o n t i n u e d t o p r o v i d e ad­ vice a n d i n f o r m a t i o n , j u s t as i t d i d at t h e t i m e o f C h a n c e l l o r L a m o n t ' s d e c i s i o n t o i m p l e m e n t i n f l a t i o n t a r g e t i n g . W h a t was i n n o v a t i v e was t h a t t h e B a n k b e g a n t o r e p o r t t o t h e p u b l i c i n d e p e n d e n t l y o f its r e g u l a r meet­ ings w i t h t h e Treasury staff a n d w i t h t h e C h a n c e l l o r . A t t h e same t i m e , t h e Treasury, w h i c h r e p o r t s d i r e c t l y t o t h e C h a n c e l l o r , has b e e n p u b l i s h ­ i n g its o w n m o n t h l y m o n e t a r y r e p o r t since D e c e m b e r 1992. T h i s p u b l i ­ c a t i o n , w h i c h a n t e d a t e d t h e Inflation Report a n d was issued m o r e fre­ q u e n t l y , t r a c k e d t h e g r o w t h o f b r o a d ( M 4 ) a n d n a r r o w (MO) m o n e y i n t h e m o n i t o r i n g ranges set b y t h e C h a n c e l l o r a n d k e p t readers a p p r i s e d o f m o v e m e n t s i n t h e f o r e i g n - e x c h a n g e a n d asset m a r k e t s , p a r t i c u l a r l y U . K . h o u s i n g . I n g r a n t i n g this m a n d a t e t o t h e Treasury, t h e C h a n c e l l o r c o m m i t t e d U . K . m o n e t a r y p o l i c y t o t h e m o n i t o r i n g o f a set o f i n d i c a t o r s c o m p i l e d b y his o w n staff, even i f t h e B a n k o f E n g l a n d was e m p h a s i z i n g o t h e r variables a n d c o m p u t i n g o t h e r n u m b e r s . T h u s t h e B a n k , despite t h e p r o m i n e n c e o f its Inflation Report, d i d n o t enjoy a m o n o p o l y o n p r o ­ v i d i n g m o n e t a r y - p o l i c y advice. T h e e m p h a s i s o n e x p l a i n i n g p o l i c y t o t h e p u b l i c , especially w h e n d i f f e r e n c e s arise b e t w e e n t h e C h a n c e l l o r ' s a n d t h e B a n k ' s p o i n t s o f view, was b u t t r e s s e d b y t h r e e a d d i t i o n a l i n s t i t u t i o n a l c h a n g e s . First, i n F e b r u a r y 1993, t h e m o n t h l y m e e t i n g b e t w e e n t h e C h a n c e l l o r a n d t h e G o v e r n o r t o set m o n e t a r y p o l i c y was f o r m a l i z e d . S e c o n d , s t a r t i n g i n N o v e m b e r 1993, t h e d e c i s i o n o n w h e n t o p u t i n t o effect a n y i n t e r e s t r a t e c h a n g e s d e c i d e d o n b y t h e C h a n c e l l o r at t h e m o n t h l y m e e t i n g was t o be l e f t t o t h e B a n k ' s d i s c r e t i o n , so l o n g as t h e y w e r e m a d e effective b e f o r e t h e n e x t m e e t i n g . C o m b i n e d w i t h t h e Bank's c o m m i t m e n t t o issue a press release e x p l a i n i n g t h e r e a s o n f o r any i n t e r e s t - r a t e c h a n g e o n c e i t h a d b e e n m a d e , t h i s d i s c r e t i o n gave t h e m a r k e t s a g r e a t d e a l o f i n f o r m a t i o n about the Bank's view o f the Chancellor's decision. T h i r d , a n d m o s t s i g n i f i c a n t , b e g i n n i n g i n A p r i l 1994, t h e m i n u t e s o f t h e m o n t h l y m e e t i n g s b e t w e e n C h a n c e l l o r a n d G o v e r n o r w e r e released t w o

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weeks after t h e n e x t m e e t i n g ( r e p l a c i n g a t h i r t y - y e a r l a g w i t h a sixweek lag). I n a very r e a l sense, t h r o u g h o u t this e n t i r e p e r i o d t h e B a n k h a d oper­ a t e d as t h e g o v e r n m e n t ' s i n s t i t u t i o n a l " c o u n t e r i n f l a t i o n a r y conscience." T h e r e was a n u n d e r l y i n g t e n s i o n i n this r o l e because t h e B a n k r e m a i n e d u n d e r t h e c o n t r o l o f t h e C h a n c e l l o r , w h o also c o n t r o l l e d t h e i n s t r u m e n t s o f m o n e t a r y policy. T h e Bank's use o f p u b l i c f o r u m s a n d o t h e r venues t o c o m m u n i c a t e its forecasts, its analyses, a n d even its e x p l i c i t m o n e t a r y p o l i c y r e c o m m e n d a t i o n s h a d t h e effect o f i n c r e a s i n g t h e cost f o r t h e g o v e r n m e n t o f g o i n g against t h e Bank's assessment, p r e s u m a b l y s e r v i n g t h e cause o f p r i c e stability. U n f o r t u n a t e l y , since t h e C h a n c e l l o r d i d n o t have a s y m m e t r i c r e q u i r e m e n t t o r e p o r t t h e r e a s o n i n g b e h i n d his p o l i c y decisions, b e y o n d w h a t h e chose t o reveal at t h e m o n t h l y m e e t i n g s , dis­ putes whose o r i g i n s m a y have l a i n i n p o l i c y preferences o r i n differences i n c o m p e t e n c e c o u l d d e g e n e r a t e i n t o c o m p e t i t i o n s over forecast accu­ racy, as we w i l l see i n t h e n e x t s e c t i o n . T h e standing given the B a n k by the m o n t h l y minutes d i d not, how­ ever, p r o v i d e m o n e t a r y p o l i c y w i t h a c c o u n t a b i l i t y b e y o n d t h a t bestowed b y elections. I t was t h e B a n k , n o t t h e financial m a r k e t s o r t h e g e n e r a l p u b l i c , t h a t was passing j u d g m e n t i n t h e Inflation Report, b u t any p u n i s h ­ m e n t o r reward for that j u d g m e n t (beyond m a r k e t reactions) h a d to wait u n t i l the n e x t election. Even u n d e r the new M o n e t a r y Policy C o m ­ m i t t e e o f t h e B a n k , w h i c h has set U . K . m o n e t a r y p o l i c y since M a y 1997, u l t i m a t e r e s p o n s i b i l i t y f o r t h e goals o f p o l i c y rests w i t h t h e p a r l i a m e n ­ tary m a j o r i t y at t h e n e x t e l e c t i o n s . N o r d i d these f o r u m s f o r t h e B a n k p r o v i d e r e a l c l a r i t y a b o u t p o l i c y i n t e n t i o n s a n d goals, since t h e C h a n c e l ­ l o r c o u l d o v e r r i d e t h e Bank's r e c o m m e n d a t i o n s w i t h o n l y l i m i t e d p u b ­ lic e x p l a n a t i o n . 11

British Monetary Policy under Inflation Targeting I n this section we s u m m a r i z e b o t h t h e m a c r o e c o n o m i c o u t c o m e s a n d t h e i n t e r a c t i o n s b e t w e e n t h e Treasury a n d t h e B a n k at c r i t i c a l j u n c t u r e s since t h e a d o p t i o n o f i n f l a t i o n targets. We d r a w o n v a r i o u s issues o f t h e Bank's q u a r t e r l y Inflation Report a n d o n t h e M i n u t e s o f t h e M o n t h l y M o n ­ etary M e e t i n g s b e t w e e n t h e C h a n c e l l o r a n d t h e G o v e r n o r . F i g u r e 7.1 tracks the p a t h o f i n f l a t i o n , i n t e r e s t rates, t h e n o m i n a l effective e x c h a n g e rate ( h e n c e f o r t h t h e "exchange r a t e " ) , G D P g r o w t h , a n d u n e m p l o y m e n t i n t h e U n i t e d K i n g d o m b o t h b e f o r e a n d after i n f l a t i o n t a r g e t i n g was introduced.

RPIX

a n d RP! I n f l a t i o n

and

Targets

B.

Overnight

and Long

—Term

Interest

Rates

Figure 7.1. U n i t e d Kingdom economic indicators. Sources: A ) Bank for International Settlements database, Bank o f England; B) Bank for International Settlements database; C) Main Economic Indicators o f the Organisation for Economic Cooperation and Development; D) Bank for International Settlements database.

A.

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T h e p e r i o d f r o m O c t o b e r 1992 ( w h e n s t e r l i n g left t h e E R M ) t o t h e e n d o f 1993 m a r k e d t h e e n d o f recession a n d t h e b e g i n n i n g o f r e c o v e r y i n t h e B r i t i s h e c o n o m y . G D P g r o w t h t u r n e d positive i n t h e first q u a r t e r o f 1993, a n d t h e u n e m p l o y m e n t rate p e a k e d at 10.6% i n D e c e m b e r 1992 ( F i g u r e 7 . 1 , P a n e l C ) . T h r o u g h o u t 1993, o u t p u t g r o w t h a c c e l e r a t e d a n d t h e u n e m p l o y m e n t rate d e c l i n e d . W i t h some b r i e f i n t e r r u p t i o n s , R P I X i n f l a t i o n c o n t i n u e d its d o w n w a r d t r e n d a n d r e a c h e d t h e m i d p o i n t o f t h e d e s i g n a t e d t a r g e t r a n g e o f 2.5% f o r t h e first t i m e i n N o v e m b e r 1993 ( P a n e l A ) . T h e e x c h a n g e rate b o t t o m e d o u t i n F e b r u a r y 1993 a n d t h e n rose t h r o u g h t h e rest o f t h e year ( P a n e l D ) . T w o m a j o r t h e m e s i n t h e discussion o f m e d i u m - t e r m i n f l a t i o n f o r e ­ casts i n t h e first t w o issues o f t h e Inflation Report ( F e b r u a r y a n d M a y 1993) were the depreciation o f sterling a n d the government's g r o w i n g b u d g e t d e f i c i t , each o f w h i c h h a d t h e p o t e n t i a l t o raise i n f l a t i o n . T h e o f f i c i a l i n t e r e s t rate ( t h e base r a t e ) h a d b e e n r e d u c e d f r o m 1 0 % i n A u g u s t 1992 t o 6% i n J a n u a r y 1993 ( P a n e l B ) , r e f l e c t i n g t h e g o v e r n m e n t ' s desire t o escape f r o m G e r m a n m o n e t a r y tightness. N o t s u r p r i s i n g l y , i n t h e five months following the U n i t e d Kingdom's exit f r o m the E R M , sterling h a d d e p r e c i a t e d b y 14.5%, as m e a s u r e d b y t h e B a n k o f E n g l a n d ' s ex­ change-rate i n d e x . O n t h e fiscal side, t h e B a n k m e n t i o n e d fears o f pos­ sible f u t u r e m o n e t i z a t i o n o f g o v e r n m e n t d e b t as a source o f i n c r e a s e d i n f l a t i o n e x p e c t a t i o n s . T h e B a n k d i d n o t , however, call f o r i m m e d i a t e fiscal a c t i o n o r d i r e c t l y c r i t i c i z e t h e g o v e r n m e n t ' s fiscal policy. D e s p i t e these c o n c e r n s a n d t h e r e c o v e r i n g e c o n o m y , t h e Bank's i n f l a t i o n p r o j e c ­ t i o n s i n these first t w o issues c o n t i n u e d t o f a l l at a l l t h e h o r i z o n s dis­ cussed. I n t h e M a y 1993 Inflation Report, t h e B a n k stated its b e l i e f t h a t t h e g o v e r n m e n t w o u l d h o l d i n f l a t i o n b e l o w 4 % over t h e f o l l o w i n g e i g h t e e n m o n t h s . T h i s was n o t a n e n d o r s e m e n t o f t h e g o v e r n m e n t ' s m o n e t a r y policy, f o r n o t o n l y h a d t h e C h a n c e l l o r c o m m i t t e d t o b e i n g w i t h i n t h e i n f l a t i o n r a n g e ( t h a t is, b e l o w 4 % ) i n t w o years, b u t h e h a d also stated t h a t h e w o u l d have i n f l a t i o n i n t h e l o w e r h a l f o f t h a t r a n g e ( b e l o w 2 . 5 % ) by 1997. T h e B a n k l i n k e d t h e possibility o f i n f l a t i o n above t a r g e t t o t h e g o v e r n m e n t ' s p o l i c y decisions, r a t h e r t h a n t o e c o n o m i c c o n d i t i o n s o u t ­ side o f t h e g o v e r n m e n t ' s c o n t r o l . T h e B a n k also expressed c o n c e r n a b o u t t h e effects o f t h e e x c h a n g e rate o n prices, n o t i n g t h a t t h e 5% a p p r e c i a ­ t i o n o f s t e r l i n g ( t r a d e - w e i g h t e d ) since F e b r u a r y p e r m i t t e d some o p t i ­ m i s m b u t n o t m u c h , as surveys a n d financial m a r k e t i n t e r e s t rates c o n ­ t i n u e d to indicate a lack o f medium-to-long-run credibility f o r the infla­ t i o n targets. T h e B a n k also e m p h a s i z e d t h a t t h e m a i n u n c e r t a i n t y a b o u t t h e i n f l a t i o n forecast, m o s t o f i t o n t h e u p s i d e , s t e m m e d f r o m u n c e r -

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t a i n t y a b o u t t h e l i k e l y course o f d o m e s t i c wages a n d p r o f i t s . F o l l o w i n g these c o n c e r n s a b o u t i n f l a t i o n t o t h e i r l o g i c a l c o n c l u s i o n , t h r e e weeks l a t e r G o v e r n o r G e o r g e o f t h e B a n k gave a speech e x p l i c i t l y w a r n i n g against a rate c u t . T h e B a n k a p p a r e n t l y f e a r e d t h a t w i t h t h e i m m i n e n t change i n chancellors ( f r o m N o r m a n L a m o n t t o K e n n e t h C l a r k e ) a n d submission o f the b u d g e t , a d e c i s i o n t o ease w o u l d be m a d e i n compensa­ tion f o r various fiscal measures. A t t h e t i m e , however, rates were n o t cut. Six m o n t h s later, i n t h e N o v e m b e r Inflation Report, t h e B a n k t o u c h e d o n t h e same t h e m e s even m o r e sharply. T h e r e was a s l i g h t p r o b a b i l i t y , according to the Bank, that i n f l a t i o n w o u l d exceed the target i n the near t e r m . M o r e o v e r , t h e B a n k said i t foresaw t h e p o t e n t i a l f o r a n o m i n a l wage p u s h i f h e a d l i n e i n f l a t i o n rose t o t h e u p p e r l i m i t o f t h e 4 % t a r g e t r a n g e . A g a i n , t h e B a n k was r e s p o n d i n g t o a p o l i t i c a l s i t u a t i o n i n w h i c h m a n y Conservative Party b a c k b e n c h e r s a n d c o m m e n t a t o r s w e r e expect­ i n g a c u t i n i n t e r e s t rates. T h e g o v e r n m e n t h a d a g r e e d t o c e r t a i n s p e n d ­ i n g cuts a n d a n e x t e n s i o n o f t h e v a l u e - a d d e d tax ( V A T ) t o d o m e s t i c f u e l a n d p o w e r s t a r t i n g i n A p r i l 1994, w h i l e news a b o u t r e a l e c o n o m i c devel­ o p m e n t s was g e n e r a l l y n o t g o o d . T h i s t i m e C h a n c e l l o r C l a r k e d i d l o w e r rates b y 0.5%, w i t h o u t f u r t h e r fiscal t i g h t e n i n g t o c o m p e n s a t e f o r t h e reduction. W h a t m a d e this c o n f l i c t b e t w e e n t h e B a n k a n d C h a n c e l l o r p a r t i c u ­ l a r l y i n t e r e s t i n g was t h a t t h e B a n k h a d already o f f e r e d a n o u t f o r t h e C h a n c e l l o r i n t h e M a y a n d N o v e m b e r issues o f t h e Inflation Report. T h e B a n k a t t r i b u t e d 0.4% o f t h e p r o j e c t e d rise i n i n f l a t i o n d u r i n g 1994 t o t h e c h a n g e i n t h e VAT, w h i c h i t a c c e p t e d as a d e f i c i t r e d u c t i o n ; f u r t h e r , t h e B a n k r e m i n d e d readers t h a t i f R P I Y ( w h i c h excludes t h e first-round effect o f taxes) r a t h e r t h a n R P I X w e r e c o n s i d e r e d , i n f l a t i o n w o u l d be o n target, a l b e i t n e a r t h e t o p o f t h e r a n g e a n d w i t h u p s i d e risks. F o r s o m e reason, t h e C h a n c e l l o r chose n o t t o take advantage o f t h e p r o f f e r e d defense. T h o u g h u n e x e r c i s e d i n this episode, this sort o f d e f i n i t i o n a l tactic raises a r e a l d i l e m m a f o r t h e m a i n t e n a n c e o f p o l i c y a c c o u n t a b i l i t y . I f i n d i r e c t taxes are t o be e x c l u d e d f r o m c o n s i d e r a t i o n , w h y d i d t h e C h a n ­ c e l l o r a n d t h e B a n k choose t o t a r g e t R P I X r a t h e r t h a n R P I Y i n t h e first place? I f t h e g o v e r n m e n t h a d i n fact s w i t c h e d t o R P I Y after t h e B a n k h a d " a l l o w e d " ( t h a t is, r e f r a i n e d f r o m c r i t i c i z i n g ) t h e m o v e , h o w c o u l d t h e financial m a r k e t s a n d t h e e l e c t o r a t e have b e e n sure t h a t this w a s j u s t a o n e - t i m e event? A n d i f t h e wage s p i r a l t h e B a n k w o r r i e d a b o u t h a d m a t e r i a l i z e d , w o u l d this s w i t c h have b e e n beside t h e p o i n t , o r w o u l d i t have a l l o w e d a shift o f b l a m e t o t h e u n i o n s ' l a c k o f sophistication? O n t h e basis o f this case, i t w o u l d a p p e a r t h a t t h e p e o p l e w h o d e f i n e a n d

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m e a s u r e t h e t a r g e t i n f l a t i o n series s h o u l d be k e p t separate f r o m t h e p e o p l e w h o assess success i n a c h i e v i n g t h e targets. T h e U n i t e d K i n g d o m ' s f r a m e w o r k m i g h t be c o m p a r e d w i t h N e w Zealand's o n this score: N e w Zealand's c e n t r a l b a n k — p a r t l y because o f t h e c o u n t r y ' s s m a l l size—re­ tains some a m o u n t o f d i s c r e t i o n over t h e s h o r t - r u n d e f i n i t i o n o f t h e tar­ get i n f l a t i o n series a n d , o n a few occasions, has exercised i t . A r o u n d t h e b e g i n n i n g o f 1994, w i t h t h e p e r f o r m a n c e o f i n f l a t i o n b e t t e r t h a n e x p e c t e d , t h e C h a n c e l l o r eased m o n e t a r y p o l i c y f u r t h e r . I n f l a t i o n a r y pressures r e m a i n e d s u b d u e d , as t h e l a g g e d effect o n prices o f t h e e a r l i e r d e p r e c i a t i o n was offset b y a r e d u c t i o n i n u n i t l a b o r costs r e l a t e d t o c o n t i n u e d weak e m p l o y m e n t . I t was a p p a r e n t at t h e t i m e t h a t pass-through o f t h e o n e - t i m e d r o p i n t h e e x c h a n g e r a t e u p o n t h e e x i t f r o m t h e E R M h a d b e e n a v e r t e d — a m a j o r success f o r t h e n e w m o n ­ etary r e g i m e . T h i s a c h i e v e m e n t was even m o r e i m p r e s s i v e t h a n t h e B a n k o f Canada's success at p r e v e n t i n g p a s s - t h r o u g h f r o m t h e 1991 t a x increase, g i v e n t h a t i t f o l l o w e d a p r e s u m p t i v e b l o w t o B r i t a i n ' s c r e d i b i l ­ i t y u p o n t h e c o u n t r y ' s e x i t f r o m t h e E R M . T h e base r a t e , w h i c h h a d b e e n r e d u c e d f r o m 6% t o 5.5% i n N o v e m b e r 1993, was c u t a n o t h e r 25 basis p o i n t s t o 5.25% i n F e b r u a r y 1994. T h e s e r e d u c t i o n s o c c u r r e d d e s p i t e p r o j e c t i o n s i n every Inflation Report f r o m A u g u s t 1993 o n t h a t i n f l a t i o n was l i k e l y t o rise. I n d e e d , i n f l a t i o n d i d n o t start t o rise u n t i l t h e e n d o f 1994. 1 2

W h e n assessing t h e q u a l i t y o f its past forecasts, t h e B a n k p o i n t e d t o specific sources o f e r r o r , s u c h as u n e x p e c t e d l y slow e a r n i n g s g r o w t h a n d a squeeze i n r e t a i l m a r g i n s . T h e C h a n c e l l o r , h a v i n g g i v e n n o e x p l i c i t forecast, d i d n o t have t o r a t i o n a l i z e his i n t e r p r e t a t i o n o f t h e data. H e r e i n lay a basic a m b i g u i t y o f t h e B r i t i s h a r r a n g e m e n t : T h e r e was n o way t o k n o w f o r sure w h e t h e r t h e d i v e r g e n c e b e t w e e n t h e Bank's o p i n i o n a n d t h e C h a n c e l l o r ' s p o l i c i e s was t h e r e s u l t o f d i f f e r e n t assessments o f t h e e c o n o m i c s i t u a t i o n o r d i f f e r i n g assessments o f t h e i m p o r t a n c e o f achiev­ i n g t h e i n f l a t i o n t a r g e t i n t h e s h o r t r u n . I n d e e d , i n g e n e r a l , so l o n g as e l e c t e d officials are n o t r e q u i r e d t o give t h e i r o w n forecasts t o be c o m ­ p a r e d w i t h those o f t h e c e n t r a l b a n k , t h e y have t h e o p t i o n o f c o n c e a l i n g w h a t m a y be a w e a k e r c o m m i t m e n t t o t h e i n f l a t i o n g o a l . T h r o u g h o u t 1994, G D P g r e w vigorously, w i t h f o u r t h - q u a r t e r r e a l G D P e x c e e d i n g t h e p r e v i o u s year's value by 4 % . F o r t h e first t e n m o n t h s o f t h e year R P I X i n f l a t i o n was t r e n d i n g d o w n w a r d , r e a c h i n g a 27-year l o w o f 2 % i n S e p t e m b e r a n d O c t o b e r , b e f o r e r i s i n g t o 2.5% i n D e c e m b e r . T h e u n e m p l o y m e n t rate c o n t i n u e d t o f a l l d u r i n g t h e year, t o a r o u n d 9 % . S t e r l i n g ( a c c o r d i n g t o t h e Bank's i n d e x ) h a d p e a k e d at t h e e n d o f 1993 a n d t r e n d e d s l i g h t l y d o w n w a r d d u r i n g 1994.

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D u r i n g t h e s u m m e r o f 1994, i t b e c a m e clear t o t h e B a n k t h a t t h e e c o n o m y was r e b o u n d i n g m o r e s t r o n g l y t h a n e x p e c t e d , a n d t h e Infla­ tion Report b e g a n t o cite evidence o f i n f l a t i o n a r y pressures, s u c h as r i s i n g wholesale prices. D e s p i t e g o o d i n f l a t i o n n u m b e r s ( b o t h R P I Y a n d R P I X i n f l a t i o n at t h e t i m e were b e l o w 2.5% a n d f a l l i n g ) , t h e C h a n c e l l o r , o n t h e advice o f t h e G o v e r n o r , raised t h e base rate o n S e p t e m b e r 12, a n d a g a i n o n D e c e m b e r 7, b y 0.5% e a c h t i m e . U n l i k e t h e t i g h t e n i n g i n 1988, these increases w e r e p r e e m p t i v e — a fact t h a t was w i d e l y n o t e d i n t h e press. T h e a b i l i t y t o tie c u r r e n t p o l i c i e s t o e x p e c t e d f u t u r e c o n d i t i o n s , t h e r e b y t a k i n g i n t o a c c o u n t t h e lags w i t h w h i c h p o l i c y affects t h e economy, is a clear advantage o f h a v i n g a n e x p l i c i t m e d i u m - t e r m objective f o r policy. 13

T h e discussions b e t w e e n C h a n c e l l o r C l a r k e a n d G o v e r n o r George d u r ­ i n g t h e m o n t h s l e a d i n g u p t o t h e S e p t e m b e r 1994 t i g h t e n i n g o f p o l i c y p r o v i d e some i n s i g h t i n t o t h e r o l e p l a y e d by t h e Bank's m e d i u m - t e r m i n ­ flation forecasts i n t h e p o l i c y process. D u r i n g t h e i r m e e t i n g o n J u l y 28, t h e G o v e r n o r p o i n t e d o u t that, o n t h e basis o f t h e Bank's latest forecast, he d i d see a risk to the inflation objective i n 1996, implying a need to tighten policy i n some degree before very long. . . . He was not, o n the current best guess, forecasting a strong u p t u r n i n inflation, and there was, as always, a significant margin o f error around that best guess. But the best guess for mid-1996 was already slightly above the mid-point o f the target range, and there was an uncomfortable sense that the upside risks to the medium-term forecast might, this time, be somewhat greater than the downside risks. (Bank of England, 1994a, July 28, p. 5) T h e C h a n c e l l o r , however, r e m a r k e d t h a t "there was a d a n g e r o f t r y i n g t o set a g a m e p l a n t o o far i n advance a n d n o t l o o k i n g at t h e actual evidence as i t u n f o l d e d . . . . T h e forecasts suggested i n f l a t i o n m i g h t be even l o w e r i n t h e n e x t few m o n t h s " (Ibid., p . 6 ) . A l t h o u g h they agreed n o t t o raise interest rates at t h e t i m e , t h a t d e c i s i o n cast d o u b t o n t h e e x t e n t t o w h i c h m o n e t a r y p o l i c y decisions were i n d e e d based o n the Bank's m e d i u m - t e r m forecast. W h i l e t h e existence o f target c o m m i t m e n t s a n d t h e Bank's o p e n statements o f o p i n i o n m o v e d t h e U . K . g o v e r n m e n t t o w a r d a m o r e for­ w a r d - l o o k i n g m o n e t a r y policy, the g o v e r n m e n t c o u l d n o t be f o r c e d t o a d o p t the policy that the Bank considered optimal. Again, the government's p r i ­ vate forecast—even i f d r i v e n as a p o l i t i c a l l y m o t i v a t e d m a r k d o w n f r o m t h e Bank's f o r m a l analysis—became t h e actual target. Moreover, because n e i ­ t h e r t h e estimate itself n o r t h e r e a s o n i n g b e h i n d i t was shared w i t h t h e p u b l i c , t h e g o v e r n m e n t forecast c o u l d n o t serve t h e f u n c t i o n o f a p u b l i c l y a n n o u n c e d target, n o r c o u l d p o l i c y be fully t r a n s p a r e n t . 14

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D u r i n g 1995, G D P g r o w t h d e c e l e r a t e d , f r o m 4 % b e t w e e n t h e f o u r t h q u a r t e r o f 1993 a n d t h e f o u r t h q u a r t e r o f 1994, t o 2 % b y t h e last q u a r t e r o f 1995. T h e u n e m p l o y m e n t rate c o n t i n u e d its g r a d u a l d e c l i n e , h o w ­ ever, r e a c h i n g 8% at year's e n d . R P I X i n f l a t i o n rose t o 2 . 8 % i n January, a n d f o r t h e rest o f t h e year fluctuated b e t w e e n 2.6% a n d 3 . 1 % w i t h o u t e x h i b i t i n g a clear t r e n d . E a r l y i n 1995, i t b e c a m e a p p a r e n t t h a t o u t p u t g r o w t h , t h o u g h b e l o w t h e pace o f 1994, m i g h t still be h i g h relative t o t h e g r o w t h i n t h e e c o n o m y ' s p r o d u c t i v e p o t e n t i a l ; this o b s e r v a t i o n c o n ­ tributed to the Bank a n d the Chancellor's belief that the inflation out­ l o o k was i n d a n g e r o f w o r s e n i n g . Consequently, o n F e b r u a r y 2, t h e base rate was raised 0.5%, t o 6.75%. D e s p i t e this p r e e m p t i v e t i g h t e n i n g o f policy, t h e e x c h a n g e r a t e f e l l over t h e n e x t t h r e e m o n t h s ; b y M a y 4, t h e B a n k o f E n g l a n d ' s s t e r l i n g i n d e x was d o w n 4 . 7 % f r o m F e b r u a r y 2. T h e d e p r e c i a t i o n aggravated t h e w o r r i s o m e d i s c r e p a n c y b e t w e e n t h e rates o f recovery i n the tradables a n d n o n t r a d a b l e s sectors. T h e " d u a l e c o n o m y " o f this p e r i o d c o u l d be seen i n t h e c o n t r a s t b e t w e e n 1 0 % g r o w t h i n e x p o r t s d u r i n g 1994, a n d flat r e t a i l sales a n d f a l l i n g e a r n i n g s g r o w t h i n t h e service i n d u s t r i e s d u r i n g early 1995. As a c o n s e q u e n c e o f t h e d e p r e c i a t i o n a n d t h e r e s u l t i n g increase i n i m p o r t prices, t h e Bank's R P I X i n f l a t i o n p r o j e c t i o n i n M a y 1995 was re­ vised u p w a r d b y n e a r l y 1 % t h r o u g h o u t 1996 f r o m t h e F e b r u a r y forecast. R P I X i n f l a t i o n r e a c h e d a l m o s t 4 % i n t h e first h a l f o f 1996 b e f o r e f a l l i n g t o a r o u n d 2.5% i n early 1 9 9 7 . T h e possible consequences o f t h e cur­ rency depreciation for the inflation o u t l o o k d o m i n a t e d the m o n t h l y m e e t i n g s o n A p r i l 5 a n d M a y 5. 15

I t was against t h e b a c k g r o u n d o f this u p w a r d r e v i s i o n o f t h e Bank's i n f l a t i o n forecast a n d t h e " d u a l e c o n o m y " p r o b l e m t h a t i n t h e i r meet­ i n g o n M a y 5, 1995, t h e C h a n c e l l o r o v e r r u l e d t h e G o v e r n o r ' s advice t o raise i n t e r e s t rates. T h a t refusal p r o v i d e s a stark e x a m p l e o f t h e c o n f l i c t t h a t arose f r o m t h e B a n k o f E n g l a n d ' s s u b o r d i n a t e status. I n d e e d , at t h e e n d o f t h a t day's m o n t h l y m e e t i n g w i t h G o v e r n o r G e o r g e , C h a n c e l l o r C l a r k e i m m e d i a t e l y s u m m o n e d t h e press a n d a n n o u n c e d t h a t h e was l e a v i n g i n t e r e s t rates u n c h a n g e d . Since, c o n t r a r y t o c u s t o m , t h e Gover­ n o r was n o t p r e s e n t t o e c h o t h e C h a n c e l l o r ' s p o s t - m e e t i n g statement, a n d C l a r k e m e n t i o n e d details o f t h e d i s c u s s i o n ( i n c l u d i n g s o m e o f George's reasons f o r c o n c l u d i n g t h a t i n f l a t i o n was a r e a l t h r e a t ) r a t h e r t h a n w a i t i n g f o r release o f t h e m i n u t e s six weeks later, i t was clear t h a t C l a r k e was o v e r r u l i n g t h e B a n k . C l a r k e c i t e d his s k e p t i c i s m a b o u t t h e g r o w t h forecasts b u t s e e m e d t o be as i n t e n t o n r e v e a l i n g t h e c o n f l i c t as o n e x p l a i n i n g i t ( C h o t e , C o g g a n , a n d Peston, 1 9 9 5 ) . 1 6

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Perhaps t h e C h a n c e l l o r ' s c a n d o r was i n response t o t h e n e w i n f l u ­ ence a c h i e v e d b y t h e B a n k t h r o u g h t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k : H e m a y have f e l t t h a t t h e best defense was a b o l d offense. I n any event, t h e c o n f l i c t w o u l d have b e c o m e e v i d e n t w i t h t h e release o f t h e Bank's M a y Inflation Report a w e e k later. T h e Bank's c e n t r a l estimate was f o r 3% i n f l a t i o n i n t w o years' t i m e , i n d i c a t i n g t h a t , c o n t r a r y t o t h e g o v e r n m e n t ' s p l e d g e , i n f l a t i o n w o u l d be i n t h e u p p e r h a l f o f t h e t a r g e t r a n g e at t h e e n d o f the current Parliament. Furthermore, the Bank added that the risks t o its forecast w e r e a l m o s t u n i f o r m l y o n t h e u p s i d e a n d w e r e "large." T h e B a n k n o t e d t h a t s t e r l i n g was c u r r e n t l y d e p r e c i a t i n g as i t h a d i n t h e f a l l o f 1992, b u t t h a t , u n l i k e t h e s i t u a t i o n t h e n , wage d e m a n d s a n d pres­ sure o n p r o d u c t i v e capacity w e r e also h i g h . U p o n t a k i n g office, C h a n c e l l o r C l a r k e h a d m a d e a c o m m i t m e n t t o G o v e r n o r G e o r g e t h a t h e w o u l d n o t censor t h e Inflation Report at any t i m e , b u t h e reserved t h e r i g h t t o disagree w i t h t h e B a n k ' s views. W h a t seems t o have e m e r g e d was a system i n w h i c h t h e C h a n c e l l o r h a d t o m a k e e x p l i c i t his i n d e p e n d e n c e f r o m t h e Bank's p o s i t i o n w h e n a dis­ a g r e e m e n t arose, a n d t o m a k e at least some m o d e s t e f f o r t t o j u s t i f y re­ j e c t i n g t h e Bank's i n f l a t i o n forecast. T h a t system m a y have h a d a salu­ tary effect o n t h e o v e r a l l t e n d e n c y o f p o l i c y t o resist i n f l a t i o n ; however, because o f t h e "game" i t set u p b e t w e e n t h e C h a n c e l l o r a n d t h e B a n k , i t m a y also have u n d e r m i n e d p u b l i c t r u s t i n t h e c o m p e t e n c e a n d objectiv­ ity o f f o r e c a s t i n g a n d p o l i c y - m a k i n g . O v e r t h e f o l l o w i n g m o n t h s , i t b e c a m e a p p a r e n t t h a t , i n t h i s instance, t h e C h a n c e l l o r h a d guessed r i g h t . F i r s t - q u a r t e r G D P g r o w t h was revised d o w n w a r d , n e w n u m b e r s o n h o u s i n g a n d m a n u f a c t u r i n g came i n b e l o w expectations, a n d a rally i n the global b o n d m a r k e t ( i n a n t i c i p a t i o n o f a n e x p e c t e d d r o p i n U . S . i n t e r e s t rates) s u p p o r t e d t h e p o u n d . I n a Sep­ t e m b e r 1995 a c c o u n t o f t h e discussions b e t w e e n t h e C h a n c e l l o r a n d t h e G o v e r n o r t h a t h a d t a k e n place since May, G o v e r n o r G e o r g e d e c l a r e d t h a t "we still t h i n k t h a t t h e chances are against a c h i e v i n g t h e i n f l a t i o n t a r g e t over t h e n e x t 18 m o n t h s o r so w i t h o u t some f u r t h e r [base r a t e ] rise," b u t h e c o n c e d e d t h a t "we are n o t i n fact pressing f o r o n e — a n d have n o t b e e n d o i n g so since before t h e s u m m e r break" (George, 1995a). So s h o u l d t h e B a n k be t a k e n t o task f o r b e i n g less accurate i n f o r e ­ c a s t i n g t h a n t h e C h a n c e l l o r i n t h i s o n e instance? Since C h a n c e l l o r Clarke's forecast o f M a y 1995 r e m a i n e d p r i v a t e , i t a g a i n p r o v e d i m p o s ­ sible t o d e t e r m i n e w h e t h e r h e d i s a g r e e d w i t h t h e B a n k because h e was s k e p t i c a l o f its forecasts, o r s i m p l y because h e was w i l l i n g t o risk g r e a t e r i n f l a t i o n t o achieve h i g h e r g r o w t h . W o u l d a p o i n t - b y - p o i n t r e b u t t a l o f t h e Inflation Report have b e e n w o r t h t h e d a m a g e i t m i g h t have d o n e t o

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p u b l i c p e r c e p t i o n s o f t h e Bank's f o r e c a s t i n g role? A r e c o r d o f forecast p e r f o r m a n c e clearly affects a c c o u n t a b i l i t y ; e q u a l l y clearly, however, re­ d u c i n g t h e m o n e t a r y p o l i c y d e b a t e t o a f o r e c a s t i n g c o m p e t i t i o n is u n d e ­ sirable. T e n s i o n appears t o be i n e v i t a b l e as l o n g as t h e forecasts a n d t h e p o l i c y decisions c o m e f r o m d i f f e r e n t sources. T h e m i n u t e s o f t h e m e e t i n g s p r o v i d e n o clear answers t o these ques­ t i o n s , b u t t h e y d o s h a r p e n t h e issues. T h e m i n u t e s give t h e i m p r e s s i o n t h a t t h e G o v e r n o r a n d t h e C h a n c e l l o r never discussed t h e r e a s o n i n g b e h i n d t h e Bank's m e d i u m - t e r m forecast itself; instead, t h e discussion c e n t e r e d o n w h e t h e r t h e d a t a f e e d i n g i n t o t h a t forecast r e f l e c t e d a n u n d e r l y i n g t r e n d o r were i n f l u e n c e d by t r a n s i t o r y d e v e l o p m e n t s . T h e m i n u t e s o f t h e discussion d u r i n g t h e J u n e 7, 1995, m e e t i n g state t h a t " w h i l e o n e s t r e n g t h o f t h e p o l i c y process was t h a t a l l t h e n e w evidence was e x a m i n e d each m o n t h f o r its i m p l i c a t i o n s f o r i n f l a t i o n , i t was i m p o r ­ t a n t n o t t o r e a d t o o m u c h i n t o o n e m o n t h ' s data w h i c h c o u l d p r o v e t o be e r r a t i c " ( B a n k o f E n g l a n d , 1995a, J u n e 7, p . 8 ) . S u c h c o n s i d e r a t i o n s m i g h t j u s t i f y less a t t e n t i o n t o t h e Bank's m e d i u m - t e r m forecast. O n J u n e 14, 1995, i n his M a n s i o n H o u s e Speech t o t h e C i t y , C h a n ­ c e l l o r C l a r k e e x t e n d e d t h e i n f l a t i o n t a r g e t b e y o n d t h e latest possible date f o r t h e n e x t g e n e r a l e l e c t i o n . H e d i d a d m i t , however, t h a t i n f l a t i o n m i g h t rise t e m p o r a r i l y above 4 % , t h e c e i l i n g o f t h e t a r g e t r a n g e , i n t h e f o l l o w i n g two years; h e also created some c o n f u s i o n a b o u t w h e t h e r "meet­ i n g t h e target" m e a n t b e i n g b e l o w t h e 4 % c e i l i n g o r b e l o w t h e 2.5% target set b y h i m a n d his predecessor f o r t h e e n d o f t h e c u r r e n t Parlia­ m e n t . G o v e r n o r G e o r g e ( 1 9 9 5 b ) , i n his speech t o t h e same a u d i e n c e , r e f e r r e d o n l y t o t h e 2.5% t a r g e t a n d c a l l e d i t achievable. I n f l a t i o n ex­ pectations at a ten-year h o r i z o n , as d e r i v e d f r o m g o v e r n m e n t - b o n d yields, rose i n response t o these r e m a r k s , f r o m 4.36% i n early M a y t o 4.94% i n late July, a m o v e m e n t t h a t b e g a n t o be reversed o n l y i n late 1996. 17

T o d e v e l o p its i n f l a t i o n o u t l o o k f o r t h e s e c o n d h a l f o f 1995, t h e B a n k w e i g h t e d t h e u p s i d e risks r e s u l t i n g f r o m t h e d e l a y e d effects o f t h e ster­ l i n g d e p r e c i a t i o n against t h e d o w n s i d e risks r e s u l t i n g f r o m signs o f a slowdown i n o u t p u t growth and a b u i l d u p i n inventories. Domestic i n ­ flation pressures r e m a i n e d weak, w i t h i n f l a t i o n i n tradables c o n t i n u i n g t o o u t p a c e i n f l a t i o n i n n o n tradables. M o r e o v e r , i n its N o v e m b e r Infla­ tion Report t h e B a n k n o t e d t h a t d u r i n g t h e c u r r e n t cycle r e a l wage g r o w t h h a d b e e n m u c h m o r e s u b d u e d t h a n e x p e c t e d . S t i l l , R P I X i n f l a t i o n , at 3 . 1 % f o r t h e year t o September, was forecast t o p e a k at a b o u t 3.5% dur­ i n g t h e first h a l f o f 1996. Substantial d o w n w a r d revisions o f G D P figures f o r t h e first t h r e e q u a r t e r s o f 1995 f o l l o w e d , however, as w e l l as a n u n e x ­ p e c t e d l y l o w R P I X i n f l a t i o n rate o f 2.9% i n t h e year t o N o v e m b e r . These

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signs o f e c o n o m i c s l a c k e n i n g set t h e stage o n D e c e m b e r 13 f o r t h e first o f f o u r successive q u a r t e r - p o i n t cuts i n t h e base rate. T h e h o p e d - f o r "soft l a n d i n g " o f t h e U . K . e c o n o m y m a t e r i a l i z e d i n 1996. G D P g r o w t h p i c k e d u p t o w a r d t h e e n d o f t h e year; i n t h e t h i r d q u a r t e r , G D P was u p 2.4% over its level f o r t h e t h i r d q u a r t e r o f 1995. T h e u n e m p l o y m e n t rate c o n t i n u e d its g r a d u a l d e c l i n e , d r o p p i n g t o 6.7% b y D e c e m b e r 1996. F r o m O c t o b e r 1995 t o S e p t e m b e r 1996, R P I X i n f l a ­ t i o n f l u c t u a t e d b e t w e e n 2.8% a n d 3% a n d t h e n rose t o 3.3% i n O c t o b e r a n d N o v e m b e r . F r o m J a n u a r y t o t h e e n d o f September, s t e r l i n g s t r e n g t h ­ e n e d gradually, t h e n rose b r i s k l y d u r i n g t h e last t h r e e m o n t h s o f t h e year, a p p r e c i a t i n g b y 11.6% i n t h a t p e r i o d . R e c e d i n g cost pressures a n d w e a k m a n u f a c t u r i n g o u t p u t data, as w e l l as G D P g r o w t h o f 0.5% f o r t h e last q u a r t e r o f 1995, p r o m p t e d t h e n e x t t w o q u a r t e r - p o i n t base-rate cuts, w h i c h o c c u r r e d o n J a n u a r y 18 a n d M a r c h 8, 1996. A t t h e i r M a r c h 8 m e e t i n g , t h e C h a n c e l l o r a n d t h e G o v e r n o r agreed that d e m a n d a n d o u t p u t were likely to p i c k u p later i n t h e year a n d t h r o u g h 1997, a n d t h a t t h e r e was a possibility t h a t t h e latest rate c u t w o u l d have t o be reversed at some p o i n t . A g a i n , t h e B a n k g r a n t e d t h e C h a n c e l l o r w h a t a m o u n t e d t o a n escape clause—or at least a j u s t i f i ­ c a t i o n o f f u t u r e p o l i c y reversals as d e e m e d necessary—by s u p p o r t i n g t h e C h a n c e l l o r ' s i n t e r p r e t a t i o n o f t h e e c o n o m y . I n M a y 1995, a s i m i l a r defense h a d b e e n o f f e r e d b u t n o t used; this t i m e t h e o p t i o n was exer­ cised. T h e Bank's assessment d i d n o t c h a n g e d u r i n g t h e s p r i n g o f 1996, a n d its m e d i u m - t e r m i n f l a t i o n p r o j e c t i o n p u b l i s h e d i n t h e M a y Inflation Re­ port was essentially u n c h a n g e d f r o m t h e p r e v i o u s o n e . T h e p r o j e c t i o n o f R P I X i n f l a t i o n i n t w o years r e m a i n e d at 2 . 5 % , w i t h t h e risks biased d o w n ­ w a r d over t h e s h o r t t e r m b u t u p w a r d over t h e m e d i u m t e r m because o f u n c e r t a i n t i e s c o n c e r n i n g t h e s t r e n g t h o f t h e e x p e c t e d p i c k u p i n activity. F o l l o w i n g the J u n e 5 m e e t i n g , despite the Governor's o p p o s i t i o n , t h e C h a n ­ c e l l o r a n n o u n c e d a n o t h e r q u a r t e r - p o i n t c u t i n t h e base rate, a r g u i n g t h a t t h e c u t "was sufficiently small n o t t o cause any significant i n f l a t i o n a r y risk, w h i l e r e d u c i n g t h e d o w n s i d e risks t o the recovery. I f c o n s u m e r d e m a n d started g r o w i n g t o o strongly, a n d p u t t h e i n f l a t i o n target at risk, t h e rates c o u l d be raised w h e n this became evident" ( B a n k o f E n g l a n d , 1996a, J u n e 5, p . 9 ) . A g a i n , t h e r e appears t o have b e e n some t e n s i o n b e t w e e n t h e B a n k ' s f o r w a r d - l o o k i n g a p p r o a c h b a s e d o n its p r o j e c t i o n s a n d t h e C h a n c e l l o r ' s t e n d e n c y t o emphasize t h e c u r r e n t e c o n o m i c s i t u a t i o n a n d t h e latest data. W i t h the e l e c t i o n a p p r o a c h i n g , t h e C h a n c e l l o r ( a n e l e c t e d official) m a y have b e e n w i l l i n g t o take greater i n f l a t i o n risks t h a n b e f o r e o n behalf o f stimulating economic growth i n the short r u n .

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T h e B a n k , i n t h e A u g u s t Inflation Report, was u n u s u a l l y f r a n k a b o u t t h e consequences o f t h e J u n e base-rate c u t i t h a d o p p o s e d . C i t i n g as evidence " l o w e r i n t e r e s t rates since May, t h e n e w Treasury forecasts f o r taxes a n d p u b l i c s p e n d i n g , a n d t h e s l i g h t l y b e t t e r - t h a n - e x p e c t e d gross e x p o r t p e r f o r m a n c e i n t h e first h a l f o f t h e year" ( B a n k o f E n g l a n d , 1996b, A u g u s t , p . 4 5 ) , t h e B a n k p r e d i c t e d t h a t i n f l a t i o n w o u l d rise above 2 . 5 % . C o n s i s t e n t w i t h t h a t p r e d i c t i o n , f r o m t h e A u g u s t m e e t i n g o n , t h e Gover­ n o r pressed f o r a rate increase; b u t i t was o n l y o n O c t o b e r 3 0 , 1 9 9 6 , t h a t t h e C h a n c e l l o r a g r e e d t o raise t h e base rate by a q u a r t e r p o i n t , t o 6%. Some m e m b e r s o f t h e financial press s p e c u l a t e d t h a t t h e d e c i s i o n t o increase t h e base rate at t h a t t i m e m i g h t have b e e n i n t e n d e d t o avert t h e n e e d f o r f u r t h e r rate increases as t h e g e n e r a l e l e c t i o n s ( w h i c h h a d t o be h e l d by M a y 1997 at t h e latest) a p p r o a c h e d . 18

T h i s c o n t i n u i n g split b e t w e e n t h e agency t h a t m a d e t h e i n f l a t i o n fore­ casts a n d t h e agency t h a t m a d e t h e p o l i c y decisions, a n d t h e bias i t i m ­ p a r t e d t o i n f l a t i o n e x p e c t a t i o n s , m i g h t be r e g a r d e d as t h e basic l i m i t a ­ t i o n o f t h e o t h e r w i s e l a r g e l y successful i n f l a t i o n - t a r g e t i n g r e g i m e i n t h e U n i t e d K i n g d o m . T h e problems arising f r o m the division o f responsibil­ ity p r o b a b l y c o n t r i b u t e d t o t h e d e c i s i o n o n M a y 6, 1997, b y t h e n e w L a b o u r Government, to grant operational independence to the Bank o f E n g l a n d . O n t h a t day, t h e n e w C h a n c e l l o r o f t h e E x c h e q u e r , G o r d o n B r o w n , c a l l e d a news c o n f e r e n c e a n d a n n o u n c e d t h a t h e has m o v i n g u p his s c h e d u l e d m o n t h l y m e e t i n g w i t h t h e G o v e r n o r o f t h e B a n k o f E n ­ g l a n d ; i t was e x p e c t e d t h a t h e w o u l d also a n n o u n c e a n interest-rate h i k e , l o n g s o u g h t by t h e B a n k , t o d e a l w i t h m o u n t i n g i n f l a t i o n . ( R P I X i n f l a ­ t i o n was forecast t o be 2.9% b y t h e e n d o f 1997.) H e d i d a n n o u n c e a q u a r t e r - p o i n t h i k e i n t h e base rate, t h e m a i n m o n e t a r y - p o l i c y i n s t r u m e n t . B u t t h e n h e m a d e t h e surprise a n n o u n c e m e n t t h a t t h e B a n k o f E n g l a n d w o u l d h e n c e f o r t h have c o n t r o l o f t h e base rate a n d o f s h o r t - t e r m ex­ change-rate i n t e r v e n t i o n . O n e i m p o r t a n t factor i n the decision to grant the B a n k o f E n g l a n d o p e r a t i o n a l i n d e p e n d e n c e was t h e B a n k ' s g e n e r a l l y successful p e r f o r ­ m a n c e i n p r o v i d i n g forecasts a n d p o l i c y advice, as m e a s u r e d against a clear a n d p u b l i c baseline. A n o t h e r f a c t o r c i t e d by C h a n c e l l o r B r o w n was the increased accountability that an i n d e p e n d e n t b a n k w o u l d b r i n g to the inflation-targeting framework—a change that w o u l d make monetary p o l i c y m o r e responsive t o p o l i t i c a l oversight. W h e n m o n e t a r y - p o l i c y goals are p u b l i c l y stated, as t h e y are i n t h e U n i t e d K i n g d o m ' s i n f l a t i o n - t a r g e t ­ i n g r e g i m e , they c a n n o t diverge f r o m t h e interests o f society f o r e x t e n d e d p e r i o d s o f t i m e , a l t h o u g h t h e y can be i n s u l a t e d f r o m s h o r t - r u n p o l i t i c a l considerations.

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I n t h e n e w r e g i m e , d e c i s i o n - m a k i n g p o w e r is vested i n a n e w l y cre­ a t e d M o n e t a r y P o l i c y C o m m i t t e e . B e g i n n i n g i n J u n e 1997, m e e t i n g s o f that C o m m i t t e e replaced the Chancellor-Governor meetings. T h e C o m ­ m i t t e e consists o f n i n e m e m b e r s : t h e G o v e r n o r a n d t w o D e p u t y Gover­ n o r s ( o n e f o r m o n e t a r y policy, o n e f o r financial m a t t e r s ) , two o t h e r B a n k Executive Directors, a n d f o u r m e m b e r s a p p o i n t e d by the g o v e r n m e n t (all w e l l - k n o w n academic o r financial e c o n o m i s t s ) . M e m b e r s serve threeyear r e n e w a b l e t e r m s , w h i c h are e v e n t u a l l y to be staggered. T h e e l e c t e d g o v e r n m e n t retains a " n a t i o n a l interest" c o n t r o l over m o n e t a r y p o l i c y t h a t allows i t t o o v e r r u l e t h e Bank's i n t e r e s t r a t e d e c i ­ sions o r p u r s u i t o f t h e i n f l a t i o n t a r g e t w h e n i t deems such a c t i o n neces­ sary. T h e g o v e r n m e n t d i d n o t specify a h e a d o f t i m e any f o r m a l process f o r i m p l e m e n t i n g t h e escape clause o r t h e c o n d i t i o n s u n d e r w h i c h t h e clause w o u l d be i n v o k e d . O n J u n e 12, j u s t p r i o r t o t h e first m e e t i n g o f t h e M o n e t a r y P o l i c y C o m m i t t e e , Chancellor B r o w n t o l d the C o m m i t t e e to pursue a target o f 2.5% f o r u n d e r l y i n g i n f l a t i o n . T h e t a r g e t r a n g e was r e p l a c e d by a 1 % " t h r e s h o l d " o n e i t h e r side o f t h e target. " T h e t h r e s h o l d s ' f u n c t i o n is t o d e f i n e t h e p o i n t s at w h i c h I s h a l l e x p e c t a n e x p l a n a t o r y l e t t e r f r o m y o u [ t h e C o m m i t t e e ] , " t h e C h a n c e l l o r stated. I n t h e letter, t h e B a n k is re­ q u i r e d t o e x p l a i n w h y i n f l a t i o n has m o v e d so far f r o m t h e target, w h a t p o l i c y actions i t w i l l take t o d e a l w i t h i t , w h e n i n f l a t i o n is e x p e c t e d t o be b a c k o n target, a n d h o w this meets its m o n e t a r y - p o l i c y objectives. T h e C h a n c e l l o r retains t h e a b i l i t y t o t e l l t h e B a n k h o w q u i c k l y t h e miss is t o be r e c t i f i e d (see C h o t e [ 1 9 9 7 ] ) . T h i s m a n d a t e d response t o a t a r g e t miss is i n t e n d e d t o p r o v i d e t h e p u b l i c w i t h t h e r e l e v a n t i n f o r m a t i o n . T h e g o v e r n m e n t is n o t c o m m i t t e d t o " p u n i s h " t h e B a n k f o r misses b y d i s m i s s i n g t h e G o v e r n o r , n o r i n d e e d t o any pre-specified course o f a c t i o n . T h u s the g o v e r n m e n t ' s c o n t r o l over t h e B a n k o f E n g l a n d is m o r e l i k e t h e c o n t r o l e x e r t e d b y t h e C a n a d i a n P a r l i a m e n t over t h e B a n k o f C a n a d a t h a n t h e c o n t r o l e x e r t e d b y t h e N e w Z e a l a n d g o v e r n m e n t o n its c e n t r a l b a n k . As i n a l l t h e cases we c o n ­ sider ( e x c e p t those o f t h e B u n d e s b a n k a n d t h e Swiss N a t i o n a l B a n k ) , however, t h e n u m e r i c a l value o f t h e i n f l a t i o n t a r g e t a n d t h e t a r g e t i n g h o r i z o n r e m a i n u n d e r t h e Cabinet's c o n t r o l . T h a t is, t h e B a n k was n o t granted goal independence. A g a i n , this c h a n g e i n f r a m e w o r k is l i k e l y t o increase t h e t r a n s p a r e n c y a n d a c c o u n t a b i l i t y o f m o n e t a r y p o l i c y a n d decrease p u b l i c u n c e r t a i n t y b y t y i n g p o l i c y decisions t o t h e forecasts a n d e x p l a n a t i o n s p u b l i s h e d i n t h e Inflation Report. I t m a y also s t r e n g t h e n t h e c r e d i b i l i t y o f t h e U n i t e d K i n g d o m ' s c o m m i t m e n t t o its i n f l a t i o n targets, because d e v i a t i o n s f r o m

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target n o w require the g o v e r n m e n t to overrule the B a n k publicly o r to reset t h e target, whereas u n d e r t h e o l d r e g i m e t h e g o v e r n m e n t c o u l d a t t r i b u t e deviations f r o m t h e target t o disagreements over s h o r t - r u n f o r e ­ casts.

Key Lessons from the United Kingdom's Experience T h e U n i t e d K i n g d o m ' s e x p e r i e n c e p r o v i d e s some p a r t i c u l a r l y interest­ i n g lessons f o r i n f l a t i o n t a r g e t i n g . U n t i l M a y 1997, i n f l a t i o n t a r g e t i n g i n B r i t a i n was c o n d u c t e d u n d e r a system i n w h i c h t h e g o v e r n m e n t , n o t t h e c e n t r a l b a n k , c o n t r o l l e d t h e m o n e t a r y - p o l i c y i n s t r u m e n t s . As a result, i t was n o t at a l l clear w h a t m o t i v a t e d a d e c i s i o n t o m o v e o r n o t t o m o v e i n t e r e s t rates: Was i t differences i n forecasts b e t w e e n t h e C h a n c e l l o r a n d t h e G o v e r n o r , o r differences i n c o m m i t m e n t t o t h e a n n o u n c e d i n ­ flation goals? A l s o u n c l e a r was w h i c h agency was a c c o u n t a b l e f o r w h e t h e r i n f l a t i o n m e t its target: Was i t t h e agency t h a t m a d e p u b l i c forecasts ( t h e B a n k o f E n g l a n d ) o r t h e agency t h a t set t h e m o n e t a r y - p o l i c y i n s t r u m e n t s (the Chancellor o f the Exchequer)? This lack o f clarity created m u c h c o n f u s i o n a b o u t t h e d e g r e e o f c o m m i t m e n t t o i n f l a t i o n targets a n d s t r o n g l y suggested t h a t s h o r t - r u n p o l i t i c a l c o n s i d e r a t i o n s w e r e i n f l u e n c ­ i n g m o n e t a r y policy. E v e n so, B r i t i s h i n f l a t i o n t a r g e t i n g b e f o r e M a y 1997 p r o d u c e d l o w e r a n d m o r e stable rates o f i n f l a t i o n t h a n t h e U n i t e d K i n g d o m h a d en­ j o y e d i n years. T h e success o f i n f l a t i o n t a r g e t i n g i n t h e U n i t e d K i n g d o m c a n be a t t r i b u t e d t o t h e B a n k o f E n g l a n d ' s focus o n t r a n s p a r e n c y a n d its r e l i a b l e e x p l a n a t i o n s o f m o n e t a r y - p o l i c y strategy. Perhaps because f o r m a n y years its p o s i t i o n was w e a k e r t h a n t h a t o f o t h e r c e n t r a l banks, t h e B a n k devised i n n o v a t i v e ways o f c o m m u n i c a t i n g w i t h t h e p u b l i c , espe­ cially t h r o u g h its Inflation Report. I n d e e d , its a c h i e v e m e n t s i n t h a t d i r e c ­ t i o n have b e e n e m u l a t e d b y m a n y o t h e r c e n t r a l b a n k s c o m m i t t e d t o i n ­ flation t a r g e t i n g .

8 Sweden: Searching for a Nominal Anchor

L I K E t h e U n i t e d K i n g d o m , Sweden a d o p t e d i n f l a t i o n t a r g e t i n g after be­ i n g f o r c e d t o a b a n d o n its exchange-rate p e g . Sweden's defense o f its fixed e x c h a n g e rate against a series o f speculative attacks was m o r e d o g g e d t h a n t h a t o f t h e B r i t i s h ; at o n e p o i n t t h e c e n t r a l b a n k raised o v e r n i g h t i n t e r e s t rates at 5 0 0 % i n o r d e r t o stem a n attack. T h i s r e l u c ­ tance t o a b a n d o n t h e p e g n o d o u b t r e f l e c t e d t h e i n f l u e n c e o f Sweden's l o n g a n d a l m o s t u n b r o k e n r e c o r d o f exchange-rate t a r g e t i n g ( a l t h o u g h w i t h f r e q u e n t d e v a l u a t i o n s ) d u r i n g t h e t w e n t i e t h c e n t u r y . Eventually, t h o u g h , as i n t h e U n i t e d K i n g d o m , t h e e c o n o m i c costs o f s h a d o w i n g G e r m a n y ' s m o n e t a r y p o l i c y b e c a m e t o o heavy t o sustain, a n d Sweden d e v a l u e d t h e k r o n a . U n w i l l i n g t o d o w i t h o u t a n o m i n a l a n c h o r f o r any e x t e n d e d p e r i o d o f t i m e , Sweden, a g a i n l i k e t h e U n i t e d K i n g d o m , f o u n d a n a l t e r n a t i v e strategy i n i n f l a t i o n t a r g e t i n g . B o t h Sweden's m o n e t a r y h i s t o r y a n d its size i n t h e w o r l d e c o n o m y d i f f e r f r o m those o f G r e a t B r i t ­ a i n , however—factors t h a t h e l p t o e x p l a i n w h y Sweden m a d e d i f f e r e n t choices i n d e s i g n i n g its t a r g e t i n g f r a m e w o r k .

Key Features of Inflation Targeting in Sweden •

Despite its l o n g h i s t o r y o f k e e p i n g m o n e t a r y p o l i c y i n service t o a n exchange-rate p e g , f o r t h e m o s t p a r t Sweden i m p l e ­ m e n t e d i n f l a t i o n t a r g e t i n g i n a flexible m a n n e r , m o r e a k i n t o the approaches o f Canada a n d the U n i t e d K i n g d o m t h a n to that o f New Zealand. For example, the i n t r o d u c t i o n o f infla­ t i o n targets was i n t e n t i o n a l l y d e l a y e d t o increase t h e flexibil­ ity o f m o n e t a r y p o l i c y i n t h e face o f d o m e s t i c f i n a n c i a l f r a g i l ­ ity a n d recession.

SWEDEN: SEARCHING FOR A NOMINAL ANCHOR

•

T h i s p h i l o s o p h y o f flexibility d i d n o t e x t e n d t o a l l aspects o f t h e Swedish f r a m e w o r k , however. Some o f t h e m o r e r i g i d as­ pects o f t h e Swedish strategy, such as t h e t a r g e t i n g o f h e a d ­ l i n e r a t h e r t h a n c o r e i n f l a t i o n (see b e l o w ) , i n c r e a s e d t h e b u r d e n o n t h e R i k s b a n k t o give persuasive p u b l i c e x p l a n a ­ t i o n s o f its p o l i c y decisions, a n d also raised t h e p o s s i b i l i t y o f i n s t r u m e n t instability, à l a N e w Z e a l a n d .

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S w e d e n targets i n f l a t i o n i n t h e h e a d l i n e C P I r a t h e r t h a n us­ i n g a m o d i f i e d p r i c e i n d e x t h a t excludes t h e effects o f cer­ t a i n shocks. Sweden's c h o i c e m a y have r e f l e c t e d t h e i m p o r ­ tance o f h e a d l i n e i n f l a t i o n i n t h e c o n t e x t o f t h e c o r p o r a t i s t wage-setting a r r a n g e m e n t s o f t h a t c o u n t r y . N o n e t h e l e s s , mea­ sures o f " u n d e r l y i n g " o r t r e n d i n f l a t i o n have p l a y e d a g r e a t e r r o l e i n t h e Riksbank's decisions a n d e x p l a n a t i o n s i n r e c e n t years, so t h a t i n t h i s respect Sweden is c o n v e r g i n g towards t h e n o r m a m o n g i n f l a t i o n targeters.

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Sweden's i n f l a t i o n t a r g e t is expressed as a fairly n a r r o w r a n g e , u s u a l l y 2 % i n w i d t h . T h e use o f a b a n d i s j u s t i f i e d as a way o f a c c o m m o d a t i n g inevitable errors i n c o n t r o l l i n g inflation. T h e t a r g e t floor f o r m e a s u r e d i n f l a t i o n has b e e n 1 % p e r a n n u m . As i n C a n a d a , t h e e m p h a s i s o n t h e n e e d f o r a floor as w e l l as a c e i l i n g r e f l e c t e d c o n c e r n s a b o u t t h e risks t o t h e financial system f r o m d e f l a t i o n , as w e l l as Sweden's p o s i t i v e e x p e r i e n c e w i t h a p r i c e - l e v e l floor d u r i n g t h e G r e a t D e p r e s ­ sion.

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T h e g o v e r n m e n t maintains legal c o n t r o l o f the Riksbank, b u t t h e R i k s b a n k sets t h e i n f l a t i o n t a r g e t a n d t h e i n s t r u m e n t i n ­ terest rates i n p r a c t i c e . T h e g o v e r n m e n t ' s u l t i m a t e c o n t r o l has a v o i d e d issues o f d i v i d e d a c c o u n t a b i l i t y , as arose, f o r ex­ a m p l e , d u r i n g t h e pre-1997 p e r i o d i n t h e U n i t e d K i n g d o m .

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Sweden, l i k e o t h e r i n f l a t i o n targeters discussed i n this b o o k , p u b l i s h e s a r e g u l a r Inflation Report. T h e Reports p e d a g o g i c strengths, b r e a d t h o f d i s t r i b u t i o n , a n d e c o n o m i c sophistica­ t i o n have i n c r e a s e d steadily over t i m e . A t t i m e s t h e Report has p r o v i d e d t h e R i k s b a n k w i t h a b u l l y p u l p i t f r o m w h i c h t o ex­ e r t pressure o n fiscal p o l i c y - m a k e r s t o c o n t r o l Sweden's b u d ­ get deficits.

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The Adoption of Inflation Targeting O n J a n u a r y 1 5 , 1 9 9 3 , t h e G o v e r n i n g B o a r d o f t h e R i k s b a n k issued a state­ m e n t t h a t t h e objective f o r m o n e t a r y p o l i c y was t o " l i m i t t h e a n n u a l i n ­ crease i n t h e c o n s u m e r p r i c e i n d e x f r o m 1995 o n w a r d s t o 2 % , w i t h a t o l e r a n c e u p o r d o w n o f 1 p e r c e n t a g e p o i n t . " T h e B o a r d also a n n o u n c e d t h a t i n b o t h 1993 a n d 1994 " m o n e t a r y p o l i c y w o u l d a i m t o p r e v e n t i n f l a ­ t i o n a r y impulses c o n n e c t e d w i t h t h e d e p r e c i a t i o n o f t h e k r o n a f r o m lead­ i n g t o a n increase i n t h e u n d e r l y i n g rate o f i n f l a t i o n " (Sveriges R i k s b a n k , 1994a, 1, p . 6 ) . C o m i n g o n l y t w o m o n t h s after t h e floating o f t h e k r o n a o n N o v e m b e r 19, 1992, t h e B o a r d ' s s t a t e m e n t r e f l e c t e d t h e u r g e n c y o f finding a n e w n o m i n a l a n c h o r t o r e p l a c e t h e o n e lost i n t h e c u r r e n c y m a r k e t t u r b u l e n c e o f t h e f a l l o f 1992. T h e d e c i s i o n t o a d o p t a n i n f l a t i o n t a r g e t was s u p p o r t e d b y a l l t h e g o v e r n i n g parties, w h i c h are r e p r e s e n t e d o n t h e Riksbank's G o v e r n i n g B o a r d . 1

E x c e p t f o r t h e years 1914 t o 1922 a n d 1931 t o 1933, Swedish m o n ­ etary p o l i c y since 1873 h a d b e e n c o n d u c t e d w i t h a f i x e d e x c h a n g e r a t e as n o m i n a l a n c h o r , first u n d e r t h e g o l d s t a n d a r d a n d l a t e r u n d e r t h e B r e t t o n W o o d s system. F r o m M a r c h 1973 t o A u g u s t 1977, Sweden par­ t i c i p a t e d i n t h e "snake," t h e b l o c float o f t h e c u r r e n c i e s o f t h e Scandina­ v i a n c o u n t r i e s a n d o f some E C m e m b e r s . I n A u g u s t 1977, t h e R i k s b a n k b e g a n t o p e g t h e k r o n a t o a t r a d e - w e i g h t e d basket o f c u r r e n c i e s , i n i t i a l l y w i t h i n a n u n a n n o u n c e d b a n d o f 2.25% a r o u n d t h e c e n t r a l value. O n S e p t e m b e r 14, 1 9 8 1 , a n d o n O c t o b e r 8, 1982 t h e R i k s b a n k d e v a l u e d t h e k r o n a b y 1 0 % a n d 1 6 % respectively (see P a n e l D o f F i g u r e 8 . 1 ) . D u r i n g t h e n e x t t e n years, n o f u r t h e r devaluations o c c u r r e d . F o l l o w ­ i n g s o m e u n r e s t i n f o r e i g n - e x c h a n g e m a r k e t s i n t h e s p r i n g o f 1985 ( t h e interest-rate effects o f w h i c h c a n be seen i n F i g u r e 8 . 1 , P a n e l B ) , t h e R i k s b a n k r e a f f i r m e d its c o m m i t m e n t t o m a i n t a i n t h e p e g a n d n a r r o w e d t h e w i d t h o f t h e exchange-rate b a n d t o 1.5%. I t was t h o u g h t t h a t a nar­ r o w e r b a n d w o u l d convey g r e a t e r c o m m i t m e n t a n d t h u s h e l p t o stabi­ lize t h e k r o n a i n f o r e i g n e x c h a n g e m a r k e t s . However, t h e s i g n a l i n g value o f a n a r r o w e r b a n d comes at a cost i n t h a t i t reduces t h e flexibility o f p o l i c y a n d is m o r e d i f f i c u l t t o m a i n t a i n , especially f o r a v e r y o p e n e c o n o m y l i k e Sweden's. I n d e e d , m a n y o f t h e E R M ' s m e m b e r s c o u l d n o t m a i n t a i n t h e i r b a n d s o f p l u s o r m i n u s 2.25% after S e p t e m b e r 1992. 2

E a r l y i n 1988, t h e R i k s b a n k , n o t i n g t h e risks o f i n f l a t i o n caused b y a b u o y a n t d o m e s t i c e c o n o m y a n d t h e associated pressures o n t h e e x c h a n g e rate, started t o t i g h t e n m o n e t a r y policy. G D P g r o w t h h a d b e e n h i g h since t h e mid-1980s a n d u n e m p l o y m e n t was b e l o w 2 % , l o w even b y Swedish

Figure 8.1. Swedish economic indicators. Sources: A ) Bank for International Settlements database, Sveriges Riksbank; B) Bank for International Settlements database; C) M a i n Economic Indicators o f the Organisation for Economic Cooperation and Development; D) Bank for International Settlements database.

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standards (see P a n e l C o f F i g u r e 8.1). Measures t a k e n e a r l i e r i n t h e 1980s t o l i b e r a l i z e t h e Swedish financial m a r k e t s , c o u p l e d w i t h p r e f e r e n t i a l tax t r e a t m e n t o f i n t e r e s t p a y m e n t s , h a d f u e l e d b o r r o w i n g b y b o t h p r i ­ vate h o u s e h o l d s a n d businesses. T h e e x p a n d e d stock o f d e b t r a i s e d t h e p o s s i b i l i t y t h a t t h e interest-rate increases necessary t o d e f e n d t h e ex­ c h a n g e rate w o u l d have a s t r o n g e r effect o n t h e r e a l e c o n o m y t h a n h a d e a r l i e r t i g h t e n i n g s o f m o n e t a r y policy. C o n s e q u e n t l y , t h e d i s p a r i t y be­ t w e e n d o m e s t i c goals a n d t h e p o l i c i e s r e q u i r e d t o m a i n t a i n t h e p e g was w i d e n i n g . T h e U n i t e d K i n g d o m — w i t h a n even m o r e l i b e r a l i z e d finan­ c i a l system a n d less s y n c h r o n i z a t i o n w i t h t h e c o n t i n e n t a l business c y c l e — e x p e r i e n c e d a s i m i l a r c o n f l i c t i n its a t t e m p t s t o m a i n t a i n its p e g , as we saw i n t h e p r e c e d i n g chapter. I n F e b r u a r y 1990, a n d a g a i n i n O c t o b e r , t h e R i k s b a n k f o u n d i t s e l f f o r c e d t o raise t h e M a r g i n a l Rate (its m a i n p o l i c y i n s t r u m e n t ) s h a r p l y i n o r d e r t o arrest large c u r r e n c y o u t f l o w s a n d d e f e n d t h e exchange-rate p e g . A t t h a t t i m e , increases i n i n t e r e s t rates h a d a n even g r e a t e r p o t e n ­ t i a l t o slow e c o n o m i c activity, because t h e t a x - d e d u c t i b l e c o m p o n e n t o f i n t e r e s t p a y m e n t s h a d b e e n r e d u c e d f r o m 4 7 % t o 4 0 % as o f J a n u a r y 1, 1990, a n d t o 3 0 % as o f j a n u a r y 1 , 1 9 9 1 . ( T h e effect o f these measures o n h e a d l i n e i n f l a t i o n is visible i n F i g u r e 8 . 1 , P a n e l A . ) C o m b i n e d w i t h t h e rise i n i n t e r e s t rates, t h e r e d u c e d tax d e d u c t i o n s i m p l i e d t h a t i n t e r e s t p a y m e n t s after tax o n h o u s e h o l d m o r t g a g e s h a d m o r e t h a n d o u b l e d b e t w e e n 1989 a n d 1 9 9 1 , m a k i n g a c o n t r a c t i o n o f t h e e c o n o m y w i t h i n t h e n e x t o n e t o t w o years a p p e a r i n c r e a s i n g l y likely. P r e s u m a b l y t h e i n ­ t e n t o f t h e c h a n g e i n t h e tax c o d e was t o r e d u c e t h e i n c e n t i v e s t h a t h a d g i v e n rise t o h i g h levels o f p r i v a t e - s e c t o r i n d e b t e d n e s s a n d i n f l a t i o n a r y p r e s s u r e ; b u t b y t h e t i m e t h e c h a n g e was e n a c t e d , i t was t o o l a t e . T h e incompatibility o f m a i n t a i n i n g the peg and choosing monetary poli­ cies a p p r o p r i a t e t o t h e state o f t h e d o m e s t i c e c o n o m y was b e c o m i n g manifest. C o n f i d e n c e i n t h e k r o n a i m p r o v e d m a r k e d l y i n D e c e m b e r 1990, w h e n t h e Swedish P a r l i a m e n t a u t h o r i z e d t h e g o v e r n m e n t t o a p p l y f o r E u r o ­ p e a n C o m m u n i t y m e m b e r s h i p . T h e y i e l d o n ten-year Swedish g o v e r n ­ m e n t bonds fell rapidly t h r o u g h o u t 1991, reflecting the economy's move­ m e n t i n t o recession a n d t h e p r o s p e c t o f closer e c o n o m i c a n d m o n e t a r y i n t e g r a t i o n w i t h t h e E C . T h e Riksbank's d e c i s i o n o n M a y 17, 1 9 9 1 , t o u n i l a t e r a l l y p e g t h e k r o n a t o t h e E C U (as o p p o s e d t o t h e t r a d e - w e i g h t e d basket o f c u r r e n c i e s u s e d p r e v i o u s l y ) was f o l l o w e d b y f u r t h e r d e c l i n e s i n b o t h s h o r t - t e r m a n d l o n g - t e r m i n t e r e s t rates. T h e changes o v e r t i m e i n t h e d e f i n i t i o n o f t h e exchange-rate target, i n response t o c h a n g i n g cir­ cumstances, i l l u s t r a t e h o w a d e g r e e o f flexibility m a y be i n t r o d u c e d even 3

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i n t o supposedly i n f l e x i b l e m o n e t a r y regimes. T h e c h a n g e i n t h e d e f i n i ­ t i o n o f t h e exchange-rate t a r g e t also served as a way o f c o m m u n i c a t i n g w i t h t h e p u b l i c b y u n d e r l i n i n g t h e g o v e r n m e n t ' s c o m m i t m e n t t o eco­ n o m i c i n t e g r a t i o n w i t h t h e E u r o p e a n C o m m u n i t y . T h e interest-rate dif­ f e r e n t i a l f o r ten-year b o n d s vis-à-vis G e r m a n y f e l l f r o m above 4 % i n Sep­ t e m b e r 1990 t o b e l o w 1.5% b y S e p t e m b e r 1 9 9 1 , i n d i c a t i n g t h e i n c r e a s e d credibility o f that c o m m i t m e n t . T o w a r d t h e e n d o f 1 9 9 1 , however, p u b l i c d o u b t s a b o u t t h e c o m p a t ­ i b i l i t y o f t h e exchange-rate p o l i c y w i t h d o m e s t i c p o l i c y objectives b e g a n t o surface. I n p a r t i c u l a r , t h e t i g h t m o n e t a r y p o l i c y i n G e r m a n y f o l l o w i n g t h a t c o u n t r y ' s r e u n i f i c a t i o n r e q u i r e d h i g h s h o r t - t e r m i n t e r e s t rates t h r o u g h o u t t h e E u r o p e a n M o n e t a r y System, as w e l l as i n c o u n t r i e s (such as Sweden) t h a t p e g g e d t h e i r c u r r e n c i e s t o t h e E C U . Yet h i g h i n t e r e s t rates w e r e c l e a r l y n o t t h e best m e d i c i n e f o r Sweden. T h e c o u n t r y h a d b e e n i n recession f o r t h e e n t i r e year o f 1 9 9 1 , u n e m p l o y m e n t was r i s i n g quickly, a n d i n f l a t i o n was o n a d o w n w a r d t r e n d f r o m a n already l o w level. I n a d d i t i o n , t h e Swedish financial sector was p l a g u e d b y e x t r e m e l y h i g h levels o f l o a n defaults, t h e r e s u l t o f t h e c o m b i n a t i o n o f m o n e t a r y t i g h t ­ e n i n g , e a r l i e r o v e r - e x p a n s i o n o f c r e d i t , a n d ill-advised changes i n r e g u ­ l a t o r y p o l i c i e s . M a t t e r s w e r e m a d e worse b y t h e F i n n i s h c e n t r a l bank's d e c i s i o n , o n N o v e m b e r 1 5 , 1 9 9 1 , t o devalue t h e m a r k k a vis-à-vis t h e E C U by 12.3%, t h u s i n c r e a s i n g m a r k e t pressure o n t h e k r o n a . T h e R i k s b a n k was nevertheless d e t e r m i n e d t o d e f e n d t h e k r o n a ' s p e g . I n response t o large c u r r e n c y outflows t h r o u g h o u t N o v e m b e r , at t h e b e g i n n i n g o f D e c e m b e r t h e R i k s b a n k raised t h e M a r g i n a l Rate b y 6% t o 17.5%. T h e R i k s b a n k a r g u e d t h a t [a] marked increase i n short interest rates can effectively break negative ex­ pectations and thereby t u r n a currency outflow into an inflow. This can be followed by a relatively rapid return to lower interest rates. Just a cautious interest rate increase i n connection with exchange rate uncertainty runs the risk o f not breaking expectations. (Sveriges Riksbank, 1992a, 1, p. 10) N o sustained r e t u r n t o l o w e r i n t e r e s t rates p r o v e d possible, however, a n d t h e p r o s p e c t o f interest-rate increases s t r e n g t h e n e d fears o f a finan­ cial crisis. T h i s d y n a m i c o f c r e d i t b o o m s f o l l o w e d b y financial fragility, w h i c h o f t e n arises w h e n a t i g h t e n i n g o f m o n e t a r y p o l i c y fails t o stave o f f a d e p r e c i a t i o n , is o n e o f t h e i n h e r e n t disadvantages o f m a i n t a i n i n g a fixed e x c h a n g e rate. D u r i n g 1992, Sweden r e m a i n e d i n recession, u n ­ e m p l o y m e n t rose f u r t h e r , t h e state o f t h e financial sector t u r n e d p e r i l ­ ous, a n d g o v e r n m e n t finances d e t e r i o r a t e d sharply. A p p l y i n g t h e same l o g i c as i n D e c e m b e r 1 9 9 1 , t h e R i k s b a n k h o p e d t h a t by r a i s i n g i n t e r e s t 4

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rates b r i e f l y b u t vigorously, i t w o u l d be able t o d e f e n d t h e p e g at accept­ able e c o n o m i c cost. O n S e p t e m b e r 8, i t a n n o u n c e d t h a t as o f S e p t e m ­ b e r 10 i t w o u l d raise t h e M a r g i n a l Rate f r o m 1 6 % t o 2 4 % . O n S e p t e m ­ b e r 10, i t a n n o u n c e d t h a t i t w o u l d a c t u a l l y raise t h e M a r g i n a l Rate t o 7 5 % . O n S e p t e m b e r 13, i t b r i e f l y l o w e r e d t h e M a r g i n a l Rate t o 2 0 % . O n " B l a c k Wednesday," S e p t e m b e r 16, i t raised t h e M a r g i n a l Rate t o 5 0 0 % a n d k e p t i t t h e r e f o r t h e rest o f t h e week. A f t e r t h e F r e n c h r e f e r e n d u m o n t h e M a a s t r i c h t Treaty o n S e p t e m b e r 20, t h e R i k s b a n k l o w e r e d t h e M a r g i n a l Rate t o 5 0 % , a n d over t h e n e x t six weeks t h e r a t e g r a d u a l l y c a m e d o w n t o 11.5%. Sweden h a d m a n a g e d t o m a i n t a i n its E C U p e g even t h o u g h t h e U n i t e d K i n g d o m a n d I t a l y h a d b e e n f o r c e d t o e x i t t h e ERM. T h e successful defense o f t h e k r o n a was n o t t o be r e p e a t e d , however. O n N o v e m b e r 12, Sweden's N a t i o n a l D e b t O f f i c e a n n o u n c e d a n u n e x ­ p e c t e d l y l a r g e b o r r o w i n g r e q u i r e m e n t , a n d t h e s u b s e q u e n t issue o f trea­ sury b i l l s was n o t f u l l y p l a c e d . T h e s e events focused a t t e n t i o n o n t h e fact t h a t t h e Riksbank's successful defense o f t h e k r o n a h a d n o t solved any o f t h e e c o n o m y ' s u n d e r l y i n g p r o b l e m s . A n e w crisis b e g a n : D u r i n g t h e f o l ­ l o w i n g week, t h e e q u i v a l e n t o f 158 b i l l i o n k r o n a i n f o r e i g n c u r r e n c y left t h e c o u n t r y . T h i s t i m e , however, t h e R i k s b a n k d i d n o t r e s o r t t o interestrate increases. I n s t e a d , o n N o v e m b e r 1 9 , 1 9 9 2 , i t d e c i d e d t o a b a n d o n its exchange-rate p e g a n d float t h e k r o n a . Immediately following that decision, the Riksbank emphasized that i t s t i l l c o n s i d e r e d p r i c e stability t o b e t h e u l t i m a t e g o a l o f its m o n e t a r y p o l i c y . I n fact, i t m a d e t h a t g o a l m u c h m o r e e x p l i c i t t h a n i n p r e v i o u s discussions o f policy. Instead o f raising the marginal rate to 20%, as announced earlier [ o n No­ vember 19], the level was set at 12.5% or 1 percentage p o i n t higher than before. I n this way the Riksbank indicated that the change to a flexible ex­ change rate d i d n o t imply any change i n the ultimate monetary policy objec­ tive; also under the new regime the Riksbank would strive for long-term price stability. (Sveriges Riksbank, 1993a, 1, p. 12) D u r i n g t h e weeks t h a t f o l l o w e d , t h e R i k s b a n k u n d e r t o o k t o devise a n e w f r a m e w o r k i n w h i c h t o c o n d u c t m o n e t a r y policy. I t was a g r e e d t h a t d o m e s t i c factors w o u l d replace t h e e x c h a n g e rate as t h e m a i n d e t e r m i ­ n a n t o f m o n e t a r y policy, a n d t h a t a b r o a d e r set o f i n f o r m a t i o n variables w o u l d b e used i n p o l i c y p l a n n i n g a n d assessment. A l t h o u g h t h e R i k s b a n k d i d n o t d e f i n e " p r i c e stability," t h e phrase was clearly n o t i n t e n d e d t o i m p l y a g o a l o f zero m e a s u r e d i n f l a t i o n o r a c o m m i t m e n t t o r e v e r s i n g past p r i c e rises. M o r e o v e r , l o w i n f l a t i o n was e v i d e n t l y n o t t h e o n l y g o a l

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o f c o n c e r n t o Swedish policy-makers. I f i t h a d b e e n , t h e y c o u l d have s i m p l y m a i n t a i n e d t h e E C U p e g irrespective o f cost t o d o m e s t i c activity a n d t h e financial sector. Finally, t h e R i k s b a n k i n t e n d e d t o c o m m u n i c a t e t o t h e p u b l i c t h e p r a c t i c a l l i m i t s o f m o n e t a r y c o n t r o l o f t h e e c o n o m y , as i n d i c a t e d b y its use o f t h e w o r d "strive" i n t h e q u o t a t i o n above. I n the eighteen m o n t h s f o l l o w i n g the Riksbank's p e g g i n g o f the k r o n a to the E C U , a significant r e d u c t i o n i n i n f l a t i o n h a d already been achieved, a n d the Riksbank w a n t e d to preserve that gain. Moreover, the Riksbank wanted to avoid giving the impression o f b e i n g w i t h o u t a g u i d e t o m o n e t a r y p o l i c y a n d a n a n c h o r f o r e x p e c t a t i o n s , at least f o r any l e n g t h o f t i m e . N o n e t h e l e s s , l i k e t h e U n i t e d K i n g d o m , d u r i n g t h e p e r i o d o f t h e p e g S w e d e n h a d n o t e n g a g e d i n any e x t e n d e d p u b l i c o r even p r i v a t e discussions o f a l t e r n a t i v e s t o e x c h a n g e - r a t e t a r g e t i n g , f o r fear t h a t s u c h discussions, i f l e a k e d , w o u l d f u r t h e r i m p e r i l t h e c o m m i t ­ m e n t to the peg. I t appeared that the Riksbank had no contingency plan for the new situa­ tion. Riksbank staff and a few invited academics were quickly summoned by the Governor to produce, under considerable time pressure, a set o f posi­ tion papers . . . Studies o f monetary policy i n Canada, New Zealand, and Switzerland were included . . . , which proved to indicate i n what direction the new monetary policy would t u r n . (Svensson, 1995, pp. 69-70) 5

T h e a d o p t i o n o f a n i n f l a t i o n t a r g e t was thus n o t a c a r e f u l l y c o n s i d e r e d o r l o n g - p l a n n e d shift i n policy. Rather, i t was a f o r c e d r e a c t i o n t o t h e loss o f a l o n g - s t a n d i n g n o m i n a l a n c h o r f o r m o n e t a r y p o l i c y . T h e R i k s b a n k , h a v i n g h a d very l i t t l e e x p e r i e n c e w i t h t h e c o n d u c t o f m o n ­ etary p o l i c y u n d e r a flexible e x c h a n g e rate, chose t o d r a w o n t h e r e c e n t e x p e r i e n c e o f o t h e r o p e n e c o n o m i e s i n s i m i l a r situations. F r o m t h e r e a d i n g o f c o n t e m p o r a r y d o c u m e n t s , i t appears t h a t t h e r e h a d been two m a i n motives b e h i n d the decision to adopt an i n f l a t i o n target. First, after t h e loss o f t h e fixed e x c h a n g e rate, a n d t h e associated loss o f p o l i c y c r e d i b i l i t y ( g i v e n t h e e x t r a o r d i n a r y e a r l i e r efforts t h a t t h e R i k s b a n k h a d m a d e i n t h e k r o n a ' s defense), t h e R i k s b a n k n e e d e d a m e d i u m t o c o m m u n i c a t e its o n g o i n g c o m m i t m e n t t o p r i c e stability. Sec­ o n d , e x p e r i e n c e d u r i n g t h e p r e v i o u s years suggested t h a t a f r a m e w o r k was necessary t h a t w o u l d p e r m i t g r e a t e r s h o r t - t e r m flexibility o f m o n ­ etary p o l i c y t o address d o m e s t i c goals a n d r e s p o n d t o v a r i o u s m a c r o e c o ­ n o m i c shocks. R e g a r d i n g t h e first m o t i v e , t h e r e c a n be n o d o u b t t h a t t h e c i r c u m ­ stances u n d e r w h i c h t h e p e g h a d c o l l a p s e d h a d h a d a d e t r i m e n t a l ef­ fect o n t h e c r e d i b i l i t y o f Swedish m o n e t a r y p o l i c y . A t t h e same t i m e ,

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t h e e c o n o m i c s i t u a t i o n r e q u i r e d a s i g n i f i c a n t l y easier stance o f m o n ­ etary p o l i c y t h a n h a d b e e n m a i n t a i n e d d u r i n g t h e e n d o f t h e k r o n a ' s p e g t o t h e E C U . T h e d i l e m m a , t h e n , was t h a t a n easing o f m o n e t a r y p o l i c y o n t h e heels o f t h e d e v a l u a t i o n ( w h i c h i n itself h a d c o n t r i b u t e d t o a n easing o f m o n e t a r y p o l i c y ) w o u l d risk r a i s i n g l o n g - r u n a n d s h o r t - r u n i n f l a t i o n expectations. I n the absence o f a . . . restriction o n interest rate policy (with no intermedi­ ate target as a guide), after the krona's fall outside observers had greater difficulty i n assessing the probable direction of monetary policy and the goals that would be established . . . Weak economic activity and high unemploy­ ment, i n Sweden as well as abroad, nourished expectations that the longterm inflation objective m i g h t be relegated i n favor o f a markedly expan­ sionary monetary policy. (Sveriges Riksbank, 1994a, 1, p. 5) W i t h n o obvious, r e l i a b l e i n t e r m e d i a t e t a r g e t t o a d o p t , a strategy o f a n n o u n c i n g a n u m e r i c a l range for the ultimate goal o f policy seemed to be t h e m o s t p r o m i s i n g m e a n s f o r a n c h o r i n g e x p e c t a t i o n s a n d c o m m u ­ n i c a t i n g t h e i n t e n t i o n s o f t h e policy-makers. C o n d u c t i n g m o n e t a r y p o l i c y w i t h o u t a n e x p l i c i t t a r g e t was n o t c o n s i d e r e d a viable o p t i o n , a view sup­ p o r t e d n o t o n l y by t h e experiences o f C a n a d a a n d N e w Z e a l a n d ( o f w h i c h t h e R i k s b a n k o f course was a w a r e ) , b u t also b y t h e Swedish p u b l i c ' s o w n largely u n b r o k e n experience o f having a n o m i n a l anchor for monetary policy. 6

R e g a r d i n g t h e s e c o n d m o t i v e , t h e n e e d f o r greater s h o r t - t e r m p o l i c y flexibility: D u r i n g t h e early 1990s, a c o n f l i c t h a d evolved b e t w e e n t h e e x t e r n a l a n d d o m e s t i c d e m a n d s o n m o n e t a r y p o l i c y i n Sweden. I n par­ ticular, as we have m e n t i o n e d , w h i l e t i g h t m o n e t a r y p o l i c y t o s u p p o r t t h e k r o n a - E C U p e g m a y have b e e n c o m p a t i b l e w i t h p r i c e stability i n t h e l o n g r u n , as t h e R i k s b a n k r e p e a t e d l y asserted, i n t h e s h o r t e r r u n i t p r o b ­ ably c o n t r i b u t e d s i g n i f i c a n t l y t o t h e 1991-93 recession. T h e b u d g e t d e f i ­ c i t t h a t r e s u l t e d f r o m these cyclical factors, a n d t h a t was w o r s e n e d b y t h e costs o f s u p p o r t i n g t h e f r a g i l e b a n k i n g system, s h o w e d signs o f b e c o m ­ i n g u n s u s t a i n a b l e . B o t h t h e p r o b l e m s o f t h e financial sector a n d t h e r e l a t e d fiscal deficits w e r e o f c o n c e r n t o t h e R i k s b a n k . M o r e b r o a d l y , t h e R i k s b a n k was p r e p a r e d t o p u r s u e m u l t i p l e p o l i c y objectives i n t h e s h o r t r u n despite its c o m m i t m e n t t o l o n g - r u n p r i c e stability, a n d i t n e e d e d a framework that w o u l d p e r m i t that flexibility. T h e R i k s b a n k v i e w e d t h e n e w f r a m e w o r k as i n v o l v i n g m o r e t h a n a c h a n g e i n m o n e t a r y policy. I t e m p h a s i z e d t h a t c r e d i b i l i t y d e m a n d e d t h a t fiscal i m b a l a n c e s be addressed as w e l l :

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For [an inflation target] to be meaningful, however, i t is necessary that the conditions that will make i t credible e x i s t . . . Consequently, other economic policies must be compatible with the price stability target. A n i m p o r t a n t fac­ tor o f uncertainty i n this respect is the development o f the government bud­ get . . . Over a period o f time, demand i n the Swedish economy has been supported by means o f public expenditure, at the same time as interest rates were h i g h because o f lack o f confidence i n economic policy and the fixed exchange rate. I f a consolidation o f the budget is achieved, this would create the conditions for lower interest rates. As a stimulant for the economy, lower interest rates—a less restrictive monetary policy—would be more effective than the fiscal policy pursued to date. ( H ö r n g r e n , 1992, pp. 73-4) I n s u m , t h e Swedish a d o p t i o n o f a n i n f l a t i o n t a r g e t h a d t w o objectives: first, t o a l l o w m o n e t a r y p o l i c y t o be d i r e c t e d t o w a r d d o m e s t i c objectives, i n c l u d i n g short-run o u t p u t stabilization; a n d second, simultaneously to reduce the public's concerns about b o t h the long-term o r i e n t a t i o n o f m o n e t a r y p o l i c y a n d t h e possibility t h a t unsustainable fiscal deficits w o u l d e v e n t u a l l y be m o n e t i z e d . T h e p u r s u i t o f m u l t i p l e objectives was i n s e e m i n g c o n t r a s t t o Sweden's successful e x p e r i e n c e w i t h a price-level t a r g e t i n t h e 1930s—the o n l y t r u e e x a m p l e o f a p r i c e - l e v e l t a r g e t f o r m o n e t a r y p o l i c y i n t h e t w e n t i e t h cen­ tury, so far as we are aware. B u t t h a t c o n t r a s t is m o r e a p p a r e n t t h a n r e a l . T h e a c h i e v e m e n t o f t h e Swedish price-level t a r g e t o f t h e 1930s was t o p r o v i d e a floor f o r prices i n t h e face o f w o r l d w i d e d e f l a t i o n a n d depres­ s i o n , a n d t h e m a i n b e n e f i t o f this p o l i c y was t o a v o i d t h e negative effects o n o u t p u t a n d e m p l o y m e n t t h a t f o l l o w e d f r o m s h a r p l y d e c l i n i n g prices. A s i m i l a r b e n e f i t o f i n f l a t i o n t a r g e t i n g (as stressed, f o r e x a m p l e , b y t h e Canadians) is t h a t a p r o p e r l y m a n a g e d i n f l a t i o n - t a r g e t i n g r e g i m e avoids d e f l a t i o n as w e l l as excessive i n f l a t i o n . By t h e t i m e t h e i n f l a t i o n target was a d o p t e d i n J a n u a r y 1993, t h e Swed­ ish e c o n o m y was i n d e e p recession. Real G D P h a d f a l l e n over 1992 b y 4 % , u n e m p l o y m e n t h a d r e a c h e d 7% a n d was c o n t i n u i n g t o rise t o w a r d u n p r e c e d e n t e d levels, a n d t h e c e n t r a l g o v e r n m e n t ' s b u d g e t d e f i c i t h a d g r o w n t o m o r e t h a n 11 % o f GDP. I n f l a t i o n , w h i c h h a d b e e n f a l l i n g steadily since early 1990, however, was d o w n t o a h i s t o r i c a l l y l o w r a t e o f 3% p e r year. W h i l e t h e 1 4 % d e p r e c i a t i o n o f t h e k r o n a (vis-à-vis b o t h t h e D M a n d t h e E C U ) over t h e last few m o n t h s o f 1992 w o u l d i n e v i t a b l y have some i n f l a t i o n a r y i m p a c t , t h e recession was sufficiently d e e p t h a t a re­ versal o f t h e d o w n w a r d t r e n d o f i n f l a t i o n s e e m e d u n l i k e l y . W h e n t h e i n f l a t i o n t a r g e t was a n n o u n c e d , t h e r e f o r e , i t a p p e a r e d p r o b a b l e t h a t i t w o u l d be a c h i e v e d w i t h o u t f u r t h e r drastic p o l i c y measures. H o w e v e r , t o

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e n h a n c e its flexibility, t h e R i k s b a n k p r o v i d e d a n escape clause b y saying t h a t t h e t a r g e t w o u l d n o t have t o be m e t u n t i l m o r e n o r m a l e c o n o m i c c o n d i t i o n s p r e v a i l e d . S o m e w h a t surprisingly, t h e fact t h a t Sweden chose t o set t h e t a r g e t f o r a p e r i o d c o m m e n c i n g after t h e pass-through effects o f t h e d e v a l u a t i o n w e r e l i k e l y t o be c o m p l e t e d d i d n o t l e a d t o t h e ex­ p l i c i t p r o v i s i o n o f a n escape clause f o r s i m i l a r shocks i n t h e f u t u r e (as was t h e case, f o r e x a m p l e , i n N e w Z e a l a n d ) . Conceivably, however, t h e use o f this defacto escape clause m a y have p r o v i d e d t h e R i k s b a n k a n d t h e Swedish g o v e r n m e n t w i t h a p r e c e d e n t o n w h i c h t o draw, s h o u l d cir­ cumstances w a r r a n t . P r o n o u n c e d p o l i t i c a l d i v i s i o n over m o n e t a r y p o l i c y arose f o l l o w i n g t h e floating o f t h e k r o n a . T h e g o v e r n i n g liberal-conservative c o a l i t i o n s u p p o r t e d t h e Riksbank's p o l i c y o f c a u t i o u s interest-rate cuts; b u t t h e Social D e m o c r a t s , t h o u g h s u p p o s e d l y s u p p o r t i n g t h e a d o p t i o n o f t h e i n f l a t i o n target, w e r e a d v o c a t i n g a m u c h m o r e aggressive m o n e t a r y ex­ p a n s i o n . Especially o d d , f r o m a p o l i t i c a l s t a n d p o i n t , was t h a t t h e t a r g e t o f 2 % C P I i n f l a t i o n ( t h e m i d p o i n t o f t h e 1 % t o 3% r a n g e ) was set f o r 1995 o n w a r d s — a p e r i o d c o m m e n c i n g after t h e n e x t g e n e r a l e l e c t i o n , w h i c h was d u e t o be h e l d n o l a t e r t h a n S e p t e m b e r 1994. T h u s t h e r e m u s t have b e e n some p u b l i c c o n f u s i o n a b o u t the force o f the g o v e r n m e n t ' s c o m m i t m e n t t o t h e target, a l t h o u g h g i v e n t h e recession a n d t h e s l o w d o w n i n i n f l a t i o n , i t d i d seem l i k e l y t h a t t h e t a r g e t w o u l d be achieved. 7

T h e e v i d e n t a b i l i t y o f i n f l a t i o n - t a r g e t i n g c o m m i t m e n t s t o survive be­ y o n d t h e c u r r e n t g o v e r n m e n t is i n t e r e s t i n g . I n the cases o f t h e U n i t e d K i n g d o m a n d Canada, we saw t h a t o n c e i n f l a t i o n targets h a d b e e n m a d e p u b l i c a n d some e f f o r t h a d b e e n i n v e s t e d i n a c h i e v i n g t h e m , s u c c e e d i n g g o v e r n m e n t s seemed t o have l i t t l e c h o i c e b u t t o e x t e n d t h e policy. T h u s a n n o u n c e m e n t s o f i n f l a t i o n targets a p p e a r t o carry some real w e i g h t w i t h t h e p u b l i c , i n d e p e n d e n t o f w h i c h p a r t y is i n c o n t r o l o f t h e g o v e r n m e n t .

The Operational Framework A p a r t f r o m t h e G o v e r n i n g B o a r d ' s i n i t i a l a n n o u n c e m e n t o n J a n u a r y 15, 1993, n o official d o c u m e n t has b e e n p u b l i s h e d t h a t o u t l i n e s t h e opera­ t i o n a l details o f Sweden's i n f l a t i o n - t a r g e t i n g f r a m e w o r k . T h i s o m i s s i o n gives rise t o c e r t a i n a m b i g u i t i e s a b o u t t h e new f r a m e w o r k , i n c l u d i n g t h e d u r a t i o n o f t h e c o m m i t m e n t . I n g e n e r a l , Sweden has n o t e m p h a s i z e d t r a n s p a r e n c y o f p o l i c y t o t h e d e g r e e t h a t some o t h e r i n f l a t i o n targeters have. I t s o m e t i m e s seems t o take t h e view t h a t p o l i c y flexibility is b e t t e r

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m a i n t a i n e d b y b e i n g less t h a n f u l l y o p e n w i t h t h e p u b l i c . As discussed i n C h a p t e r 3, w h i l e this t r a d e o f f b e t w e e n flexibility a n d t r a n s p a r e n c y does exist i n t h e s h o r t r u n i n some instances, t h e evidence suggests t h a t i n t h e l o n g e r r u n , flexibility a n d t r a n s p a r e n c y t e n d t o be m u t u a l l y r e i n ­ forcing. A c c o r d i n g t o t h e target a n n o u n c e m e n t , t h e objective o f m o n e t a r y p o l i c y was "to l i m i t t h e a n n u a l increase i n t h e c o n s u m e r p r i c e i n d e x f r o m 1995 o n w a r d s t o 2 % " (Sveriges R i k s b a n k , 1994a, 1, p . 6 ) . As w i t h a l l o t h e r i n f l a t i o n targeters, t h e o p e r a t i o n a l d e f i n i t i o n o f p r i c e stability is a m e a s u r e d i n f l a t i o n rate above zero ( t h e i n i t i a l t a r g e t r a n g e was set as 1 % t o 3 % ) . G i v e n t h e e x t r e m e f r a g i l i t y o f t h e Swedish financial system at t h e t i m e , i t was clear t h a t t h e R i k s b a n k i n t e n d e d t o p r e v e n t d e f l a t i o n , w h i c h w o u l d have w e a k e n e d t h e system f u r t h e r . N o m e n t i o n was m a d e o f i t e m s t h a t w o u l d be e x c l u d e d f r o m t h e t a r g e t C P I , n o r o f any circumstances i n w h i c h t h e d e f i n i t i o n o f t h e t a r g e t p r i c e i n d e x m i g h t be m o d i f i e d . T h i s o m i s s i o n is s u r p r i s i n g i n view of, f o r e x a m p l e , t h e s t r o n g p o t e n t i a l i m ­ p a c t o f changes i n i n d i r e c t taxes o n t h e Swedish C P I . As c a n be seen b y c o m p a r i n g t h e e v o l u t i o n o f all-items C P I i n f l a t i o n a n d i n f l a t i o n i n t h e C P I e x c l u d i n g i n d i r e c t taxes a n d subsidies ( t h e s o l i d a n d d a s h e d lines, respectively, i n P a n e l A o f F i g u r e 8.1), t h e first-round effects o f such tax changes c a n b e q u i t e l a r g e . Similarly, t h e effects o f t h e ( p r e s u m a b l y ) o n e - t i m e d e v a l u a t i o n o f t h e k r o n a i n N o v e m b e r 1992 o n o i l a n d f o o d i m p o r t s w o u l d have r e q u i r e d a response b y this d e f i n i t i o n o f t h e t a r g e t p r i c e i n d e x . T h e R i k s b a n k a v o i d e d r e s p o n d i n g t o t h e effects o f t h e de­ v a l u a t i o n , as w e l l as t o t h e interest-rate increases m e n t i o n e d earlier, b y d e l a y i n g t h e c o m m e n c e m e n t o f t h e t a r g e t i n g p e r i o d , a m o r e ad hoc ap­ p r o a c h t h a n s i m p l y e x c l u d i n g those factors f r o m t h e t a r g e t i n d e x . I n any event, this a p p a r e n t lack o f i n t e r e s t i n d i s c r i m i n a t i n g c o r e i n ­ flation f r o m h e a d l i n e C P I i n f l a t i o n d i f f e r e n t i a t e s t h e i n i t i a l Swedish f r a m e w o r k f r o m those o f o t h e r m a j o r i n f l a t i o n - t a r g e t i n g r e g i m e s . T h e c o n t r a s t w i t h N e w Z e a l a n d i n this respect is especially s t r i k i n g . As we p o i n t e d o u t i n t h e study o f N e w Z e a l a n d ( C h a p t e r 5 ) , a n a r r o w d e f i n i ­ t i o n o f i n f l a t i o n ( e x c l u d i n g m a n y types o f i n f l a t i o n a r y shocks) c o m p e n ­ sates o n l y p a r t i a l l y f o r t h e p o t e n t i a l l y d e s t a b i l i z i n g s h o r t - r u n effects o f m o n e t a r y p o l i c y o n a s m a l l , o p e n e c o n o m y . Sweden's d e c i s i o n t o t a r g e t a b r o a d or headline measure o f inflation, rather t h a n a m o d i f i e d i n d e x d e s i g n e d t o m e a s u r e c o r e i n f l a t i o n , suggests e i t h e r a w i l l i n g n e s s t o be especially flexible i n a d h e r e n c e t o t h e targets i n t h e face o f shocks, o r a h i g h t o l e r a n c e f o r risk o n t h e p a r t o f t h e policy-makers. Perhaps t h e t a r g e t i n g o f h e a d l i n e C P I i n Sweden r e f l e c t e d t h e cen­ t r a l r o l e t h a t t h a t m e a s u r e plays i n collective b a r g a i n i n g a n d wage-in-

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d e x i n g i n t h a t c o u n t r y . I t w o u l d seem, however, g i v e n t h e p u b l i c ' s aware­ ness o f i n d e x i n g a n d i n f l a t i o n issues i n t h e w a g e - b a r g a i n i n g c o n t e x t , t h a t e d u c a t i n g wage- a n d price-setters t o u n d e r s t a n d a c o r e i n f l a t i o n tar­ get w o u l d n o t have b e e n a d i f f i c u l t task. Policy-makers discussed these p r o s a n d cons actively, a n d over t i m e b e g a n t o b r i n g u n d e r l y i n g i n f l a ­ t i o n i n t o t h e p u b l i c d i s c u s s i o n . F o r e x a m p l e , t h e D e c e m b e r 1997 Infla­ tion Report p r e s e n t e d a forecast o f C P I i n f l a t i o n e x c l u d i n g i n d i r e c t taxes, subsidies, a n d i n t e r e s t costs f o r o w n e r - o c c u p i e d h o u s i n g , i n a m a n n e r s i m i l a r t o t h e r e p o r t i n g practices o f o t h e r i n f l a t i o n targeters. 8

A n o t h e r a m b i g u o u s aspect o f t h e target f o r m u l a t i o n was t h a t f o r some t i m e i t was u n c l e a r w h e t h e r t h e 2 % t a r g e t f r o m 1995 o n w a r d r e f e r r e d t o m o n t h l y i n f l a t i o n rates (as m e a s u r e d o n a n a n n u a l i z e d basis) d u r i n g 1995 a n d later, o r t o t h e full-year i n f l a t i o n rate f r o m D e c e m b e r 1994 t o D e c e m b e r 1995. " O n l y r e c e n t l y d i d R i k s b a n k officials clarify t h a t t h e t a r g e t d i d n o t a p p l y t o 1 2 - m o n t h i n f l a t i o n rates o f i n d i v i d u a l m o n t h s d u r i n g 1995" (Svensson, 1995, p . 8 2 ) . So, l i k e o t h e r i n f l a t i o n targeters, t h e R i k s b a n k b u i l t i n some flexibility b y e s t a b l i s h i n g a l o n g e r t i m e h o r i ­ z o n f o r its targets. M o r e o v e r , i t was d e c i d e d t h a t success at h i t t i n g targets was n o t t o be based o n t h e m o s t r e c e n t c a l e n d a r year, b u t i n s t e a d o n t h e most recent four quarters. 9

F u r t h e r , o n c e t h e t a r g e t was a t t a i n e d , t h e t a r g e t h o r i z o n was t o be­ c o m e o p e n - e n d e d . By c l a r i f y i n g t h e p e r i o d over w h i c h t h e t a r g e t was t o b e a c h i e v e d , i n l i n e w i t h t h e practices o f o t h e r i n f l a t i o n - t a r g e t i n g c o u n ­ tries, t h e R i k s b a n k c o u l d have i n c r e a s e d its a c c o u n t a b i l i t y a n d t h e trans­ p a r e n c y o f policy. T h e reasons f o r l e a v i n g this c o m m i t m e n t vague at t h e o u t s e t are u n c l e a r ; t h e effect was t o leave t h e p u b l i c guessing w h e t h e r h e a d l i n e i n f l a t i o n above 3% i n early 1995 s h o u l d be c o n s i d e r e d as a t a r g e t miss. N o r was i t m a d e clear w h a t w o u l d h a p p e n i n t h e e v e n t o f a target b r e a c h . However, as i n t h e c u r r e n t B r i t i s h f r a m e w o r k , t h e R i k s b a n k is r e q u i r e d t o p u b l i s h e x p l a n a t i o n s , at least o n c e a year, o f any d e v i a t i o n s f r o m the band. A c c o r d i n g t o t h e Riksbank's c l a r i f i c a t i o n , t h e n , t h e p o l i c y f r a m e w o r k c a l l e d f o r a p e r i o d o f t h r e e years d u r i n g w h i c h i n f l a t i o n was t o be steered i n t o t h e t a r g e t b a n d o f 1 % t o 3%. T h e l e a d e r s h i p o f t h e R i k s b a n k chose a n a r r o w t a r g e t r a n g e r a t h e r t h a n a p o i n t target, despite t h e i r r e c e n t experience w i t h the difficulties o f observing a n a r r o w target b a n d for t h e e x c h a n g e rate, because t h e y sensed t h e n e e d t o reestablish c r e d i b i l ­ ity after t h e loss o f t h e E C U p e g . As we discussed i n C h a p t e r 3, t h e r e is a t r a d e o f f i m p l i c i t i n t h e c h o i c e o f t h e w i d t h o f t h e t a r g e t r a n g e : T h e nar­ r o w e r t h e t a r g e t r a n g e , t h e m o r e l i k e l y t h e p u b l i c is t o take seriously t h e c e n t r a l b a n k ' s c o m m i t m e n t t o t h e i n f l a t i o n g o a l , a l l else e q u a l . O n t h e

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o t h e r h a n d , a n a r r o w r a n g e reduces p o l i c y flexibility, increases t h e risk o f i n a d v e r t e n t l y m i s s i n g t h e r a n g e , a n d m a y raise t h e p o s s i b i l i t y o f i n ­ s t r u m e n t i n s t a b i l i t y (as i n t e r e s t rates are adjusted s h a r p l y i n a t t e m p t s t o k e e p i n f l a t i o n w i t h i n t h e d e s i r e d b o u n d s ) . A g a i n , Sweden d i d set its tar­ get r a n g e floor at 1 % , p u t t i n g some space above zero i n f l a t i o n i n l i g h t o f o n g o i n g p r o b l e m s i n t h e f i n a n c i a l sector. A c c o r d i n g t o t h e J a n u a r y 1993 a n n o u n c e m e n t , t h e reason f o r h a v i n g a n i n i t i a l p e r i o d w i t h o u t Canadian-style g u i d e l i n e s f o r t h e i n f l a t i o n t r a n ­ s i t i o n p a t h was t o increase s h o r t - t e r m flexibility—in p a r t i c u l a r , t o free m o n e t a r y p o l i c y f r o m h a v i n g t o c o u n t e r a c t t h e f i r s t - r o u n d effects o f t h e N o v e m b e r 1992 d e v a l u a t i o n . I n s t e a d , p o l i c y was m e r e l y r e q u i r e d t o p r e ­ v e n t t h e d e v a l u a t i o n effects f r o m i n c r e a s i n g "the u n d e r l y i n g rate o f i n ­ flation," m u c h as i n o t h e r i n f l a t i o n - t a r g e t i n g c o u n t r i e s . O n c e a g a i n , t h e delay i n i m p l e m e n t i n g t h e targets a m o u n t e d t o t h e i n v o c a t i o n o f a n es­ cape clause. However, g i v e n t h e absence f r o m t h e f r a m e w o r k o f some measure o f u n d e r l y i n g i n f l a t i o n , this escape clause c o u l d , i n effect, never be used a g a i n . T h e i m p l i c i t c o n t r a d i c t i o n b e t w e e n t h e use o f a n escape clause a n d t h e absence o f a m e a s u r e o f u n d e r l y i n g i n f l a t i o n i n t h e tar­ geting p r o c e d u r e became a r e c u r r i n g b u r d e n for the Riksbank to justify: I f i t is acceptable t o have a n escape clause t h a t p e r m i t s t h e a u t h o r i t i e s t o i g n o r e shocks t h a t d o n o t affect c o r e i n f l a t i o n , t h e n i t w o u l d seem t h a t t h e a p p r o p r i a t e t a r g e t is a m e a s u r e o f c o r e i n f l a t i o n , n o t h e a d l i n e i n f l a ­ tion. T h e R i k s b a n k stressed t h a t i t w o u l d n o t e m p l o y any o n e i n t e r m e d i a t e target i n t h e n e w f r a m e w o r k : This decision has to do with the lack o f a variable which can be presumed to meet the criteria o f controllability and a stable relationship with price forma­ tion. . . . Monetary policy control i n Sweden, as i n most other countries with a flexible exchange rate, starts instead from attempts to form a comprehen­ sive picture o f economic development and the course o f inflation by study­ ing several indicators of future activity and future inflation. (Sveriges Riksbank, 1994a, 1, pp. 6-7.) T h e i n f o r m a t i o n variables t h a t t h e R i k s b a n k a d o p t e d i n c l u d e d m o n e t a r y a n d c r e d i t aggregates, t h e e x c h a n g e rate, i n t e r e s t rates ( i n t h e f o r m o f a y i e l d spread, o r c o m b i n e d w i t h t h e e x c h a n g e rate as a m o n e t a r y c o n d i ­ t i o n s i n d e x ) , wages, a n d some goods prices ( s u c h as i m p o r t prices a n d c o m m o d i t y p r i c e s ) . T h i s use o f m a n y types o f i n f o r m a t i o n i n f o r m u l a t ­ i n g p o l i c y is consistent w i t h t h e view t h a t t h e c u r r e n t i n f l a t i o n forecast i t s e l f s h o u l d be t r e a t e d b o t h as t h e i n t e r m e d i a t e t a r g e t a n d as t h e basis for e x p l a i n i n g policy decisions. 10

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Since t h e Riksbank's G o v e r n i n g B o a r d is t o some e x t e n t a n a r m o f P a r l i a m e n t , p a r l i a m e n t a r y s u p e r v i s i o n o f m o n e t a r y p o l i c y seems assured. F o u r o f t h e B o a r d m e m b e r s , i n c l u d i n g t h e C h a i r m a n , are a p p o i n t e d b y the governing party (or parties), a n d the other three by the o p p o s i t i o n . T h e m e m b e r s serve f o r t h e d u r a t i o n o f t h e P a r l i a m e n t . A l t h o u g h t h e a p p o i n t m e n t o f outsiders is possible, m o s t o f t h e a p p o i n t e e s are t h e m ­ selves m e m b e r s o f P a r l i a m e n t . T h e G o v e r n o r is c h o s e n b y t h e B o a r d m e m b e r s f o r a t e r m o f five years a n d c a n be dismissed b y t h e m at any t i m e . By a l l t h e s t a n d a r d l e g a l measures, t h e R i k s b a n k is o n e o f t h e least i n d e p e n d e n t c e n t r a l b a n k s i n E u r o p e . I n p r a c t i c e , however, t h e R i k s b a n k does exercise r e a s o n a b l e a u t o n o m y , a n d even has r e s p o n s i ­ b i l i t y f o r exchange rate i n t e r v e n t i o n ( u n l i k e most E u r o p e a n c e n t r a l banks). B e f o r e t h e k r o n a was f l o a t e d , a g o v e r n m e n t - a p p o i n t e d c o m m i t t e e h a d b e e n w o r k i n g o n proposals f o r r e f o r m i n g t h e R i k s b a n k . I t p r e s e n t e d its r e p o r t t o t h e g o v e r n m e n t i n M a r c h 1993. T h e r e p o r t r e c o m m e n d e d a l e g i s l a t e d p r i c e s t a b i l i t y g o a l a n d a m o r e i n d e p e n d e n t status f o r t h e R i k s b a n k . However, faced w i t h o p p o s i t i o n b y t h e Social D e m o c r a t par­ l i a m e n t a r y f a c t i o n , a n d t h e far m o r e pressing n e e d t o d e c i d e o n a n d t o i m p l e m e n t a n e w m o n e t a r y f r a m e w o r k , t h e g o v e r n m e n t chose n o t t o submit the proposal to Parliament. A similarly ill-timed j u x t a p o s i t i o n o f proposals o c c u r r e d i n Canada, w i t h t h e n e e d f o r a n e w n o m i n a l an­ c h o r c r o w d i n g o u t plans f o r f o r m a l l y i n c r e a s i n g t h e i n d e p e n d e n c e o f t h e c e n t r a l b a n k . However, i n Sweden, as i n Canada, t h e i n f l a t i o n - t a r g e t ­ i n g r e g i m e de facto i n c r e a s e d o p e r a t i o n a l i n d e p e n d e n c e o f t h e c e n t r a l b a n k . I n 1997, t h e legislative i n i t i a t i v e t o increase t h e Riksbank's l e g a l i n d e p e n d e n c e was r e v i v e d a n d s u r v i v e d a first p a r l i a m e n t a r y r e a d i n g . 11

1 2

Since, as we n o t e d , t h e R i k s b a n k is i n some respects a n a r m o f t h e g o v e r n m e n t , t h e r e is n o e x p l i c i t oversight m e c h a n i s m f o r m o n e t a r y p o l i c y i n Sweden. A c c o u n t a b i l i t y p r e s u m a b l y is e n s u r e d t h r o u g h p a r l i a m e n ­ tary elections, since t h e p e r f o r m a n c e o f m o n e t a r y p o l i c y h e l p s t o deter­ m i n e t h e e l e c t o r a l fate o f t h e g o v e r n m e n t . Nevertheless, m a n y e c o n o ­ mists ( i n c l u d i n g ourselves) r e g a r d t h e Swedish a r r a n g e m e n t as a p o o r second-best t o a f u l l y i n s t r u m e n t - i n d e p e n d e n t c e n t r a l b a n k . T h e Riksbank reports to the p u b l i c o n monetary policy t h r o u g h infla­ t i o n r e p o r t s ( t i t l e d Inflation and Inflation Expectations in Sweden u n t i l N o ­ v e m b e r 1995, Inflation Report t h e r e a f t e r ) , w h i c h i t p u b l i s h e d t h r e e t i m e s a year f r o m J u n e 1993 t o D e c e m b e r 1995, a n d f o u r t i m e s a year since t h e n . Since its first issue, t h e f o r m a t has u n d e r g o n e a n u m b e r o f changes. I n its p r e s e n t f o r m , t h e Report surveys various measures o f i n f l a t i o n . I t also covers measures o f c u r r e n t i n f l a t i o n a r y pressures (e.g., capacity u t i -

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l i z a t i o n rates), d e v e l o p m e n t s i n i m p o r t a n t sectors a n d i n t h e l a b o r mar­ ket, fiscal policy, a n d m o n e t a r y aggregates. A s e c t i o n o n i n f l a t i o n expec­ tations r e p o r t s t h e results o f surveys o f h o u s e h o l d s a n d firms (at a o n e year h o r i z o n ) , b o n d investors (at two-year a n d five-year h o r i z o n s ) a n d , since O c t o b e r 1994, o f m o n e y - m a r k e t agents, p u r c h a s i n g m a n a g e r s , a n d e m p l o y e r a n d e m p l o y e e o r g a n i z a t i o n s (at h o r i z o n s o f o n e , t w o , a n d five years). Because o f t h e c e n t r a l i z e d , c o r p o r a t i s t w a g e - b a r g a i n i n g arrange­ m e n t s i n Sweden, i t m a y be easier t o o b t a i n accurate measures o f i n f l a ­ t i o n e x p e c t a t i o n s t h e r e t h a n i n o t h e r c o u n t r i e s . T h i s s e c t i o n o f t h e re­ p o r t also lists some financial-market i n d i c a t o r s o f i n f l a t i o n e x p e c t a t i o n s , such as m o v e m e n t s i n i m p l i e d f o r w a r d interest-rate curves a n d interestrate d i f f e r e n t i a l s vis-à-vis G e r m a n y . I n a d d i t i o n , t h e Inflation Report, l i k e t h e r e p o r t s p u b l i s h e d b y o t h e r i n f l a t i o n - t a r g e t i n g c e n t r a l banks, carries f r e q u e n t e x p l a n a t i o n s o f t h e e c o n o m i c significance o f t h e m a t t e r s dis­ cussed, a i m e d at e d u c a t i n g t h e p u b l i c . U n t i l J u n e 1995, t h e Inflation Report was p u b l i s h e d b y t h e Riksbank's E c o n o m i c s D e p a r t m e n t a n d s i g n e d b y its h e a d , n o t b y t h e G o v e r n o r o r t h e G o v e r n i n g B o a r d . T h e i m p l i e d distance b e t w e e n t h e p r o f e s s i o n a l assessment o f t h e i n f l a t i o n s i t u a t i o n a n d t h e p o l i t i c a l forces a f f e c t i n g t h e R i k s b a n k m a y have i n c r e a s e d t h e c r e d i b i l i t y o f t h a t assessment, t h o u g h at some cost i n a c c o u n t a b i l i t y . Since N o v e m b e r 1995, however, t h e Inflation Report has b e e n p u b l i s h e d b y t h e R i k s b a n k a n d s i g n e d by t h e G o v e r n o r . I n its F o r e w o r d , i t states t h a t "the G o v e r n i n g B o a r d has discussed t h e f u t u r e d e s i g n o f m o n e t a r y p o l i c y i n t h e l i g h t o f t h e i n f l a ­ t i o n analysis." T h i s m a y be seen as a n a t t e m p t t o a v o i d t h e s o r t o f sepa­ r a t i o n b e t w e e n p o l i c y analysis a n d p o l i c y r e s p o n s i b i l i t y t h a t h a d o c c u r r e d i n t h e U n i t e d K i n g d o m . I n theory, o f course, t h e r e is still r o o m f o r o p e n d i s a g r e e m e n t over policy, s h o u l d t h e p o l i t i c a l l y a p p o i n t e d G o v e r n i n g B o a r d choose t o o v e r r u l e t h e G o v e r n o r . T h e Riksbank, m u c h like the Bundesbank, d i d n o t initially p u b l i s h an i n f l a t i o n forecast o f its o w n . O n l y since J u n e 1995 has t h e Inflation Report c o n t a i n e d statements t o t h e effect t h a t t h e R i k s b a n k expects i n f l a t i o n d u r i n g t h e n e x t t w o years t o be w i t h i n o r o u t s i d e t h e t a r g e t r a n g e , a n d w h e t h e r i n t h e u p p e r o r l o w e r h a l f o f i t . I n t e r m s o f concreteness, t h e R i k s b a n k was t h u s at t h e o p p o s i t e e n d o f t h e s p e c t r u m f r o m t h e Reserve Bank o f New Zealand, w i t h the Bank o f England a n d the Bank o f Canada s o m e w h e r e i n b e t w e e n . As w i t h t h e t a r g e t i n g o f t h e h e a d l i n e C P I , i n this area t h e p r a c t i c e o f t h e R i k s b a n k has s h i f t e d over t i m e t o w a r d t h e n o r m e s t a b l i s h e d b y o t h e r i n f l a t i o n t a r g e t e r s . As o f D e c e m b e r 1997, t h e R i k s b a n k h a d b e g u n p u b l i s h i n g its i n f l a t i o n forecast i n g r a p h i c a l f o r m , i n the m a n n e r o f the Bank o f England.

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As we m e n t i o n e d earlier, so far t h e m o s t a m b i t i o u s e f f o r t at r e f o r m o f t h e R i k s b a n k was t h e r e p o r t o f t h e g o v e r n m e n t - a p p o i n t e d R i k s b a n k C o m m i t t e e , w h i c h was p r e s e n t e d t o t h e g o v e r n m e n t i n e a r l y M a r c h 1 9 9 3 . I t c o n t a i n e d t h r e e m a i n proposals: (1) t o have P a r l i a m e n t for­ m u l a t e a s t a t u t o r y objective f o r t h e R i k s b a n k b y t h e Swedish P a r l i a m e n t , (2) t o c h a n g e t h e rules f o r t h e a p p o i n t m e n t a n d c o m p o s i t i o n o f t h e G o v e r n i n g Board, w i t h the a i m o f distancing the B o a r d f r o m Parliament, a n d (3) ( i n a n e x p e r t r e p o r t a p p e n d e d t o t h e C o m m i t t e e ' s r e p o r t ) t o i m p o s e s t r i n g e n t p e r f o r m a n c e c o n d i t i o n s ( e n f o r c e d b y t h r e a t o f dis­ missal) o n e i t h e r t h e m e m b e r s o f t h e G o v e r n i n g B o a r d o r o n t h e Gover­ nor. 13

T h o u g h t h e C o m m i t t e e r e p o r t was n o t p r o p o s e d as l e g i s l a t i o n , i t is w o r t h c o n s i d e r i n g briefly, b o t h because o f t h e effect i t has h a d o n t h e Swedish p u b l i c d e b a t e a n d t h e view i t takes o n t h e l i n k b e t w e e n i n f l a t i o n t a r g e t i n g a n d c e n t r a l b a n k i n d e p e n d e n c e . T h e f o r m u l a t i o n o f a statu­ t o r y objective f o r t h e R i k s b a n k was seen as a m o v e t o w a r d a m o r e i n d e ­ p e n d e n t r o l e f o r t h e R i k s b a n k . "Greater i n d e p e n d e n c e f o r t h e R i k s b a n k p r e s u p p o s e s . . . t h a t a n o b j e c t i v e f o r its activities is l a i d d o w n b y [Par­ l i a m e n t ] . T h i s gives m o n e t a r y a n d e x c h a n g e - r a t e p o l i c y a d e m o c r a t i c f o u n d a t i o n . " T h e C o m m i t t e e f u r t h e r proposed that the Riksbank's objective should be . . . price stability. A specific target i n the form o f a quantified rate o f inflation should n o t be enacted. The objective is taken to refer to the development o f inflation i n the medium- and the long-term. T h e g o a l o f p r i c e stability was t o be g i v e n a n o p e r a t i o n a l d e f i n i t i o n t h a t c o u l d be v a r i e d over t i m e w i t h c h a n g i n g circumstances, t h a t w o u l d n o t b e u n d u l y b i n d i n g i n t h e s h o r t e r t e r m , a n d t h a t h a d as its m a i n p u r p o s e the a n c h o r i n g o f l o n g - r u n i n f l a t i o n expectations. T h e proposal w e n t f u r t h e r i n s t a t i n g t h a t t h e p u r s u i t o f p r i c e stability was n o t t o b e seen i n i s o l a t i o n f r o m t h e p u r s u i t o f o t h e r objectives. Neither does the objective o f price stability imply that monetary policy is n o t to take other objectives into account. I n so far as other objectives can be promoted without prejudice to the goal of price stability, the Riksbank should support general economic policy and contribute to the attainment of its other objectives. A g a i n , this d i s t i n c t i o n b e t w e e n l o n g - r u n c o m m i t m e n t t o p r i c e stabil­ ity a n d s h o r t - r u n i n f l e x i b i l i t y , b e t w e e n i n f l a t i o n t a r g e t i n g as a f r a m e w o r k a n d as a r u l e , has b e e n f o l l o w e d i n d e s i g n a n d i n p r a c t i c e t o a g r e a t e r o r lesser d e g r e e b y a l l c o u n t r i e s discussed h e r e ( n o t e t h e s i m i l a r i t y i n l a n -

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guage t o t h e B u n d e s b a n k ' s charter, f o r e x a m p l e ) . T h i s C o m m i s s i o n re­ p o r t , t h o u g h i t was n o t a d o p t e d , is w i d e l y k n o w n i n Sweden a n d is c o n ­ sistent w i t h t h e c u r r e n t v i s i o n o f t h e Riksbank's objective a n d r o l e .

Swedish Monetary Policy under Inflation Targeting W e t u r n n o w t o d e v e l o p m e n t s i n Swedish m o n e t a r y p o l i c y since t h e tar­ get a d o p t i o n i n J a n u a r y 1993. As t h e panels i n F i g u r e 8.1 suggest, t h e p e r i o d since t h e n c a n be d i v i d e d i n t o t h r e e episodes. T h e first, w h i c h spans t h e p e r i o d f r o m t a r g e t a d o p t i o n u n t i l A p r i l 1994, is c h a r a c t e r i z e d by falling inflation, a r e b o u n d i n GDP growth, a n d falling short-term i n t e r e s t rates. T h e s e c o n d episode covers t h e p e r i o d f r o m M a y 1994 u n t i l t h e e n d o f 1995. D u r i n g t h a t t i m e i n f l a t i o n increased, r e a c h i n g t h e u p ­ p e r h a l f o f t h e t a r g e t r a n g e o f 1 % t o 3%; G D P g r o w t h was s t r o n g ; a n d s h o r t - t e r m i n t e r e s t rates rose. D u r i n g t h e t h i r d episode, f r o m t h e b e g i n ­ n i n g o f 1996 t o t h e e n d o f 1997, t h e p a t t e r n o f 1994-1995 was reversed: I n f l a t i o n f e l l rapidly, b r e a c h i n g t h e l o w e r b o u n d o f t h e t a r g e t r a n g e ; G D P g r o w t h s l o w e d d o w n ; a n d s h o r t - t e r m i n t e r e s t rates f e l l sharply. A n n u a l i z e d C P I i n f l a t i o n rose s i g n i f i c a n t i y i n J a n u a r y 1993, t o 4 . 8 % , f r o m 2 % i n D e c e m b e r 1992. T h e increase was d u e m o s t l y t o a swift passt h r o u g h o f t h e effects o f t h e N o v e m b e r 1992 d e v a l u a t i o n o n i m p o r t prices. T h e i n f l a t i o n rate rose g r a d u a l l y t o a p e a k o f 5.2% i n A p r i l . T h e y i e l d o n ten-year g o v e r n m e n t b o n d s i n c r e a s e d s l i g h t l y d u r i n g t h e first h a l f o f January, b u t f o l l o w i n g t h e t a r g e t a n n o u n c e m e n t , i t r e s u m e d t h e d e c l i n e t h a t h a d b e g u n f o l l o w i n g t h e d e v a l u a t i o n o f t h e k r o n a . W e l l aware o f the degree o f u n c e r t a i n t y a m o n g m a r k e t participants over future m o n e t a r y p o l i c y at this t i m e , t h e R i k s b a n k p u r s u e d a p o l i c y o f cautious interest-rate cuts. E x p e c t a t i o n s f o r i n f l a t i o n i n 1994 were above 4 % , based a p p a r e n t l y o n t h e b e l i e f t h a t t h e R i k s b a n k w o u l d l o w e r i n t e r e s t rates aggressively t o fight t h e recession. I n d e e d , s o o n after t h e R i k s b a n k re­ d u c e d t h e M a r g i n a l Rate f r o m 10.5% t o 9.75% o n F e b r u a r y 5, i t was forced to intervene i n the m o n e y market to prevent short-term interest rates f r o m f a l l i n g b e l o w 9 % . T h e k r o n a c o n t i n u e d t o d e p r e c i a t e d u r i n g t h e first q u a r t e r o f 1993, possibly i n response t o t h e g r i d l o c k i n Parlia­ m e n t over w h a t t o d o a b o u t t h e g o v e r n m e n t b u d g e t d e f i c i t , w h i c h was r i s i n g t o r e c o r d levels. F r o m A p r i l 1993 t h r o u g h t h e e n d o f t h e year, i n f l a t i o n f e l l ( w i t h t h e exception o f a brief upward blip i n October and November). The yield o n ten-year g o v e r n m e n t b o n d s d e c l i n e d f r o m above 1 0 % i n J a n u a r y t o 7.25% i n December, r e d u c i n g t h e y i e l d d i f f e r e n t i a l vis-à-vis G e r m a n y f r o m

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m o r e t h a n 3% i n J a n u a r y t o s l i g h t l y above 1 % at year's e n d — t h a t is, t o levels l o w e r t h a n h a d ever b e e n a c h i e v e d u n d e r t h e E C U p e g . T h e R i k s b a n k c o n t i n u e d its p o l i c y o f c a u t i o u s easing b y c u t t i n g t h e M a r g i n a l Rate i n e i g h t q u a r t e r - p e r c e n t steps, t o 7.75%. By N o v e m b e r , i n f l a t i o n e x p e c t a t i o n s at t h e two-year h o r i z o n o b t a i n e d f r o m a survey o f b o n d investors h a d d e c l i n e d t o 3%, w h i l e i n f l a t i o n e x p e c t a t i o n s at t h e fiveyear h o r i z o n w e r e still above 4 % . A r o u n d t h e e n d o f 1993, t h e r e w e r e signs t h a t G D P g r o w t h was t u r n i n g positive a g a i n , l e d b y g r o w t h i n ex­ p o r t s . T h e d e v a l u a t i o n , t o g e t h e r w i t h f a l l i n g u n i t l a b o r costs i n t h e w a k e o f t h e massive j o b s h e d d i n g d u r i n g t h e recession, h a d i m p r o v e d t h e c o m ­ petitiveness o f Sweden's e x p o r t sector. By year's e n d , t h e k r o n a h a d de­ p r e c i a t e d f r o m its N o v e m b e r 1992 level b y 2 4 % i n t r a d e - w e i g h t e d t e r m s . H e a d l i n e i n f l a t i o n f e l l t o 1.9% i n J a n u a r y 1994, d o w n f r o m 5% i n N o v e m b e r 1993 a n d f r o m 4 . 1 % i n D e c e m b e r , as t h e d i r e c t i m p a c t o f t h e d e v a l u a t i o n r e c e d e d . I n f l a t i o n r e m a i n e d at this new, l o w level t h r o u g h A p r i l . T h e y i e l d o n ten-year g o v e r n m e n t b o n d s b o t t o m e d o u t at 7% i n J a n u a r y 1994. D u r i n g t h e d o w n t u r n i n t h e i n t e r n a t i o n a l b o n d m a r k e t f r o m F e b r u a r y t o A u g u s t 1994, however, t h e ten-year y i e l d rose f r o m 7.0% t o 11.4%, a n d t h e d i f f e r e n t i a l b e t w e e n Swedish a n d G e r m a n t e n year yields w i d e n e d f r o m j u s t above 1 % t o over 4 % . F r o m J a n u a r y t h r o u g h May, m o t i v a t e d b y d o m e s t i c r e a l factors a n d t h e f i n a n c i a l s i t u a t i o n , t h e R i k s b a n k c o n t i n u e d t o c u t t h e M a r g i n a l Rate, i n t h r e e q u a r t e r - p e r c e n t steps, t o 7%. T h e i n f l a t i o n t a r g e t d i d n o t officially take h o l d u n t i l t h e e n d o f 1995, b u t t h e a n n o u n c e m e n t o f t h e t a r g e t f r a m e w o r k h a d appar­ e n t l y succeeded i n l o c k i n g i n i n f l a t i o n e x p e c t a t i o n s at t h e l o w levels a c h i e v e d p r i o r t o t h e d e v a l u a t i o n o f t h e k r o n a . E q u a l l y g r a t i f y i n g was t h e absence o f any s i g n i f i c a n t pass-through o f t h e o n e - t i m e i n f l a t i o n a r y s h o c k f r o m t h e d e v a l u a t i o n . As i n t h e U n i t e d K i n g d o m , Sweden's s w i t c h f r o m a n exchange-rate t a r g e t t o a n i n f l a t i o n t a r g e t p r o v i d e d t h e flexibil­ i t y t o l o o s e n p o l i c y i n a c c o r d w i t h d o m e s t i c ( r a t h e r t h a n G e r m a n ) needs, w i t h n o a p p a r e n t cost i n t e r m s o f i n f l a t i o n — d e s p i t e t h e w i d e l y h e l d ex­ p e c t a t i o n t h a t e x i t i n g t h e E R M w o u l d be a m a j o r b l o w t o t h e c r e d i b i l i t y o f m o n e t a r y policy. Estimates o f i n f l a t i o n expectations o b t a i n e d f r o m p o l l i n g p r o f e s s i o n a l forecasters stayed m o s t l y u n c h a n g e d d u r i n g t h e first h a l f o f 1994, at 2 % f o r t h e year 1994 a n d 3% f o r 1995, w i t h i n t h e t a r g e t r a n g e . H e a d l i n e i n f l a t i o n rose i n M a y 1994 t o 2.3%, f r o m 1.8% i n A p r i l . T h e signals f r o m t h e r e a l side o f t h e e c o n o m y w e r e m i x e d : A l t h o u g h e x p o r t s a n d p r i v a t e c o n s u m p t i o n rose d u r i n g t h e first quarter, i n v e s t m e n t was s t i l l f a l l i n g . T h e R i k s b a n k c o n c l u d e d i n its Inflation Report, p u b l i s h e d i n m i d - J u n e , t h a t " e c o n o m i c g r o w t h t o date i n 1994 seems t o b e weak," a n d t h a t i n f l a -

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t i o n a r y i m p u l s e s f r o m t h e l a b o r m a r k e t w e r e w e a k as w e l l (Sveriges R i k s b a n k , 1994b, J u n e , p . 1 6 ) . A b s e n t clear signs o f e m e r g i n g i n f l a t i o n ­ ary pressures, t h e R i k s b a n k c l a i m e d t h a t t h e rise i n l o n g - t e r m yields "may have t o d o w i t h factors t h a t d o n o t r e p r e s e n t i n c r e a s e d i n f l a t i o n expec­ tations," c i t i n g f o r e x a m p l e changes i n b o n d i n v e s t m e n t strategies a n d t h e still u n r e s o l v e d p r o b l e m o f t h e g o v e r n m e n t b u d g e t d e f i c i t (Sveriges R i k s b a n k , 1994b, J u n e , p . 3 6 ) . T h i s view was s u p p o r t e d b y t h e fact t h a t t h e k r o n a a p p r e c i a t e d m a r k e d l y d u r i n g t h e first h a l f o f t h e year. M o r e i m p o r t a n t l y , t h e Riksbank's e x p l a n a t i o n e m p h a s i z e d t o t h e p u b l i c t h e l i m i t s o f m o n e t a r y p o l i c y ' s c o n t r o l over t h e e c o n o m y . T h e R i k s b a n k also revealed that, despite t h e fact t h a t t h e official t a r g e t was d e f i n e d i n t e r m s o f headline inflation, n o t all movements i n inflation w o u l d produce the same r e a c t i o n f r o m m o n e t a r y policy. S h o r t l y after t h e p u b l i c a t i o n o f t h e J u n e Inflation Report, i t b e c a m e clear t h a t t h e o u t l o o k f o r i n f l a t i o n was less b e n i g n t h a n first t h o u g h t . H e a d l i n e i n f l a t i o n rose t o 2.9% i n J u l y a n d f e l l o n l y t o 2 . 7 % i n Septem­ ber. Measures o f u n d e r l y i n g i n f l a t i o n s h o w e d a p r o n o u n c e d rise d u r i n g t h e s p r i n g , r e v e a l i n g t h a t t h e p r i c e increases w e r e b r o a d l y based a n d w e r e o c c u r r i n g i n a l l m a j o r sectors o f t h e e c o n o m y . F u r t h e r m o r e , as a r e s u l t o f t h e r e d u c t i o n i n p r o d u c t i o n capacity t h a t h a d t a k e n place d u r ­ i n g t h e recession, t o g e t h e r w i t h t h e v i g o r o u s g r o w t h i n e x p o r t d e m a n d f o l l o w i n g t h e k r o n a ' s d e p r e c i a t i o n , t h e r e m a i n i n g p r o d u c t i o n capacity was a l m o s t f u l l y u t i l i z e d . By this t i m e , measures o f capacity u t i l i z a t i o n — key i n d i c a t o r s o f i n f l a t i o n a r y pressures—were at t h e i r h i g h e s t levels since 1989. I n f l a t i o n e x p e c t a t i o n s a m o n g p r o f e s s i o n a l forecasters f o r t h e year 1 9 9 4 j u m p e d f r o m 2 % t o 3% d u r i n g t h e s u m m e r , w h i l e i n f l a t i o n expec­ tations a m o n g b o n d investors h a d r i s e n t o 3.4% a n d 4 . 2 % at t h e t w o year a n d five-year h o r i z o n s respectively. M e a n w h i l e , t h e g o v e r n m e n t ' s n e e d t o b o r r o w h a d r e m a i n e d stable, b u t at a v e r y h i g h level. O n A u g u s t 11 these d e v e l o p m e n t s p r o m p t e d t h e R i k s b a n k t o raise t h e r e p o rate ( w h i c h h a d as o f J u n e 1 r e p l a c e d t h e M a r g i n a l Rate as t h e Riksbank's p o l i c y i n s t r u m e n t ) f r o m 6.92% t o 7.20%, r e v e r s i n g t h e d o w n w a r d t r e n d i n s h o r t - t e r m i n t e r e s t rates t h a t h a d p r e v a i l e d since t h e N o v e m b e r 1992 devaluation. T h e p a r l i a m e n t a r y elections o n S e p t e m b e r 1 8 , 1 9 9 4 , b r o u g h t t h e gov­ e r n m e n t i n t o t h e c o n t r o l o f t h e Social D e m o c r a t s , as h a d b e e n w i d e l y e x p e c t e d . D u r i n g t h e weeks b e f o r e t h e elections, t h a t p a r t y h a d m a d e clear t h a t t h e y w o u l d n e i t h e r a l t e r t h e i n f l a t i o n t a r g e t n o r replace t h e Riksbank's G o v e r n o r , U r b a n B ä c k s t r ö m . A f t e r f o r m i n g a m i n o r i t y gov­ e r n m e n t , t h e Social D e m o c r a t s a p p o i n t e d t h e last Social D e m o c r a t fi­ n a n c e m i n i s t e r , K j e l l - O l o f F e l d t , w h o h a d r e t i r e d f r o m p o l i t i c s a n d was

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n o t a m e m b e r o f P a r l i a m e n t , as c h a i r m a n o f t h e G o v e r n i n g B o a r d , fur­ t h e r s i g n a l i n g t h a t t h e y w o u l d abstain f r o m e x e r t i n g d i r e c t p o l i t i c a l pres­ sure o n m o n e t a r y policy. A l t h o u g h t h e o r i g i n a l a n n o u n c e m e n t o f i n f l a ­ t i o n targets h a d stated t h a t t h e y w o u l d a p p l y i n d e f i n i t e l y f r o m 1995 for­ w a r d , t h e d e c i s i o n o f t h e n e w g o v e r n m e n t t o leave t h e targets u n c h a n g e d was a n i m p o r t a n t c o n f i r m a t i o n o f t h a t p r i n c i p l e . As i n C a n a d a a n d t h e U n i t e d K i n g d o m , the switch f r o m a right-majority to a left-majority i n t h e P a r l i a m e n t after t h e a d o p t i o n o f i n f l a t i o n targets d i d n o t r e s u l t i n a c h a n g e o f t h e targets, b u t a c t u a l l y s t r e n g t h e n e d t h e p u b l i c ' s sense t h a t t h e g o v e r n m e n t h a d a l o n g - t e r m c o m m i t m e n t t o p r i c e stability. I m p o r ­ tantly, this c o n t i n u i t y o f p o l i c y was o b s e r v e d i n c o u n t r i e s i n w h i c h t h e c h o i c e o f m o n e t a r y p o l i c y objectives was clearly t h e p r e r o g a t i v e o f t h e government, w i t h n o legal o r p r o c e d u r a l barriers to m a k i n g a change. A p p a r e n t l y , a p u b l i c a n n o u n c e m e n t o f i n f l a t i o n targets c a n act as a p o w ­ e r f u l c o n s t r a i n t o n t h e p r i o r i t i e s o f a n e l e c t e d g o v e r n m e n t , w i t h o u t fur­ t h e r n e e d f o r " b i n d i n g ( t h e g o v e r n m e n t ' s ) hands." W i t h t h e elections o u t o f t h e way, t h e R i k s b a n k s t e p p e d u p its c r i t i ­ c i s m o f fiscal policy. I n t h e Inflation Report p u b l i s h e d i n m i d - O c t o b e r , t h e R i k s b a n k stated: The inflation expectations and the associated weak exchange rate and h i g h l o n g term interest rates, are a consequence o f the central government bor­ rowing requirement being very high . . . [ A ] consolidation o f central govern­ m e n t finance is essential for achieving a sustainable development o f central government debt. Conditions would then be created for lower inflation ex­ pectations, a fall i n long interest rates and an appreciation o f the krona. (Sveriges Riksbank, 1994b, October, p. 8) I n f l a t i o n expectations, a n d t h e r e f o r e l o n g - t e r m interest rates, r e m a i n e d v u l n e r a b l e t o t h e h i g h g o v e r n m e n t b u d g e t deficits d u r i n g 1993 a n d 1994. T h e existence o f t h e i n f l a t i o n t a r g e t e n a b l e d t h e R i k s b a n k t o d e l i n e a t e those aspects o f p o l i c y f o r w h i c h i t was responsible a n d gave i t a p l a t f o r m f r o m w h i c h t o appraise ( a n d c r i t i c i z e ) those p o l i c i e s f o r w h i c h i t was not. A f t e r a g r a d u a l d e c l i n e d u r i n g t h e t h i r d q u a r t e r o f 1994, h e a d l i n e i n f l a t i o n b e g a n t o rise i n N o v e m b e r 1994, p e a k i n g at 3.4% i n A p r i l 1995. T h e y i e l d o n ten-year g o v e r n m e n t b o n d s fluctuated u n t i l A p r i l b e t w e e n 1 1 % a n d 1 2 % , a n d t h e d i f f e r e n t i a l vis-à-vis t h e y i e l d o n G e r m a n g o v e r n ­ m e n t b o n d s w i d e n e d t o above 4 % d u r i n g M a r c h a n d A p r i l . A c c o r d i n g to surveys p u b l i s h e d i n t h e F e b r u a r y 1995 a n d J u n e 1995 issues o f t h e Inflation Report, i n f l a t i o n at t h e h o r i z o n s o f o n e , t w o , a n d t h r e e years was e x p e c t e d t o be b e t w e e n 3.5% a n d 4 % . C l e a r l y t h e p u b l i c d i d n o t e x p e c t

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t h a t t h e i n f l a t i o n t a r g e t w o u l d be m e t , o r t h a t i n f l a t i o n w o u l d d e c l i n e d u r i n g t h e rest o f t h e year. T h e R i k s b a n k h a d raised t h e r e p o rate o n O c t o b e r 27 a n d a g a i n o n D e c e m b e r 13, 1994, t o 7.6%. T h e s e actions w e r e f o l l o w e d b y a r a p i d succession o f rate increases d u r i n g F e b r u a r y t h r o u g h A p r i l 1995, w i t h t h e r e p o rate t o p p i n g o u t at 8.5%. D e s p i t e t h e rise i n s h o r t - t e r m i n t e r e s t rates, t h e k r o n a d e p r e c i a t e d s h a r p l y d u r i n g t h e first q u a r t e r o f 1995. D u r i n g t h e s u m m e r o f 1995, t h e o u d o o k b e g a n t o i m p r o v e . H e a d l i n e inflation h a d peaked i n A p r i l , a n d by July i t h a d fallen back i n t o the u p p e r h a l f o f t h e t a r g e t r a n g e . T h e ten-year g o v e r n m e n t b o n d y i e l d a n d t h e interest-rate d i f f e r e n t i a l w i t h G e r m a n y h a d p e a k e d i n A p r i l as w e l l , at 11.4% a n d 4 . 7 % respectively. T h e k r o n a h a d n o t d e p r e c i a t e d any fur­ t h e r since M a r c h a n d s t a r t e d t o a p p r e c i a t e i n J u n e . O n J u l y 5, t h e R i k s b a n k raised t h e r e p o rate t o 8 . 9 1 % , a n d left i t u n c h a n g e d f o r t h e rest o f t h e year. B y t h e t i m e t h a t t h e R i k s b a n k h a d p u b l i s h e d its N o v e m ­ b e r Inflation Report, t h e effects o f t h e t i g h t e r stance o f m o n e t a r y p o l i c y w e r e b e c o m i n g visible. Measures o f u n d e r l y i n g i n f l a t i o n h a d b e e n o n a steady d o w n w a r d p a t h since A p r i l . Private c o n s u m p t i o n h a d n o t i n ­ creased, a n d i n d u s t r i a l capacity u t i l i z a t i o n h a d b e e n m o s t l y u n c h a n g e d since late 1994, i n p a r t because a h e a l t h y increase i n i n d u s t r i a l invest­ m e n t h a d increased p r o d u c t i v e capacity. T h e state o f g o v e r n m e n t finances h a d i m p r o v e d m a r k e d l y d u r i n g 1995, a n d t h e o n g o i n g fiscal t i g h t e n i n g was e x p e c t e d t o have a f u r t h e r d a m p e n i n g effect o n p r i v a t e c o n s u m p ­ t i o n . T h e stance o f m o n e t a r y p o l i c y was s u p p o r t e d b y t h e a p p r e c i a t i o n o f t h e k r o n a b y a b o u t 1 0 % since J u n e . Based o n these d e v e l o p m e n t s , t h e Riksbank's o w n assessment o f l i k e l y C P I i n f l a t i o n d u r i n g 1996 was b e t w e e n 2.5% a n d 3%. By t h e e n d o f 1995, i n f l a t i o n e x p e c t a t i o n s o b t a i n e d f r o m a l l t h e sur­ veys c o n s i d e r e d b y t h e R i k s b a n k h a d f a l l e n b e l o w 3% at t h e one-, two-, a n d five-year h o r i z o n s . By J a n u a r y 1996, h e a d l i n e i n f l a t i o n was d o w n t o 2 % . T h e y i e l d o n 10-year g o v e r n m e n t b o n d s h a d decreased since A p r i l by 3.2% t o 8.2%, n a r r o w i n g t h e d i f f e r e n t i a l vis-à-vis G e r m a n g o v e r n m e n t b o n d s t o 2.5%. T h e i m p r o v e m e n t s i n t h e o u t l o o k f o r i n f l a t i o n o v e r t h e p r e v i o u s six m o n t h s p r o m p t e d t h e R i k s b a n k t o l o w e r t h e r e p o rate i n f o u r steps by 80 basis p o i n t s t o 8.05% d u r i n g J a n u a r y a n d February. I m ­ p l i e d f o r w a r d i n t e r e s t rates i n late F e b r u a r y s h o w e d t h a t investors ex­ p e c t e d s h o r t - t e r m i n t e r e s t rates t o f a l l t o 7.25% u n t i l t h e e n d o f t h e year. I m p l i e d f o r w a r d rates at t h e ten-year h o r i z o n , however, h a d r i s e n b y a l m o s t 150 basis p o i n t s since t h e first r e p o r a t e c u t i n J a n u a r y , i n d i c a t ­ i n g yet a n o t h e r d i p i n the public's faith i n the c o m m i t m e n t to p r i c e stability.

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I n its M a r c h 1996 Inflation Report, t h e R i k s b a n k expressed c o n f i d e n c e t h a t i n f l a t i o n a r y pressures h a d r e c e d e d . First, b o t h d o m e s t i c a n d i n t e r ­ n a t i o n a l e c o n o m i c activity h a d slowed d o w n d u r i n g t h e s e c o n d h a l f o f 1995. S e c o n d , i n f l a t i o n d u r i n g 1995 h a d t u r n e d o u t t o be c o n s i d e r a b l y l o w e r t h a n h a d b e e n e x p e c t e d at t h e e n d o f 1994. T h i s l e d t h e R i k s b a n k to c o n c l u d e t h a t . . . the fact that unexpectedly strong growth i n 1995 was accompanied by relatively limited inflation and that inflation expectations have been subdued indicate that earlier patterns o f inflation are being broken up. But i t remains to adapt wage formation so that employment can rise at the same time as the development o f wage costs is compatible w i t h price stability. (Sveriges Riksbank, 1996b, March, p. 10) L i k e t h e B u n d e s b a n k , t h e R i k s b a n k h a d t o c o n f r o n t c e n t r a l i z e d wages e t t i n g m e c h a n i s m s , as w e l l as t h e g o v e r n m e n t ' s t e n u o u s fiscal policy, i n its a t t e m p t t o h o l d d o w n i n f l a t i o n e x p e c t a t i o n s . T h e R i k s b a n k t o o k t h e p o s i t i o n t h a t t h e rate o f wage increase does n o t necessarily d e t e r m i n e t h e rate o f p r i c e increase. T h u s , even t h o u g h t h e R i k s b a n k n o t e d t h e risks t o i n f l a t i o n r e s u l t i n g f r o m h i g h wage settlements, i t stated t h a t i t considered the conditions for "inflation developing i n line w i t h the i n ­ flation t a r g e t . . . t o b e g o o d " (Sveriges R i k s b a n k , 1996b, M a r c h , p . 1 0 ) . I n f l a t i o n c o n t i n u e d to fall d u r i n g the second a n d t h i r d quarters o f 1996, at a rate c o n s i d e r a b l y faster t h a n e x p e c t e d . I n A p r i l h e a d l i n e i n f l a ­ t i o n s t o o d at 1.3%. I n its Inflation Report p u b l i s h e d at t h e b e g i n n i n g o f J u n e , t h e R i k s b a n k a t t r i b u t e d t h e l o w e r - t h a n - e x p e c t e d i n f l a t i o n figure m o s t l y t o l o w e r i m p o r t prices a n d l o w e r m o r t g a g e rates. T h e c o n t i n u e d a p p r e c i a t i o n o f t h e k r o n a also h a d t h e effect o f r e d u c i n g f o r e i g n de­ m a n d f o r Swedish e x p o r t s , c o n t r i b u t i n g t o a m a r k e d s l o w d o w n i n G D P g r o w t h d u r i n g t h e first h a l f o f 1996. T h e y i e l d o n ten-year g o v e r n m e n t b o n d s r e m a i n e d l a r g e l y u n c h a n g e d d u r i n g t h e first h a l f o f 1996, at be­ t w e e n 8% a n d 8.5%, i n d i c a t i n g t h a t t h e d r o p i n i n f l a t i o n was seen as l a r g e l y cyclical a n d t r a n s i t o r y . D u r i n g t h e m o n t h s f r o m M a r c h t o M a y t h e R i k s b a n k h a d c u t t h e r e p o rate f u r t h e r b y 155 basis p o i n t s t o 6.5%. I n f l a t i o n expectations o n e a n d t w o years a h e a d h a d f a l l e n t o 2 % t o 2.5%. T h e R i k s b a n k c o n s i d e r e d i t " p r o b a b l e . . . t h a t i n t h e l a t t e r p a r t o f 1996 inflation (measured w i t h the CPI) will t e n d to move up... b u t that the r a t e d u r i n g t h e m a i n p a r t o f t h e year w i l l b e b e l o w 2 % " (Sveriges R i k s b a n k , 1996b, J u n e , p . 1 9 ) . I n c o n t r a s t t o its o p t i m i s m i n t h e M a r c h Inflation Report, however, t h e R i k s b a n k n o w e m p h a s i z e d t h e d o w n s i d e risks t o i n f l a t i o n r e s u l t i n g f r o m t h e p o s s i b i l i t y o f a p r o l o n g e d i n t e r n a ­ t i o n a l s l o w d o w n a n d f r o m l a b o r - m a r k e t weakness.

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I t appears t h a t t h e R i k s b a n k h a d b e e n s u r p r i s e d by t h e r a p i d f a l l i n i n f l a t i o n d u r i n g t h e s u m m e r a n d f a l l o f 1996. B y September, h e a d l i n e i n f l a t i o n h a d f a l l e n b e l o w t h e b o t t o m o f t h e t a r g e t r a n g e , t o 0.2%. By O c t o b e r t h e R i k s b a n k h a d c u t t h e r e p o rate b y a n o t h e r 185 basis p o i n t s , t o 4.65%, w h i l e t h e y i e l d o n ten-year g o v e r n m e n t b o n d s f e l l b e l o w 8%. G D P g r o w t h r e m a i n e d stable at a l o w level t h r o u g h t h e s e c o n d a n d t h i r d quarters. I n O c t o b e r , despite a rise i n t h e average i n d u s t r i a l wage o f 6% i n t h e 1996 pay r o u n d , Sweden saw its first d e f l a t i o n since 1959, w i t h h e a d l i n e C P I d r o p p i n g 0 . 1 % year-over-year. T h e R i k s b a n k a n d t h e gov­ e r n m e n t p o i n t e d t o t h e o n e - t i m e effects o f a r e d u c t i o n i n t h e valuea d d e d tax o n f o o d ( f r o m 2 1 % t o 1 2 % ) a n d a r e d u c t i o n i n h o m e m o r t ­ gage i n t e r e s t rates; despite t h e absence o f a n official m e a s u r e o f c o r e i n f l a t i o n , t h e a u t h o r i t i e s m a d e a p o i n t o f n o t i n g t h a t i n f l a t i o n exclusive o f those effects was still b e t w e e n 1.5% a n d 2 % , a n d t h e r e f o r e f e l l w i t h i n t h e t a r g e t r a n g e . F i n a n c e M i n i s t e r E r i k A s b r i n k stated t h a t t h e g o v e r n ­ m e n t c o n s i d e r e d e c o n o m i c d e v e l o p m e n t s " e x t r e m e l y positive . . . . I t is n o t d e f l a t i o n i n t h e sense t h a t we are o n t h e b r i n k o f a n e c o n o m i c d o w n ­ t u r n . O n t h e c o n t r a r y , t h e r e are i n c r e a s i n g l y s t r o n g signs t h a t we are o n t h e verge o f a n e c o n o m i c u p s w i n g " ( M c l v e r , 1 9 9 6 ) . Swedish m o n e t a r y policy-makers w o u l d n o t l e t a t a r g e t b r e a c h d e t e r m i n e t h e i r p o l i c y so l o n g as t h e u n d e r l y i n g rate o f i n f l a t i o n r e m a i n e d s u b d u e d , even t h o u g h t h e i r stated t a r g e t c o m m i t m e n t was t o t h e h e a d l i n e C P I i n f l a t i o n rate. I n t h e D e c e m b e r 1996 Inflation Report, f o l l o w i n g a n o t h e r m o n t h o f C P I d e f l a t i o n , t h e R i k s b a n k a d m i t t e d t h a t " [ i j n f l a t i o n i n 1996 w i l l be b e l o w t h e i n f l a t i o n target's l o w e r t o l e r a n c e l i m i t . T h e l o w rate o f i n f l a ­ t i o n is m a i n l y a consequence o f i n c r e a s i n g c o n f i d e n c e i n e c o n o m i c policy, a n d this has b r o u g h t i n t e r e s t rates d o w n a n d s t r e n g t h e n e d t h e e x c h a n g e rate" (Sveriges R i k s b a n k , 1996b, D e c e m b e r , p . 4 ) . T h e missed forecast was t a k e n as a s i g n o f u n e x p e c t e d gains i n t h e f r a m e w o r k ' s c r e d i b i l i t y . L a t e r i n t h e Report, w h i l e a c k n o w l e d g i n g the d i s i n f l a t i o n a r y consequences o f o u t p u t below the economy's potential, the Riksbank expanded o n this h o p e f u l i n t e r p r e t a t i o n : There are, moreover, other signs o f more permanent changes i n price for­ mation. Together with the low inflation and decreased inflation expectations i n recent years, i t seems that increased domestic and international competi­ tion has altered price behaviour. Such changes appear to be particularly marked i n trade i n everyday goods and clothes . . . . I n an economy where inflation is stable and low, relative price shifts w i t h i n and between product groups are more transparent. This leads to tighter competition and less pos­ sibility o f automatically passing o n costs to consumer prices. (Sveriges Riksbank, 1996b, December, p. 7)

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T h e R i k s b a n k d i d a l l o w t h a t t h e passage o f t i m e a n d t h e c o l l e c t i o n o f a d d i t i o n a l data w e r e r e q u i r e d b e f o r e s u c h a j u d g m e n t c o u l d be s t r o n g l y s u p p o r t e d . I n l i g h t o f h i g h wage increases i n t h e i n d u s t r i a l sector as w e l l as t h e r i s i n g u n e m p l o y m e n t level i n Sweden, i t also n o t e d t h a t "wage f o r m a t i o n has n o t y e t b e e n a d a p t e d t o t h e l o w - i n f l a t i o n e c o n o m y " (Sveriges R i k s b a n k , 1996b, D e c e m b e r , p . I I ) . T h e r e was n o q u e s t i o n t h a t i n f l a t i o n e x p e c t a t i o n s h a d d e c l i n e d , b u t also n o i n d i c a t i o n t h a t i n ­ flation was t u r n i n g i n t o d e f l a t i o n . T h e survey o f h o u s e h o l d e x p e c t a t i o n s p u t two-year-ahead C P I i n f l a t i o n at 1.5%, a n d t h e e x p e c t e d five-year-ahead rate at 2 % , b o t h consistent w i t h t h e a n n o u n c e d i n f l a t i o n target. 1 4

O f p a r t i c u l a r i n t e r e s t is t h e Riksbank's s t a t e m e n t a b o u t h o w m o n ­ etary p o l i c y s h o u l d react t o i n f l a t i o n b e l o w b o t h forecasts a n d t h e "toler­ ance i n t e r v a l " o f a r o u n d 2 % . I n a c h a p t e r t i t l e d " M o n e t a r y P o l i c y C o n ­ clusions" i n t h e D e c e m b e r 1996 Inflation Report, t h e R i k s b a n k e m p h a ­ sized t h e close c o n n e c t i o n b e t w e e n t h e l a g i n t h e effect o f m o n e t a r y p o l i c y o n i n f l a t i o n a n d t h e n e e d t o m a k e assessments o f f u t u r e i n f l a t i o n w h e n s e t t i n g c u r r e n t policy. I n p a r t i c u l a r , t h e response t o a substantive c h a n g e i n t h e b e h a v i o r o f i n f l a t i o n , w h i c h m a y have b e e n c r e a t e d b y t h e a d o p t i o n o f i n f l a t i o n targets, h a d t o be cautious. Effects o f monetary policy o n demand and inflation can also be difficult to foresee i n that historical relationships may have been changed by the move to a flexible exchange rate and a price stability target. The economy may also move onto new paths that could n o t be predicted when the monetary policy was constructed. I f the economic trend seems to be r u n n i n g counter to the inflation target, the monetary stance is adapted so that inflation gradually comes into line with the target. I n such a situation, an ambition to keep inflation i n line with the target even i n the very short r u n could require more drastic, perhaps unreasonable, monetary policy measures that m i g h t lead to destabilising effects. (Sveriges Riksbank, 1996b, December, p. 26) U n l i k e t h e Reserve B a n k o f N e w Z e a l a n d , t h e R i k s b a n k t r e a t e d t a r g e t breaches as less o f a p r o b l e m t h a n t h e sharp m o v e m e n t s i n m o n e t a r y p o l i c y i n s t r u m e n t s t h a t w o u l d be necessary t o p r e v e n t such breaches. A t t h e t i m e t h e passage q u o t e d above was w r i t t e n , Swedish h e a d l i n e C P I i n f l a t i o n h a d b e e n b e l o w t h e 1 % t o 3% target f o r six m o n t h s . T h o s e breaches d i d n o t cause a collapse o f c r e d i b i l i t y , as can be seen f r o m t h e i n f l a t i o n e x p e c t a t i o n s data, so t h e Riksbank's exercise o f p o l i c y flexibil­ i t y a p p e a r e d t o be costless, at least i n t h e s h o r t r u n . I t m i g h t have b e e n a r g u e d t h a t t h e R i k s b a n k was t r e a t i n g its i n f l a t i o n targets asymmetrically, r e s p o n d i n g less s t r o n g l y to targets u n d e r s h o t t h a n t o targets overshot, m u c h i n t h e same way t h a t t h e B u n d e s b a n k has some-

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t i m e s t r e a t e d its m o n e y - g r o w t h targets. Yet t h e Riksbank's emphasis o n t h e n e e d f o r g r a d u a l i s m a n d its c o n c e r n f o r " d e s t a b i l i z i n g effects," j u x ­ taposed w i t h t h e d e t a i l e d d e s c r i p t i o n o f l o n g e r - t e r m e x p e c t a t i o n s w i t h i n t h e t a r g e t r a n g e , m a k e t h a t i n t e r p r e t a t i o n u n l i k e l y t o be c o r r e c t . M o r e ­ over, w h e t h e r t h e B u n d e s b a n k r e s p o n d e d t o t a r g e t misses i n m o n e y g r o w t h has d e p e n d e d l a r g e l y o n t h e i n f l a t i o n s i t u a t i o n ; t h e B u n d e s b a n k has s h o w n l i t t l e a s y m m e t r y i n r e s p o n d i n g t o i n f l a t i o n rates above a n d b e l o w t h e d e s i r e d level. Sweden's p o l i c y s h o u l d be seen i n s t e a d as an­ o t h e r instance i n w h i c h t r a n s p a r e n c y a n d c o m m u n i c a t i o n ( i n c l u d i n g r e m a r k s a b o u t f o r w a r d - l o o k i n g i n d i c a t o r s a n d u n d e r l y i n g i n f l a t i o n , de­ spite t h e fact t h a t t h e official target was t h e h e a d l i n e C P I ) have e n h a n c e d t h e flexibility o f policy. T h e l i n k b e t w e e n flexibility i n r e s p o n d i n g t o t a r g e t misses a n d trans­ p a r e n c y i n e x p l a i n i n g t h e e c o n o m i c forecast was u n d e r l i n e d i n r e m a r k s b y R i k s b a n k D e p u t y G o v e r n o r Lars H e i k e n s t e n at a c o n f e r e n c e i n J a n u ­ ary 1997. A f t e r s u m m a r i z i n g t h e c o m b i n a t i o n o f factors ( a p p r e c i a t i o n o f t h e k r o n a , decreased m o r t g a g e i n t e r e s t rates, a n d so o n ) t h a t h a d l e d to headline CPI deflation, Heikensten explained why n o monetary-policy m o v e was f o r t h c o m i n g t o b r i n g i n f l a t i o n b a c k i n t o t h e t a r g e t r a n g e : I t is because o f temporary effects that the average level o f inflation i n 1996 is outside the Riksbank's target interval. As a rule, the interval surrounding the target figure should suffice to absorb changes o f this type i n the composition of inflation. That this was not the case i n 1996 had to do with the marked reappraisal o f the situation i n Sweden. (Heikensten, 1997, p. 2) H e r e t h e R i k s b a n k was r e g a r d i n g t h e t a r g e t r a n g e as a source o f b u i l t - i n flexibility. However, w h e n faced w i t h t h e c h o i c e o f r e s p o n d i n g t o t e m p o ­ r a r y factors o r m i s s i n g a r a n g e t h a t h a d p r o v e d t o b e t o o n a r r o w , t h e R i k s b a n k a l l o w e d t h e target t o be missed. D e p u t y G o v e r n o r H e i k e n s t e n ' s s t a t e m e n t also u n d e r s c o r e d t h e l i m i t s o f m o n e t a r y c o n t r o l ; i n p a r t i c u l a r , t h e R i k s b a n k appears t o have t a k e n t h e view t h a t changes i n i n f l a t i o n a r y e x p e c t a t i o n s , even salutary ones l i n k e d t o t h e a d o p t i o n o f a n e w m o n ­ etary f r a m e w o r k , are t o some d e g r e e e x o g e n o u s a n d h e n c e u n c o n t r o l ­ lable. T h u s , m o n e t a r y policy-makers i n Sweden have c h o s e n n o t t o take t o o m u c h credit f o r changes i n i n f l a t i o n a n d i n f l a t i o n expectations. H e i k e n s t e n e x t e n d e d his view a b o u t w h a t m o n e t a r y p o l i c y c a n a n d can­ n o t d o b y r e m i n d i n g his a u d i e n c e : I t was not u n t i l the [government] budget outcome started to t u r n that we could reap the positive effect o n b o n d rates, etc. . . . I n view o f the political

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debate, there may be cause to underscore fiscal policy's importance for m o n ­ etary policy. A tighter fiscal policy normally implies a better situation for inflation; i t makes i t easier for the Riksbank to fulfill the inflation target i n conjunction with low interest rates. I n addition, a fiscal policy which lacks credibility creates problems for monetary policy—as was the case d u r i n g m u c h o f the period 1990-95. The radical lowering o f interest rates d u r i n g 1996 is s o m e t h i n g f o r w h i c h o u r thanks are very m u c h due to fiscal policy. (Heikensten, 1997, p. 3) T h e i m p o r t a n c e o f a l l these d e v e l o p m e n t s , b o t h w i t h i n a n d o u t s i d e t h e c o n t r o l o f t h e R i k s b a n k , was p r i m a r i l y t h e i r i m p l i c a t i o n f o r t h e i n f l a t i o n forecast. As l o n g as t h e i n f l a t i o n forecast r e m a i n e d w i t h i n t h e d e s i r e d b o u n d s , t h e r e was n o n e e d t o r e s p o n d t o t h e r e a l i z a t i o n o f l o w e r - t h a n t a r g e t i n f l a t i o n . As H e i k e n s t e n p u t i t , "Figures f o r 'yesterday's' i n f l a t i o n are t h e r e f o r e r e l e v a n t o n l y i n so far as t h e y say s o m e t h i n g a b o u t t h e f u t u r e . . . . I n t h e m a i n , however, [ t h e last six m o n t h s ' figures] have r e f l e c t e d t h e s t r e n g t h o f t r a n s i e n t effects" (Ibid., p . 5 ) . D u r i n g j a n u a r y a n d F e b r u a r y 1997, year-over-year h e a d l i n e C P I i n f l a ­ t i o n c o n t i n u e d to decline, while u n d e r l y i n g inflation ( e x c l u d i n g house m o r t g a g e rates a n d t h e effects o f changes i n i n d i r e c t taxes a n d subsi­ dies) r e m a i n e d u n c h a n g e d at 1 % . I n t h e M a r c h 1997 Inflation Report, the Riksbank c o n t i n u e d to attribute m u c h o f the unexpectedly l o w infla­ t i o n t o a " l o w e r i n f l a t i o n p r o p e n s i t y " i n t h e Swedish e c o n o m y , b u t i t also a c k n o w l e d g e d t h a t " r e g i s t e r e d i n f l a t i o n as m e a s u r e d w i t h t h e C P I has b e e n affected b y t r a n s i t o r y factors t o a g r e a t e r e x t e n t t h a n e x p e c t e d " (Sveriges R i k s b a n k , 1 9 9 7 b , M a r c h , p . 4 ) . O f e q u a l c o n c e r n t o t h e R i k s b a n k , as m e a s u r e d b y t h e n u m b e r o f pages d e v o t e d t o t h e t o p i c , was t h e c o n t i n u i n g sluggishness o f e m p l o y m e n t g r o w t h t h r o u g h t h e 1990s. Analysis o f t h e B e v e r i d g e c u r v e f o r t h e Swedish e c o n o m y ( t h e r e l a t i o n ­ s h i p b e t w e e n t o t a l u n e m p l o y m e n t a n d u n f i l l e d j o b vacancies) i n d i c a t e d t h a t t h e process o f m a t c h i n g j o b s a n d w o r k e r s i n t h e l a b o r m a r k e t was b e c o m i n g less a n d less effective. T h e discussion was as m u c h t o s h o w w h y s u c h u n e m p l o y m e n t was n o t d u e t o m o n e t a r y p o l i c y as t o clarify this issue o f p u b l i c debate. I n general, however, the pattern i n recent years suggests that Sweden is now experiencing the problems o f persistently high unemployment that the rest o f Western Europe has been facing i n recent decades Diminishing labour market efficiency implies that unemployment acts as less o f a restraint o n wage formation and the h i g h unemployment becomes still more permanent. This could be one reason why 1995 settlements gave wage increases around 6 per cent even though unemployment was rising. (Sveriges Riksbank, 1997b, March, p. 13).

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I f u n e m p l o y m e n t i n Sweden was n o l o n g e r m u c h r e l a t e d e i t h e r t o m o n ­ etary p o l i c y o r t h e level o f i n f l a t i o n , t h e R i k s b a n k a r g u e d , t h e n r i s i n g u n e m p l o y m e n t s h o u l d n o t be used as a j u s t i f i c a t i o n f o r easing m o n e t a r y policy. Pressures f o r a response t o t h e u n e m p l o y m e n t p r o b l e m , however, were i m p l i c i t l y a c k n o w l e d g e d w i t h r e p e a t e d references i n t h e M a r c h Inflation Report t o h o w f a r t h e r e p o rate h a d already b e e n l o w e r e d {e.g., " I n t h e course o f 1996 t h e r e p o rate was l o w e r e d a t o t a l o f 4.81 percentage p o i n t s " [ p . 7 ] ) . T h e a u t h o r s o f t h e Inflation Report r e m i n d e d Swedes t h a t f o r a s m a l l , o p e n e c o n o m y , t h e a c t u a l effect o f m o n e t a r y p o l i c y was i n t h e c o m b i n a t i o n o f i n f l a t i o n a n d e x c h a n g e rate: The somewhat higher real short-term interest rate i n the early part o f 1997 has thus been countered by a weaker real exchange rate. Since the Decem­ ber report, the overall monetary conditions—the impact o f interest and ex­ change rates o n demand—have become somewhat m o r e expansionary. (Sveriges Riksbank, 1997b, March, p . 1 9 ) 15

F o r a l l t h e e x p l a n a t i o n s a n d j u s t i f i c a t i o n s , however, m o n t h s o f b e l o w t a r g e t i n f l a t i o n h a d b e g u n t o t a k e a t o l l . I n m o s t surveys o f i n f l a t i o n e x p e c t a t i o n s c i t e d b y t h e R i k s b a n k , o n e - a n d two-year a h e a d i n f l a ­ t i o n expectations were below the 2 % target. T h e Riksbank a t t e m p t e d t o address t h e f a c t t h a t , i n 1997, t r a n s i t i o n a l f a c t o r s w o u l d c o n t i n u e to keep headline inflation below u n d e r l y i n g inflation a n d below the target. These observations l e d t o t h e c o n c l u s i o n t h a t t h e Riksbank's " m a i n scenario a n d its u n d e r l y i n g assumptions d o n o t p r e c l u d e s o m e w h a t m o r e s t i m u l a t o r y m o n e t a r y c o n d i t i o n s because i n f l a t i o n in 1998 is e x p e c t e d t o be s o m e w h a t u n d e r 2 p e r c e n t " (Sveriges R i k s b a n k , 1997b, M a r c h , p . 5; o u r e m p h a s i s ) . T h e Riksbank's l o o k i n g a h e a d t o 1998 raises a k e y p o i n t : W h i l e Swedish m o n e t a r y p o l i c y w o u l d ease i n response t o b e l o w target i n f l a t i o n , l e t t i n g t h e t a r g e t floor stabilize o u t p u t a n d prices as we saw i n Canada, i t w o u l d d o so o n l y t o t h e e x t e n t t h a t c u r r e n t c o n d i t i o n s presaged b e l o w - t a r g e t i n f l a t i o n i n t h e f u t u r e . T h e R i k s b a n k w o u l d n o t ease p o l i c y i n response t o l o w i n f l a t i o n i f t h e l o w rate was d u e e n t i r e l y t o t r a n s i t o r y factors; similarly, m o n e t a r y p o l i c y w o u l d n o t ease i n response to m o u n t i n g u n e m p l o y m e n t i f the predictive relationship between u n ­ e m p l o y m e n t a n d i n f l a t i o n n o l o n g e r h e l d . T h i s strategy s h o u l d n o t b e i n t e r p r e t e d as saying t h a t t h e R i k s b a n k was u n c o n c e r n e d a b o u t r e a l o u t ­ comes o r a b o u t m a i n t a i n i n g i n f l a t i o n above t h e floor o f t h e t a r g e t r a n g e ; i t does i n d i c a t e a r e c o g n i t i o n t h a t t h e lags o f m o n e t a r y p o l i c y i m p l y t h e need f o r forward-looking policies.

200 T h r o u g h mid-1997, headline CPI inflation

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fluctuated

between 0.0%

a n d 0 . 2 % , a n d u n d e r l y i n g i n f l a t i o n stayed b e t w e e n 1 % a n d 1.5% ( b y v a r i o u s m e a s u r e s ) . B o t h rates w e r e i n l i n e w i t h R i k s b a n k forecasts. T h e many months during which headline inflation had remained below target w i t h o u t i n d u c i n g a m o n e t a r y - p o l i c y response o r sanctions f r o m t h e g o v e r n m e n t (or, f o r t h a t m a t t e r , w i t h o u t l e a d i n g t o p r o t e s t s f r o m t h e p u b l i c o r t h e financial m a r k e t s ) r e p r e s e n t e d a de facto shift o f p o l i c y toward targeting underlying rather than headline inflation. The need to respond only to t r e n d inflation (and n o t to transitory i n f l a t i o n shocks) i n o r d e r t o c a r r y o u t a f o r w a r d - l o o k i n g p o l i c y c o m p e l l e d Swed­ ish policy-makers to m a t c h t h e i r practice to that o f o t h e r inflation-tar­ g e t i n g countries, despite the differences i n declarations. C o n t i n u i n g i n t h i s d i r e c t i o n , t h e R i k s b a n k discussed i n g r e a t d e t a i l v a r i o u s m e a ­ sures o f u n d e r l y i n g i n f l a t i o n i n its J u n e 1997 Inflation

Report. I t also

w a r n e d o f t h e t r a n s i t o r y effects t h a t g o v e r n m e n t p r o p o s a l s f o r t a x c h a n g e s i n t h e S p r i n g E c o n o m i c B i l l w e r e l i k e l y t o have o n h e a d l i n e inflation, p r e p a r i n g the public for the l i k e l i h o o d that monetary policy w o u l d n o t r e s p o n d t o t h o s e effects (Sveriges R i k s b a n k , 1 9 9 7 b , J u n e , p. 28). T h e p r o l o n g e d divergence o f u n d e r l y i n g inflation f r o m headline i n f l a t i o n , w h i c h s e e m e d t o i n d i c a t e t h a t o n e - t i m e i n f l a t i o n a r y shocks w e r e n o t b e i n g passed t h r o u g h t o i n c r e a s e s i n wages a n d p r i c e s , p r o m p t e d t h e R i k s b a n k t o ask, "Has t h e i n f l a t i o n process c h a n g e d ? " U s i n g P h i l l i p s - c u r v e e s t i m a t i o n , R i k s b a n k researchers analyzed w h e t h e r the break i n household inflation expectations that appeared i n t h e i r surveys t r a n s l a t e d i n t o a c h a n g e i n t h e i n f l a t i o n process.

16

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ers f o u n d t h a t w h e n d e m a n d was r e p r e s e n t e d b y i n d i c a t o r s o f a n o u t ­ p u t g a p , i n f l a t i o n t e n d e d t o b e o v e r p r e d i c t e d f o r t h e years after 1993; h o w e v e r , " w h e n d e m a n d is r e p r e s e n t e d i n s t e a d b y u n e m p l o y m e n t , t h e r e l a t i o n s h i p n o l o n g e r overestimates i n f l a t i o n i n t h e p e r i o d after 1993" (Sveriges R i k s b a n k , 1 9 9 7 b , J u n e , p . 9 ) . As we m e n t i o n e d i n C h a p t e r 6, C a n a d a also e x p e r i e n c e d a p e r i o d o f u n e x p e c t e d l y l o w ( b e l o w - t a r g e t r a n g e ) rates o f b o t h u n d e r l y i n g i n f l a t i o n a n d h e a d l i n e C P I i n f l a t i o n i n t h e 1990s. H o w e v e r , since i n C a n a d a l o w i n f l a t i o n was a c c o m p a n i e d b y recession ( r a t h e r t h a n b y t h e c o m b i n a t i o n o f G D P g r o w t h a n d r i s i n g u n e m p l o y m e n t experienced i n Sweden a n d i n E u r o p e generally), the B a n k o f C a n a d a t o o k t h e l o w i n f l a t i o n as e v i d e n c e t h a t p r a c t i c e s o f wage- a n d p r i c e - f o r m a t i o n w e r e slow t o c h a n g e , d e s p i t e t h e d o w n w a r d shift i n i n f l a t i o n expectations.

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Key Lessons from Sweden's Experience Sweden's e x p e r i e n c e illustrates m a n y o f t h e r e c u r r i n g t h e m e s c o n c e r n ­ i n g t h e r e l a t i o n s h i p o f flexibility a n d t r a n s p a r e n c y i n t h e i n f l a t i o n - t a r ­ g e t i n g f r a m e w o r k . As i n a l l t h e o t h e r c o u n t r i e s s t u d i e d h e r e , Sweden's a d o p t i o n o f i n f l a t i o n targets was n o i n d i c a t i o n t h a t t h e c e n t r a l b a n k was u n c o n c e r n e d a b o u t o u t p u t , e m p l o y m e n t , a n d f i n a n c i a l stability i n t h e s h o r t r u n . O n t h e c o n t r a r y , its c o n c e r n f o r these aspects o f t h e e c o n o m y was d e m o n s t r a t e d b y t h e l o n g t r a n s i t i o n f r o m t h e exchange-rate p e g t o t h e i n f l a t i o n target, w h i c h effectively served as a n escape clause. ( I n ­ d e e d , as w i t h t h e U n i t e d K i n g d o m , i f l o w i n f l a t i o n h a d b e e n t h e o n l y g o a l o f Sweden's policy, t h e r e w o u l d have b e e n l i t t l e b a r r i e r t o t h a t c o u n ­ t r y m a i n t a i n i n g its E C U p e g , o r s e t t i n g i t at a d i f f e r e n t parity.) T h e r e p l a c e m e n t o f a n exchange-rate-based p o l i c y t h a t was i n d i r e c t c o n f l i c t w i t h d o m e s t i c e c o n o m i c goals w i t h a m o r e flexible i n f l a t i o n - t a r g e t i n g r e g i m e a p p a r e n t l y d i d n o t d a m a g e t h e R i k s b a n k ' s c r e d i b i l i t y , despite t h e crisis t h a t r e s u l t e d i n t h e loss o f t h e exchange-rate p e g . T h e e v o l u t i o n o f Sweden's d e f i n i t i o n o f t h e i n f l a t i o n t a r g e t d e m o n ­ strates a n o t h e r aspect o f t h e r e l a t i o n s h i p b e t w e e n t r a n s p a r e n c y a n d flex­ i b i l i t y . F r o m t h e outset, t h e R i k s b a n k a n d t h e g o v e r n m e n t stated t h a t h e a d l i n e C P I i n f l a t i o n w o u l d be t a r g e t e d , p r o b a b l y r e f l e c t i n g t h e r o l e o f t h e h e a d l i n e C P I i n n a t i o n a l wage b a r g a i n i n g . I t m a y have also b e e n a concession t o those w h o f e l t t h a t a s t r o n g , t r a n s p a r e n t c o m m i t m e n t t o p r i c e stability, p e r h a p s even t o a price-level target, was necessary t o offset t h e c r e d i b i l i t y losses a r i s i n g f r o m t h e loss o f t h e p e g . D e s p i t e its stated i n t e n t i o n s , however, t h e R i k s b a n k d i d n o t r e s p o n d t o r e p e a t e d shortt e r m movements i n headline inflation, a policy that a m o u n t e d to adop­ t i o n o f a n u n d e r l y i n g o r c o r e i n f l a t i o n target. I n o t h e r w o r d s , w h e n faced w i t h t h e c h o i c e , t h e R i k s b a n k c o u l d n o t b r i n g itself t o sacrifice i m p o r ­ t a n t e l e m e n t s o f flexibility t o achieve m a x i m u m transparency. I n s t e a d , Sweden's p r a c t i c e was l i k e t h a t o f o t h e r i n f l a t i o n targeters, w h o r e g u ­ l a r l y i g n o r e "special" o r " t r a n s i t o r y " i n f l u e n c e s o n c u r r e n t i n f l a t i o n rates, so l o n g as t h e y d o n o t affect t h e forecast o f f u t u r e i n f l a t i o n . T h e r e c o g n i t i o n o f these realities b y t h e R i k s b a n k p r o b a b l y accounts f o r t h e i n c r e a s e d v i s i b i l i t y a n d completeness o f t h e Inflation Report, as w e l l as o t h e r efforts t o i n f o r m a n d educate t h e p u b l i c . As i n a l l t h e o t h e r c o u n t r i e s we have s t u d i e d , t h e t r a n s p a r e n c y a c h i e v e d b y b e t t e r c o m m u ­ n i c a t i o n was v i e w e d as a n i m p o r t a n t b e n e f i t f o r policy. I n p a r t i c u l a r , t h e R i k s b a n k was able t o convey t h a t a n a r r o w t a r g e t d e f i n i t i o n i n t h e s h o r t

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r u n d i d n o t conflict w i t h the pursuit o f a long-run goal for t r e n d infla­ t i o n . I n t h i s respect, t h e R i k s b a n k n o w m o s t resembles t h e B a n k o f Canada, w h i c h c o n s t a n t l y c o m p a r e s d e v e l o p m e n t s i n h e a d l i n e i n f l a t i o n a n d core inflation, targeting a n d r e s p o n d i n g to core inflation i n the s h o r t r u n b u t a s k i n g t o be j u d g e d o n t h e p e r f o r m a n c e o f h e a d l i n e i n f l a ­ t i o n i n the l o n g r u n .

Three Small Open Economies: Israel, Australia, and Spain

INFLATION t a r g e t i n g has spread b e y o n d its o r i g i n a l p r o p o n e n t s t o a d i ­ verse set o f c o u n t r i e s . I n this chapter, we e x a m i n e t h e e x p e r i e n c e s o f three small, o p e n economies: Israel, Australia, a n d Spain. A l l three a d o p t e d i n f l a t i o n t a r g e t i n g after e x t e n d e d d i s i n f l a t i o n s a n d even l o n g e r histories o f i n f l a t i o n . T h o u g h t h e y d i f f e r a l o n g m a n y d i m e n s i o n s , i n ­ c l u d i n g their degree o f development a n d o f integration w i t h the major i n d u s t r i a l e c o n o m i e s , these c o u n t r i e s r e s p o n d e d t o t h e challenges o f t h e n e w p o l i c y a p p r o a c h i n s i m i l a r ways. E a c h a c h i e v e d h i s t o r i c a l l y l o w i n f l a t i o n rates, w h i l e at t h e same t i m e e x h i b i t i n g fiscal r e s t r a i n t a n d m a n a g i n g t h e t r a n s i t i o n f r o m exchange-rate pegs t o t h e m o r e flexible a p p r o a c h . T h e i r success s u p p o r t s t h e view t h a t i n f l a t i o n t a r g e t i n g is a viable strategy i n a w i d e r a n g e o f e c o n o m i c c o n t e x t s .

Key Features of Inflation Targeting in Israel, Australia, and Spain •

I n a l l t h r e e cases, t h e t r a n s i t i o n t o i n f l a t i o n t a r g e t i n g was g r a d u a l , w i t h n o sharp shift i n r e g i m e s as i n N e w Z e a l a n d a n d t h e U n i t e d K i n g d o m . T h e precise t i m i n g o f t h e A u s t r a ­ l i a n m o v e t o i n f l a t i o n t a r g e t i n g is p a r t i c u l a r l y d i f f i c u l t t o p i n ­ p o i n t . As t h e p o l i c y f r a m e w o r k s o f these c o u n t r i e s b e c a m e b e t t e r d e f i n e d , however, p o l i c y t r a n s p a r e n c y increased, a n d i n f l a t i o n e x p e c t a t i o n s stabilized.

•

A l l t h r e e c o u n t r i e s a d o p t e d i n f l a t i o n t a r g e t i n g as a m e a n s o f b a l a n c i n g t h e u n c e r t a i n t i e s o f t h e i r e x t e r n a l e c o n o m i c envi­ r o n m e n t , p a r t i c u l a r l y t h e b e h a v i o r o f t h e e x c h a n g e rate, w i t h t h e n e e d t o a n c h o r t h e p u b l i c ' s i n f l a t i o n e x p e c t a t i o n s . Israel a n d Spain g r a d u a l l y de-emphasized strict exchange-rate bands

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i n favor o f a p o l i c y t h a t r e s p o n d s t o exchange-rate changes o n l y w h e n t h e y are d e e m e d l i k e l y t o affect d o m e s t i c prices. A u s t r a l i a chose a " t h i c k p o i n t " i n f l a t i o n t a r g e t r a t h e r t h a n a t a r g e t r a n g e a n d has p a i d relatively less a t t e n t i o n t o t h e beh a v i o r o f t h e e x c h a n g e rate. •

Israel a n d S p a i n have c h o s e n t o t a r g e t i n f l a t i o n as m e a s u r e d by t h e all-items " h e a d l i n e " C P I . A u s t r a l i a ' s reference i n f l a t i o n series is a n " u n d e r l y i n g " i n f l a t i o n series t h a t excludes m a n y v o l a t i l e prices.

•

L i k e a l l t h e o t h e r c o u n t r i e s we have discussed, these t h r e e c o u n t r i e s chose a n i n f l a t i o n g o a l g r e a t e r t h a n zero, b o t h at t h e outset a n d over t h e l o n g e r t e r m . I n Israel, a l t h o u g h furt h e r d i s i n f l a t i o n is p l a n n e d , even a t a r g e t i n t h e r a n g e o f 8% t o 1 0 % i n f l a t i o n has served t o a n c h o r i n f l a t i o n e x p e c t a t i o n s . O n c e a g a i n , t h e r e appears t o be n o t h i n g special a b o u t zero i n f l a t i o n as a n o m i n a l a n c h o r .

•

I n Israel, r e s p o n s i b i l i t y f o r s e t t i n g t h e i n f l a t i o n t a r g e t has l a i n primarily w i t h the Finance Minister, i n consultation w i t h the B a n k o f Israel. S p a i n t o o k t h e o p p o s i t e tack, g i v i n g t h e B a n c o de E s p a ñ a the p r i c e stability m a n d a t e r e q u i r e d by the M a a s t r i c h t treaty. I n A u s t r a l i a , t h e a d o p t i o n o f i n f l a t i o n targets was a u n i l a t e r a l d e c i s i o n b y t h e c e n t r a l b a n k .

•

Israel a n d A u s t r a l i a m a d e m o r e e x p l i c i t statements o f t h e cent r a l bank's r e s p o n s i b i l i t y f o r t h e s h o r t - r u n r e a l effects o f m o n etary p o l i c y t h a n d i d any o f t h e c o u n t r i e s c o n s i d e r e d i n t h e p r e v i o u s chapters. H o w e v e r , n o n e o f these t h r e e c o u n t r i e s i n s t i t u t e d e x p l i c i t escape clauses o f t h e N e w Z e a l a n d sort. Instead, all three a d o p t e d a gradualist approach to b r i n g i n g i n f l a t i o n b a c k t o t a r g e t f o l l o w i n g a m a c r o e c o n o m i c shock.

•

Since a l l t h r e e c o u n t r i e s have sizable p u b l i c sectors a n d pervasive i n d e x a t i o n o f wages t o i n f l a t i o n , t h e c e n t r a l banks expressed c o n c e r n a b o u t t h e a b i l i t y o f t h e w a g e - b a r g a i n i n g m e c h a n i s m s t o adjust t o a l o w - i n f l a t i o n e n v i r o n m e n t . U n l i k e t h e c e n t r a l banks o f C a n a d a a n d N e w Z e a l a n d , w h i c h w e r e o p t i m i s t i c f r o m t h e start, t h e c e n t r a l banks o f these t h r e e c o u n t r i e s t o o k f o r g r a n t e d t h a t wage structures w o u l d be slow

T H R E E SMALL OPEN

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to c h a n g e . T h e s e t h r e e c e n t r a l banks also f r e q u e n t l y spoke i n s u p p o r t o f fiscal c o n s o l i d a t i o n . I n e m p h a s i z i n g t h e i m p o r ­ tance o f l a b o r m a r k e t f l e x i b i l i t y a n d fiscal p o l i c y f o r m a c r o economic outcomes, the monetary authorities attempted to give clear signals t o t h e p u b l i c a b o u t w h a t m o n e t a r y p o l i c y c o u l d a n d c o u l d n o t be e x p e c t e d t o achieve. •

T o m a i n t a i n t r a n s p a r e n c y o f policy, a l l t h r e e c e n t r a l banks have p u b l i s h e d r e g u l a r r e p o r t s o n m o n e t a r y p o l i c y a n d i n f l a ­ t i o n , p r o v i d e d p u b l i c testimonies, a n d encouraged p u b l i c discussions a l o n g t h e lines o f those i n o t h e r i n f l a t i o n - t a r g e t ­ i n g c o u n t r i e s . T h e i r d e c i s i o n t o d o so is a r e m i n d e r t h a t a c o m m i t m e n t t o i n f l a t i o n t a r g e t i n g leads n a t u r a l l y t o a c o m ­ m i t m e n t t o greater p u b l i c disclosure a n d e x p l a n a t i o n s . N o n e o f t h e t h r e e c o u n t r i e s h a d h a d such a t r a d i t i o n i n t h e past.

•

B o t h Israel a n d S p a i n e x p e r i e n c e d a b r i e f c o n f l i c t b e t w e e n t h e i r surviving ( t h o u g h looser) exchange-rate targets a n d t h e i r d o m e s t i c i n f l a t i o n goals. T h e y chose n o t t o r e s p o n d t o shortt e r m exchange-rate f l u c t u a t i o n s , however, a n d m a n a g e d t o k e e p b o t h i n f l a t i o n e x p e c t a t i o n s a n d i n t e r e s t rates stable. A u s t r a l i a faced a s i m i l a r p o t e n t i a l f o r c o n f l i c t w h e n c u r r e n t i n f l a t i o n a n d forecast i n f l a t i o n d i v e r g e d i n 1995 i n response to a s h o r t - r u n p r i c e rise. K e e p i n g its focus o n t h e i n f l a t i o n target, however, t h e A u s t r a l i a n Reserve B a n k e x p l a i n e d w h y i t chose n o t t o react t o t h e increase. A g a i n , these episodes i l l u s t r a t e t h a t t r a n s p a r e n c y tends t o e n h a n c e t h e f l e x i b i l i t y a n d effectiveness o f m o n e t a r y p o l i c y i n t h e l o n g r u n .

ISRAEL Israel's Adoption of an Inflation Target O n D e c e m b e r 17, 1 9 9 1 , t h e M i n i s t r y o f Finance a n d t h e B a n k o f Israel j o i n t i y a n n o u n c e d t h a t C P I i n f l a t i o n w o u l d be k e p t b e t w e e n 14% a n d 15% d u r i n g 1992. I n each year since, a n i n f l a t i o n target has b e e n a n n o u n c e d for t h e f o l l o w i n g year. T h e Finance M i n i s t e r has h a d p r i m a r y responsibil­ ity f o r setting t h e target, usually i n c o n s u l t a t i o n w i t h t h e B a n k o f Israel. 1

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Israel is u n i q u e a m o n g t h e i n f l a t i o n - t a r g e t i n g c o u n t r i e s we have s t u d ­ i e d i n at least t w o ways. First, i t is t h e o n l y c o u n t r y t h a t b e g a n t a r g e t i n g i n f l a t i o n w h e n its i n f l a t i o n rate was at d o u b l e - d i g i t levels. S e c o n d , i t is t h e o n l y o n e o f those c o u n t r i e s t h a t sets official targets f o r b o t h i n f l a t i o n a n d t h e e x c h a n g e rate. Reliance o n t h e e x c h a n g e rate as a g u i d e t o p o l i c y has d i m i n i s h e d over t i m e , however, as t h e c r e d i b i l i t y o f t h e B a n k o f Israel's c o m m i t m e n t t o p r i c e stability has i m p r o v e d a n d as i n f l a t i o n has b e g u n to come under control. 2

Israel's m o v e m e n t t o w a r d i n f l a t i o n t a r g e t i n g b e g a n at a time o f mac­ r o e c o n o m i c crisis. I n 1985, u n d e r e x t r e m e fiscal pressure f r o m t h e costs o f t h e w a r i n L e b a n o n a n d its extensive social safety n e t , t h e c o u n t r y was o n t h e verge o f h y p e r i n f l a t i o n . T h e fiscal d e f i c i t was r u n n i n g at a n u n ­ sustainable rate o f 1 4 % o f GDP, a n d ( p u b l i c a n d p r i v a t e ) d e b t o b l i g a ­ t i o n s t o f o r e i g n e r s w e r e at 8 0 % o f GDP. I n J u l y 1985, u n d e r t h e l e a d e r s h i p o f B a n k o f Israel G o v e r n o r M i c h a e l B r u n o , Israel a d o p t e d a m a j o r e c o n o m i c s t a b i l i z a t i o n p r o g r a m . I n a d d i ­ t i o n t o steps d e s i g n e d t o c o n t r o l t h e b u d g e t d e f i c i t , t h e g o v e r n m e n t a n n o u n c e d a n exchange-rate t a r g e t t o serve as a n o m i n a l a n c h o r f o r prices. F o r t h e first year, t h e shekel's e x c h a n g e rate was fixed against t h e U . S . d o l l a r ; t h e r e a f t e r i t was fixed against a c u r r e n c y basket c o n s i s t i n g o f t h e c u r r e n c i e s o f t h e G5 c o u n t r i e s . 3

T h e p r o g r a m was r e m a r k a b l y successful. W i t h i n a few m o n t h s , i n f l a ­ t i o n h a d f a l l e n f r o m a n n u a l rates o f a b o u t 4 0 0 % t o 2 0 % . M o r e o v e r , t h a t g a i n h e l d : U n t i l 1990, i n f l a t i o n i n Israel r e m a i n e d i n t h e v i c i n i t y o f 1 6 % t o 1 8 % p e r year. B u t even t h a t rate o f i n f l a t i o n was t o o h i g h t o be c o n s i s t e n t w i t h a f i x e d e x c h a n g e rate f o r t h e shekel. As I s r a e l i prices rose, t h e fixed v a l u e o f t h e s h e k e l i m p l i e d a steady r e a l a p p r e c i a t i o n o f t h e e x c h a n g e rate a n d a loss o f c o m p e t i t i v e n e s s f o r t h e I s r a e l i e x p o r t sector. M o r e o v e r , i n o r d e r t o m a i n t a i n t h e fixed e x c h a n g e rate, t h e c e n t r a l b a n k h a d t o i n t e r ­ vene f r e q u e n t l y i n t h e f o r e i g n e x c h a n g e m a r k e t , l e a d i n g t o w i d e swings b o t h i n i n t e r e s t rates a n d i n f o r e i g n reserves. O c c a s i o n a l d e v a l u a t i o n s o f t h e s h e k e l , as i n J a n u a r y 1987, f a i l e d t o f u l l y resolve t h e p r o b l e m o f ex­ change-rate m a n a g e m e n t , since t h e r e a l e x c h a n g e rate r e m a i n e d h i g h l y v a r i a b l e a n d d i f f i c u l t t o p r e d i c t , w i t h c o n s e q u e n t damage t o t r a d e . I n J a n u a r y 1989, t h e g o v e r n m e n t d e c i d e d t o l e t t h e e x c h a n g e rate fluctuate w i t h i n n a r r o w bands, w i t h p r o v i s i o n s f o r i n t e r m i t t e n t devalua­ t i o n s o f t h e c e n t r a l p a r i t y as w e l l . I n i t i a l l y t h e w i d t h o f t h e exchange-rate b a n d was set at 3% o n e i t h e r side o f t h e target; t h a t t o l e r a n c e was i n ­ creased t o 5% i n M a r c h 1990. D e v a l u a t i o n s o f t h e c e n t r a l p a r i t y o c c u r r e d i n J u n e 1989, M a r c h 1990, S e p t e m b e r 1990, a n d A p r i l 1 9 9 1 .

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A l t h o u g h the i n t r o d u c t i o n o f the bands a r o u n d the central parity drastically r e d u c e d real-exchange rate v a r i a b i l i t y , t h e p e r i o d i c r e a l i g n ­ m e n t s o f t h e e x c h a n g e rate h a d u n d e s i r a b l e side effects, m o s t n o t a b l y r e c u r r e n t speculative attacks against t h e shekel: 4

[T]he band was shifted upwards by 6 to 10% every six to eight months. N o t only d i d the new system fail to stop the speculative capital movements, but after March 1991 these even intensified, once i t had become clear that un­ der an exchange rate band discrete changes i n the exchange rate could still occur. (Ben-Bassat, 1995, p. 21) Increasingly, m o n e t a r y p o l i c y makers were d i v e r t e d f r o m i n f l a t i o n c o n t r o l a n d o t h e r m a c r o e c o n o m i c objectives by t h e n e e d t o r e s p o n d t o specula­ tive attacks o n t h e shekel. S o m e t h i n g h a d t o be d o n e . I n D e c e m b e r 1 9 9 1 , after standing f i r m against another major speculative attack, t h r o u g h a con­ siderable rise i n short-term interest rates, the authorities relaxed the fixity o f the central parity rate. Instead, they announced an upward crawl o f this rate at a pre-announced pace . . . [ U ] p o n i m p l e m e n t i n g the shift to a crawling band regime the authorities had to determine the upward slope o f the band. I t was decided that the slope o f the pre-announced rate o f crawl o f the cen­ tral parity for a given year would be approximately equal to the difference between the authorities' inflation target for that year and a forecast o f the average inflation rate for Israel's main trading partners. This is how the infla­ tion target became a goal o f policy. (Bufman et al, 1995, pp. 172-73, emphasis i n the original) T h e d e c i s i o n t o relate t h e exchange-rate t a r g e t t o a n i n f l a t i o n t a r g e t was m a d e j o i n t l y by t h e F i n a n c e M i n i s t r y a n d t h e B a n k o f Israel. I t was n o t c o n s i d e r e d a m a j o r p o l i t i c a l step at t h e t i m e . I n fact, t h e i n f l a t i o n t a r g e t was m e n t i o n e d o n l y i n t h e second-to-last p a r a g r a p h o f t h e press release a n n o u n c i n g t h e i n t r o d u c t i o n o f a " c r a w l i n g b a n d " f o r t h e e x c h a n g e rate. T h e a d o p t i o n o f a n i n f l a t i o n t a r g e t d i d n o t m e a n t h a t a lost n o m i n a l a n c h o r was b e i n g r e p l a c e d (as i n t h e U n i t e d K i n g d o m o r S w e d e n ) , n o r was i t i n t e n d e d t o l o c k i n d i s i n f l a t i o n a r y gains (as i n N e w Z e a l a n d a n d C a n a d a ) . Rather, i t seems t o have b e e n a n a t t e m p t t o l o o s e n t h e straitj a c k e t i m p o s e d b y t h e fixed-exchange-rate r e g i m e o n m o n e t a r y p o l i c y o n c e t h e p e g h a d l o w e r e d i n f l a t i o n a n d h a d b e s t o w e d some c r e d i b i l i t y o n the central bank. [ I ] t is safe to assert that the explicit inflation target was n o t embraced by policymakers because o f its own virtues, but rather as an i m p o r t a n t i n p u t to the choice o f a specific upward slope for the crawling exchange rate band. I t

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is perhaps for this reason that the i n t r o d u c t i o n o f an explicit inflation target for 1992 was not even noticed by large segments o f the public ( i n c l u d i n g economists) i n Israel . . . [ T ] h e r e was no clear perception o f the degree o f commitment by the authorities vis-à-vis the target. I t was only gradually, over the years, that the inflation target began to have a life o f its own. (Ibid., p. 173, emphasis i n the original) Paying a t t e n t i o n t o b o t h t h e exchange rate a n d i n f l a t i o n was a n at­ t e m p t t o balance m a c r o e c o n o m i c objectives. I n a n e c o n o m y as s m a l l a n d o p e n as Israel's, t h e e x c h a n g e rate is a variable t h a t c a n n o t be i g n o r e d by m o n e t a r y policy. We have seen t h e p o l i t i c a l a n d o p e r a t i o n a l difficulties t h e Reserve B a n k o f N e w Z e a l a n d e n c o u n t e r e d w h e n i t was p e r c e i v e d as b e i n g u n c o n c e r n e d w i t h t h e e x c h a n g e rate. Israeli policy-makers appar­ e n t l y d e c i d e d t h a t exchange-rate stability was t o o i m p o r t a n t a n objective f o r t h e exchange-rate bands t o be a b a n d o n e d altogether. However, t h e persistence o f i n f l a t i o n i n t h e l o w d o u b l e - d i g i t range was also a c o n c e r n ; t h e i n f l a t i o n targets were a n a t t e m p t t o deal w i t h t h a t p r o b l e m . F o r t h e first t i m e , t h e a u t h o r i t i e s specified t h e pace at w h i c h progress was t o be m a d e i n l o w e r i n g t h e rate o f i n f l a t i o n . A t t h e same time, t h e y h o p e d t h a t the i n f l a t i o n targets, together w i t h a g r a d u a l a p p r o a c h t o disinflation, w o u l d p r o t e c t t h e e c o n o m y f r o m excessive r e a l costs. I t was felt that the stability provided by this system, along with the favourable aggregate supply conditions, would allow for gradual reduction o f the infla­ tion target and the slope o f the exchange rate crawl, perhaps at little or no cost - i n terms o f real output loss . . . [ T ] here is little public support for an active program to reduce inflation to single-digit Western levels, i f such a program is likely to incur real costs i n the short r u n . (Offenbacher, 1996, pp. 6 1 , 63) U n f o r t u n a t e l y , t h e e v i d e n c e reveals t h a t d i s i n f l a t i o n does g e n e r a t e r e a l costs, i n t e r m s o f lost o u t p u t a n d j o b s , i n t h e s h o r t r u n (see C h a p t e r 1 0 ) . R e c o g n i z i n g t h e p o l i t i c a l p r o b l e m s associated w i t h d i s i n f l a t i o n a n d its b u r d e n s , t h e B a n k o f I s r a e l chose t o take a m o r e o p e n a p p r o a c h w i t h t h e p u b l i c r a t h e r t h a n t r y i n g t o c o n c e a l its d i s i n f l a t i o n a r y i n t e n t i o n s . Its h o p e was t h a t openness a n d p e r s u a s i o n m i g h t e n c o u r a g e m o r e f o r w a r d l o o k i n g b e h a v i o r o n t h e p a r t o f wage- a n d price-setters a n d p e r h a p s p r o m p t a m o v e m e n t away f r o m t h e w i d e s p r e a d i n d e x a t i o n o f c o n t r a c t s . T h e r e was l i t t l e i n t e r n a t i o n a l e x p e r i e n c e t o g o o n at t h e t i m e : T h e o n l y e x p e r i m e n t s w i t h i n f l a t i o n t a r g e t i n g w e r e o f less t h a n t w o years' d u r a ­ t i o n i n N e w Z e a l a n d , a n d o f t e n m o n t h s i n Canada. T h e B a n k ' s d e c i s i o n t o l i n k its exchange-rate p o l i c y t o i n f l a t i o n targets was t h u s a d a r i n g a n d creative step.

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I n summary, the Israeli monetary authorities a n n o u n c e d an inflation t a r g e t after s o m e c e n t r a l - b a n k c r e d i b i l i t y h a d b e e n a c h i e v e d ( f o l l o w i n g t h e 1985 s t a b i l i z a t i o n ) , b u t at a t i m e w h e n f u r t h e r progress t o w a r d p r i c e stability h a d stalled. T h e persistence o f d o u b l e - d i g i t i n f l a t i o n , c o m b i n e d w i t h t h e c o m m i t m e n t t o a f i x e d e x c h a n g e rate, p l a c e d t o o heavy a b u r ­ d e n o n b o t h m o n e t a r y p o l i c y a n d t h e e x p o r t sector. T h e a n n o u n c e m e n t o f an inflation target i n c o n j u n c t i o n w i t h the move toward c o n t r o l l e d d e v a l u a t i o n o f t h e shekel was m e a n t t o d i s c o u r a g e speculative attacks a n d t o focus o n i n f l a t i o n c o n t r o l . A t t h e same t i m e , i t p r o v i d e d t h e m o n ­ etary a u t h o r i t i e s w i t h a f r a m e w o r k i n w h i c h t o c o m m u n i c a t e t h e i n t e n d e d rate o f d i s i n f l a t i o n t o t h e p u b l i c . T h u s , a l m o s t accidentally, t h e I s r a e l i m o n e t a r y a u t h o r i t i e s h a d f o u n d a new, c o h e r e n t a p p r o a c h t o m a k i n g policy.

The Operational Framework of Israel's Inflation Targeting T h e I s r a e l i m o n e t a r y a u t h o r i t i e s chose t o use all-items C P I i n d e f i n i n g t h e i n f l a t i o n target. Prices o f v o l a t i l e items s u c h as f r u i t a n d vegetables are n o t e x c l u d e d f r o m t h a t i n d e x , n o r are m o r t g a g e i n t e r e s t costs o r t h e p r i c e o f a p a r t m e n t s . T h e r a t i o n a l e is t h a t i t e m s whose prices are v o l a t i l e make u p about 40% o f the CPI, and that indexation o f financial and wage contracts t o t h e all-items C P I is still w i d e s p r e a d . M o r e o v e r , prices a n d wages have t r a d i t i o n a l l y b e e n l i n k e d t o t h e all-items " h e a d l i n e " C P I i n Israel. I n its p o l i c y - m a k i n g , t h e B a n k o f Israel p r o b a b l y p u t s as m u c h w e i g h t o n t h e h e a d l i n e C P I (as o p p o s e d t o c o r e o r u n d e r l y i n g i n f l a t i o n measures) as any c e n t r a l b a n k covered i n o u r study. However, " [ d ] espite t h e fact t h a t t h e C P I was chosen as t h e target, i t does n o t serve o n its o w n t o d e t e r m i n e m o n e t a r y policy, a n d t h e t h r e e volatile c o m p o n e n t s a n d u n d e r l y i n g i n f l a t i o n are also t a k e n i n t o c o n s i d e r a t i o n " (Ben-Bassat, 1995, p . 4 3 ) . I t is i n t e r e s t i n g t h a t a core-CPI measure o f i n f l a t i o n t h a t excludes t h e prices o f h o u s i n g , fruits, a n d vegetables was l o w e r t h a n h e a d l i n e C P I i n f l a t i o n i n five o f t h e six years f o l l o w i n g 1992 a n d was less volatile as w e l l . E a c h year Israel a n n o u n c e s its i n f l a t i o n t a r g e t f o r t h e f o l l o w i n g year ( i n some cases, as late as D e c e m b e r ) . Since m o n e t a r y p o l i c y actions i n m o s t c o u n t r i e s affect i n f l a t i o n w i t h lags r a n g i n g f r o m six m o n t h s t o m o r e t h a n t w o years, it is difficult to determine whether the target indeed reflected a strong com­ m i t m e n t by policy-makers, or just a 'realistic' forecast o f inflation to be used to calculate the rate o f crawl o f the central parity exchange rate. This ambi-

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guity as to whether the inflation target is really a 'policy target'—meaning that the authorities are expected to take definitive policy measures to achieve the target—or a reasonable inflation 'forecast' has accompanied the policy since its inception. (Bufman et al, 1995, p. 174) E v i d e n c e has r e c e n t l y b e e n p r e s e n t e d t h a t changes i n t h e B a n k o f Israel's i n s t r u m e n t i n t e r e s t rate a n d i n M l ( n a r r o w m o n e y ) affect i n f l a t i o n rela­ tively q u i c k l y , w i t h t h e m a i n effects o c c u r r i n g w i t h i n t w o q u a r t e r s . I f t h a t e v i d e n c e is c o r r e c t , t h e n even s h o r t - h o r i z o n i n f l a t i o n targets m i g h t b e achievable b y m o n e t a r y p o l i c y i n I s r a e l . I n any event, t h e a n n o u n c e ­ m e n t o f t h e i n f l a t i o n t a r g e t f o r 1997 suggested t h a t t h e t a r g e t h o r i z o n m i g h t be e x t e n d e d t o a m u l t i - y e a r f r a m e w o r k . "Recently t h e g o v e r n m e n t a d o p t e d a m o r e r i g o r o u s l o n g - t e r m strategy a n d d e c i d e d t o c o m p l e t e t h e d i s i n f l a t i o n process by t h e year 2 0 0 1 , w i t h a n i n f l a t i o n rate e q u a l t o t h e level p r e v a i l i n g i n t h e O E C D c o u n t r i e s " ( F r e n k e l , 1996, p . 5 3 ) . Start­ i n g w i t h t h e a n n o u n c e m e n t o f t h e 1998 target, this was e m b o d i e d i n a g o v e r n m e n t c o m m i t m e n t t o r e d u c e i n f l a t i o n gradually, a c k n o w l e d g i n g t h e lags o f m o n e t a r y p o l i c y ' s effect. 5

6

T h e i n f l a t i o n t a r g e t f o r 1992 was f o r m u l a t e d as a n a r r o w r a n g e , o n l y 1 % w i d e , a n d t h e targets f o r 1993 a n d 1994 w e r e f o r m u l a t e d as p o i n t targets. H o w e v e r , since 1995 targets have b e e n f o r m u l a t e d as b r o a d e r ranges, w i t h a w i d t h o f 2 % ( 1 9 9 6 ) o r 3 % (1995 a n d 1 9 9 7 ) . Setting a band for the inflation target is essential, because the l i n k between policy tools and inflation is n o t stable . . . I n the short term, moreover, the economy is affected by various shocks—principally o n the supply side—which also contribute to deviations from the target. I n view o f these considerations, it is evident that setting a specific p o i n t cannot be credible. A t the same time, there is a danger that the public will ascribe credibility only to the upper l i m i t o f the band, so i t should be relatively narrow. (Ben-Bassat, 1995, p. 45) As we f o u n d i n e a r l i e r case studies, t h e use o f a t a r g e t r a n g e e n c o u r ­ ages financial m a r k e t s a n d t h e p u b l i c t o focus o n t h e l i m i t s o f t h e b a n d (especially t h e u p p e r l i m i t ) , r a t h e r t h a n o n t h e c e n t r a l g o a l . T h e Israelis w o u l d have p r e f e r r e d t o use a p o i n t t a r g e t f o r i n f l a t i o n , l i k e t h e Swiss a n d t h e B r i t i s h , b u t t h e y f e a r e d t h a t t h e i r c o n t r o l over i n f l a t i o n was t o o imprecise to make such a c o m m i t m e n t credible. T h e p r a c t i c e o f a n n o u n c i n g targets o n l y f o r t h e year a h e a d has l e d t o e x t r e m e g r a d u a l i s m i n t h e pace o f d i s i n f l a t i o n . As we have m e n t i o n e d , i t was f e l t t h a t g r a d u a l i s m was necessary t o m a i n t a i n p u b l i c s u p p o r t f o r t h e g o a l o f p r i c e stability i n t h e face o f t h e r e a l costs e n t a i l e d b y d i s i n f l a t i o n . T h e first target, o f 1 4 % t o 1 5 % i n f l a t i o n f o r 1992, was f o l l o w e d b y tar-

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gets o f 1 0 % f o r 1993, 8% f o r 1994, 8% t o 1 1 % f o r 1995, 8% t o 1 0 % f o r 1996, 7% t o 1 0 % f o r 1997, a n d 7% t o 1 0 % f o r 1998. T h e s e t t i n g o f t h e t a r g e t every year is t h e r e s u l t o f a d e c i s i o n - m a k i n g process t h a t takes i n t o a c c o u n t b o t h p o l i t i c a l a n d e c o n o m i c factors. T h e t i m i n g o f t h e a n n o u n c e m e n t itself has v a r i e d , a p r a c t i c e t h a t p r o b a b l y reduces t r a n s p a r e n c y a n d increases u n c e r t a i n t y : T h e 1994 t a r g e t (a p o i n t ) was a n n o u n c e d as early as J u l y 1993, r e f l e c t i n g a s p i r i t o f o p t i ­ m i s m , w h i l e t h e 1997 t a r g e t (a r a n g e ) was a n n o u n c e d as late as possible i n 1996 ( o n D e c e m b e r 2 7 ) , r e f l e c t i n g p o l i t i c a l pressures o n t h e F i n a n c e M i n i s t r y , a n d t h r o u g h i t o n t h e B a n k o f Israel. T h e m e t h o d by w h i c h t h e p a t h f o r t h e e x c h a n g e rate is set makes clear t h a t this v a r i a b l e f u n c t i o n s t o some d e g r e e as a n i n t e r m e d i a t e tar­ get. I n d e e d , t h e r e are i n t e r e s t i n g parallels b e t w e e n t h e d e t e r m i n a t i o n o f t h e e x c h a n g e rate p a t h i n Israel a n d o f t h e m o n e t a r y targets i n Ger­ many. As we saw i n C h a p t e r 4, G e r m a n y ' s m o n e t a r y targets are d e r i v e d i n a process t h a t begins w i t h a n i n f l a t i o n objective. T h i s objective is l i n k e d t o assumptions o n t h e rate o f g r o w t h o f p o t e n t i a l o u t p u t a n d t h e t r e n d i n velocity t h r o u g h t h e q u a n t i t y e q u a t i o n ( a n i d e n t i t y w h i c h states t h a t m o n e y g r o w t h plus the t r e n d i n velocity must equal o u t p u t g r o w t h plus i n f l a t i o n ) , t o find t h e w a r r a n t e d rate o f m o n e y g r o w t h . Similarly, t h e e x c h a n g e rate p a t h i n Israel ( t h e "rate o f c r a w l " o f t h e p e g ) is deter­ m i n e d b y t h e i n f l a t i o n t a r g e t p l u s assumptions o n t h e l i k e l y rates o f i n ­ flation a b r o a d , l i n k e d t h r o u g h t h e p u r c h a s i n g p o w e r p a r i t y r e l a t i o n s h i p ( w h i c h states t h a t t h e d e p r e c i a t i o n o f t h e I s r a e l i e x c h a n g e rate m u s t equal the difference between Israeli a n d f o r e i g n inflation rates). A t the same t i m e , I s r a e l i m o n e t a r y policy-makers c o n s i d e r m a n y o t h e r factors besides t h e value o f t h e shekel, j u s t as m o n e t a r y p o l i c y - m a k e r s i n Ger­ m a n y r e s p o n d t o d e v e l o p m e n t s o t h e r t h a n those r e f l e c t e d i n t h e g r o w t h o f t h e m o n e y stock. 7

A d i f f e r e n c e i n t h e I s r a e l i a n d G e r m a n p o l i c y f r a m e w o r k s is t h a t sta­ b i l i z a t i o n o f t h e e x c h a n g e rate i n Israel has some i n d e p e n d e n t u t i l i t y i n t h e eyes o f t h e policy-makers, whereas t h e r e are n o d i r e c t consequences o f m i s s i n g t h e m o n e t a r y target i n G e r m a n y . I n p a r t i c u l a r , t h e e x c h a n g e rate affects p a t t e r n s o f trade, a n d t h e r e is t h e d a n g e r o f speculative r u n s i f t h e e x c h a n g e rate w a n d e r s t o o far f r o m its target. T h u s t h e exchangerate c o m m i t m e n t i n Israel m a y c o n s t i t u t e a s t r o n g e r c o n s t r a i n t o n p o l i c y t h a n are t h e m o n e t a r y targets i n G e r m a n y . U l t i m a t e l y , however, i n Israel as i n G e r m a n y , m o n e t a r y p o l i c y is d r i v e n p r i m a r i l y by t h e i n f l a t i o n tar­ get, w h i c h b o t h d e t e r m i n e s t h e s e t t i n g o f t h e i n t e r m e d i a t e targets a n d imposes a l o n g - r u n c o n s t r a i n t o n p o l i c y choices. As i n G e r m a n y , I s r a e l i policy-makers have b e c o m e i n c r e a s i n g l y w i l l i n g t o s u b o r d i n a t e t h e i n -

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t e r m e d i a t e t a r g e t ( t h e e x c h a n g e rate, i n Israel) t o t h e i n f l a t i o n objec­ tive, a n d t o use i n f o r m a t i o n b e y o n d t h e i n t e r m e d i a t e t a r g e t t h a t is r e l ­ evant t o h i t t i n g t h e i n f l a t i o n g o a l . Israel's a b i l i t y t o d o w n p l a y t h e e x c h a n g e rate i n favor o f a n a p p r o a c h t h a t targets t h e " f u l l - i n f o r m a t i o n " forecast o f i n f l a t i o n ( i n t h e sense o f Svensson [ 1 9 9 7 a ] ) is p a r t i c u l a r l y s t r i k i n g f o r a c o u n t r y t h a t c o m p l e t e d a n exchange-rate-based s t a b i l i z a t i o n o n l y a decade b e f o r e , w i t h t h e at­ t e n d a n t emphasis o n exchange-rate stability t h a t such a n a p p r o a c h b r i n g s . As w e have seen, however, t h e t r a n s i t i o n f r o m t h e c r a w l i n g p e g b e i n g t h e sole g u i d e f o r m o n e t a r y p o l i c y t o its b e i n g s u b o r d i n a t e d t o t h e i n f l a ­ t i o n t a r g e t has b e e n q u i t e g r a d u a l since i n f l a t i o n targets b e c a m e effec­ tive i n 1992. A consensus has e m e r g e d t h a t , as t h e d i s i n f l a t i o n p r o c e e d s , t h e exchange-rate targets w i l l be e m p h a s i z e d less a n d less. I t can be argued that with the passage o f time the Israeli economy moved more and more toward enhanced exchange rate flexibility, and shifted to inflation targets as anchors. A natural continuation o f this process w o u l d allow for an even larger degree o f exchange rate flexibility, e.g. i n the context o f a wider exchange rate band than the one at the present time. (Bufman et al, 1995, p. 189) T h e B a n k o f Israel m o n i t o r s a v a r i e t y o f i n f l a t i o n series a n d measures o f i n f l a t i o n e x p e c t a t i o n s , w h i c h i t derives f r o m t h e c o m p a r i s o n o f yields o n i n d e x e d a n d n o n - i n d e x e d Treasury securities w i t h s i m i l a r m a t u r i t i e s . " T h e Treasury c u r r e n t l y issues n o n - i n d e x e d securities w i t h m a t u r i t i e s o f u p t o t h r e e years a n d t h e r e is a f a i r l y active secondary m a r k e t f o r b o t h n o n - i n d e x e d a n d i n d e x e d securities m a t u r i n g at various f r e q u e n c i e s u p t o t w o years" (Offenbacher, 1996, p p . 64-5). T h e s o p h i s t i c a t i o n a n d d e p t h o f t h e I s r a e l i f i n a n c i a l m a r k e t s e n a b l e t h e B a n k o f Israel t o g a t h e r for­ w a r d - l o o k i n g p r i v a t e sector i n f o r m a t i o n a n d t o c o n d u c t s t e r i l i z e d i n t e r ­ v e n t i o n i n f o r e i g n e x c h a n g e m a r k e t s . T h a t m a y be o n e r e a s o n w h y Is­ r a e l has b e e n able t o a d o p t i n f l a t i o n targets despite its b o r d e r l i n e status as a d e v e l o p i n g c o u n t r y i n o t h e r respects. T h e B a n k o f Israel uses v a r i ­ ous o t h e r i n d i c a t o r s i n f o r e c a s t i n g i n f l a t i o n , i n c l u d i n g asset p r i c e s , M l g r o w t h , a n d i n d i c a t o r s o f t h e state o f t h e r e a l e c o n o m y . T h e B a n k has n o t p u b l i s h e d a n o f f i c i a l i n f l a t i o n r e p o r t u n t i l v e r y re­ c e n t l y ( M a r c h 1 9 9 8 ) . I t has, however, p u b l i s h e d a 10-page d o c u m e n t every t h r e e m o n t h s t i t l e d "Recent E c o n o m i c D e v e l o p m e n t s , " w h i c h re­ p o r t s o n a b r o a d r a n g e o f i n d i c a t o r s o f t h e state o f t h e e c o n o m y . T h i s d o c u m e n t ' s seven sections c o r r e s p o n d t o those o f t h e B a n k ' s Annual Reports: m a i n d e v e l o p m e n t s , t h e p r i n c i p a l i n d u s t r i e s , t h e l a b o r m a r k e t , f o r e i g n t r a d e a n d t h e b a l a n c e o f p a y m e n t s , prices, g o v e r n m e n t finances,

THREE SMALL OPEN

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a n d m o n e y a n d c a p i t a l m a r k e t s . T h i s p u b l i c a t i o n reviews e c o n o m i c de­ v e l o p m e n t s b u t does n o t c o n t a i n any forecasts o r discussions o f t h e ef­ fect o f those d e v e l o p m e n t s o n m o n e t a r y p o l i c y . I t is l i k e l y t h a t this l i m ­ i t e d r e p o r t i n g over t h e first years o f Israel's i n f l a t i o n - t a r g e t i n g r e g i m e i n c r e a s e d t h e p u b l i c ' s u n c e r t a i n t y a b o u t t h e Bank's efforts t o c o n d u c t policy i n a forward-looking manner. T h e B a n k o f Israel L a w o f 1954 specifies several m o n e t a r y - p o l i c y goals, i n c l u d i n g " ( 1 ) t h e s t a b i l i s a t i o n o f t h e value o f t h e c u r r e n c y i n Israel a n d o u t s i d e Israel; ( 2 ) a h i g h level o f p r o d u c t i o n , e m p l o y m e n t , n a t i o n a l i n ­ c o m e a n d c a p i t a l investments i n I s r a e l . " A s k e d w h e t h e r i t was t i m e t o review t h e law, B a n k o f Israel G o v e r n o r J a c o b F r e n k e l said: 8

Yes, I believe the time has come to review it. A t present the law sets us mul­ tiple objectives—to increase the standard o f living and achieve price stabil­ ity. The time has come when the objectives should reflect the reality that monetary policy has a comparative advantage i n affecting inflation. I would recommend the adoption o f Maastricht-style language, where the setting o f price stability is the overriding objective. (Frenkel, 1996, pp. 56-7) T h e B a n k o f I s r a e l enjoys a h i g h d e g r e e o f i n d e p e n d e n c e , p a r t i c u ­ l a r l y i n t h e day-to-day c o n d u c t o f policy. T h e G o v e r n o r is a p p o i n t e d f o r a r e n e w a b l e five-year t e r m o f office (as c o m p a r e d t o a m a x i m u m f o u r year e l e c t o r a l cycle i f a g o v e r n i n g c o a l i t i o n survives). T h e G o v e r n o r c o n ­ sults w i t h a n A d v i s o r y C o u n c i l a n d a n A d v i s o r y C o m m i t t e e , w h i c h have n o m a n a g e r i a l a u t h o r i t y b u t serve solely (as t h e i r n a m e s suggest) i n a n advisory capacity. Since t h e a d o p t i o n o f t h e e c o n o m i c s t a b i l i z a t i o n p r o ­ g r a m i n 1985, t h e B a n k has b e e n b a r r e d f r o m financing t h e g o v e r n m e n t d e f i c i t . T h e G o v e r n o r also acts as e c o n o m i c advisor t o t h e g o v e r n m e n t . T h e F i n a n c e M i n i s t e r , a c t i n g as a representative o f t h e g o v e r n m e n t , a n d w i t h t h e advice a n d c o o p e r a t i o n o f t h e c e n t r a l b a n k , sets t h e i n f l a ­ t i o n targets a n d h o l d s t h e B a n k responsible f o r m e e t i n g t h e m . T h i s is the same p r o c e d u r e f o l l o w e d i n Canada, N e w Zealand, Sweden, a n d (rela­ tively r e c e n t l y ) t h e U n i t e d K i n g d o m . G o v e r n o r F r e n k e l has expressed a p p r o v a l o f t h i s a r r a n g e m e n t : " W h e n set b y t h e g o v e r n m e n t , [ t h e i n f l a ­ t i o n targets] b e c o m e a n i n t e g r a l p a r t o f t h e o v e r a l l p o l i c y objectives f o r t h e e c o n o m y " ( F r e n k e l , 1996, p . 5 3 ) . However, the active p a r t i c i p a t i o n o f the B a n k o f Israel i n the g o v e r n m e n t ' s d e c i s i o n - m a k i n g p r o c e s s has r a i s e d q u e s t i o n s a b o u t w h e t h e r this d i v i s i o n o f responsibility, w h i c h is clear i n p r i n c i p l e , is q u i t e so clear i n p r a c t i c e . D u r i n g t h e t r a n s i t i o n a l p e r i o d , w h e n i t was some­ times less t h a n e v i d e n t w h e t h e r t h e e x c h a n g e rate o r t h e i n f l a t i o n t a r g e t w o u l d take p r e c e d e n c e , this a m b i g u i t y h a d a c e r t a i n l o g i c . As i n a l l c o u n -

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tries w i t h i n d e p e n d e n t c e n t r a l banks, r e s p o n s i b i l i t y f o r exchange-rate p o l i c y i n Israel is s h a r e d b y t h e F i n a n c e M i n i s t r y a n d t h e c e n t r a l b a n k , w i t h t h e decisions a b o u t s h o r t - r u n i n t e r v e n t i o n left l a r g e l y t o t h e B a n k . T h e i n f l a t i o n targets f o r 1993 a n d 1994 also w e r e set j o i n t l y b y t h e M i n ­ istry o f F i n a n c e a n d t h e B a n k o f Israel, r e f l e c t i n g t h e close r e l a t i o n s h i p b e t w e e n i n f l a t i o n targets a n d exchange-rate policy. A f t e r t h e 1994 over­ s h o o t i n g o f t h e i n f l a t i o n target, however, target-setting b e c a m e a p o l i t i ­ cally c h a r g e d a n d e c o n o m i c a l l y s i g n i f i c a n t d e c i s i o n , especially since i t w o u l d r e q u i r e a c o m m i t m e n t t o a p a t h f o r d i s i n f l a t i o n ; h e n c e , t h e gov­ e r n m e n t b e g a n t o take a l e a d i n g r o l e . R e g a r d i n g t h e t a r g e t f o r 1996, "differences o f o p i n i o n as t o t h e p r o p e r t a r g e t a n d as t o t h e r o l e o f m o n ­ etary p o l i c y i n a c h i e v i n g t h e t a r g e t l e d t o t h e F i n a n c e M i n i s t e r a n n o u n c ­ i n g i t w i t h o u t t h e c o n c u r r e n c e o f t h e B a n k o f Israel" ( O f f e n b a c h e r , 1996, p . 6 3 ) . T h e t a r g e t f o r 1998 (set i n J u l y 1997) was discussed b y t h e e n t i r e C a b i n e t , w i t h t h e l e a d o f t h e F i n a n c e M i n i s t e r . These d e v e l o p m e n t s have s e t t l e d t h e q u e s t i o n o f w h i c h e n t i t y s h o u l d set t h e target, a n d be h e l d a c c o u n t a b l e f o r t h a t d e c i s i o n . O n e I s r a e l i official s u m m a r i z e d t h e m a t ­ t e r as follows: A necessary, but n o t sufficient, condition for improving credibility is for the Ministry o f Finance and the Bank to work out an institutional program by which the cabinet formally decides o n the ultimate goal o f monetary policy and assigns both responsibility and tools to the Bank o f Israel for attaining it. (Ibid., p. 64) E v e n so, a c c o u n t a b i l i t y is c o m p l i c a t e d by t h e n e e d f o r c o n s t a n t disci­ p l i n e i n fiscal matters o n t h e p a r t o f t h e e l e c t e d g o v e r n m e n t . I n t h e absence o f s u c h d i s c i p l i n e , t h e a b i l i t y o f m o n e t a r y p o l i c y - m a k e r s t o c o n ­ t r o l i n f l a t i o n w i t h o u t r e s o r t i n g t o p a i n f u l l y restrictive measures is u n d e r ­ c u t . T h i s t e n s i o n b e t w e e n fiscal p o l i c y a n d m o n e t a r y p o l i c y is c o m m o n w h e n t h e focus o f m o n e t a r y p o l i c y is o n p r i c e stability, w h i l e t h e focus o f fiscal p o l i c y is o n o t h e r m a t t e r s . I t appears t h a t i n f l a t i o n t a r g e t i n g i n Israel, as i n C a n a d a a n d N e w Z e a l a n d , has at least f o r c e d t h e g o v e r n ­ m e n t t o a c k n o w l e d g e t h e effects o f g o v e r n m e n t s p e n d i n g o n i n f l a t i o n a n d inflation expectations.

Israel's Experience under Inflation Targeting Israel's e x p e r i e n c e w i t h i n f l a t i o n t a r g e t i n g has, o n t h e w h o l e , b e e n suc­ cessful. (See F i g u r e 9.1 f o r a h i s t o r y o f key m a c r o e c o n o m i c i n d i c a t o r s f o r Israel.) W i t h t h e e x c e p t i o n o f t h e large ( 6 % ) o v e r s h o o t i n g o f t h e

1994

1996

1990

1992

1994

1998

1998

1986

D.

1986

1988

Rate

Rate

1988

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Shekel

1990

1994

1992

1994

1996

1996

Rate

Rates

Exchange

1992

IN

Discount and T-Bill

USD/New

T-Bïii

Discount

B.

1998

1998

Figure 9.1. Israeli economic indicators. Sources: A ) International Financial Statistics o f the International Monetary Fund, Bank o f Israel; B) International Financial Statistics o f the International Monetary Fund; C) International Financial Statistics o f the International Monetary Fund; D) International Financial Statistics o f the International Monetary Fund

1988

1996

1992

1986

1990 Rate

1988

C. G D P G r o w t h a n d U n e m p l o y m e n t

1986

A. C P ! I n f l a t i o n a n d T a r g e t s

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t a r g e t i n 1994, since 1992 t h e i n f l a t i o n targets have e i t h e r b e e n m e t o r have b e e n e x c e e d e d b y less t h a n 1 % , a n d i n f l a t i o n has averaged 10.6% a n n u a l l y . R e c e n t i n f l a t i o n rates have b e e n i n t h e single digits. E v e n after t h e t a r g e t miss i n 1994, n e i t h e r i n f l a t i o n n o r i n f l a t i o n e x p e c t a t i o n s ap­ p e a r t o have g o t t e n o u t o f c o n t r o l . N o r has t h e r e d u c e d a t t e n t i o n t o t h e e x c h a n g e rate, a n d t h e r e s u l t i n g i n c r e a s e d flexibility o f policy, c r e a t e d p r o b l e m s ; i n d e e d , t h e i n c i d e n c e o f speculative attacks o n t h e s h e k e l has d e c l i n e d . F u r t h e r , t h e s h e k e l has b e e n c o n s i s t e n t l y h i t t i n g t h e l o w e r ( s t r o n g e r ) e n d o f its c r a w l i n g b a n d , even f o l l o w i n g r e p e a t e d w i d e n i n g s o f t h e b a n d a n d a r e d u c t i o n i n t h e slope o f t h e b a n d ' s l o w e r b o u n d a r y (which implies a lower expected inflation differential between Israel a n d t h e G-5). I n s h o r t , I s r a e l i i n f l a t i o n t a r g e t i n g p r o v i d e s a s t r i k i n g e x a m p l e o f h o w m o n e t a r y p o l i c y c a n be m a d e m o r e flexible w i t h n o a p p a r e n t loss o f c r e d i b i l i t y a n d effectiveness. T h e c r i t i c a l p o i n t f o r t h e I s r a e l i i n f l a t i o n t a r g e t i n g strategy o c c u r r e d i n 1994. As o f 1993, t h e r e l a t i v e i m p o r t a n c e o f t h e exchange-rate t a r g e t a n d t h e i n f l a t i o n t a r g e t was still a m b i g u o u s . F o r e x a m p l e , i n t h a t year t h e B a n k o f Israel i m p o s e d a 3% d e v a l u a t i o n o f t h e s h e k e l i n o r d e r t o offset t h e effects o f a r e d u c t i o n i n e x p o r t subsidies, c i t i n g its c o n c e r n f o r private-sector c o m p e t i t i v e n e s s as t h e reason f o r its a c t i o n . M e a n w h i l e , t h e a n n o u n c e m e n t o f t h e i n f l a t i o n t a r g e t was b u r i e d at t h e e n d o f a series o f a n n o u n c e m e n t s r e l a t i n g t o changes i n t h e exchange-rate b a n d . T h e w o r d i n g o f t h e i n f l a t i o n t a r g e t a n n o u n c e m e n t f o r 1994, h o w ­ ever, was far m o r e e x p l i c i t t h a n i n p r e v i o u s years a n d set a n a m b i t i o u s p o i n t t a r g e t f o r i n f l a t i o n o f 8%. M o r e o v e r , f o r t h e first t i m e ever, i t was clearly t h e i n f l a t i o n t a r g e t t h a t d e t e r m i n e d t h e exchange-rate target, as t h e slope o f t h e exchange-rate b a n d was r e d u c e d t o m a k e i t c o n s i s t e n t w i t h t h e i n f l a t i o n objective. Policy-makers also b e g a n t o r e s p o n d s t r o n g l y to t h e i n f l a t i o n target: T h e B a n k o f Israel's i n s t r u m e n t i n t e r e s t r a t e r e a c h e d a l o w o f 1 3 % i n A u g u s t 1994 b u t t h e n was raised steadily as i t b e c a m e clear t h a t t h e i n f l a t i o n t a r g e t was g o i n g t o be overshot. B y Feb­ r u a r y 1995, t h e i n s t r u m e n t i n t e r e s t rate s t o o d at 1 8 % . T h e i n f l a t i o n t a r g e t o f 8% f o r 1994 was b a d l y overshot, b y 6.5%. M o r e i m p o r t a n t t h a n t h e target miss, however, was the fact t h a t t h e B a n k sharply t i g h t e n e d m o n e t a r y p o l i c y i n response t o t h e h i g h e r i n f l a t i o n , despite t h e fact t h a t t h e e x c h a n g e rate was a l m o s t precisely o n t a r g e t (at its cen­ t r a l p a r i t y ) . T h u s , w h e n t h e t w o objectives came i n t o c o n f l i c t , t h e B a n k o f Israel m a d e i t clear t h a t a c h i e v i n g t h e i n f l a t i o n t a r g e t t o o k prece­ d e n c e over m a i n t a i n i n g t h e exchange-rate p e g . T h e Bank's key m e a s u r e o f private-sector i n f l a t i o n e x p e c t a t i o n s — t h e d i f f e r e n c e b e t w e e n n o m i ­ n a l a n d i n d e x e d g o v e r n m e n t b o n d s — p e a k e d i n N o v e m b e r 1994 at a n

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e x p e c t e d i n f l a t i o n rate o f 1 5 % , i n l i n e w i t h a c t u a l i n f l a t i o n . H o w e v e r , perhaps reflecting the Bank's g r o w i n g anti-inflation credibility, i n f l a t i o n e x p e c t a t i o n s f e l l swiftly as t h e B a n k m o v e d aggressively o n i n t e r e s t rates. T h e p o w e r o f t h e e x c h a n g e rate t o d e t e r m i n e m o n e t a r y p o l i c y was f u r t h e r w e a k e n e d i n 1995 w h e n t h e exchange-rate b a n d was w i d e n e d t o 1 4 % , at t h e same t i m e t h a t r e s t r i c t i o n s o n i n t e r n a t i o n a l c a p i t a l flows w e r e r e d u c e d o r e l i m i n a t e d . These steps w e r e t a k e n despite a w o r r i s o m e fiscal e x p a n s i o n t h a t was o c c u r r i n g at t h e t i m e . T h e fiscal d e f i c i t over­ s h o t its t a r g e t i n 1995 (a d e f i c i t o f 3.2% o f G D P versus a t a r g e t o f 2.75%, exclusive o f i n t e r e s t p a y m e n t s o n t h e g o v e r n m e n t d e b t ) a n d missed even m o r e d r a m a t i c a l l y i n 1996 ( 4 . 6 % versus 2 . 5 % ) . R e f l e c t i n g t h a t m o v e ­ m e n t , u n e m p l o y m e n t f e l l f r o m 11.2% i n 1992 t o 6.7% i n 1996 despite massive Russian i m m i g r a t i o n , a n d t h e c u r r e n t a c c o u n t d e f i c i t i n c r e a s e d as t h e shekel d e p r e c i a t e d m o r e slowly t h a n e x p e c t e d . L a x fiscal p o l i c y n o d o u b t c o n t r i b u t e d t o a sharp rise i n i n f l a t i o n e x p e c t a t i o n s (as mea­ s u r e d b y t h e interest-rate d i f f e r e n t i a l b e t w e e n n o m i n a l a n d i n d e x e d b o n d s ) , w h i c h p e a k e d a g a i n at 1 5 % i n J u l y 1996. 9

D e s p i t e these e n o r m o u s pressures, m o n e t a r y p o l i c y h e l d t h e l i n e . I n ­ terest rates rose, a n d e c o n o m i c g r o w t h slowed i n t h e s e c o n d h a l f o f 1996. By year's e n d , i n f l a t i o n h a d o v e r s h o t its t a r g e t b y o n l y 0.6% ( t h e c e i l i n g o f t h e t a r g e t r a n g e was 1 0 % ) , a n d i n f l a t i o n e x p e c t a t i o n s f e l l i n l i n e . T h e s h o r t b u t consistent r e c o r d o f t h e Bank's c o u n t e r - i n f l a t i o n a r y c o m m i t ­ m e n t appears t o have l i m i t e d t h e d a m a g e o f a n o v e r h e a t e d e c o n o m y w i t h o u t t h e n e e d f o r drastic measures, even as t h e c o m m i t m e n t t o t h e e x c h a n g e rate was b e i n g l o o s e n e d . Because the fiscal deficit overshootings i n 1995 a n d 1996 were t h e re­ sults o f intense p o l i t i c a l pressures f r o m a variety o f sources, t h e r e was l i t t l e s u p p o r t i n t h e c a b i n e t f o r a m b i t i o u s i n f l a t i o n goals i n t h e f o l l o w i n g years. I t seemed likely t h a t fiscal p o l i c y w o u l d be h i g h l y e x p a n s i o n a r y a n d p r o b ­ ably i n f l a t i o n a r y i n 1997, i n accordance w i t h a f a m i l i a r p a t t e r n i n Israel. As we have m e n t i o n e d , t h e Finance M i n i s t r y p o s t p o n e d its a n n o u n c e m e n t o f the 1997 i n f l a t i o n target u n t i l t h e very e n d o f 1996 a n d m a d e n o secret o f t h e fact t h a t t h e delay h a d b e e n caused by a c o n f l i c t b e t w e e n t h e M i n i s ­ t r y a n d t h e B a n k over t h e target. T h e i n f l a t i o n target o f 7% t o 10% finally a n n o u n c e d by t h e F i n a n c e M i n i s t r y was a c o m p r o m i s e : T h o u g h i t h e l d the line o n inflation, i t r e q u i r e d n o further disinflation. D e s p i t e this c o m p r o m i s e , t h e existence o f t h e i n f l a t i o n t a r g e t a n d t h e g o v e r n m e n t ' s c o m m i t m e n t t o ( u l t i m a t e ) p r i c e stability h a d positive ef­ fects. Clearly, w i t h t h e i n f l a t i o n - t a r g e t i n g r e g i m e i n place, t h e I s r a e l i g o v e r n m e n t c o u l d n o t announce a significantly h i g h e r i n f l a t i o n target i n 1997 t h a n i n 1996—let a l o n e f o r e g o a target a l t o g e t h e r — w i t h o u t draw-

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i n g a t t e n t i o n t o its v i o l a t i o n o f t h e c o m m i t m e n t t o stabilize prices. S t r e n u ­ ous p o l i t i c a l n e g o t i a t i o n s b r o u g h t t h e 1997 d e f i c i t d o w n t o its t a r g e t o f 2.8% o f GDP. Progress against i n f l a t i o n c o n t i n u e d i n 1997. T h e shekel, a g a i n , was r e p e a t e d l y d r i v e n t o t h e s t r o n g e n d o f its exchange-rate b a n d ; at last i t was a n n o u n c e d t h a t t h e b a n d w o u l d be w i d e n e d f r o m 1 4 % t o 2 8 % i n 1997, a n d t h e n t o 3 0 % i n 1998, w h i l e t h e l o w e r ( s t r o n g ) b a n d ' s rate o f d e p r e c i a t i o n w o u l d be r e d u c e d f r o m 6% t o 4 % . M o n e t a r y c r e d i b i l i t y was clearly h i g h a n d r i s i n g . M e a n w h i l e , because o f t h e e x t r e m e l y w i d e b a n d s a r o u n d the c e n t r a l parity, t h e exchange-rate target was l o s i n g some o f its significance as a c o n s t r a i n t o n m o n e t a r y policy. 1 0

D i s i n f l a t i o n is o f t e n a c c o m p a n i e d b y r e c e s s i o n , a n d t h e I s r a e l i e c o n o m y h a d clearly b e g u n t o slow i n 1997. I n t h e face o f c o n c e r n s a b o u t r i s i n g u n e m p l o y m e n t , t h e i n f l a t i o n t a r g e t was k e p t u n c h a n g e d f o r 1998, again f o r g o i n g the c o m m i t m e n t to further disinflation. This t i m e , how­ ever, t h e i n f l a t i o n t a r g e t was a n n o u n c e d i n A u g u s t 1997 a n d was clearly t h e r e f e r e n c e p o i n t f o r a l l o t h e r e c o n o m i c p o l i c i e s . As o f this w r i t i n g , i n m i d - 1 9 9 8 , i n f l a t i o n i n Israel is r u n n i n g b e l o w t h e 7% floor o f t h e t a r g e t r a n g e . I t w i l l be i n t e r e s t i n g t o see i f t h e B a n k o f Israel follows t h e Cana­ d i a n e x a m p l e i n t r e a t i n g t h e floor o f t h e target r a n g e as b e i n g o f e q u a l i m p o r t a n c e as t h e c e i l i n g o f t h e r a n g e . By 1998, Israel h a d c o m p l e t e d t h e t r a n s i t i o n f r o m t h e fixed e x c h a n g e rate o n w h i c h i t based its s t a b i l i z a t i o n i n 1985 t o t h e m o r e flexible a n d f o r w a r d - l o o k i n g strategy o f i n f l a t i o n t a r g e t i n g as p r a c t i c e d i n o t h e r c o u n ­ tries. T h e p o t e n t i a l c o n f l i c t b e t w e e n t h e e x c h a n g e rate a n d t h e i n f l a t i o n targets h a d b e e n m a n a g e d w i t h o u t i n c i d e n t b u t h a d c e r t a i n l y s l o w e d t h e B a n k ' s efforts t o w i n s u p p o r t f o r f u r t h e r d i s i n f l a t i o n . I n p a r t i c u l a r , t h e e x p l i c i t r e c o g n i t i o n o f t h e exchange-rate b a n d s p r i o r t o t h e g r a n t i n g o f p r i m a c y t o t h e i n f l a t i o n t a r g e t gave i n t e r e s t g r o u p s such as e x p o r t e r s a n o p p o r t u n i t y t o c o m m e n t o n m o n e t a r y policy. T h e final m o v e t o w a r d p u t t i n g p r i m a r y emphasis o n i n f l a t i o n thus p r o v i d e d some p o l i t i c a l i n ­ s u l a t i o n f o r t h e B a n k o f Israel, a l t h o u g h t h e B a n k has c e r t a i n l y r e m a i n e d a c c o u n t a b l e t o t h e g o v e r n m e n t f o r t h e effects o f its p o l i c i e s .

AUSTRALIA Australia's Adoption of an Inflation Target O n S e p t e m b e r 26, 1994, t h e G o v e r n o r o f t h e Reserve B a n k o f A u s t r a l i a d e c l a r e d , " I n o u r o p i n i o n , u n d e r l y i n g i n f l a t i o n o f 2 t o 3 p e r c e n t is a reasonable g o a l f o r m o n e t a r y policy." H e c o n t i n u e d :

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These figures, incidentally, are n o t intended to define a (narrow) range; rather, they are indicative of where we would like to see the average rate over a r u n o f years. Such a rate . . . is similar to the informal goals o f the US Federal Reserve and the Bundesbank, and not dramatically different from the more formal targets i n the U n i t e d Kingdom, Canada and New Zealand. (Fraser, 1994c, p. 21) T h e fact t h a t this s t a t e m e n t was m a d e i n a speech g i v e n b y then-Gov­ e r n o r Fraser t o a c o n f e r e n c e o f e c o n o m i s t s m e e t i n g i n a h o l i d a y r e s o r t illustrates t h e i n f o r m a l c h a r a c t e r o f t h e Reserve Bank's m o v e t o w a r d a n i n f l a t i o n target. T h e l a g b e t w e e n a shift o f p o l i c y t o w a r d a strategy f o ­ cused o n i n f l a t i o n c o n t r o l a n d t h e f o r m a l a n n o u n c e m e n t o f a n i n f l a t i o n target was n o t u n i q u e t o A u s t r a l i a ; s i m i l a r lags o c c u r r e d i n N e w Z e a l a n d a n d Canada. H o w e v e r , t h e a d o p t i o n o f a n i n f l a t i o n t a r g e t i n A u s t r a l i a was m o r e g r a d u a l a n d i n c r e m e n t a l t h a n i n any o f t h e o t h e r c o u n t r i e s we have discussed. Australia's a d o p t i o n o f a n i n f l a t i o n t a r g e t was a u n i l a t e r a l d e c i s i o n o n t h e p a r t o f t h e Reserve B a n k ; i t was n o t p r o m p t e d b y a c h a n g e i n t h e legislated m a n d a t e o f t h e B a n k , as h a d b e e n t h e case i n N e w Z e a l a n d a n d S p a i n . N o r was t h e r e any a t t e m p t t o p r e s e n t t h e a d o p t i o n o f a n i n f l a t i o n t a r g e t as a j o i n t p o l i c y o f t h e g o v e r n m e n t a n d t h e c e n t r a l b a n k , e i t h e r i n t h e f o r m o f a j o i n t d e c l a r a t i o n , as i n C a n a d a a n d Israel, o r as a d i r e c t i v e b y t h e g o v e r n m e n t , as i n t h e U n i t e d K i n g d o m . Possibly t h e G o v e r n o r d i d n o t r e g a r d t h e i n f l a t i o n t a r g e t as a s i g n i f i c a n t d e p a r t u r e f r o m t h e Bank's p r e v i o u s i n t e r p r e t a t i o n o f its m a n d a t e : S e c t i o n 10 o f t h e Reserve B a n k A c t o f 1959 stipulates o n l y t h a t t h e objectives o f m o n ­ etary p o l i c y are "the stability o f t h e c u r r e n c y o f A u s t r a l i a ; t h e m a i n t e ­ nance of full e m p l o y m e n t i n Australia; a n d the economic prosperity a n d welfare o f t h e p e o p l e o f A u s t r a l i a . " I n his 1994 speech, G o v e r n o r Fraser u n d e r l i n e d t h e c o n t i n u i t y o f p o l i c y after t h e a d o p t i o n o f t h e i n f l a t i o n t a r g e t ("Personally, I a m q u i t e c o m f o r t a b l e w i t h those m u l t i p l e objec­ tives" [Ibid., p . 1 9 ] . ) T h e fact t h a t f o r a substantial p e r i o d o f t i m e t h e Reserve B a n k chose n o t t o assume t h e a c c o u n t a b i l i t y associated w i t h a p u b l i c c o m m i t m e n t to e x p l i c i t targets makes i t h a r d t o i d e n t i f y t h e precise s t a r t i n g d a t e o f i n f l a t i o n t a r g e t i n g i n A u s t r a l i a . U n l i k e several o f t h e o t h e r c o u n t r i e s we have c o n s i d e r e d , t h e r e was n o s u d d e n loss o f a n o m i n a l a n c h o r t h a t w o u l d have f o r c e d t h e Reserve B a n k t o l o o k f o r a n e w strategy. Target­ i n g o f m o n e y g r o w t h (specifically, o f t h e b r o a d aggregate M 3 ) h a d b e e n a b a n d o n e d i n 1985, a n d A u s t r a l i a h a d s u r v i v e d t h e 1980s w i t h o u t any sense o f m o n e t a r y crisis.

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T h e Reserve Bank's o w n view is t h a t i t has h a d a n i n f l a t i o n target since early 1993. W h i l e c o n c e d i n g t h a t t h e r e is some ambiguity, we p r e f e r t o date t h e b e g i n n i n g o f i n f l a t i o n t a r g e t i n g i n A u s t r a l i a as S e p t e m b e r 1994, w i t h G o v e r n o r Fraser's statement. T h a t date is consistent w i t h o u r view t h a t i n f l a t i o n t a r g e t i n g begins w i t h t h e p u b l i c a n n o u n c e m e n t o f a n u ­ m e r i c a l g o a l f o r a specified measure o f i n f l a t i o n a n d a specific h o r i z o n . T h i s is n o t j u s t a n academic q u e s t i o n , since we w o u l d l i k e t o be able t o d i s t i n g u i s h w h e t h e r t h e c o m p l e t e i n f l a t i o n - t a r g e t i n g f r a m e w o r k , o r sim­ p l y t h e desire t o s t r e n g t h e n c o n t r o l o f i n f l a t i o n ( w h i c h was p r e s e n t i n A u s t r a l i a p r i o r t o S e p t e m b e r 1994), is necessary f o r a c h i e v i n g t h e m a x i ­ m u m b e n e f i t . T h e A u s t r a l i a n e x p e r i e n c e suggests t h a t e x p l i c i t a d o p t i o n o f t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k is h e l p f u l ; as we w i l l see, t h e response o f f i n a n c i a l markets t o t h e Reserve Bank's p o l i c y moves i m p r o v e d follow­ i n g its actions t o increase transparency b e t w e e n 1993 a n d early 1995. 11

M o n e t a r y - p o l i c y actions i n A u s t r a l i a r e s e m b l e d those o f N e w Z e a l a n d q u i t e closely f r o m at least t h e latter p a r t o f t h e 1980s, suggesting t h a t eco­ n o m i c c o n d i t i o n s a n d p o l i c y objectives were q u i t e s i m i l a r i n those two closely r e l a t e d economies. L i k e N e w Z e a l a n d , A u s t r a l i a c o n s i d e r e d its i n ­ flation rate t o be a p r o b l e m d u r i n g t h e late 1980s. F o r e x a m p l e , b e t w e e n F e b r u a r y 1988 a n d N o v e m b e r 1989, t h e Reserve B a n k raised its i n s t r u ­ m e n t interest rate, t h e Cash Rate, f r o m 10% to 18%, despite l i t t l e c h a n g e i n h e a d l i n e i n f l a t i o n a n d a d e c l i n e i n u n d e r l y i n g i n f l a t i o n . Evidently, t h e Reserve B a n k c o n s i d e r e d t h e i n f l a t i o n rate, a b o u t 7% at t h e t i m e , t o be unsatisfactory. I n a speech g i v e n t h r e e years later, t h e n - D e p u t y G o v e r n o r (subsequently G o v e r n o r ) M a c f a r l a n e r e m a r k e d , "Policy was conscious o f t h e n e e d t o capitalize o n t h e 'once-in-a-decade' o p p o r t u n i t y t o r e d u c e i n f l a t i o n " (Macfarlane, 1992, p . 1 5 ) . As i n N e w Zealand, t h o u g h perhaps n o t t o t h e same degree, t h e r e h a d b e e n a f e e l i n g a m o n g policy-makers i n A u s t r a l i a i n t h e 1980s t h a t years o f l a x p o l i c y a n d t h e resultant h i g h rates o f i n f l a t i o n a n d i n f l a t i o n expectations h a d t o be reversed. H o w e v e r , w h i l e N e w Z e a l a n d i m p o s e d f o r m a l i n f l a t i o n targets at t h e e n d o f 1989, t h e Reserve B a n k o f A u s t r a l i a m a d e n o p u b l i c c o m m i t m e n t t o a n u m e r i c a l t a r g e t f o r i n f l a t i o n . I n s t e a d , over s u b s e q u e n t years i t t r i e d t o convey t o t h e p u b l i c t h a t t h e A u s t r a l i a n d i s i n f l a t i o n , w h i c h was l a r g e l y c o m p l e t e d b y t h e e n d o f 1 9 9 1 , was t h e r e s u l t o f a p e r m a n e n t shift i n p o l i c y objectives a n d n o t j u s t a side effect o f t h e 1990-91 recession. I n the words o f Deputy Governor Macfarlane: 12

I n our Annual Report released [ i n August 1992], and its predecessor i n 1991, we pointed out that monetary policy i n this cycle had developed a more medium-term anti-inflationary focus. I t is a difficult story to tell because i t is

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about a change i n emphasis, rather than the abandonment o f one policy approach and the embrace o f a totally different one . . . The Bank has p u t out numerous articles, speeches and reports highlighting the costs o f infla­ tion, and the opportunities available for a return to low inflation. (Macfarlane, 1992, p. 14) T h i s e f f o r t t o b u i l d p u b l i c s u p p o r t f o r p r i c e stability w i t h o u t a d o p t i n g a n e w f r a m e w o r k f o r p o l i c y is r e m i n i s c e n t o f t h e B a n k o f Canada's state­ m e n t s i n t h e years b e t w e e n G o v e r n o r Crow's H a n s o n l e c t u r e a n d t h e a d o p t i o n o f i n f l a t i o n targets i n 1991 (see C h a p t e r 6 ) . By early 1993, a n u m b e r o f o p e r a t i o n a l aspects o f w h a t was t o b e c o m e Australia's i n f l a t i o n - t a r g e t i n g r e g i m e were already i n place. I n a speech g i v e n o n M a r c h 3 1 , 1993, G o v e r n o r Fraser said t h a t i n his view " i f t h e rate o f i n f l a t i o n i n underlying t e r m s c o u l d be h e l d t o a n average o f 2 t o 3 p e r c e n t over a p e r i o d o f years, t h a t w o u l d be a g o o d o u t c o m e " (Fraser, 1993, p . 2, emphasis i n t h e o r i g i n a l ) . Yet i n t h e same speech, h e said: To my knowledge, no country has reduced its inflation by incantation, rather than by creating slack i n the economy. My reading o f the evidence is that Australia reduced inflation at least as effectively ( i n terms o f the trade-off between inflation and lost output) as countries like New Zealand, which have an inflation target . . . A n inflation target o f the narrow '0 to 2 percent' variety would, I believe, do us more h a r m than good. I n particular, such targets are apt to bias policy responses to shocks which i m p i n g e o n prices. Such shocks are probably best absorbed by changes i n both prices and activ­ ity b u t i f the authorities are b o u n d to a narrow inflation target then virtu­ ally all o f the shock has to impact o n activity. (Fraser, 1993, pp. 3-4, empha­ sis i n the original) T h e last two sentences reveal why, at this stage, t h e p o l i c y - m a k e r s i n t h e Reserve B a n k were u n w i l l i n g t o f o l l o w t h e r o u t e o f t h e i r c o u n t e r p a r t s i n N e w Z e a l a n d a n d Canada. I n t h e i r view, t h e c o n s t r a i n t a r i s i n g f r o m a n explicit n u m e r i c a l inflation target w o u l d impose inflexibility o n policy a n d w o u l d h a r m t h e r e a l e c o n o m y . F u r t h e r , u n l i k e t h e cases o f N e w Zealand a n d Canada p r i o r to target a d o p t i o n , i n Australia the central b a n k issued n o p u b l i c statements stressing t h e positive benefits o f for­ m a l targets; f o r e x a m p l e , i t d i d n o t declare t h a t a c h a n g e i n t h e p o l i c y f r a m e w o r k m i g h t a l t e r t h e p a t t e r n s o f wage- a n d p r i c e - s e t t i n g o r r e d u c e t h e o u t p u t a n d e m p l o y m e n t costs o f f u r t h e r d i s i n f l a t i o n . T h e c o n c e r n t h a t a n i n f l a t i o n t a r g e t w o u l d l i m i t t h e Reserve B a n k ' s flexibility seems t o have d i m i n i s h e d over t h e f o l l o w i n g 18 m o n t h s , h o w ­ ever, l e a d i n g u p t o t h e G o v e r n o r ' s S e p t e m b e r 1994 speech. M o r e i m p o r -

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tantly, i t is l i k e l y t h a t e c o n o m i c circumstances p r o m p t e d t h e Reserve B a n k t o be m o r e specific a b o u t its c o m m i t m e n t t o m a i n t a i n i n g p r i c e stability t h a n i t h a d b e e n i n t h e past. W h i l e i t b e c a m e clear i n early 1994 t h a t t h e A u s t r a l i a n e c o n o m y was r e b o u n d i n g s t r o n g l y f r o m t h e 1990-91 recession, t h e b o n d - m a r k e t d o w n t u r n over t h e first h a l f o f 1994 sent 10year g o v e r n m e n t - b o n d yields f r o m 6.4% t o 9.6%. T h a t was twice t h e i n ­ crease i n l o n g - t e r m yields i n t h e U n i t e d States, a n d 1 % m o r e t h a n t h a t i n N e w Z e a l a n d , suggesting t h a t t h e Reserve Bank's c o m m i t m e n t t o p r i c e stability was n o t f u l l y c r e d i b l e a m o n g financial m a r k e t p a r t i c i p a n t s . T h e view that i n f l a t i o n targeting m i g h t h e l p to anchor i n f l a t i o n expectations gained increasing credibility. I n his S e p t e m b e r speech, as we have n o t e d , t h e G o v e r n o r d e c l a r e d u n d e r l y i n g i n f l a t i o n o f 2 % t o 3% t o be "a reasonable g o a l " f o r t h e Re­ serve B a n k ' s m o n e t a r y policy. H e also discussed i n some d e t a i l t h e issues i n v o l v e d i n c h o o s i n g a p p r o p r i a t e measures o f i n f l a t i o n , as w e l l as t h e use o f i n d i c a t o r s a n d t h e Reserve B a n k ' s o w n i n f l a t i o n forecasts i n t h e p o l i c y process. D e s p i t e A u s t r a l i a ' s "impressive" i n f l a t i o n r e c o r d o v e r t h e p r e v i o u s t h r e e years, t h e G o v e r n o r c a u t i o n e d t h a t "we w i l l n e e d t o sus­ t a i n l o w rates o f i n f l a t i o n t h r o u g h t h e u p s w i n g o f t h e c u r r e n t cycle t o b u i l d r e a l c r e d i b i l i t y " (Fraser, 1994c, p . 2 3 ) . W h i l e t h e speech left a m ­ b i g u o u s h o w t h e Reserve B a n k ' s p e r f o r m a n c e was t o be e v a l u a t e d i n t h e absence o f a m o r e c l e a r l y d e f i n e d t a r g e t h o r i z o n , t h e B a n k h a d never­ theless c o m m i t t e d i t s e l f t o a n u m e r i c a l t a r g e t f o r i n f l a t i o n . T h e l a n g u a g e t h e Reserve B a n k u s e d t o describe its i n f l a t i o n t a r g e t b e c a m e g r a d u a l l y m o r e specific. I n a speech g i v e n o n M a r c h 30, 1995, G o v e r n o r Fraser m e n t i o n e d a n average u n d e r l y i n g i n f l a t i o n o f 2 % t o 3% "over a r u n o f years" as "the Reserve B a n k ' s objective" (Fraser, 1995, p . 2 2 ) . T h e w o r d "target" first appears i n a s t a t e m e n t g i v e n b y t h e Gover­ n o r t o t h e H o u s e o f Representatives S t a n d i n g C o m m i t t e e o n B a n k i n g , F i n a n c e a n d P u b l i c A d m i n i s t r a t i o n o n O c t o b e r 19, 1995: Like other central banks, we have an inflation objective or 'target' to help guide monetary policy. This is to h o l d underlying inflation to 2-3 percent o n average over a r u n o f years. As we have explained o n many occasions, this does n o t mean that underlying inflation should be between 2 and 3 percent every year; rather, i t means that over the cycle the average rate o f inflation should be '2 p o i n t something.' (Reserve Bank, 1995, November, p. 7) T h e t i m e h o r i z o n t o b e u s e d i n e v a l u a t i n g t h e Reserve Bank's p e r f o r ­ m a n c e was n o w t i e d t o "the cycle," w h i c h was n o t f u r t h e r s p e c i f i e d . I n s u m m a r y , t h e a d o p t i o n o f a n i n f l a t i o n t a r g e t i n A u s t r a l i a was a u n i l a t e r a l d e c i s i o n b y t h e Reserve B a n k m a d e after a d i s i n f l a t i o n h a d

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b e e n c o m p l e t e d . T h e a d o p t i o n o f t h e t a r g e t was n e i t h e r p r o m p t e d b y n o r a c c o m p a n i e d b y a c h a n g e i n t h e Reserve B a n k ' s statute, n o r was i t subject t o any a g r e e m e n t b e t w e e n g o v e r n m e n t a n d t h e Reserve B a n k . Rather, i t was p a r t o f a g r a d u a l r e o r i e n t a t i o n o f m o n e t a r y p o l i c y t o w a r d r e c o g n i z i n g p r i c e stability as its p r i m a r y g o a l . T h e Reserve B a n k c o m ­ m i t t e d i t s e l f t o a t a r g e t at a t i m e w h e n p u b l i c u n c e r t a i n t y a b o u t its c o m ­ m i t m e n t threatened to unleash inflation expectations a n d to damage t h e p r i c e stability t h a t h a d a l r e a d y b e e n a c h i e v e d .

The Operational Framework of Australia's Inflation Targeting T o u n d e r s t a n d t h e A u s t r a l i a n v a r i a n t o f i n f l a t i o n t a r g e t i n g , we m i g h t best c o m p a r e i t w i t h t h e e x p e r i e n c e o f o t h e r s m a l l , o p e n e c o n o m i e s , s u c h as N e w Z e a l a n d , Israel, a n d S p a i n . L i k e those c o u n t r i e s , A u s t r a l i a faced t h e p r o s p e c t o f h a v i n g its e c o n o m y b u f f e t e d b y shocks t o t h e ex­ t e r n a l sector a n d t o t h e t e r m s o f t r a d e . L i k e t h e m , A u s t r a l i a f a c e d a b u s i ­ ness cycle d r i v e n as m u c h b y a l a r g e t r a d i n g p a r t n e r ( t h e U n i t e d States) as b y d o m e s t i c factors. A g a i n l i k e these o t h e r e c o n o m i e s , A u s t r a l i a was t r y i n g t o c o n s o l i d a t e t h e i n f l a t i o n gains i t h a d m a d e i n r e c e n t years f o l ­ l o w i n g a l o n g p e r i o d i n w h i c h its c o m m i t m e n t t o p r i c e stability h a d b e e n p e r c e i v e d as weak. I n sharp c o n t r a s t t o N e w Zealand's t a r g e t i n g f r a m e w o r k , however, t h e Reserve B a n k o f A u s t r a l i a e m p h a s i z e d flexibility i n a l l aspects o f its o p ­ erations, f r o m t h e d e f i n i t i o n o f t a r g e t t o t h e r e c o g n i t i o n o f its d i s c r e t i o n i n r e s p o n d i n g t o s h o c k s . T h e closest a n a l o g y m a y be t h e Swiss m o n ­ etary t a r g e t i n g f r a m e w o r k ( C h a p t e r 4 ) . L i k e t h e Swiss N a t i o n a l B a n k , t h e Reserve B a n k o f A u s t r a l i a e m p h a s i z e d t h e d i f f i c u l t i e s i n v o l v e d i n m e e t i n g a n exact i n f l a t i o n t a r g e t r a n g e over a s h o r t p e r i o d o f t i m e . T h e A u s t r a l i a n t a r g e t is f o r a " t h i c k p o i n t " t a r g e t o f " a r o u n d 2-3% o v e r t h e m e d i u m t e r m " (Stevens a n d D e b e l l e , 1995, p . 8 2 ) . T h e i n f l a t i o n rate t o w h i c h t h e t a r g e t refers is i n " u n d e r l y i n g t e r m s " f o r t h e rate o f increase i n c o n s u m e r prices. G i v e n t h e relative i n d e p e n d e n c e o f t h e Reserve B a n k to set its i n s t r u m e n t s , a n d t h e relatively non-specific c o m m i t m e n t t o its targets, t h e o v e r a l l t o n e o f A u s t r a l i a n p o l i c y is very s i m i l a r t o t h e "disci­ p l i n e d d i s c r e t i o n " o f t h e Swiss N a t i o n a l B a n k : 13

[The 2% to 3% target] is n o t a range w i t h i n which the Bank feels inflation must, or necessarily can, be maintained at all times and under any circum­ stances. Such a narrow band w o u l d i n our view be m u c h too ambitious, given the difficulties o f short-term forecasting and c o n t r o l o f inflation . . .

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Given some cyclical variation i n inflation and the occurrence o f myriad m i n o r shocks affecting prices, some deviations will almost certainly occur. (Ibid.) T h e Reserve B a n k denies t h a t i t c a n specify i n advance t h e c o n d i t i o n s u n d e r w h i c h i t w o u l d have t o deviate f r o m its t a r g e t ( u n l i k e t h e Reserve B a n k o f N e w Z e a l a n d ) , o r even t h a t i t c a n be h e l d t o its t a r g e t i n t h e s h o r t e r t e r m . As some o f t h e designers o f t h e A u s t r a l i a n p o l i c y f r a m e ­ w o r k state, " T h i s does n o t r e p r e s e n t , i n o u r view, a lesser d e g r e e o f c o m ­ m i t m e n t t o ' p r i c e stability' as a l o n g - t e r m objective f o r m o n e t a r y p o l i c y . I t reflects, instead, a m e a s u r e o f c a u t i o n a b o u t w h a t A u s t r a l i a n m o n ­ etary p o l i c y c a n c l a i m t o be capable o f a c h i e v i n g over s h o r t p e r i o d s " (Stevens a n d D e b e l l e , 1995, p . 8 2 ) . T h e Reserve B a n k o f A u s t r a l i a ap­ pears t o have d r a w n m u c h t h e same i n t e r p r e t a t i o n o f t h e N e w Z e a l a n d e x p e r i e n c e as we d i d i n C h a p t e r 5, t h a t a n excessively i n f l e x i b l e p u r s u i t o f a s t r i c t i n f l a t i o n t a r g e t i n t h e s h o r t t e r m is l i k e l y t o p r o d u c e i n s t a b i l i t y i n policy a n d i n the economy. Regarding Australia's choice o f a "thick p o i n t " rather t h a n a target r a n g e , G r e n v i l l e (1997, p . 147) states Considering the regular terms-of-trade shocks which Australia experienced, and looking at the history o f cyclical fluctuations i n inflation i n Australia (going back to the period o f price stability i n the 1950s and 1960s), i t was clear that these variations were greater than the 2 per cent i n the New Zealand specification. 14

A s t r i k i n g s i m i l a r i t y b e t w e e n t h e A u s t r a l i a n a n d Swiss m o n e t a r y f r a m e ­ w o r k s is t h a t A u s t r a l i a m a n a g e d t o a c q u i r e a Swiss-like d e g r e e o f p o l i c y d i s c r e t i o n a n d still i m p r o v e its i n f l a t i o n p e r f o r m a n c e , despite h a v i n g n o t h i n g l i k e t h e l o n g Swiss r e c o r d o f p r i c e stability t o d r a w o n . T h e A u s t r a l i a n t a r g e t itself, as w e have n o t e d , is o p e n - e n d e d ( f o r "a r u n o f years") r a t h e r t h a n f o r a s p e c i f i c h o r i z o n . T h e t a r g e t has always b e e n set above z e r o m e a s u r e d i n f l a t i o n . M e a s u r e m e n t e r r o r , h o w e v e r , has n o t b e e n f e a t u r e d as a n e x p l a n a t i o n f o r c h o o s i n g a tar­ g e t g r e a t e r t h a n z e r o . R a t h e r , as i n m a n y o t h e r c o u n t r i e s t h a t h a v e a d o p t e d above-zero i n f l a t i o n t a r g e t s , t h e r a t i o n a l e has b e e n c o n c e r n over w h e t h e r the benefits o f c o n t i n u e d disinflation for the real e c o n o m y o u t w e i g h t h e costs w h e n t h e i n f l a t i o n r a t e is a l r e a d y v e r y low. A n n o u n c e m e n t o f a relatively low target for inflation i n Austra­ lia apparently proved sufficient to anchor inflation expectations, w i t h d e b a t e s o v e r t h e u l t i m a t e a m o u n t o f d i s i n f l a t i o n l e f t safely t o t h e f u ­ ture. 1 5

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T h e Reserve B a n k o f A u s t r a l i a does share o n e o p e r a t i o n a l aspect w i t h N e w Z e a l a n d , i n t h a t t h e t a r g e t " u n d e r l y i n g C P I " series is specifically d e f i n e d , w i t h m a n y e x e m p t i o n s . T h e series excludes m o v e m e n t s i n t h e prices o f f r u i t a n d vegetables, p e t r o l , m o r t g a g e interest, p u b l i c - s e c t o r goods a n d services, a n d " o t h e r v o l a t i l e p r i c e s . " Since t h e Reserve B a n k o f A u s t r a l i a , u n l i k e t h e Reserve B a n k o f N e w Z e a l a n d , is n o t subject t o a " h a r d " b a n d o n its target, m a k i n g t h e d e f i n i t i o n o f t h e t a r g e t series so specific seems a b i t i n c o n g r u o u s . T h e Reserve B a n k o f A u s t r a l i a ' s prac­ tice is closer t o t h e Swiss e x a m p l e o f " s i m p l e rules, c o m p l i c a t e d e x p l a n a ­ tions." F o r e x a m p l e , w i t h r e g a r d t o t h e r o l e o f t h e m o r t g a g e i n t e r e s t rate i n t h e t a r g e t series, " . . . t h e r e is a n e e d f o r t h e B a n k t o e x p l a i n clearly w h a t these i n t e r e s t rate effects are, w h y i t abstracts f r o m t h e m f o r p o l i c y purposes, a n d t h a t t h e r e is a r e q u i r e m e n t t h a t p r i c e a n d wage setters d i s t i n g u i s h b e t w e e n h e a d l i n e a n d u n d e r l y i n g i n f l a t i o n rates i n t h e i r o w n decisions" (Stevens a n d D e b e l l e , 1995, p . 8 4 ) . W h e r e a c c o u n t a b i l i t y can­ n o t be a m e c h a n i c a l c o m p a r i s o n o f p e r f o r m a n c e o f a series t o some s t a n d a r d , because rigid p u r s u i t o f t h a t s t a n d a r d is i t s e l f h a r m f u l , t h e b u r d e n o f m a k i n g clear e x p l a n a t i o n s t o t h e p u b l i c increases. 17

T h e indefinite ( m e d i u m - t e r m ) t i m e h o r i z o n for achieving the target i m p l i e s t h a t t h e Reserve B a n k is c o n c e r n e d a b o u t t h e l o n g e r - t e r m aver­ age o f i n f l a t i o n ; t h e r e w i l l be n o reversals o f s h o r t - t e r m o v e r s h o o t i n g s o r u n d e r s h o o t i n g s o f i n f l a t i o n i n t h e A u s t r a l i a n f r a m e w o r k . I t appears t h a t t h e Reserve B a n k i n t e n d s t o r e s p o n d t o shocks t o t h e e c o n o m y as i t deems necessary i n t h e s h o r t t e r m , w i t h o u t recourse t o t h e "escape clauses" o f t h e N e w Z e a l a n d f r a m e w o r k , o r even t o t h e r e q u i r e d e x p l a n a t i o n s f o r breaches o f t h e t a r g e t r a n g e i n t h e a p p r o a c h r e c e n t l y a d o p t e d by t h e U n i t e d K i n g d o m . I n d e e d , t h e Reserve B a n k has b e e n m o r e e x p l i c i t t h a n any o t h e r c e n t r a l b a n k we have discussed i n r e s p o n d i n g t o s h o r t - r u n f l u c t u a t i o n s i n o u t p u t a n d e m p l o y m e n t . As G o v e r n o r Fraser n o t e d , t h e r e never was s t r o n g s u p p o r t f o r m a k i n g p r i c e stability t h e sole g o a l o f m o n ­ etary p o l i c y : There was also a feeling that, taken literally, [shifting to a single goal o f price stability] made the task o f monetary policy too simple—or simplistic . . . The Bank understood that, for the most part, there would be no conflict between activity and price objectives (and, i n fact, activity would be a principal for­ ward indicator o f inflation); when there was a conflict ( i n the case o f a sup­ ply-side shock, or when a structural reduction i n inflation was needed), this could not be resolved by the simplistic expedient o f giving an absolute over­ r i d i n g priority to prices. (Grenville, 1997, p. 149) O n c e a g a i n , this p r a g m a t i c t o n e is r e m i n i s c e n t o f t h e Swiss a p p r o a c h .

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As w i t h a l l t h e i n f l a t i o n targeters we have c o n s i d e r e d , A u s t r a l i a ' s c o n ­ c e r n f o r real-side goals is e m b o d i e d p r i m a r i l y i n t h e g r a d u a l a d j u s t m e n t o f i n f l a t i o n f o l l o w i n g a s h o c k t o t h e p r i c e level. T h e Reserve B a n k has n o t s p e c i f i e d a t i m e l i m i t f o r r e a c h i n g its i n f l a t i o n g o a l f o l l o w i n g a n u n e x p e c t e d shift i n i n f l a t i o n . " [ I ] n t h e event o f a n u n a n t i c i p a t e d c h a n g e i n i n f l a t i o n . . . t h e r e is a c o m m i t m e n t t o adjust p o l i c y settings i n s u c h a way as t o achieve a r e t u r n t o t h e 2-3 p e r c e n t level as q u i c k l y as feasible. W h a t is feasible c a n n o t be p r e d i c t e d i n a d v a n c e — i t d e p e n d s u p o n t h e n a t u r e o f t h e event, a n d is a f u n c t i o n of, a m o n g o t h e r t h i n g s , t h e slope o f t h e s h o r t - r u n P h i l l i p s c u r v e [ t h a t is, t h e u n e m p l o y m e n t cost o f each p o i n t o f d i s i n f l a t i o n ] " (Stevens a n d D e b e l l e , 1995, p . 8 4 ) . I n m a k i n g its forecast o f i n f l a t i o n , t h e Reserve B a n k pays close atten­ t i o n t o measures o f real e c o n o m i c activity, such as changes i n e m p l o y ­ m e n t , changes i n s p e n d i n g , a n d t h e l i k e . I t also takes i n t o a c c o u n t p r i ­ vate-sector i n f l a t i o n e x p e c t a t i o n s a n d forecasts, as w e l l as c u r r e n t wage settlements. Interestingly, a n d i n contrast to S p a i n a n d Israel, t h e Reserve B a n k is n o t usually responsive t o s h o r t - t e r m fluctuations i n t h e exchange rate. T h i s a t t i t u d e is consistent w i t h t h e Bank's b e l i e f t h a t m a n y ( t h o u g h n o t all) m o v e m e n t s o f t h e exchange rate reflect shifts i n t h e terms o f t r a d e ( t h a t is, t h e relative p r i c e o f A u s t r a l i a n g o o d s ) , r a t h e r t h a n changes i n i n f l a t i o n expectations o r business cycles. T h e a s s u m p t i o n is n o t u n r e a s o n ­ able, g i v e n Australia's o r i e n t a t i o n t o w a r d c o m m o d i t y exports. H o w e v e r , t h e d i f f e r e n c e b e t w e e n t h e A u s t r a l i a n a p p r o a c h t o t h e ex­ c h a n g e rate a n d t h a t o f N e w Z e a l a n d a n d Canada, t w o o t h e r c o m m o d i t y e x p o r t e r s , is q u i t e m a r k e d . C a n a d a a n d , m o r e recently, N e w Z e a l a n d have a d o p t e d as o p e r a t i n g guides t o p o l i c y a " m o n e t a r y c o n d i t i o n s i n ­ d e x , " o r M C I , w h i c h c o m b i n e s changes i n d o m e s t i c i n t e r e s t rates a n d changes i n e x c h a n g e rates ( C h a p t e r s 5 a n d 6 ) . T h u s m o n e t a r y p o l i c y i n C a n a d a a n d N e w Z e a l a n d reacts f a i r l y v i g o r o u s l y t o changes i n t h e ex­ c h a n g e rate. T o t h e e x t e n t t h a t shifts i n t h e e x c h a n g e rate d o i n fact r e p r e s e n t changes i n t h e t e r m s o f t r a d e , m o n e t a r y p o l i c y s h o u l d n o t offset t h e m , as a n M C I r e q u i r e s . Clearly, A u s t r a l i a believes i t s e l f t o be f a c i n g a d i f f e r e n t e x t e r n a l e n v i r o n m e n t f r o m t h a t faced b y C a n a d a a n d N e w Z e a l a n d . W h e t h e r t h a t b e l i e f is c o r r e c t is u l t i m a t e l y a n e m p i r i c a l q u e s t i o n ; still, i t is s u r p r i s i n g t h a t such a p p a r e n t l y s i m i l a r e c o n o m i e s w o u l d d i f f e r o n this key p o i n t . T h e strengths a n d weaknesses o f u s i n g a n M C I i n t h e c o n t e x t o f i n f l a t i o n t a r g e t i n g are topics w o r t h y o f f u r t h e r research. T h e p r i m a r y v e h i c l e f o r r e p o r t s o n t h e state o f t h e e c o n o m y , speeches g i v e n b y t h e G o v e r n o r a n d D e p u t y G o v e r n o r s , a n d o c c a s i o n a l research articles is t h e Reserve B a n k ' s m o n t h l y Bulletin. E x c e p t f o r t h e speeches,

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a l l articles p u b l i s h e d i n t h e Bulletin are u n s i g n e d . W e l l b e f o r e 1993, t h e Reserve B a n k was already p u b l i s h i n g i n every t h i r d issue o f t h e Bulletin a r e p o r t t i t l e d " T h e E c o n o m y a n d F i n a n c i a l M a r k e t s , " d i v i d e d i n t o sec­ tions o n "The I n t e r n a t i o n a l Economy" a n d "The Australian Economy." T h e l a t t e r s e c t i o n i n c l u d e d discussions o f d e v e l o p m e n t s i n prices a n d costs, as w e l l as o t h e r measures o f e c o n o m i c activity. Since 1993, t h e B a n k has c o n t i n u e d t o p u b l i s h a q u a r t e r l y r e p o r t o n t h e e c o n o m y i n t h e Bulletin, b u t t h e f o r m a t has c h a n g e d substantially. T h a t r e p o r t , w h i c h since J a n u a r y 1995 has b e e n c a l l e d t h e " Q u a r t e r l y R e p o r t o n t h e E c o n o m y a n d F i n a n c i a l M a r k e t s " ( h e n c e f o r t h Q u a r t e r l y R e p o r t ) , u s u a l l y consists o f a s e c t i o n o n financial m a r k e t d e v e l o p m e n t s as w e l l as sections o n t h e international economy a n d the domestic economy. T h e section o n the d o m e s t i c e c o n o m y c o n t i n u e s t o discuss a v a r i e t y o f m a t t e r s b u t n o w i n ­ cludes i n f o r m a t i o n o n i n f l a t i o n t r e n d s a n d prospects, wholesale prices a n d m a r g i n s , l a b o r costs, a n d i n f l a t i o n e x p e c t a t i o n s . T h e F i n a n c i a l M a r ­ kets s e c t i o n deals w i t h d e v e l o p m e n t s i n i n t e r n a t i o n a l b o n d a n d e q u i t y m a r k e t s , m o n e t a r y p o l i c y a n d s h o r t - t e r m i n t e r e s t rates, d e v e l o p m e n t s i n t h e b a n k i n g sector, a n d f o r e i g n - e x c h a n g e m a r k e t s . T h e shift t o w a r d i n f l a t i o n t a r g e t i n g d u r i n g 1993 a n d 1994 was a c c o m ­ p a n i e d b y i n c r e a s e d emphasis i n t h e Q u a r t e r l y R e p o r t o n forecasts o f i n f l a t i o n , f r o m b o t h o u t s i d e a n d i n s i d e t h e Reserve B a n k , a n d o n cur­ r e n t d e v e l o p m e n t s i n m o n e t a r y policy. C o n s u m e r s ' one-year-ahead ex­ p e c t a t i o n s o f i n f l a t i o n f r o m t h e M e l b o u r n e I n s t i t u t e Survey w e r e already b e i n g p u b l i s h e d b e f o r e 1993. Since 1994, t h e Consensus Forecasts, w h i c h reflect t h e o p i n i o n s o f private-sector f o r e c a s t i n g professionals, are dis­ cussed as w e l l . F o l l o w i n g t h e first o f t h r e e consecutive increases i n t h e Cash rate o n A u g u s t 17, 1994 ( t h a t is, b e g i n n i n g w i t h t h e O c t o b e r 1994 issue), t h e Q u a r t e r l y R e p o r t has e x p l a i n e d changes i n m o n e t a r y p o l i c y as w e l l . Finally, since A p r i l 1995 t h e Q u a r t e r l y R e p o r t has p u b l i s h e d t h e Reserve Bank's official i n f l a t i o n o u t l o o k , t h o u g h i n relatively vague t e r m s r e m i n i s c e n t o f t h e Swedish R i k s b a n k ' s references ( b e f o r e D e c e m b e r 1997) t o t h e p o s i t i o n o f i n f l a t i o n relative t o its target. 1 8

T h e B a n k also engages i n m o r e f o r m a l r e p o r t i n g . Since 1 9 9 1 , t h e B a n k ' s Annual Report, w h i c h is p r e s e n t e d i n t h e b u d g e t session o f Parlia­ m e n t , has b e e n subject t o a h e a r i n g b y t h e H o u s e o f Representatives Standing Committee o n Banking, Finance a n d Public A d m i n i s t r a t i o n ( a l t h o u g h at first t h e C o m m i t t e e seems t o have m a d e l i t t l e use o f this o p p o r t u n i t y , as r e p o r t e d b y Fraser [ 1 9 9 3 ] ) . W h e n G o v e r n o r M a c f a r l a n e was a p p o i n t e d t o succeed Fraser o n A u g u s t 14, 1996, t h e T r e a s u r e r a n d t h e G o v e r n o r - d e s i g n a t e released a " S t a t e m e n t o n t h e C o n d u c t o f M o n ­ etary Policy." I n i t , t h e parties a g r e e d t h a t

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the Governor (designate) will support the release by the Bank o f specific statements on monetary policy and the role i t is playing i n achieving the Bank's objectives. I t is intended that these statements will include informa­ tion on the outlook for inflation and will be released at roughly six m o n t h l y intervals. (Reserve Bank o f Australia, 1996, September, pp. 2-3) A c c o r d i n g l y , since M a y 1997, t h e B a n k has p r o v i d e d t h e Semi-Annual Statement on Monetary Policy. T h e Statement is, i n effect, t h e official i n f l a t i o n r e p o r t o f t h e Reserve B a n k . T h o u g h s i m i l a r i n s t r u c t u r e t o t h e Q u a r t e r l y R e p o r t , i t is m u c h m o r e d e t a i l e d , a b o u t f o u r times as l o n g , a n d r e p l e t e w i t h pedagogic devices, such as boxes e x p l a i n i n g e c o n o m i c concepts a n d measurements, as w e l l as n u m e r o u s h i s t o r i c a l comparisons o f t h e c u r r e n t state o f t h e e c o n o m y w i t h previous business cycles. L i k e t h e Q u a r t e r l y R e p o r t , t h e Statement starts w i t h a n i n - d e p t h discussion o f t h e e c o n o m i c s i t u a t i o n a b r o a d . T h e section o n domestic e c o n o m i c activity covers devel­ o p m e n t s i n households, business, a n d r u r a l sectors, the balance o f pay­ m e n t s , a n d t h e l a b o r m a r k e t . C o n d i t i o n s i n t h e c r e d i t markets, financial i n t e r m e d i a r i e s , a n d m o n e t a r y aggregates are t h e subject o f a section o n t h e financial sector. T h e Statement concludes w i t h a section o n i n f l a t i o n trends a n d prospects. Several measures o f i n f l a t i o n , i m p o r t a n d p r o d u c e r prices, deflators, a n d trends i n l a b o r costs are surveyed, as are n u m e r o u s measures o f i n f l a t i o n expectations. T h e Reserve Bank's o w n i n f l a t i o n o u t ­ l o o k is m o r e fully covered h e r e t h a n i n the Q u a r t e r l y R e p o r t , i n t h a t t h e factors s h a p i n g t h e o u t l o o k , as w e l l as t h e upside a n d d o w n s i d e risks, are e x p l a i n e d i n some d e t a i l . However, t h e Statement, l i k e t h e Q u a r t e r l y Re­ p o r t , does n o t p r o v i d e a q u a n t i t a t i v e i n f l a t i o n forecast. Instead, i t p r o ­ vides o n l y a g e n e r a l assessment o f w h e r e i n f l a t i o n is l i k e l y t o be relative t o t h e target over a h o r i z o n t h a t is n o t very clearly specified. A n i m p o r t a n t aspect o f t h e Statement is t h a t i t c o n t a i n s a s t r o n g e n ­ d o r s e m e n t b y t h e g o v e r n m e n t o f t h e i n f l a t i o n t a r g e t a n d emphasizes t h e i n d e p e n d e n c e o f t h e Reserve B a n k t o c o n d u c t m o n e t a r y p o l i c y i n p u r s u i t o f t h e target. T h i s show o f s u p p o r t , t o g e t h e r w i t h t h e p r o m i ­ n e n c e a c c o r d e d t h e n o w twice-yearly f o r m a l appearances b e f o r e t h e Par­ l i a m e n t a r y C o m m i t t e e , has a d d e d l e g i t i m a c y t o t h e m o n e t a r y p o l i c y framework i n Australia.

Australia's Experience under Inflation Targeting I n A u s t r a l i a , as i n N e w Z e a l a n d , t h e c r i t i c a l episode i n m o n e t a r y p o l i c y since 1993 was t h e t i g h t e n i n g o f m o n e t a r y p o l i c y i n 1994, a n d t h e rise i n i n f l a t i o n t h a t f o l l o w e d i n 1995.

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M a c r o e c o n o m i c c o n d i t i o n s i n A u s t r a l i a a n d N e w Z e a l a n d w e r e re­ m a r k a b l y s i m i l a r d u r i n g t h e early 1990s ( c o m p a r e t h e panels i n F i g u r e 9.2 t o t h e i r c o u n t e r p a r t s i n F i g u r e 5.1). G D P g r o w t h rates a n d t h e i n ­ creases i n u n e m p l o y m e n t rates i n t h e t w o c o u n t r i e s b e t w e e n 1990 a n d 1992 w e r e a l m o s t i d e n t i c a l , a n d after 1990 t h e rates o f b o t h h e a d l i n e i n f l a t i o n a n d u n d e r l y i n g i n f l a t i o n i n t h e t w o c o u n t r i e s h a d m o v e d closely t o g e t h e r as w e l l . A l s o s i m i l a r w e r e financial m a r k e t i n d i c a t o r s (such as t h e n o m i n a l e x c h a n g e rate a n d l o n g - t e r m i n t e r e s t rates) a n d m o n e t a r y policy, as r e f l e c t e d i n s h o r t - t e r m i n t e r e s t rates. By t h e e n d o f 1993 Australia's recovery f r o m t h e 1991 recession h a d gained g r o u n d , w i t h real GDP growth accelerating toward 4%, i n line w i t h t h e Reserve B a n k ' s e x p e c t a t i o n s . As t h e u n e m p l o y m e n t rate re­ m a i n e d i n t h e v i c i n i t y o f 1 1 % t h r o u g h o u t 1993, t h e Reserve B a n k ' s as­ sessment was t h a t r e a l g r o w t h o f 4 % w o u l d have t o be sustained t o re­ store u n e m p l o y m e n t t o a m o r e acceptable level. G i v e n t h e a m o u n t o f slack i n t h e e c o n o m y , t h e o n l y risk o f i n f l a t i o n at this stage c a m e f r o m e x t e r n a l factors: T h e A u s t r a l i a n d o l l a r h a d f a l l e n b y 2 0 % i n t r a d e w e i g h t e d t e r m s over t h e two years t o S e p t e m b e r 1993, t o t h e p o i n t t h a t "the Reserve B a n k i n t e r v e n e d heavily i n t h e f o r e i g n e x c h a n g e m a r k e t at t h e t i m e , a n d also c o n s i d e r e d r a i s i n g i n t e r e s t rates t o s u p p o r t t h e ex­ c h a n g e rate" (Fraser, 1994b, p . 2 1 ) . I n t h e event, t h e A u s t r a l i a n d o l l a r r e c o v e r e d , a n d t h e Reserve B a n k h e l d its i n s t r u m e n t Cash Rate stable at 4.75%. T h e data available at t h e b e g i n n i n g o f 1994 i n d i c a t e d t h a t t h e recov­ ery was i n c r e a s i n g l y broad-based, a n d a l t h o u g h t h e r e was s t i l l slack i n the economy, t h e rate o f u n e m p l o y m e n t was e x p e c t e d t o f a l l d u r i n g 1994. A c c o r d i n g t o t h e J a n u a r y 1994 Q u a r t e r l y R e p o r t , t h e d e p r e c i a t i o n o f t h e A u s t r a l i a n d o l l a r b e f o r e S e p t e m b e r 1993 was "the m a i n source o f i n f l a t i o n a r y pressure o n t h e cost side" (Reserve B a n k o f A u s t r a l i a , 1994, January, p . 8 ) , w h i l e g r o w t h i n l a b o r costs r e m a i n e d s u b d u e d . T h e Re­ serve Bank's b e n i g n view o f t h e prospects f o r i n f l a t i o n was s h a r e d b y t h e m a r k e t s i n early 1994. T h e yields o f 90-day bills h a d e d g e d d o w n t o 4 . 8 % , a n d futures prices f o r those bills i n d i c a t e d t h a t n o t i g h t e n i n g was ex­ p e c t e d over t h e c o m i n g m o n t h s . Yields o n 10-year g o v e r n m e n t b o n d s f e l l t o 6.4% i n January. T h e n , f o l l o w i n g t h e U.S. F e d e r a l Reserve's t i g h t e n i n g m o v e o n Feb­ r u a r y 4, 1994, t h e assessment o f f u t u r e i n f l a t i o n i n t h e b o n d m a r k e t changed quite suddenly a n d dramatically. D u r i n g February a n d M a r c h , A u s t r a l i a n 10-year b o n d yields rose f r o m 6.4% to 8%. T h e Reserve B a n k d i d n o t share t h e financial m a r k e t s ' view t h a t t h e risks o f h i g h e r i n f l a -

C.

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1984

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1982

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1998

Figure 9.2. Australian economic indicators. Sources: A) Main Economic Indicators o f the Organisation for Economic Cooperation and Development, Reserve Bank o f Australia; B) Main economic indicators o f the Organisation for Economic Cooperation and Development, Reserve Bank o f Australia; C) M a i n Economic Indicators o f the Organisation for Economic Cooperation and Development; D) Bank for International Settlements database.

A.

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t i o n h a d increased. I n a speech o n M a r c h 30, 1994, G o v e r n o r Fraser l i s t e d several reasons w h y l o w i n f l a t i o n c o u l d be e x p e c t e d t o persist, even t h o u g h g r o w t h was a c c e l e r a t i n g a b i t above 4 % (Fraser, 1994a). O n e o f t h e reasons h e gave—the closer i n t e g r a t i o n w i t h w o r l d m a r k e t s o f t h e A u s t r a l i a n e c o n o m y f o l l o w i n g t h e r e f o r m measures o f t h e 1980s— is r e m i ­ n i s c e n t o f views expressed at a b o u t t h e same t i m e b y t h e Reserve B a n k o f N e w Z e a l a n d , t h a t e a r l i e r s t r u c t u r a l r e f o r m s m i g h t have raised t h e sus­ t a i n a b l e g r o w t h rate o f t h e e c o n o m y . By early July, however, t h e Reserve B a n k b e g a n t o p r e p a r e t h e g r o u n d f o r a t i g h t e n i n g o f policy, w h i l e at t h e same t i m e d e f e n d i n g its c u r r e n t p o l i c y stance. Its o u t l o o k h a d c h a n g e d n e i t h e r w i t h respect t o o u t p u t g r o w t h , w h i c h was still e x p e c t e d t o b e i n t h e 4 % t o 5% r a n g e over t h e n e x t 12 m o n t h s , n o r w i t h respect t o i n f l a t i o n , w h i c h was forecast t o re­ m a i n i n t h e 2 % t o 3% range over t h e same h o r i z o n . " T h e e c o n o m y is n o t a b o u t t o b u r s t o u t o f its c u r r e n t 4 t o 5 p e r c e n t g r o w t h range, a n d t h e r e are few signs t h a t wage o r o t h e r cost increases are accelerating. I n d e e d , t h e r e is every reason t o believe t h a t c u r r e n t g r o w t h a n d i n f l a t i o n rates w i l l be sustained i n 1 9 9 4 / 9 5 " (Fraser, 1994b, p . 2 2 ) . H o w e v e r t h e f i n a n c i a l mar­ kets clearly disagreed w i t h t h a t assessment, w i t h 10-year b o n d yields hav­ i n g risen by 3.2% b e t w e e n F e b r u a r y 3 a n d J u n e 30, c o m p a r e d t o 1.6% i n t h e U n i t e d States a n d , significantly, o n l y 2 . 1 % i n N e w Z e a l a n d . The higher-than-average rise i n b o n d yields i n Australia appears to reflect judgments by the market that the already fast-growing Australian economy could be pushed even faster by rising commodity prices, generating infla­ tionary pressures which, i n the eyes o f the market, the authorities would be slow to respond to. While the stronger outlook for Australia and the w o r l d economy suggests that b o n d yields should be higher today than they were, say, a year ago, the authorities i n Australia have indicated that they do not share the j u d g m e n t about the outlook for inflation which is implicit i n the rise i n Australian b o n d yields. (Reserve Bank o f Australia, 1994, July, p. 15) T h e yields o n 90-day b i l l s h a d r i s e n t o 5.8% b y late J u n e , a n d t h e y i e l d i m p l i e d b y prices f o r S e p t e m b e r futures o n 90-day bills h a d r i s e n t o 6.4%, reflecting the market's expectation that a t i g h t e n i n g o f monetary policy was a b o u t t o occur. T h e absence o f e i t h e r a c l e a r l y f o r m u l a t e d i n f l a ­ t i o n t a r g e t o r a n e x a c t s t a t e m e n t o f h o w t h e Reserve B a n k e x p e c t e d i n f l a t i o n t o d e v e l o p c o n t r i b u t e d t o u n c e r t a i n t y a b o u t t h e f u t u r e course of inflation. O n A u g u s t 17 t h e Reserve B a n k finally b e g a n t o t i g h t e n policy, rais­ i n g t h e Cash Rate b y 0.75% t o 5.5%. " A l t h o u g h t h e t i m i n g o f t h e m o v e has b e e n i n f l u e n c e d by t h e latest rise i n U . S . i n t e r e s t rates, t h e m o v e

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i t s e l f is d r i v e n b y t h e m a r k e d t u r n a r o u n d i n Australia's d o m e s t i c eco­ n o m i c c o n d i t i o n s " (Reserve B a n k o f A u s t r a l i a , 1994, September, p . 2 3 ) . I n its O c t o b e r 1994 Q u a r t e r l y R e p o r t , t h e Reserve B a n k n o t e d t h a t "cyclical p r i c e pressures c a n be e x p e c t e d t o increase as spare capacity i n t h e e c o n o m y is t a k e n u p " (Reserve B a n k o f A u s t r a l i a , 1994, O c t o b e r , p . 1 ) , b u t a g a i n i t gave n o i n d i c a t i o n o f w h e r e i t e x p e c t e d i n f l a t i o n t o g o . Real G D P h a d g r o w n b y 4 . 3 % i n t h e year t o J u n e , w h i l e u n d e r l y i n g i n f l a ­ t i o n h a d r e m a i n e d steady at 1.9% over t h e same p e r i o d . U n e m p l o y m e n t h a d b e e n f a l l i n g since N o v e m b e r 1993, f r o m 1 1 % t o 9.5%. T h e r e h a d b e e n l i t t l e m a r k e t r e a c t i o n f o l l o w i n g t h e A u g u s t 17 Cash Rate h i k e , w h i c h h a d b e e n w i d e l y a n t i c i p a t e d . Yet b y t h e t i m e o f t h e O c t o b e r R e p o r t , 90day b i l l yields h a d r i s e n f r o m 5.7% t o 6.4% "as m a r k e t s b e g a n t o p r i c e i n t h e p o s s i b i l i t y o f a f u r t h e r t i g h t e n i n g o f p o l i c y " (Ibid., p . 1 1 ) . Ten-year b o n d yields, w h i c h h a d f a l l e n t o 9.2% f o l l o w i n g t h e A u g u s t 17 m o v e , h a d r i s e n t o 10.3% b y t h e e n d o f September, b r i n g i n g t h e rise since F e b r u a r y 3 close t o 4 % . T h e w a t e r s h e d came i n t h e f o u r t h q u a r t e r o f 1994, as t h e Reserve B a n k raised t h e Cash Rate twice, o n O c t o b e r 24 a n d o n D e c e m b e r 14, b y 1 % e a c h t i m e , t o 7.5%. I n its s t a t e m e n t f o l l o w i n g t h e D e c e m b e r 14 rise, t h e Reserve B a n k a c k n o w l e d g e d t h a t This further tightening has occurred rather sooner than some m i g h t have expected, basically because o f evidence that the economy overall has been growing more strongly than earlier thought . . . To date, price and wage increases remain well contained. I n underlying terms, consumer prices are increasing by about 2 percent . . . L o o k i n g ahead, however, this reassuring situation could not be expected to continue at current rates o f growth. (Re­ serve Bank o f Australia, 1995, January, p. 27) B o t h t i g h t e n i n g s h a d b e e n a n t i c i p a t e d , as r e f l e c t e d i n t h e rise i n t h e y i e l d o f t h e 90-day bills above t h e Cash Rate w e l l b e f o r e t h e Reserve Bank's moves. Ten-year g o v e r n m e n t b o n d yields h e l d steady a r o u n d 1 0 % . However, t h e Reserve Bank's i n f l a t i o n o u t l o o k i n t h e a f t e r m a t h o f t h e t i g h t e n i n g s , as r e f l e c t e d i n t h e J a n u a r y 1995 Q u a r t e r l y R e p o r t , r e m a i n e d opaque. I n its A p r i l 1995 Q u a r t e r l y R e p o r t , t h e Reserve B a n k f i n a l l y f u r n i s h e d its forecast o f i n f l a t i o n over t h e c o m i n g year. T h a t p r a c t i c e has persisted. A l t h o u g h t h e r e w e r e t e n t a t i v e signs t h a t t h e Cash Rate increases h a d h a d some m o d e r a t i n g effect o n e c o n o m i c activity, a n d a l t h o u g h u n d e r ­ lying inflation had remained a r o u n d 2%, developments i n the financial m a r k e t s c o n t i n u e d t o be i n a u s p i c i o u s . Ten-year b o n d yields fluctuated b e t w e e n 1 0 % a n d 10.5%, a n d t h e A u s t r a l i a n d o l l a r f e l l 1 1 % over t h e

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first q u a r t e r relative t o t h e c u r r e n c i e s o f its t r a d i n g p a r t n e r s . T h e Re­ serve B a n k c o n c e d e d t h a t t h e f a l l i n t h e A u s t r a l i a n d o l l a r [in] part also clearly reflected concerns specific to Australia. Other curren­ cies which often move i n tandem with the Australian dollar—namely, the New Zealand dollar and the Canadian dollar—were stronger d u r i n g the quar­ ter; i n b o t h cases, they were underpinned by further rises i n official interest rates . . . . O f more direct relevance to Australia, [ b o n d ] yields i n Canada and New Zealand fell sharply to 8.5 percent and 7.9 percent respectively. (Re­ serve Bank o f Australia, 1995, A p r i l , p. 17) T h e r e t r e a t o f t h e A u s t r a l i a n d o l l a r was i n n o s m a l l m e a s u r e d u e t o t h e deterioration o f the current account, w h i c h i n t u r n reflected the strong g r o w t h i n d o m e s t i c d e m a n d d u r i n g 1994. A t any rate, t h e Reserve B a n k expressed t h e c o n c e r n t h a t "the u n d e r l y i n g rate o f i n f l a t i o n is e x p e c t e d to m o v e u p w a r d s — a n d c o u l d rise above 3 p e r c e n t — d u r i n g 1995" (Ibid., p. 15). These d e v e l o p m e n t s p o s e d a c h a l l e n g e t o t h e Reserve B a n k ' s p o l i c y strategy. T h e advantage o f t h e Reserve B a n k ' s "soft" a p p r o a c h t o i n f l a ­ t i o n t a r g e t i n g was t h a t , so l o n g as t h e rise o f u n d e r l y i n g i n f l a t i o n above 3% was c o n s i d e r e d t e m p o r a r y , i t n e e d n o t e l i c i t a p o l i c y response. Prospective developments o n inflation owe more to the i n h e r e n t dynamics of the business cycle than they do to any loss o f resolve o n the part o f the authorities to maintain low inflation. This cyclical variation i n inflation, as well as the fairly wide margin o f uncertainty a r o u n d forecasts o f inflation, are among the reasons why the Bank has eschewed a narrow, hard-edged inflation target, preferring instead to focus o n keeping the average rate o f underlying inflation to 2 to 3 percent over a r u n o f years. Monetary policy will continue to be directed towards m a i n t a i n i n g that outcome. {Ibid., pp. 15-16) T h e p r o b l e m i n h e r e n t i n this a p p r o a c h , however, was h o w t o c o n v i n c e t h e p u b l i c t h a t t h e r e was n o n e e d t o t i g h t e n p o l i c y f u r t h e r , even as G D P g r o w t h c o n t i n u e d h i g h a n d t h e e x c h a n g e rate was w e a k e n i n g rapidly. Possibly, b y this p o i n t , t h e Reserve B a n k also saw a l i n k b e t w e e n t h e su­ perior performance o f the Canadian a n d New Zealand currencies a n d b o n d m a r k e t s a n d t h e greater emphasis those c o u n t r i e s h a d p u t o n c o m ­ m u n i c a t i n g t h e stance o f t h e i r m o n e t a r y policy. T h e e x p e c t e d rise i n u n d e r l y i n g i n f l a t i o n set i n d u r i n g t h e n e x t t w o q u a r t e r s . U n d e r l y i n g i n f l a t i o n rose f r o m 1.9% ( m e a s u r e d year-on-year) i n M a r c h t o 2.5% i n J u n e a n d 3 . 1 % i n September. By t h a t t i m e , however, t h e Reserve B a n k h a d a p p a r e n t l y b e e n successful i n c o n v i n c i n g t h e p u b -

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lie o f t h e t e m p o r a r y n a t u r e o f t h e increase; its shift t o a m o r e o p e n policy, closer i n s p i r i t t o t h a t o f o t h e r i n f l a t i o n targeters, a p p e a r e d t o be h a v i n g a n effect. Yields o n 10-year g o v e r n m e n t b o n d s b e g a n t o f a l l , f r o m j u s t b e l o w 1 0 % at t h e e n d o f M a r c h t o 9 % b y t h e e n d o f j u n e , a n d t o 8.5% b y t h e e n d o f September. T h e f a l l i n l o n g - t e r m i n t e r e s t rates c a m e a m i d i n c r e a s i n g signs t h a t t h e p o l i c y t i g h t e n i n g d u r i n g 1994 was s l o w i n g r e a l G D P g r o w t h t o b e l o w 5%. By late J u n e , 90-day b i l l yields h a d f a l l e n t o 7.5%, t h e same as t h e p r e v a i l i n g level o f t h e Cash Rate, i n d i c a t i n g t h a t f o r t h e first t i m e i n over a year t h e m a r k e t s d i d n o t e x p e c t any f u r t h e r t i g h t e n i n g o f policy. F u r t h e r m o r e , after s t a b i l i z i n g d u r i n g t h e s e c o n d quarter, the exchange rate regained d u r i n g the t h i r d quarter almost the e n t i r e g r o u n d t h a t i t h a d lost d u r i n g t h e first, suggesting t h a t t h e cur­ r e n t account deficit h a d peaked. T h e g r a d u a l d o w n w a r d t r e n d i n t h e f i n a n c i a l m a r k e t s ' i n f l a t i o n ex­ pectations, as r e f l e c t e d i n l o n g - t e r m yields, differences b e t w e e n t h e yields o f i n d e x e d a n d n o n - i n d e x e d b o n d s , a n d surveys o f p r i v a t e sector f o r e ­ casters, c o n t i n u e d i n t o 1996. T h e d e c l i n e i n b o n d yields c a m e t o a t e m ­ p o r a r y h a l t i n February, l a r g e l y i n response t o d e v e l o p m e n t s a b r o a d , i n p a r t i c u l a r t h e assessment t h a t t h e U . S . i n t e r e s t rate cycle h a d b o t t o m e d o u t . B e t w e e n J a n u a r y 18 a n d A p r i l 9 , 1 9 9 6 , A u s t r a l i a n 10-year b o n d yields rose by 85 basis p o i n t s , t o 9 % . Significantly, however, i n c o n t r a s t t o early 1994, this t i m e A u s t r a l i a n b o n d yields rose less t h a n yields i n N e w Z e a l a n d . M o r e o v e r , i n A p r i l , f o r t h e first t i m e since 1990, t h e d i f f e r e n t i a l b e t w e e n A u s t r a l i a n a n d N e w Z e a l a n d b o n d yields closed, a n d f r o m J u n e o n w a r d A u s t r a l i a n yields f e l l b e l o w those i n N e w Z e a l a n d . T h e Reserve B a n k p r e d i c t e d (accurately, as i t t u r n e d o u t ) i n its J a n u ­ ary 1996 Q u a r t e r l y R e p o r t t h a t u n d e r l y i n g i n f l a t i o n w o u l d rise b e y o n d its S e p t e m b e r 1995 v a l u e o f 3 . 1 % b e f o r e m o v i n g b a c k t o w a r d t h e 2 % t o 3% r a n g e i n t h e s e c o n d h a l f o f 1996. D e s p i t e this, a n d despite t h e t r e n d i n i n f l a t i o n e x p e c t a t i o n s , t h e Cash Rate was k e p t at 7.5% f o r t h e first h a l f o f 1996. T h e m a i n source o f c o n c e r n f o r t h e Reserve B a n k was t h e h i g h r a t e ( 5 % t o 6 % ) at w h i c h wages w e r e r i s i n g . Clearly, these [wage increases] w i l l have to come down as they are inconsis­ tent w i t h the low-inflationary w o r l d we now live i n . A stronger exchange rate, or some squeezing o f profit margins, would help to cushion final product prices temporarily from higher labour costs, but on-going wage increases o f 5 percent or more would n o t be consistent with h o l d i n g inflation to an aver­ age o f between 2 and 3 percent. (Macfarlane, 1995, p. 13) T h e Reserve B a n k m a d e c l e a r t h a t i t w o u l d a c c e p t t h e p r e s e n t w a g e i n c r e a s e s as " b y g o n e s " a n d w o u l d n o t t r y t o reverse t h e m b y t i g h t e n -

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i n g p o l i c y f u r t h e r . H o w e v e r t h e B a n k was e q u a l l y c l e a r t h a t i t was det e r m i n e d t o p r e v e n t s u c h wage increases f r o m b e c o m i n g t h e n o r m . As wage g r o w t h m o d e r a t e d t o a r o u n d 4 % b y July, a n d t h e J u n e figu r e s h o w e d t h a t u n d e r l y i n g i n f l a t i o n , at 3.1 % , h a d p e a k e d i n t h e p r e v i ous q u a r t e r , t h e Reserve B a n k r e d u c e d t h e Cash Rate b y h a l f a p e r c e n t age p o i n t , t o 7 % . F o u r m o r e r e d u c t i o n s o f 50 basis p o i n t s e a c h w o u l d f o l l o w over t h e n e x t twelve m o n t h s . U n d e r l y i n g i n f l a t i o n passed t h r o u g h t h e 2 % t o 3% t a r g e t r a n g e i n S e p t e m b e r b e f o r e f a l l i n g b e l o w t h e " t h i c k p o i n t " i n J u n e 1997 t o 1.7%. T h r o u g h o u t 1996, G D P g r o w t h r e m a i n e d m o d e r a t e at 2 . 8 % p e r c e n t , a n d t h e u n e m p l o y m e n t r a t e r e m a i n e d a r o u n d 8.5%, u n c h a n g e d f r o m its l e v e l i n m i d - 1 9 9 5 . W i t h a n o t h e r b r i e f i n t e r r u p t i o n i n e a r l y 1997, y i e l d s o n A u s t r a l i a n g o v e r n m e n t b o n d s c o n t i n u e d t h e i r d o w n w a r d t r e n d , f a l l i n g b e l o w 7 % i n J u l y 1997. B y the e n d o f that m o n t h , the yield differential between Australian a n d U . S . 10-year g o v e r n m e n t b o n d s h a d n a r r o w e d t o 35 basis p o i n t s , w h i l e N e w Z e a l a n d b o n d s b o r e y i e l d s 30 basis p o i n t s h i g h e r t h a n A u s t r a lian bonds. Overall, Australia's approach to inflation targeting m o v e d toward i n t e r n a t i o n a l n o r m s r a t h e r slowly, w i t h l i t t l e e m p h a s i s at first o n c o m m u n i c a t i o n , transparency, a n d a c c o u n t a b i l i t y . I n c r e a s i n g l y , t h o u g h , t h e Reserve B a n k b e c a m e m o r e e x p l i c i t a b o u t its forecasts a n d its objectives. T h a t m o v e m e n t appears t o have p a i d o f f i n t e r m s o f c o n t r o l l i n g i n f l a t i o n e x p e c t a t i o n s , p a r t i c u l a r l y as r e f l e c t e d i n b o n d m a r k e t s , a n d i n h e l p i n g t o m a i n t a i n a l o w a n d stable r a t e o f i n f l a t i o n .

SPAIN Spain's Adoption of an Inflation Target T h e G o v e r n o r o f t h e B a n c o de E s p a ñ a a n n o u n c e d a n i n f l a t i o n t a r g e t f o r S p a i n i n his address t o t h e S p a n i s h P a r l i a m e n t a r y C o m m i t t e e o n E c o n o m i c A f f a i r s o n N o v e m b e r 28, 1 9 9 4 . T h e a n n o u n c e m e n t was m a d e i n c o m p l i a n c e w i t h t h e L a w o n t h e A u t o n o m y o f t h e B a n c o de E s p a ñ a , w h i c h h a d b e e n a d o p t e d o n J a n u a r y 1 o f t h a t year a n d h a d c o m e i n t o f o r c e o n J u n e 2. T h e a d o p t i o n o f a n i n f l a t i o n t a r g e t h a d been a u n i l a t e r a l decision by the G o v e r n i n g C o u n c i l o f the Bank, i n a c c o r d a n c e w i t h A r t i c l e 7 ( 2 ) o f t h e Law, w h i c h states, " T h e B a n k s h a l l define a n d i m p l e m e n t m o n e t a r y policy w i t h the p r i m a r y objective o f a c h i e v i n g p r i c e stability," a n d w i t h A r t i c l e 8, w h i c h states, " T h e B a n k s h a l l f o r m u l a t e m o n e t a r y p o l i c y b y e s t a b l i s h i n g , as a p p r o p r i a t e , i n t e r 19

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m e d i a t e objectives f o r rates o f g r o w t h o f m o n e t a r y aggregates o r f o r i n t e r ­ est rates, o r by u s i n g o t h e r p r o c e d u r e s as i t deems necessary." I n a n a r r o w sense, t h e a d o p t i o n o f a n i n f l a t i o n t a r g e t was a d i r e c t c o n s e q u e n c e o f t h e e n a c t m e n t o f t h e Law. I n a b r o a d e r sense, however, t h r e e d e v e l o p m e n t s h a d l e d t o t h e t a r g e t a d o p t i o n . First, t h e Spanish g o v e r n m e n t , as a s i g n a t o r y t o t h e M a a s t r i c h t Treaty o n E u r o p e a n U n i o n , was o b l i g e d t o g r a n t t h e B a n k a u t o n o m y at some p o i n t p r i o r t o E u r o ­ p e a n M o n e t a r y U n i o n ( E M U ) . T h e Law, however, w e n t b e y o n d g r a n t i n g i n d e p e n d e n c e o f t h e B a n k f r o m g o v e r n m e n t i n f l u e n c e as r e q u i r e d u n ­ d e r t h e M a a s t r i c h t Treaty; i t l a i d d o w n , i n t h e articles c i t e d above, t h e B a n k ' s r e s p o n s i b i l i t y t o d e f i n e a f r a m e w o r k i n w h i c h t o p u r s u e its objec­ t i v e s — i n p a r t i c u l a r , p r i c e stability. S e c o n d , t h e Spanish peseta h a d re­ m a i n e d i n s i d e t h e E x c h a n g e Rate M e c h a n i s m ( E R M ) o f t h e E u r o p e a n M o n e t a r y System, despite successive devaluations f o l l o w i n g t h e S e p t e m ­ b e r 1992 crisis. T h e w i d e n i n g o f t h e b a n d s f o r c u r r e n c y fluctuations i n ­ side t h e E R M t o 15% f o l l o w i n g t h e J u l y 1993 crisis, however, h a d p r e ­ v e n t e d t h e E R M c o m m i t m e n t f r o m f u n c t i o n i n g as a n o m i n a l a n c h o r , as i t h a d d o n e since t h e peseta's e n t r y i n t o t h e E R M i n J u n e 1989. T h u s , some n e w means o f a n c h o r i n g t h e p r i c e level a n d e x p e c t a t i o n s a p p e a r e d necessary. Finally, t h e r e was m o u n t i n g evidence o f i n s t a b i l i t y i n t h e rela­ t i o n s h i p b e t w e e n n o m i n a l i n c o m e a n d l i q u i d assets h e l d b y t h e p u b l i c ( g i v e n t h e Spanish a c r o n y m " A L P " ) , t h e b r o a d m o n e t a r y aggregate f o r w h i c h t h e B a n k h a d set a n n u a l m o n e t a r y targets since 1984. As i n m a n y o t h e r c o u n t r i e s , i n s t a b i l i t y i n t h e r e l a t i o n s h i p b e t w e e n m o n e y aggregates a n d i n c o m e c r e a t e d pressure t o r e p l a c e a n a p p r o a c h based o n t h e use o f m o n e y g r o w t h as a n i n t e r m e d i a t e t a r g e t w i t h a n a p p r o a c h t h a t u s e d m o r e c o m p l e t e i n f o r m a t i o n t o t a r g e t t h e g o a l v a r i a b l e directly. 20

Since 1978, t h e B a n k h a d b e e n s e t t i n g targets f o r t h e g r o w t h rate o f t h e m o n e t a r y aggregate A L P . I n s t a b i l i t y i n t h e d e m a n d f o r A L P , d u e i n p a r t t o t h e r a p i d d e v e l o p m e n t o f t h e Spanish financial sector i n t h e m i d 1980s, l e d t h e B a n k t o choose successively b r o a d e r t a r g e t ranges f o r t h e g r o w t h o f this aggregate, t h e r e b y r e n d e r i n g t h e t a r g e t i n g p r o c e d u r e n e a r l y meaningless. Despite t h e peseta's e n t r y i n t o the E R M i n J u n e 1989, t h e B a n k c o n t i n u e d t o set a n n u a l targets f o r t h e g r o w t h o f A L P . H o w ­ ever, any c o n f l i c t b e t w e e n a d h e r e n c e t o t h e m o n e t a r y targets a n d t h e exchange-rate p e g was t o be resolved i n favor o f t h e latter, effectively r e d u c i n g A L P t o a n i n f o r m a t i o n v a r i a b l e r a t h e r t h a n a target. [OJrderly movements i n interest rates, consistent with exchange rate stabil­ ity, were the priority o f monetary policy. Only i n the m e d i u m r u n , and i n so far as the exchange rate offered sufficient scope, were monetary policy mea-

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sures adopted to aim at approaching the target path for ALP. I n this setting, the period 1989-93 saw the domestic and external strands o f monetary policy pose considerable conflicts and dilemmas regarding the objectives to pur­ sue. (Ortega and Bonilla, 1995, p. 52) So, as i n t h e case o f Israel after its s t a b i l i z a t i o n , m a i n t e n a n c e o f t h e ex­ change-rate p e g b e c a m e a d o m i n a n t c o n c e r n o f Spanish m o n e t a r y policy­ m a k e r s after 1989. T h e e x c h a n g e rate r e m a i n e d a p o l i c y objective after 1994, a l t h o u g h , as n o t e d , t h e m u c h w i d e r b a n d s a r o u n d t h e c e n t r a l p a r i t y r e d u c e d t h e d e g r e e t o w h i c h t h e e x c h a n g e rate c o n s t r a i n e d policy. T h e i n t r o d u c t i o n o f t h e i n f l a t i o n target, as i n Israel, p r o v i d e d a n a l t e r n a t i v e n o m i n a l an­ chor. A r t i c l e 11 o f t h e L a w d e f i n e d exchange-rate p o l i c y as t h e d o m a i n o f t h e g o v e r n m e n t , w i t h t h e p r o v i s o t h a t i t " m u s t be c o m p a t i b l e w i t h t h e objective o f p r i c e stability." W i t h o u t a specified i n f l a t i o n n u m e r i c a l tar­ get a n d t i m e h o r i z o n , however, t h e m e a n i n g o f " c o m p a t i b i l i t y " r e m a i n e d unclear. T h a t p u t a l i m i t o n t h e Bank's a c c o u n t a b i l i t y . A t t h e t i m e t h e t a r g e t was a d o p t e d , t h e r e c o v e r y o f t h e S p a n i s h e c o n o m y f r o m t h e 1993 recession ( w h i c h h a d b e e n i n d u c e d b y h i g h E u r o p e a n i n t e r e s t rates after G e r m a n r e u n i f i c a t i o n ) was g a t h e r i n g m o ­ m e n t u m . Real G D P g r o w t h , above 2 % d u r i n g 1994, was r i s i n g (see Fig­ u r e 9.3, P a n e l C ) . C P I i n f l a t i o n h a d r e a c h e d a l o w p o i n t at 4 % i n M a r c h 1993 f r o m a h i g h o f 8% i n 1989; b e t w e e n 1989 a n d 1995 i t fluctuated between 4 % a n d 5% w i t h o u t m o v i n g f u r t h e r d o w n w a r d ( F i g u r e 9.3, Panel A ) . T h e peseta h a d b e e n d e v a l u e d t h r e e times b e t w e e n S e p t e m b e r 1992 a n d M a y 1993, a n d b e t w e e n J a n u a r y 1993 a n d J u l y 1994 s h o r t - t e r m i n ­ terest rates h a d b e e n c u t a l m o s t i n half, f r o m 1 4 % t o 7.35% ( F i g u r e 9.3, Panels B a n d D ) . Clearly, however, t h e c o m m i t m e n t t o p r i c e stability h a d some c r e d i b i l i t y , since t h e Spanish i n f l a t i o n rate d i d n o t rise f o l l o w i n g those devaluations, n o r d i d i n f l a t i o n e x p e c t a t i o n s escalate. Nonetheless, t h e B a n k was clearly c o n c e r n e d t h a t i n f l a t i o n a r y expec­ tations m i g h t rise s o o n , a d e v e l o p m e n t t h a t w o u l d t h r e a t e n its m e d i u m t e r m objective o f a s i g n i f i c a n t r e d u c t i o n i n i n f l a t i o n . I n p a r t i c u l a r , i t w o r r i e d that the slight i m p r o v e m e n t i n CPI inflation d u r i n g the closing m o n t h s o f 1994 m i g h t be s w a m p e d by a rise i n V A T a n d excise duties, w h i c h was t o take effect J a n u a r y 1, 1995. As i n Canada, t h e a n n o u n c e ­ m e n t o f a n i n f l a t i o n t a r g e t was t i m e d t o convey t h e o n e - t i m e n a t u r e o f t h e effect o f t h e V A T increase o n i n f l a t i o n t o p r e v e n t a n increase i n i n f l a t i o n e x p e c t a t i o n s . I f t h e r e w e r e n o r e a c t i o n b y wage- a n d price-set­ ters t o t h e rise i n i n f l a t i o n , a response t h a t w o u l d m i t i g a t e t h e l o n g e r t e r m effects o f t h e increase i n t h e VAT, t h e r e w o u l d a c c o r d i n g l y be n o

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n e e d f o r t h e B a n k t o t i g h t e n m o n e t a r y policy. A t t h e same t i m e , t h e B a n k professed u n c e r t a i n t y as t o h o w effective t h e n e w f r a m e w o r k w o u l d be i n k e e p i n g i n f l a t i o n f r o m r i s i n g . [ T ] he widely satisfactory result of direct inflation-targeting strategies i n other countries had only been observable d u r i n g the downward phase o f the cycle, there being no experience o f their effectiveness i n controlling inflation i n an economic u p t u r n . As the Spanish economy was i n a process o f recovery, i t was n o t known to what extent the introduction o f [an inflation target] could adequately confront the inflationary risks proper to the foreseeable f i r m i n g of economic activity. (Banco de España, 1995a, p. 17) O f course, as we saw i n C h a p t e r 4 ( G e r m a n y a n d S w i t z e r l a n d ) , C h a p t e r 7 ( U n i t e d K i n g d o m ) , a n d Chapter 8 (Sweden), there were abundant p r e c e d e n t s f o r c e n t r a l b a n k s t o a n n o u n c e i n f l a t i o n targets n o t o n l y i n t h e face o f l o o m i n g o n e - t i m e shocks t o t h e p r i c e - l e v e l , b u t even w h e n t h e i n t e n d e d n e x t m o v e i n i n t e r e s t rates was d o w n w a r d . W h a t S p a i n s h a r e d w i t h t h e o t h e r targeters was t h e d i f f i c u l t d e c i s i o n o f w h e t h e r t o a d o p t targets d u r i n g a s l a c k e n i n g o f i n f l a t i o n , w h e n t h e y w e r e sure t o be m e t ; o r w h e t h e r i n s t e a d t o a d o p t t h e m at a t i m e w h e n t h e i r a b i l i t y t o c o n s t r a i n expectations a n d t h e second- a n d t h i r d - r o u n d effects o f a shock t o t h e p r i c e level w o u l d be p u t a l m o s t i m m e d i a t e l y t o t h e test. T h e a r g u m e n t s i n s u p p o r t o f a d o p t i n g a n i n f l a t i o n t a r g e t w e r e consist e n t w i t h t h e Law's s t i p u l a t i o n t h a t p r i c e stability b e t h e p r i m a r y objective o f m o n e t a r y policy. T h e B a n k was c h a r g e d w i t h t h e task o f f o r m u l a t i n g t h e m o s t suitable f r a m e w o r k f o r a c h i e v i n g t h a t objective. I n view o f t h e i n c r e a s i n g l y u n r e l i a b l e r e l a t i o n s h i p b e t w e e n t h e m o n e y aggregates a n d i n c o m e , f u r t h e r r e l i a n c e o n m o n e t a r y targets was seen as h a r m f u l t o t h e t r a n s p a r e n c y o f p o l i c y a n d d e c r e a s i n g o p e r a t i o n a l u t i l i t y . By c o n trast, "the s e t t i n g o f d i r e c t objectives i n t e r m s o f p r i c e s involves b i n d i n g t h e [ o p e r a t i o n a l ] objective o f m o n e t a r y p o l i c y t o t h e s t a t u t o r y objective, w h i c h m a y h e l p t o increase t h e t r a n s p a r e n c y a n d c r e d i b i l i t y o f t h e cent r a l bank's actions" ( O r t e g a a n d B o n i l l a , 1995, p . 5 0 ) . T h e B a n k was clearly aware t h a t i t was f o r s a k i n g a n i n t e r m e d i a t e target, a n d t h a t t h e exchange-rate c o m m i t m e n t , t h o u g h relevant, was n o t g o i n g t o replace i t . Rather, t h e i n f l a t i o n forecast w o u l d b e t h e g u i d e t o policy, a n d t h u s the anchor for expectations. T o s u m m a r i z e , S p a i n a d o p t e d i n f l a t i o n t a r g e t i n g i n response t o i n s t i t u t i o n a l changes i n t h e status o f t h e B a n k , i n t u r n b r o u g h t a b o u t b y t h e g o v e r n m e n t ' s d e t e r m i n a t i o n t o c o m p l y w i t h t h e M a a s t r i c h t Treaty. A d o p t i o n o f a n i n f l a t i o n t a r g e t c a m e after t h e exchange-rate c o m m i t m e n t h a d ceased t o be a b i n d i n g c o n s t r a i n t o n m o n e t a r y policy, a n d after

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m o n e t a r y t a r g e t i n g h a d b e c o m e u n r e l i a b l e as a g u i d e t o a c h i e v i n g p r i c e stability. T h e n e w a p p r o a c h was also a d o p t e d at a t i m e w h e n t h e B a n k was c o n c e r n e d t h a t i n f l a t i o n e x p e c t a t i o n s were a b o u t t o p i c k u p , i n response b o t h t o t h e r e c o v e r y o f t h e Spanish e c o n o m y a n d t o t h e firstr o u n d effects o f a n increase i n i n d i r e c t taxes o n i n f l a t i o n . I n s h o r t , o t h e r t h a n the Maastricht c o m m i t m e n t s , the m o t i v a t i o n f o r target a d o p t i o n was a n a l o g o u s i n n e a r l y a l l respects t o t h a t i n N e w Z e a l a n d , C a n a d a , t h e U n i t e d K i n g d o m , a n d Sweden.

The Operational Framework of Spain's Inflation Targeting T h e N o v e m b e r 1994 a n n o u n c e m e n t o f t h e i n f l a t i o n t a r g e t s p e c i f i e d t h a t t h e m e d i u m - t e r m objective o f m o n e t a r y p o l i c y was "a g r a d u a l a n d stable r e d u c t i o n i n t h e i n f l a t i o n rate, m e a s u r e d i n t e r m s o f c o n s u m e r prices, t o less t h a n 3% over t h e course o f t h e n e x t three years" (Banco de E s p a ñ a , 1995b, January, p . 1 2 ) . T h e measure o f i n f l a t i o n chosen was t h e 1 2 - m o n t h p e r c e n t a g e c h a n g e i n t h e all-items C P I , w h i c h i n c l u d e s v o l a t i l e c o m p o nents, interest-rate effects, tax effects, a n d t h e l i k e . I n p r a c t i c e this means t h a t , as i n Israel, t h e B a n k has c h o s e n a s i m p l e target d e f i n i t i o n w i t h t h e l i k e l i h o o d t h a t c o m p l i c a t e d e x p l a n a t i o n s o f deviations f r o m t h e t a r g e t w i l l be n e e d e d . I n i n t r o d u c i n g t h e target, however, t h e B a n k o b s e r v e d t h a t factors o u t o f its c o n t r o l , s u c h as fiscal p o l i c y a n d aggressive wages e t t i n g , m i g h t affect i n f l a t i o n o u t c o m e s . 21

By 1997, t h e a n n o u n c e m e n t t h a t i n f l a t i o n was t o be b e l o w 3% h a d c o m e t o m e a n t h a t 3% was t o be t r e a t e d as a s t r i c t c e i l i n g f o r i n f l a t i o n — a r e q u i r e m e n t that, i f t a k e n literally, w o u l d leave l i t t l e scope f o r p o l i c y flexibility o r c o n t r o l e r r o r . T h e " h a r d " u p p e r l i m i t creates a d i f f i c u l t d i l e m m a f o r the Bank: I f the policy-makers try to avoid overshootings by t a r g e t i n g i n f l a t i o n at a level b e l o w t h e c e i l i n g , they are b e i n g less t h a n honest w i t h the p u b l i c about t h e i r intentions. B u t i f they try to meet the target, t h e y are l i k e l y t o o v e r s h o o t t h e c e i l i n g w i t h some frequency. T h e B a n k d i d n o t c o n f r o n t these issues i m m e d i a t e l y . C i t i n g t h e V A T increase effective J a n u a r y 1, 1995, t h e B a n k chose n o t t o set any t a r g e t f o r 1995 (a tactic t h a t was e m p l o y e d by C a n a d a a n d Sweden i n t h e i r t r a n s i t i o n s t o i n f l a t i o n t a r g e t i n g ) . B u t even a t a r g e t p u s h e d i n t o t h e f u t u r e r e q u i r e s t h a t a t r a n s i t i o n p a t h f r o m c u r r e n t levels o f i n f l a t i o n be specified. T h e B a n k suggested t h a t By early 1996, once the impact o f VAT has been absorbed, the 12-month growth rate o f the CPI should be i n a range o f 3.5% to 4%. From this posi-

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tion i t could advance more rapidly towards the medium-term objective. (Banco de España, 1995b, January, p. 12) I n J a n u a r y 1995 i n f l a t i o n was 4 . 3 % , so i f t h e r e was n o s i g n i f i c a n t passt h r o u g h t o i n f l a t i o n f r o m t h e V A T increase, those levels l o o k e d a t t a i n able. E v e n t h o u g h t h e B a n k was p r o p o s i n g t o l o w e r t h e i n f l a t i o n rate by less t h a n 1.5%, a p p a r e n t l y i t still r e g a r d e d a g r a d u a l a p p r o a c h as desirable. I n D e c e m b e r 1996 t h e B a n k e x t e n d e d t h e t a r g e t h o r i z o n i n t o 1998: The specific objective is to place the twelve-month rate o f [CPI inflation] close to 2% i n the course o f 1998. To attain this goal, the twelve-month rate of inflation should, at end-1997, be r u n n i n g at close to 2.5%, making i t possible thereafter to converge progressively towards the medium-term target set. (Banco de España, 1997b, January, p. 7) As we have m e n t i o n e d , Spain's i n f l a t i o n t a r g e t seems t o d i f f e r f r o m those o f N e w Z e a l a n d , Canada, a n d t h e U n i t e d K i n g d o m i n t h a t i t coexists w i t h a n exchange-rate target, r e f l e c t i n g Spain's m e m b e r s h i p i n t h e E R M . T h a t d i s t i n c t i o n is m o r e a p p a r e n t t h a n r e a l , however. W h i l e t h e exchange-rate c o m m i t m e n t was n o t m a d e s u b o r d i n a t e t o t h e i n f l a t i o n target at t h e start, i t q u i c k l y t o o k o n a secondary r o l e (as i n t h e case o f I s r a e l ) . Spain's m e m b e r s h i p i n t h e E R M does n o t i m m e d i a t e l y p r o v i d e a n i n t e r m e d i a t e t a r g e t f o r m o n e t a r y policy, g i v e n t h e w i d t h o f t h e E R M bands. I f S p a i n follows t h e c o n v e r g e n c e c r i t e r i a f o r i n f l a t i o n l a i d d o w n i n t h e M a a s t r i c h t Treaty, as i t has t h r o u g h t h e t i m e o f this w r i t i n g , i t is h a r d t o i m a g i n e t h a t t h e e x c h a n g e rate c o u l d w a n d e r o u t s i d e t h e 1 5 % b a n d . As we w i l l see, so far t h e r e has b e e n o n l y o n e instance i n w h i c h t h e i n f l a t i o n t a r g e t a n d t h e exchange-rate g o a l have c o m e i n t o c o n f l i c t . T h e s u b o r d i n a t i o n o f t h e e x c h a n g e rate t o t h e i n f l a t i o n t a r g e t is c o n sistent w i t h t h e e m e r g i n g consensus i n E u r o p e : [RJecent years have taught that exchange rate stability, which is a key objective b o t h per se and because o f its contribution to nominal stability, can but be attained i n a stable manner as a consequence o f economic policies that are consistent overall with [the objective of price stability]. (Banco de España, 1994a, p. 20) Spain's m o n e t a r y p o l i c y strategy is i n any case finite, as c o n t r o l o f m o n e t a r y p o l i c y w i l l be h a n d e d over t o t h e E u r o p e a n C e n t r a l B a n k i n J a n u a r y 1999 (defacto i n M a y 1998, w h e n t h e o f f i c i a l p a r i t i e s are set). We will r e t u r n to the implications o f inflation targeting for the European C e n t r a l B a n k i n C h a p t e r 12. F o r S p a i n , g i v e n t h e finite t i m e u n t i l E M U , a n d t h e lags o f m o n e t a r y policy, t h e o n l y B a n k actions l i k e l y t o m a t t e r

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have already b e e n t a k e n as o f this w r i t i n g . So its i n f l a t i o n t a r g e t i n g c a n already be p r o n o u n c e d successful i n k e e p i n g i n f l a t i o n e x p e c t a t i o n s o n a d o w n w a r d p a t h t h r o u g h t h e 1990s. T h a t a c h i e v e m e n t is impressive, because i n 1995 i t was n o t e v i d e n t t h a t S p a i n w o u l d m a k e i t i n t o t h e first r o u n d o f E M U ; so i t was necessary t h a t t h e strategy w o r k . T h e B a n k uses various sources o f i n f o r m a t i o n i n a d d i t i o n t o t h e C P I a n d its c o m p o n e n t s . I t draws o n p r o d u c e r prices, prices o f a g r i c u l t u r a l p r o d u c t s , i m p o r t prices, wages, u n i t l a b o r costs, a n d c o r p o r a t e p r o f i t m a r g i n s . I t also considers v a r i o u s measures o f aggregate d e m a n d , i n ­ c l u d i n g a measure o f t h e i m p a c t o f fiscal p o l i c y o n i n f l a t i o n . By t h e Bank's o w n d e s c r i p t i o n , t h e forecast c o n t i n u e s t o i n c l u d e subjective e v a l u a t i o n , b u t a n A L P g r o w t h rate o f less t h a n 8% is still u s e d as a p r i m a r y b e n c h ­ m a r k , a r e m n a n t o f t h e e a r l i e r m o n e y - g r o w t h t a r g e t i n g . I n fact, S p a i n is t h e o n l y i n f l a t i o n t a r g e t e r t o i d e n t i f y e x p l i c i t l y a p r i m a r y i n d i c a t o r f o r its i n f l a t i o n forecast, w h e t h e r m o n e t a r y o r o t h e r . T h e m o n e y - m a r k e t o v e r n i g h t i n t e r e s t rate is t h e o p e r a t i o n a l t a r g e t f o r changes i n m o n e t a r y policy, b u t t h e a c t u a l i n s t r u m e n t u s e d b y t h e B a n k is its so-called "inter­ v e n t i o n " i n t e r e s t rate, t h e rate o n 10-day repos. T h e s e practices are s i m i ­ lar t o those used p r i o r t o t h e shift f r o m t a r g e t i n g A L P t o t a r g e t i n g i n f l a ­ tion. Details o f t h e B a n k ' s c o m m u n i c a t i o n a n d a c c o u n t a b i l i t y are c o v e r e d by A r t i c l e 10 o f t h e Law. P a r a g r a p h 1 r e q u i r e s t h a t 22

A t least once a year, and whenever significant changes occur, the Bank shall make public the general objectives o f the monetary policy that i t has set and the procedures that i t plans to use i n its implementation. P a r a g r a p h 2 stipulates t h a t The Bank shall regularly i n f o r m parliament and the government o f its objec­ tives and the implementation o f monetary policy, and must report, as rel­ evant, o n the obstacles to the maintenance o f price stability i t encounters. T h e G o v e r n o r , b e g i n n i n g w i t h t h e N o v e m b e r 1994 address i n w h i c h h e a n n o u n c e d t h e i n f l a t i o n target, has a p p e a r e d a n n u a l l y b e f o r e t h e Span­ ish P a r l i a m e n t a r y C o m m i t t e e o n E c o n o m i c Affairs t o describe t h e m o n ­ etary-policy objectives f o r t h e c o m i n g year. T h a t d e g r e e o f f o r m a l legis­ lative a c c o u n t a b i l i t y is r e l a t i v e l y substantial b y E u r o p e a n standards f o r a legally i n d e p e n d e n t c e n t r a l b a n k ( c o m p a r e d , f o r e x a m p l e , w i t h t h e prac­ tice i n G e r m a n y a n d S w i t z e r l a n d ) . O n t h e o t h e r h a n d , t h e B a n k c l e a r l y has m o r e i n d e p e n d e n c e i n s e t t i n g its i n f l a t i o n targets t h a n t h e B a n k o f E n g l a n d o r t h e Swedish R i k s b a n k ; i n t h i s r e g a r d i t is m o r e l i k e t h e Bundesbank o r the B a n k o f Canada.

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T h e G o v e r n o r ' s a n n u a l address is r e p r i n t e d i n t h e J a n u a r y issue o f t h e Bank's m o n t h l y Boletín Económico ( w h i c h appears q u a r t e r l y i n E n ­ g l i s h as t h e Economic Bulletin). B o t h t h e Annual Report a n d t h e m o n t h l y Bulletin have b e e n u p g r a d e d i n t h e e x t e n t a n d accessibility o f t h e i r cov­ erage o f m o n e t a r y policy. M o r e o v e r , a l t h o u g h n o t r e q u i r e d b y t h e Law, t h e B a n k has p u b l i s h e d a n Inflation Report ( i n b o t h Spanish a n d E n g l i s h ) every six m o n t h s since M a r c h 1995. T h e Inflation Report follows a f o u r p a r t f o r m a t , b e g i n n i n g w i t h a n overview. T h e s e c o n d p a r t discusses de­ v e l o p m e n t s i n t h e C P I a n d its c o m p o n e n t s , w i t h p a r t i c u l a r emphasis o n a "core-CPF'-type series c a l l e d "services a n d n o n - e n e r g y processed goods i n d e x , " o r I P S E B E N E b y its Spanish a c r o n y m . T h e a t t e n t i o n g i v e n t o this series, despite t h e o f f i c i a l c o m m i t m e n t t o t a r g e t i n g t h e h e a d l i n e C P I i n f l a t i o n rate, does n o t seem t o have c o n f u s e d t h e p u b l i c . D e v e l o p ­ m e n t s i n p r o d u c e r prices, a g r i c u l t u r a l p r o d u c t prices, i m p o r t prices, a n d various sectoral deflators are r e p o r t e d as w e l l . T h e t h i r d p a r t o f t h e Re­ port covers e x t e r n a l factors as w e l l as t h e c o m p o n e n t s o f aggregate de­ m a n d ; supply-side d e v e l o p m e n t s , i n c l u d i n g measures o f capacity u t i l i z a ­ t i o n a n d l a b o r - m a r k e t tightness; a n d m o n e t a r y a n d financial i n d i c a t o r s such as i n t e r e s t rates a n d interest-rate d i f f e r e n t i a l s b e t w e e n S p a i n a n d other countries. T h e o n l y p a r t o f t h e Report t h a t c o n t a i n s any f o r w a r d - l o o k i n g i n f o r ­ m a t i o n at a l l is t h e f o u r t h , t i t l e d " M o n e t a r y P o l i c y a n d t h e I n f l a t i o n O u t l o o k . " H o w e v e r , even this p a r t presents n o precise forecasts f o r any variables. I n s t e a d , t h e B a n k ' s views are s u m m a r i z e d b y a one-sentence, q u a l i t a t i v e s t a t e m e n t r e g a r d i n g t h e efforts t h a t w i l l be r e q u i r e d t o m e e t t h e i n f l a t i o n target, m u c h i n t h e m a n n e r o f A u s t r a l i a a n d o f Sweden p r i o r t o D e c e m b e r 1997. T h i s s t a t e m e n t is f o l l o w e d b y a d e t a i l e d discus­ s i o n ( a g a i n w i t h o u t n u m b e r s ) o f t h e u p w a r d a n d d o w n w a r d risks t o t h e i n f l a t i o n o u t l o o k . A l s o absent are any statements o f t h e l a g w i t h w h i c h m o n e t a r y p o l i c y is e x p e c t e d t o affect i n f l a t i o n . G i v e n t h e b r i e f t i m e i n w h i c h t h e B a n k ' s activities are l i k e l y t o have a n i m p a c t o n t h e Spanish economy, a n d the possibility that the B a n k w i l l disclaim responsibility f o r f u t u r e o u t c o m e s o n c e t h e t r a n s i t i o n t o t h e e u r o b e g i n s , this last o m i s s i o n is s u r p r i s i n g . T h e absence o f b o t h a n e x p l i c i t i n f l a t i o n forecast a n d a t i m e l i n e f o r i n f l a t i o n r e d u c t i o n c o m p l i c a t e s any o u t s i d e m o n i t o r ­ ing o f the Bank's c u r r e n t policy actions. 23

As m e n t i o n e d above, A r t i c l e 7 ( 2 ) o f t h e L a w specifies: The Bank shall define and implement monetary policy with the primary ob­ jective o f achieving price stability. W i t h o u t prejudice to this objective, m o n ­ etary policy shall support the general economic policy o f the government.

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T h e P r e a m b l e o f t h e L a w p o i n t s o u t t h a t "the n e w law balances t h e p r o ­ visions o f t h e Treaty o n E u r o p e a n U n i o n w i t h t h e m a n d a t e s o f o u r C o n ­ stitution." I t continues: Article 7, for example, which defines the objectives towards which monetary policy should be directed, sets price stability as a priority objective, which is an essential, though admittedly not the sole, element o f the "economic sta­ bility" referred to i n article 40 o f the Constitution. T h i s passage suggests t h a t , as i n a l l o t h e r i n f l a t i o n - t a r g e t i n g c o u n ­ t r i e s , r e a l e c o n o m i c d e v e l o p m e n t s , a n d i n p a r t i c u l a r t h e costs o f d i s i n f l a t i o n i n t e r m s o f lost o u t p u t a n d j o b s , are n o t t o be i g n o r e d . T h e basic t h r u s t o f t h e L a w is t o g u a r a n t e e t h e a u t o n o m y o f m o n e t a r y policy f r o m government interference. T h e Governing Council o f the B a n k , w h i c h is t h e p o l i c y - s e t t i n g body, consists, a c c o r d i n g t o A r t i c l e 20, o f t e n m e m b e r s , e i g h t o f w h o m are a l l o w e d t o vote o n m a t t e r s o f m o n ­ etary p o l i c y : t h e G o v e r n o r , t h e D e p u t y G o v e r n o r , a n d six e l e c t e d c o u n c i l m e m b e r s . A r t i c l e s 24 a n d 25 specify t h a t t h e G o v e r n o r is t o be a p p o i n t e d b y t h e g o v e r n m e n t f o r o n e n o n - r e n e w a b l e six-year t e r m , a n d t h a t t h e D e p u t y G o v e r n o r is t o be a p p o i n t e d b y t h e g o v e r n m e n t , f o l l o w i n g a p r o ­ posal by t h e G o v e r n o r , f o r a s i m u l t a n e o u s six-year n o n - r e n e w a b l e t e r m . T h e six e l e c t e d c o u n c i l m e m b e r s are a p p o i n t e d by t h e g o v e r n m e n t " f o l ­ l o w i n g a p r o p o s a l b y t h e E c o n o m y a n d F i n a n c e m i n i s t e r , after consulta­ t i o n w i t h t h e g o v e r n o r o f t h e B a n k " f o r a four-year t e r m a n d m a y be r e a p p o i n t e d once. These eight members o f the G o v e r n i n g C o u n c i l can be dismissed b y t h e g o v e r n m e n t due to permanent incapacity to p e r f o r m their functions, serious lack o f com­ pliance with their obligations, incompatibility [i.e., conflicts o f interest] that may have arisen d u r i n g the term o f office, or prosecution for deliberate crimes. (Article 25 [4.d] ) N o specific p e r f o r m a n c e clauses o f t h e sort c o n t a i n e d i n t h e Reserve B a n k o f N e w Z e a l a n d A c t are i n c l u d e d .

Spain's Experience under Inflation Targeting Since i n f l a t i o n targets w e r e a d o p t e d i n S p a i n , i n f l a t i o n has r e a c h e d its lowest level i n r e c e n t decades ( F i g u r e 9.3, Panel A ) . As o f t h e s u m m e r o f 1997, Spain's i n f l a t i o n rate h a d m e t t h e M a a s t r i c h t c o n v e r g e n c e c r i t e ­ r i o n . T h e B a n k has steadily l o w e r e d its i n s t r u m e n t i n t e r e s t rate since D e c e m b e r 1995, a n d l o n g - t e r m financial-market i n t e r e s t rates have f o l -

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l o w e d t h a t rate a n d t h e i n f l a t i o n rate d o w n w a r d ( F i g u r e 9.3, P a n e l B ) . W h i l e u n e m p l o y m e n t has r e m a i n e d e x t r a o r d i n a r i l y h i g h , e c o n o m i c g r o w t h has r e c o v e r e d despite c o n c e r t e d fiscal c o n s o l i d a t i o n a n d d e c l i n i n g i n f l a t i o n ( P a n e l C ) . By A u g u s t 1997, Spain's h e a d l i n e i n f l a t i o n was 1.8% ( m e a s u r e d year-on-year), w e l l b e l o w t h e stated " U p p e r L i m i t Target" f o r 1997 o f 3 % . T h a t t a r g e t was l a t e r m o d i f i e d b y t h e s t a t e m e n t " T h e t w e l v e - m o n t h rate o f i n f l a t i o n , s h o u l d , at t h e e n d o f 1997, be close t o 2 . 5 % " ( B a n c o d e E s p a ñ a , 1997c, September, p . 6 ) . A l t h o u g h t h e i n f l a t i o n rate h a d r i s e n s l i g h t l y f r o m its l o w o f 1.5% i n May, as o f this w r i t i n g i t was still b e l o w t h e a n n o u n c e d t a r g e t f o r 1998 o f 2 % , w i t h l i t t l e reason t o e x p e c t any u p w a r d t r e n d . T h e o n l y r e a l c h a l l e n g e t o t h e b r i e f i n f l a t i o n - t a r g e t i n g r e g i m e i n Spain o c c u r r e d early, i n t h e o n e instance so far i n w h i c h t h e d o m e s t i c i n f l a t i o n objective a n d t h e exchange-rate objective came i n t o p o t e n t i a l c o n f l i c t . I n M a r c h 1995, i n t h e a f t e r m a t h o f t h e M e x i c a n crisis ( w h i c h b e g a n i n D e c e m b e r 1 9 9 4 ) , speculative pressures o n t h e peseta b e c a m e s t r o n g e n o u g h t o f o r c e a d e v a l u a t i o n o f its E R M parity, despite t h e 1 5 % b a n d s o n t h e e x c h a n g e rate ( P a n e l D o f F i g u r e 9 . 3 ) . S p a i n was f a c i n g a d u a l c h a l l e n g e i n t h a t i t h a d t o l i m i t t h e pass-through o f b o t h a o n e - t i m e s h o c k t o t h e e x c h a n g e rate a n d a rise i n i n d i r e c t taxes. I n t h e event, t h e B a n k f e l t t h a t t h e i n f l a t i o n t a r g e t was n o t i n serious d a n g e r o f b e i n g b r e a c h e d , a n d s h o r t - t e r m i n t e r e s t rates w e r e n o t raised s i g n i f i c a n t l y t o d e f e n d t h e parity. T h e c h a l l e n g e t o t h e n e w f r a m e w o r k t u r n e d o u t t o be m o r e h y p o t h e t i c a l t h a n r e a l , because t h e peseta p r o v e d r e s i l i e n t . W i t h i n a year, t h e c u r r e n c y h a d r e t u r n e d t o its level p r i o r t o t h e r e a l i g n m e n t o f its E R M c e n t r a l p a r i t y i n M a r c h . " I t . . . t h u s c o m p l e t e l y t u r n e d a r o u n d t h e heavy d e p r e c i a t i o n i t u n d e r w e n t i n t h e o p e n i n g m o n t h s o f 1995, d i s p e l l i n g t h e i n f l a t i o n a r y risks a r i s i n g f r o m such a slide i n t h e peseta" ( B a n c o d e E s p a ñ a , 1996c, M a r c h , p . 7 ) . By m i d - A p r i l o f 1995, t h e peseta b e g a n t o a p p r e c i a t e against t h e d e u t s c h e m a r k . F r o m S e p t e m b e r t o D e c e m b e r 1995, a p e r i o d l o n g e n o u g h after t h e d e v a l u a t i o n f o r its effects o n prices t o be felt, i n f l a t i o n averaged 4.35%, i n c l u d i n g t h e effects o f t h e i n d i r e c t tax increase. T h e m a x i m u m m o n t h l y i n f l a t i o n rate, 5.2%, o c c u r r e d i n A p r i l . By F e b r u a r y 1996, w h e n t h e effects o f t h e i n d i r e c t tax increase h a d l a r g e l y d i e d d o w n , h e a d l i n e C P I i n f l a t i o n d r o p p e d t o 3.7%, w e l l w i t h i n t h e d e c l a r e d t a r g e t r a n g e . As we saw i n t h e case o f Israel ( a n d i n the exit f r o m the E R M o f the U n i t e d K i n g d o m and Sweden), backing o f f f r o m a n i n a p p r o p r i a t e exchange-rate c o m m i t m e n t c a n a p p a r e n t l y be done w i t h o u t d a m a g i n g the central bank's inflation-fighting credibility. T h e d r o p i n i n f l a t i o n even s h o w e d u p sufficiently i n private-sector ex-

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pectations (as m e a s u r e d b y wage bargains a n d y i e l d curves) t h a t t h e B a n k was able t o c u t its i n t e r v e n t i o n rate twice, each t i m e by 25 basis p o i n t s , o n D e c e m b e r 22, 1995, a n d o n J a n u a r y 12, 1996. T h e B a n k d i d n o t t r y t o g r a b c r e d i t f o r these d e v e l o p m e n t s , o r even to c l a i m t h a t t h e r e w e r e n o risks t o t h e forecast. I n d e e d , i n a w a r n i n g r e p e a t e d i n various f o r m s i n every Inflation Report thus far, t h e B a n k stated: I n this connection, the effectiveness o f the macroeconomic policy design should n o t rest exclusively o n the anti-inflationary discipline o f monetary policy. To continue lowering the inflation rate, i t is essential to dispel uncertainty over the fiscal consolidation process, eliminate income- and price-indexing mechanisms and further the liberalisation o f the economy . . . The fiscal policy stance should pay particular heed to avoiding those effects that may translate into inflationary pressures. (Ibid., p. 7) I n defining the limits o f what monetary policy could a n d c o u l d n o t do, a n d i n e m p h a s i z i n g t h e r o l e o f s o u n d fiscal p o l i c y i n fighting i n f l a t i o n , t h e B a n k o f S p a i n was f o l l o w i n g t h e p a t t e r n o f s i m i l a r d e c l a r a t i o n s b y t h e B a n k o f Canada, t h e Reserve B a n k o f N e w Z e a l a n d , a n d t h e postr e u n i f i c a t i o n B u n d e s b a n k . I n S p a i n those d e c l a r a t i o n s a p p a r e n t l y h a d a salutary effect i n t h a t t h e y h e l p e d t o f o r c e t h e g o v e r n m e n t t o address t h e i m p l i c a t i o n s f o r i n f l a t i o n o f t h e i r fiscal moves. T h e B a n k c u t its i n t e r e s t rate b y a f u r t h e r 50 basis p o i n t s t o 8.25% o n M a r c h 13. A t t h e same t i m e i t a n n o u n c e d a n e w m e d i u m - t e r m objective o f m o n e t a r y p o l i c y " w h i c h consist [ e d ] o f p l a c i n g t h e i n f l a t i o n rate steadily b e l o w 3% d u r i n g 1997" (Ibid, p . 2 8 ) . T h e B a n k c o n t i n u e d t o l o o s e n p o l i c y d u r i n g t h e r e m a i n d e r o f 1996, as i n f l a t i o n h e a d e d d o w n w a r d t o w a r d t h e t a r g e t level. U n d e r s t a n d i n g these tactics r e q u i r e d s o m e r e c o g n i t i o n b y t h e p u b l i c t h a t t h e B a n k ' s p o l i c y was p r e e m p t i v e i n n a t u r e a n d t h a t t h e B a n k was a l r e a d y l o o k i n g b e y o n d c u r r e n t d e v e l o p m e n t s . W h i l e t h e B a n k d i d n o t specify t h e h o r i z o n at w h i c h i t e x p e c t e d its c u r r e n t changes i n i n t e r e s t rates t o b e effective, i t d i d tie its actions t o o n g o i n g changes i n t h e e c o n o m i c e n v i r o n ment: The fall i n the Banco de E s p a ñ a intervention rate initiated i n December 1995 was able to continue after the release o f the last Inflation Report [March 1996] thanks to two factors: first the perceptible improvement i n inflation, which can be seen i n other price indicators; and further, the climate o f confidence progressively established as the new government's economic policy commitment to give priority to attaining the convergence criteria laid down by the Treaty o n European U n i o n . . . became patent. There were three sue-

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cessive cuts i n the basic rate i n A p r i l , May and June this year (the first for half a p o i n t , the other two for a quarter o f a p o i n t ) . . , (Banco de E s p a ñ a , 1996c, September, p p . 5-6) A l t h o u g h t h e B a n k stated its t a r g e t i n t e r m s o f h e a d l i n e C P I i n f l a t i o n , i t c o n t i n u e d t o m o n i t o r measures o f " u n d e r l y i n g " i n f l a t i o n , i n c l u d i n g t h e I P S E B E N E series, wholesale p r o d u c e r prices, i m p o r t u n i t values, a n d even v a r i o u s G D P deflators. I n p a y i n g a t t e n t i o n b o t h t o t h e h e a d l i n e series (used i n i n d e x i n g a n d f e a t u r e d i n p u b l i c discussion) a n d t h e less w e l l - k n o w n measures o f i n f l a t i o n t r e n d s , t h e B a n k is f o l l o w i n g t h e practice o f c e n t r a l banks i n a l l i n f l a t i o n - t a r g e t i n g c o u n t r i e s . I n u s i n g t h e h e a d l i n e series as its official target, t h e B a n k differs f r o m c e n t r a l banks t h a t focus m o r e closely o n measures o f " c o r e " i n f l a t i o n . I n this r e g a r d , S p a i n follows t h e p r a c t i c e o f Sweden; p e r h a p s t h e c o m m o n t h r e a d is t h e large p u b l i c sector a n d t h e use o f wage c o n t r a c t s i n d e x e d t o t h e h e a d l i n e C P I i n b o t h c o u n t r i e s . U n l i k e t h e R i k s b a n k , however, t h e B a n k o f S p a i n has m a d e calls f o r t h e e v e n t u a l e r a d i c a t i o n o f i n d e x i n g . As i n f l a t i o n i n S p a i n d e c l i n e d t o u n u s u a l l y l o w levels, i t b e g a n t o app e a r t h a t f u r t h e r r e d u c t i o n s w o u l d be q u i t e d i f f i c u l t because o f t h e d o w n w a r d "stickiness" o f i n f l a t i o n a n d i n f l a t i o n e x p e c t a t i o n s . I n S e p t e m b e r 1996, t h e B a n k stated, This has visibly been the case b o t h i n consumer expectations, drawn from the corresponding confidence surveys, and i n the inflation forecasts released by the markets. The inadequate solidification o f inflation expectations has fed through to wage settlements... The stabilising o f average wage growth at levels between 3.5% and 4% does not seem compatible w i t h inflation rates below 3%. {Ibid., pp. 26-7) T h e p h e n o m e n o n o f sticky d o w n w a r d wage e x p e c t a t i o n s as i n f l a t i o n a p p r o a c h e d n e w lows was a c r i t i c a l p o i n t o f d e b a t e i n C a n a d a as w e l l ( C h a p t e r 6 ) . T h e B a n k clearly c o u l d have c h o s e n t o d i s i n f l a t e f u r t h e r regardless o f t h e stickiness o f wage a n d p r i c e e x p e c t a t i o n s , a n d i n d o i n g so m i g h t have a c h i e v e d t h e M a a s t r i c h t i n f l a t i o n c r i t e r i o n m o r e q u i c k l y . C o n c e r n a b o u t e x a c e r b a t i n g t h e already h i g h u n e m p l o y m e n t rate was t h e l i k e l y reason t h a t t h e B a n k d i d n o t p r o c e e d m o r e aggressively. Progress o n i n f l a t i o n , however, c o n t i n u e d t o be m a d e . A n e w target a n n o u n c e m e n t s t i p u l a t e d t h a t i n f l a t i o n s h o u l d be b r o u g h t close t o 2.5% by t h e e n d o f 1997, r a t h e r t h a n r e m a i n i n g at 3% t h r o u g h o u t t h e year. T h e shift t o 2.5% as a de facto p o i n t target at year's e n d , i n place o f t h e 3% c e i l i n g , was n o t , however, emphasized by the B a n k . O v e r a l l , t h e r e has b e e n relatively less a t t e n t i o n t o q u a n t i t a t i v e m e a s u r e m e n t o f p e r f o r m a n c e a n d

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a c c o u n t a b i l i t y b y t h e B a n k . T h e change i n target is a n i n t e r e s t i n g e x a m p l e o f re-setting targets w h e n circumstances are favorable, r a t h e r t h a n t h e m o r e c o m m o n practice o f re-setting targets w h e n c o n d i t i o n s are adverse. As c o n f i d e n c e i n c r e a s e d t h a t t h e l o w e r i n f l a t i o n t a r g e t w o u l d b e m e t , t h e i n s t r u m e n t i n t e r e s t rate was l o w e r e d a g a i n , i n f o u r steps, t o 5.75% by M a r c h 1997. C P I i n f l a t i o n h a d d r o p p e d f r o m 3.7% i n A u g u s t 1996 t o 2.5% i n F e b r u a r y 1997. C o r e i n f l a t i o n , as m e a s u r e d b y t h e I P S E B E N E i n d e x , f e l l t o 2.3% i n February. A g a i n , t h e B a n k e m p h a s i z e d t h a t v a r i o u s c o n d i t i o n s i n f l u e n c i n g t h e i n f l a t i o n forecast, n o t past i n f l a t i o n p e r f o r m a n c e per se, h a d e n a b l e d i t t o c u t t h e i n t e r e s t rates: Fresh scope to continue lowering interest rates, used cautiously by the Banco de E s p a ñ a so as to u p h o l d its commitment to sustain a climate o f macroeconomic stability, was offered by a series o f factors. These were, namely: the results emerging on the budget o u t t u r n ; the gradual recovery i n demand; the measures unveiled to improve the economy's competitiveness and make aggregate supply more flexible; the behaviour o f the monetary and financial aggregates; and finally the aforementioned headway i n reducing the inflation rate. (Banco de España, 1997c, March, p. 6) N o t a b l e f o r its absence is any d i r e c t m e n t i o n o f t h e p e r f o r m a n c e o f t h e peseta as a m o t i v a t i n g f a c t o r i n t h e interest-rate cuts. W h i l e t h e B a n k d i d cite t h e stability o f t h e peseta against t h e d e u t s c h e m a r k l a t e r i n t h e rep o r t , i t has g e n e r a l l y t a k e n t h e view t h a t i f i n f l a t i o n p e r f o r m a n c e is g o o d , t h e peseta w i l l be s t r o n g . Later, i n discussing e l e m e n t s o f u n c e r t a i n t y t o t h e i n f l a t i o n forecast, t h e B a n k n o t e d " T h e c o n s i d e r a b l e d e p r e c i a t i o n o f t h e peseta against t h e d o l l a r a n d t h e o d d E u r o p e a n c u r r e n c y i n r e c e n t m o n t h s is a n a d d i t i o n a l f a c t o r t h a t m a y b e a r negatively o n i m p o r t prices i n 1997" (Ibid., p . 8 ) . Since t h e rate against t h e d e u t s c h e m a r k r e m a i n e d steady, however, a n d t h e excess o f Spanish i n f l a t i o n over t h e M a a s t r i c h t r e f e r e n c e value f o r i n f l a t i o n ( t h e average o f t h e t h r e e lowest a n n u a l i n f l a t i o n rates o f E R M m e m b e r c o u n t r i e s ) d e c l i n e d , t h e d e p r e c i a t i o n was n o t t r e a t e d as a major concern. I n fact, w h i l e t h e B a n k a l l o w e d t h a t d e m a n d f o r t h e U.S. d o l l a r , as w e l l as d o u b t s a b o u t E u r o p e a n m o n e t a r y i n t e g r a t i o n i n t h e r u n - u p t o E M U , c o u l d l e a d t o some d o w n w a r d pressure o n t h e peseta, i t i n s i s t e d t h a t t h e i n f l a t i o n t a r g e t w o u l d be t h e u l t i m a t e d e t e r m i n a n t o f policy. Changing market sentiment is no doubt one o f the factors that may most closely influence monetary policy i m p l e m e n t a t i o n d u r i n g 1997. But the monetary authorities' decisions will be primarily determined by the foresee-

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able course o f inflation and its conditioning factors . . . N o t only has the inflation rate moved ahead o f schedule to the medium-term target set i n 1995, but i t is also reasonably likely that the new medium-term objective set i n the monetary programming exercise for 1997 [to 2% CPI inflation i n 1998] . . . will prove attainable. Attesting to this are the various indicators o f inflation expectations, which i n recent months have gradually begun to converge and progressively adjusted downwards. (Ibid., p. 29) T h e i n f l a t i o n forecast is w h a t drives m o n e t a r y p o l i c y i n S p a i n , a n d t h e e x c h a n g e rate is t a k e n i n t o c o n s i d e r a t i o n o n l y insofar as i t i n f l u e n c e s t h a t forecast. M o r e o v e r , t h e i n f l a t i o n targets themselves are re-evaluated a n d c h a n g e d i n a f o r w a r d - l o o k i n g m a n n e r as i t b e c o m e s clear w h e t h e r they are l i k e l y t o be achieved. Despite t h e s e e m i n g c o n s t r a i n t o f t h e E R M , t h e B a n k o f Spain has b e e n p u r s u i n g a p a r a d i g m a t i c i n f l a t i o n - t a r g e t i n g strategy b o t h i n w h a t motivates its m o n e t a r y - p o l i c y moves a n d i n h o w i t j u s t i f i e s those moves t o t h e p u b l i c . As we n o t e d at t h e outset o f this section, t h e Bank's i n f l a t i o n - t a r g e t i n g strategy p r o v e d a success. I n f l a t i o n r e a c h e d 1.8% i n A u g u s t 1997, assuring t h a t t h e target o f 2.5% by t h e e n d o f 1997 w o u l d be m e t c o m f o r t a b l y . Perhaps m o r e i m p o r t a n t , as o f J u l y 1997, Spain h a d c o m e i n t o c o m p l i ance w i t h t h e M a a s t r i c h t i n f l a t i o n convergence c r i t e r i o n . T h e Bank's i n s t r u m e n t interest rate was c u t b y 25 basis p o i n t s twice m o r e , i n A p r i l a n d May, cute t h a t were r e f l e c t e d across t h e e n t i r e t e r m s t r u c t u r e o f interest rates ( B a n c o de E s p a ñ a , 1997c, September, p . 7 ) . T h e B a n k gave c r e d i t for f a l l i n g rates n o t j u s t t o m o n e t a r y policy b u t also t o " . . . a fiscal policy a i m e d at r e d u c i n g the b u d g e t deficit a n d . . . a package o f liberalising measures designed t o h e i g h t e n m a r k e t efficiency a n d flexibility" (Ibid., p . 8 ) . W i t h o u t m a k i n g any d i r e c t r e f e r e n c e t o t h e fact t h a t m o n e t a r y - p o l i c y moves m a d e i n late 1997 o r l a t e r w o u l d be o n l y f e l t after E M U t o o k place ( o n J a n u a r y 1, 1 9 9 9 ) , t h e B a n k b e g a n t o shift r e s p o n s i b i l i t y f o r economic outcomes: [ T ] he move to E M U involves a progressive reduction o f the scope for monetary policy autonomy. The prospect o f convergence i n monetary conditions between participants i n the E M U project constrains the contribution Spanish monetary policy may make to stabilizing expenditure and containing financing flows. Rather, a greater onus will be placed on fiscal policy as a regulator o f domestic demand i n the task o f entrenching the macroeconomic stability attained. (Ibid., p. 9) T h u s t h e c o m m u n i c a t i o n s c h a n n e l s established i n S p a i n u n d e r i n f l a t i o n t a r g e t i n g have b e e n f o u n d useful i n e d u c a t i n g t h e p u b l i c a b o u t t h e

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changes t o c o m e w h e n S p a i n j o i n s t h e E M U , i n p a r t i c u l a r t h e changes i n t h e c o n d u c t o f a n d a c c o u n t a b i l i t y f o r m o n e t a r y policy. E v e n w h e n m o n e t a r y a u t o n o m y decreases, t r a n s p a r e n c y c a n r e d u c e u n c e r t a i n t y a n d m a x i m i z e w h a t e v e r flexibility r e m a i n s .

Key Lessons from Israel, Australia, and Spain Israel, A u s t r a l i a , a n d S p a i n , as s m a l l o p e n e c o n o m i e s , m u s t b e a c u t e l y aware o f t h e i n t e r n a t i o n a l value o f t h e i r c u r r e n c i e s . Nevertheless, t h e i r e x p e r i e n c e s , as r e p o r t e d i n this chapter, i l l u s t r a t e t h e advantages o f us­ i n g i n f l a t i o n t a r g e t i n g r a t h e r t h a n exchange-rate t a r g e t i n g . I f t h e ex­ change-rate b a n d is n a r r o w , exchange-rate t a r g e t i n g p u t s v e r y t i g h t c o n ­ straints o n m o n e t a r y policy, raises t h e t h r e a t o f speculative attacks, a n d makes t h e d o m e s t i c e c o n o m y e x c e e d i n g l y v u l n e r a b l e t o m a c r o e c o n o m i c shocks a n d p o l i c y decisions e m a n a t i n g f r o m a b r o a d . I f t h e e x c h a n g e rate b a n d is w i d e , t h e n t a r g e t i n g t h e e x c h a n g e rate m a y be a n i n a d e q u a t e means o f establishing a n o m i n a l a n c h o r a n d o f little guidance to policy­ m a k e r s . I n f l a t i o n t a r g e t i n g p u t s t h e p r i m a r y focus o f m o n e t a r y p o l i c y o n d o m e s t i c e c o n o m i c c o n d i t i o n s , w h i l e also p r o v i d i n g c o n d i t i o n s c o n ­ sistent w i t h l o n g - r u n stability o f t h e e x c h a n g e rate. Israel a n d S p a i n b o t h i n c r e a s e d p o l i c y flexibility b y s h i f t i n g f r o m a n emphasis o n t h e e x c h a n g e rate t o w a r d i n f l a t i o n t a r g e t i n g . M o r e o v e r , t h e y a p p e a r t o have e x p e r i e n c e d n o costs i n loss o f c r e d i b i l i t y , h i g h e r i n f l a t i o n o r i n f l a t i o n e x p e c t a t i o n s , o r even exchange-rate i n s t a b i l i t y . A u s t r a l i a has g o n e even f u r t h e r i n d e - e m p h a s i z i n g t h e i m p o r t a n c e o f t h e exchange rate f o r m o n e t a r y policy. I t pays l i t t l e a t t e n t i o n t o exchangerate fluctuations, even w h e n m a k i n g i n f l a t i o n forecasts. I n a l l t h r e e c o u n ­ tries, l o n g - t e r m i n t e r e s t rates r e m a i n e d steady o r d r o p p e d even as p o l i c y was released f r o m t h e exchange-rate c o n s t r a i n t , i n d i c a t i n g t h a t m o n ­ etary p o l i c y c a n be m a d e m o r e flexible w i t h o u t l o s i n g a n t i - i n f l a t i o n c r e d ­ ibility. T h e decisions m a d e a b o u t t h e o p e r a t i o n a l d e s i g n o f i n f l a t i o n target­ i n g i n these t h r e e c o u n t r i e s c o n f o r m e d i n large m e a s u r e t o w h a t w e have t e r m e d t h e " e m e r g i n g best p r a c t i c e . " I n p a r t i c u l a r , a l l t h r e e c o u n ­ tries f o l l o w e d i n t h e g e n e r a l t r e n d t o w a r d greater flexibility ( f o r e x a m p l e , l o n g e r t a r g e t h o r i z o n s a n d less a t t e n t i o n t o t r a n s i t o r y changes i n p r i c e s ) . A l l t h r e e c e n t r a l banks substantially i n c r e a s e d t h e i r c o m m u n i c a t i o n w i t h the government a n d w i t h the public, thereby e n h a n c i n g b o t h account­ a b i l i t y a n d p u b l i c u n d e r s t a n d i n g o f w h a t m o n e t a r y p o l i c y c o u l d reason­ ably be h e l d a c c o u n t a b l e for. T h a t a u g m e n t e d c o m m u n i c a t i o n was par-

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t i c u l a r l y useful i n l a y i n g o u t f o r t h e p u b l i c t h e consequences o f c h a n g ­ i n g fiscal p o l i c i e s ( a l l t h r e e c o u n t r i e s u n d e r w e n t fiscal c o n s o l i d a t i o n s d u r i n g this p e r i o d ) , a n d c h a n g i n g exchange-rate r e g i m e s . As i n t h e o t h e r c o u n t r i e s we have e x a m i n e d , i n c r e a s e d t r a n s p a r e n c y a n d a c c o u n t a b i l i t y i n these t h r e e e c o n o m i e s has h a d b e n e f i c i a l effects o n p u b l i c discussion o f m o n e t a r y policy. F o r e x a m p l e , t h e d e b a t e o n m o n e t a r y p o l i c y i n t h e I s r a e l i c a b i n e t has b e c o m e f o c u s e d m o r e o n t h e rate o f f u t u r e d i s i n f l a t i o n t h a n o n s h o r t - t e r m e m p l o y m e n t t r e n d s . I n g e n e r a l , i n f l a t i o n t a r g e t i n g i n t h e Swiss style, w h i c h emphasizes l o n g r u n evaluations o f t h e results o f a relatively flexible m o n e t a r y policy, seems t o have w o r k e d w e l l i n these c o u n t r i e s . Israel, A u s t r a l i a , a n d S p a i n , c o u n t r i e s w i t h relatively p o o r r e c o r d s o n p r i c e stability a n d s i g n i f i c a n t fiscal a n d s t r u c t u r a l p r o b l e m s , w e r e able t o m a i n t a i n l o w rates o f i n f l a t i o n after a d o p t i n g i n f l a t i o n t a r g e t i n g . T h e i r e c o n o m i c p e r f o r m a n c e is s t r o n g evidence t h a t t h e c o m b i n a t i o n o f trans­ parency a n d flexibility associated \ k h m o d e r n i n f l a t i o n - t a r g e t i n g regimes can w o r k w e l l i n a w i d e variety o f e c o n o m i c c o n t e x t s . %

10 Inflation Targeting: How Successful Has It Been?

D O E S the a d o p t i o n o f an inflation-targeting framework for monetary p o l i c y affect t h e rate o f i n f l a t i o n i n t h e a d o p t i n g country? Does a d o p ­ t i o n o f i n f l a t i o n t a r g e t i n g a l t e r t h e p r i v a t e sector's i n f l a t i o n e x p e c t a t i o n s a n d , i f so, h o w quickly? W h a t effect does i n f l a t i o n t a r g e t i n g have o n t h e r e a l e c o n o m y , i n p a r t i c u l a r o n t h e o u t p u t a n d e m p l o y m e n t costs o f d i s i n f l a t i o n ? T h e o r e t i c a l a r g u m e n t s a b o u t t h e n e e d f o r a n o m i n a l an­ c h o r a n d f o r p o l i c y t r a n s p a r e n c y m a y h e l p to j u s t i f y a m o v e t o w a r d i n f l a ­ t i o n t a r g e t i n g , b u t i t is e q u a l l y i m p o r t a n t t o k n o w h o w w e l l this a p p r o a c h has w o r k e d i n actual a p p l i c a t i o n s . T h e q u e s t i o n o f w h e t h e r i n f l a t i o n t a r g e t i n g has b e e n effective i n a p a r t i c u l a r c o u n t r y a m o u n t s t o a s k i n g w h e t h e r t h e c o u n t r y o b t a i n e d eco­ n o m i c benefits t h a t i t w o u l d o t h e r w i s e n o t have e n j o y e d . Since we can­ n o t k n o w w h a t w o u l d have o c c u r r e d i n a g i v e n c o u n t r y h a d i n f l a t i o n t a r g e t i n g n o t b e e n a d o p t e d , a n s w e r i n g this q u e s t i o n is d i f f i c u l t a n d nec­ essarily s o m e w h a t speculative. Nevertheless, i n this c h a p t e r we m a k e a start i n t h e e m p i r i c a l e v a l u a t i o n o f i n f l a t i o n t a r g e t i n g by b r i n g i n g t o b e a r a variety o f types o f evidence f r o m a n u m b e r o f c o u n t r i e s , i n c l u d ­ i n g some c o u n t r i e s t h a t a d o p t e d i n f l a t i o n t a r g e t i n g w i t h i n o u r sample p e r i o d a n d some t h a t d i d n o t . T h e i n f l a t i o n - t a r g e t i n g c o u n t r i e s we w i l l c o n s i d e r i n o u r analyses are N e w Z e a l a n d , Canada, t h e U n i t e d K i n g d o m , a n d Sweden. These are t h e O E C D c o u n t r i e s t h a t have e n g a g e d i n i n f l a t i o n t a r g e t i n g f o r at least f o u r years. O n e g e n e r a l a p p r o a c h t h a t we w i l l use i n this c h a p t e r is t o c o m ­ p a r e each c o u n t r y ' s e c o n o m i c p e r f o r m a n c e after target a d o p t i o n w i t h its p e r f o r m a n c e p r i o r t o a d o p t i o n . Since n o n e o f these c o u n t r i e s has b e e n t h r o u g h a c o m p l e t e business cycle since a d o p t i o n , however, a n d since they d i d n o t a l l a d o p t t a r g e t i n g u n d e r s i m i l a r circumstances ( t w o r e p l a c e d a n exchange-rate peg, a n d two installed a n o m i n a l a n c h o r w h e r e p r e v i o u s l y t h e r e h a d b e e n n o n e ) , such a c o m p a r i s o n has o b v i o u s l i m i t a ­ tions. As a n a l t e r n a t i v e a p p r o a c h , we also use a " c o n t r o l g r o u p " strategy, i n w h i c h we c o m p a r e various aspects o f e c o n o m i c p e r f o r m a n c e i n a n i n f l a ­ t i o n - t a r g e t i n g c o u n t r y w i t h t h e analogous d e v e l o p m e n t s i n a c o u n t r y

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w h i c h is b r o a d l y similar, b u t w h i c h d i d n o t a d o p t i n f l a t i o n t a r g e t i n g d u r ­ i n g t h e p e r i o d we e x a m i n e . F o r C a n a d a a n d N e w Z e a l a n d , o u r c o m p a r i ­ son c o u n t r y is A u s t r a l i a ( i n o u r e m p i r i c a l w o r k u t i l i z i n g t h e c o n t r o l s , we use data f r o m t h e p e r i o d b e f o r e 1994, w h e n A u s t r a l i a j o i n e d t h e r a n k s o f i n f l a t i o n t a r g e t e r s ) . A l l t h r e e o f these c o u n t r i e s are s m a l l , o p e n , re­ s o u r c e - e x p o r t i n g e c o n o m i e s t i e d closely t o t h e U.S. business cycle. W e c o m p a r e Sweden a n d t h e U n i t e d K i n g d o m w i t h Italy, each o f w h i c h is a E u r o p e a n i n d u s t r i a l e c o n o m y f o r c e d t o a b a n d o n its e x c h a n g e rate p e g by speculative attacks i n 1992. Finally, we c o m p a r e t h e effects o f m o n ­ e t a r y p o l i c y u n d e r i n f l a t i o n t a r g e t i n g t o t h e effects seen i n t h e t w o targeters ( t h o u g h o f m o n e y , n o t o f i n f l a t i o n ) o f l o n g s t a n d i n g , G e r m a n y a n d S w i t z e r l a n d , a n d also to t h e effects o b s e r v e d i n t h e U n i t e d States, a l o w - i n f l a t i o n c o u n t r y t h a t h o w e v e r has n o t yet a n n o u n c e d a n u m e r i c a l inflation goal. 1

E v e n a c u r s o r y l o o k at t h e d a t a f o r t h e f o u r i n f l a t i o n - t a r g e t i n g c o u n ­ tries i n o u r study suggests t h a t i n f l a t i o n t a r g e t i n g has b e e n a success, at least i n its o w n terms: I n f l a t i o n was w i t h i n o r b e l o w t h e t a r g e t r a n g e f o r all t h e t a r g e t i n g c o u n t r i e s , a n d n o t i c e a b l y b e l o w t h e average i n f l a t i o n levels o f t h e 1970s a n d 1980s. Yet, w h i l e t h e r e d u c t i o n o f i n f l a t i o n i n these c o u n t r i e s represents a g e n u i n e a c h i e v e m e n t , i t is n o t clear w h e t h e r i t was t h e r e s u l t o f forces t h a t w e r e a l r e a d y i n p l a c e b e f o r e i n f l a t i o n t a r g e t i n g was a d o p t e d o r w h e t h e r t h e a d o p t i o n o f t a r g e t i n g c o n t r i b ­ u t e d t o t h e process. M o r e o v e r , we w o u l d l i k e t o k n o w h o w i n f l a t i o n t a r g e t i n g a f f e c t e d o t h e r i m p o r t a n t m a c r o e c o n o m i c variables, s u c h as o u t p u t a n d i n t e r e s t rates, d u r i n g t h e d i s i n f l a t i o n processes. I n this chap­ ter, we p r e s e n t t h r e e sets o f tests o f t h e effectiveness o f i n f l a t i o n target­ ing. I n t h e first test, u s i n g so-called sacrifice r a t i o s a n d P h i l l i p s - c u r v e e q u a t i o n s , we e x a m i n e w h e t h e r d i s i n f l a t i o n i n t h e i n f l a t i o n - t a r g e t i n g c o u n t r i e s has b e e n a c h i e v e d at a l o w e r e c o n o m i c cost t h a n w o u l d o t h e r w i s e b e e x p e c t e d , o r w h e t h e r i n f l a t i o n has d e c l i n e d t o a g r e a t e r e x t e n t t h a n can be a t t r i b u t e d to n o r m a l cyclical factors, domestic a n d international. I n t h e s e c o n d test, we l o o k at private-sector i n f l a t i o n e x p e c t a t i o n s , as i n f e r r e d f r o m surveys o f forecasters a n d f r o m interest-rate d i f f e r e n t i a l s , to see w h e t h e r they have d e c l i n e d after t a r g e t i n g b e y o n d t h e d e g r e e associated w i t h a d r o p i n i n f l a t i o n . Finally, i n t h e t h i r d test we use s i m u l a t i o n s f r o m a s i m p l e f o r e c a s t i n g m o d e l to determine whether the interactions a m o n g inflation, monetary policy, a n d r e a l G D P have c h a n g e d f o l l o w i n g t h e a d o p t i o n o f i n f l a t i o n targeting.

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W e use t h r e e tests because t h e r e are several d i s t i n c t issues t o address a n d because t h e l i m i t s o f t h e sample size ( t h e s m a l l n u m b e r o f i n f l a t i o n t a r g e t i n g c o u n t r i e s a n d t h e l i m i t e d span o f t i m e since t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g ) c a u t i o n us against r e l y i n g o n any o n e p i e c e o f evi­ d e n c e . O u r a p p r o a c h differs f r o m t h a t o f c o m p a r a t i v e e m p i r i c a l assess­ m e n t s o f i n f l a t i o n t a r g e t i n g , w h i c h t e n d t o focus o n j u s t o n e m e a s u r e , usually t h e e x p e c t a t i o n s o f t h e financial m a r k e t s . By u s i n g t h r e e differ­ e n t tests a n d data f r o m a v a r i e t y o f t a r g e t i n g a n d n o n - t a r g e t i n g c o u n ­ tries, we h o p e t o be able t o p r o v i d e some reasonably r o b u s t e v i d e n c e o n t h e effects a n d effectiveness o f i n f l a t i o n t a r g e t i n g . 2

T o f o r e s h a d o w t h e results, we find t h a t i n f l a t i o n t a r g e t i n g appears t o have b e e n successful i n r e d u c i n g b o t h i n f l a t i o n a n d ( w i t h a l a g ) p r i v a t e sector i n f l a t i o n e x p e c t a t i o n s . I t m a y also have c o n t r i b u t e d t o t h e m a i n ­ t e n a n c e o f p r i c e stability, o n c e a c h i e v e d , p a r t i c u l a r l y by p r e v e n t i n g o n e ­ t i m e shocks t o i n f l a t i o n f r o m p e r m a n e n t l y a f f e c t i n g t h e i n f l a t i o n rate. U n f o r t u n a t e l y , however, we find essentially n o evidence t h a t t h e a d o p ­ t i o n o f i n f l a t i o n targets has r e d u c e d t h e r e a l o u t p u t a n d e m p l o y m e n t costs o f d i s i n f l a t i o n , at least n o t d u r i n g t h e early stages o f t h e n e w ap­ proach.

Does Inflation Targeting Make Disinflation Less Costly? W e l o o k first at t h e response o f i n f l a t i o n t o t h e business cycle. W e c o n ­ sider t w o r e l a t e d measures: so-called "sacrifice ratios" a n d forecasts based o n e s t i m a t e d P h i l l i p s curves.

Evidence from Sacrifice Ratios Sacrifice ratios are measures o f t h e loss o f o u t p u t o r e m p l o y m e n t t h a t a n e c o n o m y m u s t sustain i n o r d e r t o achieve a r e d u c t i o n i n i n f l a t i o n . A sacrifice r a t i o is usually c a l c u l a t e d as t h e n u m b e r o f "point-years" o f re­ d u c e d g r o w t h i n o u t p u t o r i n increased u n e m p l o y m e n t that a c o u n t r y m u s t accept i n o r d e r t o achieve a o n e - p e r c e n t a g e - p o i n t r e d u c t i o n i n t h e i n f l a t i o n rate. Several hypotheses have b e e n a d v a n c e d a b o u t t h e d e t e r m i n a n t s o f sacrifice ratios. F o r e x a m p l e , i t has b e e n suggested t h a t i f a d i s i n f l a t i o n a r y p o l i c y is c l e a r l y stated i n advance, a n d i f t h e c e n t r a l b a n k ' s c o m m i t m e n t t o t h e p o l i c y is c r e d i b l e t o t h e p u b l i c , t h e n t h e sacrifice r a t i o w i l l b e lower. D i s i n f l a t i o n m i g h t be less costly u n d e r a c r e d i b l e p o l i c y because

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t h e p u b l i c ' s e x p e c t a t i o n s s h o u l d adjust m o r e q u i c k l y , l e a d i n g t o a m o r e r a p i d re-setting o f prices a n d wages. Since o n e o f t h e objectives o f i n f l a ­ t i o n t a r g e t i n g is t o increase t h e c e n t r a l b a n k ' s c r e d i b i l i t y , i t w i l l be i n t e r ­ e s t i n g t o see w h e t h e r t h e i n t r o d u c t i o n o f i n f l a t i o n t a r g e t i n g does i n ­ d e e d r e s u l t i n l o w e r sacrifice ratios. I n s t u d y i n g t h e effect o f i n f l a t i o n t a r g e t i n g o n sacrifice r a t i o s , we need to c o n t r o l for other potential determinants o f the real economic losses r e s u l t i n g f r o m d i s i n f l a t i o n . F o r e x a m p l e , i t seems p l a u s i b l e t h a t t h e cost o f r e d u c i n g i n f l a t i o n b y o n e p e r c e n t a g e p o i n t w i l l be s m a l l e r w h e n t h e i n f l a t i o n r a t e is h i g h t h a n w h e n i t is low. A t l o w rates o f i n f l a ­ t i o n , wage- a n d price-setters are less c o n c e r n e d a b o u t t h e effects o f i n f l a t i o n , a n d h e n c e m a y b e less aware of, o r less l i k e l y t o r e s p o n d t o , changes i n t h e c e n t r a l b a n k ' s p o l i c i e s . T h u s a g r e a t e r s h o r t - r u n loss o f o u t p u t o r a g r e a t e r i n c r e a s e i n u n e m p l o y m e n t m a y b e necessary t o i n d u c e changes i n wages a n d p r i c e s . Conversely, i f t h e i n f l a t i o n r a t e is h i g h , o r i f t h e d i s i n f l a t i o n is a large o n e , we w o u l d e x p e c t a faster a n d m o r e p r o n o u n c e d response b y wage-setters a n d price-setters, l e a d i n g p e r h a p s t o a s m a l l e r o u t p u t loss p e r p o i n t o f d i s i n f l a t i o n a c h i e v e d . F o r s i m i l a r reasons, t h e o u t p u t effects o f a d i s i n f l a t i o n m i g h t w e l l d e p e n d o n t h e speed w i t h w h i c h t h e d i s i n f l a t i o n takes place. O u r analysis w i l l c o n t r o l f o r t h e size a n d speed o f t h e d i s i n f l a t i o n , as w e l l as t h e i n i t i a l level o f i n f l a t i o n . To c o m p u t e t h e sacrifice ratios f o r t h e c o u n t r i e s u n d e r c o n s i d e r a t i o n , we f o l l o w t h e m e t h o d o l o g y o f B a l l ( 1 9 9 4 ) , u s i n g q u a r t e r l y d a t a t h r o u g h ­ o u t . B a l l focuses o n o u t p u t loss r a t h e r t h a n o n e m p l o y m e n t loss. First h e defines t h e p a t h o f trend inflation f o r each c o u n t r y as a c e n t e r e d n i n e q u a r t e r m o v i n g average o f a n n u a l i n f l a t i o n rates. H e t h e n identifies peaks ( t r o u g h s ) i n t r e n d i n f l a t i o n as q u a r t e r s i n w h i c h t r e n d i n f l a t i o n is h i g h e r (lower) than i n b o t h the preceding f o u r quarters a n d the subsequent f o u r q u a r t e r s . W e w i l l f o l l o w Ball's d é f i n i t i o n o f a disinflation as a n e p i ­ sode t h a t starts at a n i n f l a t i o n p e a k a n d ends at a n i n f l a t i o n t r o u g h , w i t h a n a n n u a l i n f l a t i o n rate at t h e t r o u g h at least t w o p e r c e n t a g e p o i n t s l o w e r t h a n at t h e peak. H a v i n g i d e n t i f i e d periods o f disinflation for each country, Ball n e x t estimates t h e associated loss i n o u t p u t . T o d o so, h e assumes t h a t o u t ­ p u t is at its t r e n d l e v e l at t h e i n f l a t i o n p e a k a n d f o u r q u a r t e r s after t h e i n f l a t i o n t r o u g h ( t h u s a l l o w i n g f o r t h e p o s s i b i l i t y t h a t o u t p u t has re­ c o v e r e d o n l y after a l a g f r o m a n e p i s o d e o f d i s i n f l a t i o n ) . H e t h e n cal­ culates t r e n d o u t p u t f o r t h e w h o l e p e r i o d b y d r a w i n g a s t r a i g h t l i n e b e t w e e n r e a l G D P ( i n l o g a r i t h m s ) at t h e i n f l a t i o n p e a k a n d r e a l G D P f o u r q u a r t e r s after t h e i n f l a t i o n t r o u g h . T h e n u m e r a t o r o f t h e sacrifice

256

C H A P T E R 10

r a t i o — t h a t is, t h e o u t p u t loss d u r i n g t h e d i s i n f l a t i o n — i s c o m p u t e d as the difference between t r e n d real GDP a n d the real actually observed G D P . T h e d e n o m i n a t o r is t h e c h a n g e i n t r e n d i n f l a t i o n o v e r t h e d i s i n f l a t i o n a r y episode. I n c o m m e n t i n g o n Ball's paper, F r i e d m a n (1994) a n d C e c c h e t t i (1994) level a n u m b e r o f c r i t i c i s m s at his m e t h o d o l o g y . F r i e d m a n raises t h e q u e s t i o n o f w h e t h e r t h e sacrifice s h o u l d be m e a s u r e d as o u t p u t f o r e ­ g o n e , o r i n s t e a d as t h e increase i n u n e m p l o y m e n t , a n d q u e s t i o n s Ball's a p p r o a c h t o t h e m e a s u r e m e n t o f t r e n d o u t p u t . Since o u r g o a l h e r e is t o c o m p a r e sacrifice ratios b o t h across t i m e a n d across c o u n t r i e s , however, we are p r i m a r i l y i n t e r e s t e d i n t h e relative m a g n i t u d e o f t h e ratios. I n t h i s sense, consistent m i s m e a s u r e m e n t w o u l d n o t s i g n i f i c a n t l y affect t h e results. C e c c h e t t i notes t h a t Ball's i n t e r p r e t a t i o n o f t h e o u t p u t loss as b e i n g d u e t o d e m a n d c o n t r a c t i o n s only, w h i c h leads h i m l a r g e l y t o i g ­ n o r e t h e p o t e n t i a l effects o f s u p p l y shocks, affects t h e results critically. W e w i l l r e t u r n t o this q u e s t i o n l a t e r b e f o r e we p r e s e n t results based o n e s t i m a t e d P h i l l i p s curves. I n a p p l y i n g Ball's m e t h o d o l o g y , we use d a t a o n r e a l G D P f r o m t h e O E C D M a i n E c o n o m i c I n d i c a t o r s a n d a l l - i t e m C P I series f r o m t h e B a n k f o r I n t e r n a t i o n a l Settlements ( B I S ) . W e c o m p u t e q u a r t e r l y i n f l a t i o n as t h e p e r c e n t a g e c h a n g e o f t h e C P I i n t h e last m o n t h o f t h e q u a r t e r over t h e c o r r e s p o n d i n g m o n t h o f t h e p r e v i o u s year. F o r each o f t h e n i n e c o u n t r i e s i n o u r sample, we i d e n t i f y t w o c o m p l e t e d d i s i n f l a t i o n s , f o l l o w ­ i n g each o f t h e t w o o i l shocks ( i n 1973 a n d 1 9 7 9 ) ; a n d f o r a l l t h e c o u n ­ tries e x c e p t G e r m a n y a n d S w i t z e r l a n d , we i d e n t i f y a t h i r d c o m p l e t e d d i s i n f l a t i o n d u r i n g t h e early 1990s, w h i c h gives us a t o t a l o f twenty-five d i s i n f l a t i o n a r y episodes f r o m w h i c h we c o m p u t e sacrifice ratios. As a c h e c k , we c o m p a r e d o u r results w i t h those o f B a l l w h e r e possible ( i n p a r t i c u l a r , f o r t h e first t w o d i s i n f l a t i o n s f o r seven c o u n t r i e s i n o u r sample f o r w h i c h B a l l also r e p o r t s sacrifice ratios based o n q u a r t e r l y d a t a ) . T h e m e a n o f Ball's sacrifice ratios f o r these episodes is 1.59, w h i l e t h a t o f t h e c o m p a r a b l e episodes i n o u r s a m p l e is 1.35. T h e c o r r e l a t i o n b e t w e e n t h e t w o sets o f ratios is 0 . 7 1 , i n d i c a t i n g reasonable consistency b e t w e e n o u r results a n d B a l l ' s . 4

5

W i t h t h e e s t i m a t e d sacrifice ratios i n h a n d , we c o n s i d e r w h e t h e r t h e c o u n t r i e s t h a t a d o p t e d i n f l a t i o n targets d i d i n fact l o w e r t h e i r costs o f d i s i n f l a t i o n , relative b o t h t o t h e i r o w n past a n d t o c o m p a r a b l e c o u n t r i e s t h a t d i d n o t a d o p t i n f l a t i o n targets. T h e regression r e p o r t e d i n Table 10.1 a t t e m p t s t o e x p l a i n v a r i a t i o n i n t h e sacrifice r a t i o b y t h e i n i t i a l level o f i n f l a t i o n ( t o c h e c k w h e t h e r , at l o w e r i n i t i a l i n f l a t i o n levels, d i s i n f l a t i o n is m o r e costly); t h e t o t a l a m o u n t o f d i s i n f l a t i o n i n t h e episode ( t o test

I N F L A T I O N T A R G E T I N G : H O W S U C C E S S F U L HAS I T B E E N ?

257

w h e t h e r a l a r g e r d i s i n f l a t i o n i n d u c e s a s m a l l e r cost p e r p o i n t o f d i s i n f l a t i o n ) ; a n d t h e l e n g t h o f t h e d i s i n f l a t i o n a r y episode ( t o d e t e r m i n e w h e t h e r q u i c k e r disinflations are m o r e c r e d i b l e a n d t h e r e f o r e less costly). O u r results, based o n t h e sample o f 25 sacrifice ratios, c o n f i r m t h e i m ­ p o r t a n c e o f i n i t i a l i n f l a t i o n a n d t h e l e n g t h o f t h e d i s i n f l a t i o n a r y episode f o r d e t e r m i n i n g t h e sacrifice r a t i o , i n t h a t t h e e s t i m a t e d coefficients o n these t w o variables are statistically s i g n i f i c a n t a n d o f t h e e x p e c t e d sign. U s i n g t h e e s t i m a t e d coefficients l i s t e d i n Table 1 0 . 1 , as w e l l as t h e level o f i n f l a t i o n f o r each c o u n t r y at the b e g i n n i n g o f its latest d i s i n f l a t i o n , t h e r e d u c t i o n i n i n f l a t i o n , a n d t h e l e n g t h o f t h e d i s i n f l a t i o n , we c o m ­ p u t e t h e value o f t h e sacrifice r a t i o we w o u l d p r e d i c t based o n o u r re­ gression results. F o r t h r e e o f t h e f o u r i n f l a t i o n targeters i n o u r sample (all e x c e p t S w e d e n ) , we find t h a t t h e actual sacrifice r a t i o e x p e r i e n c e d after t h e i n t r o d u c t i o n o f i n f l a t i o n t a r g e t i n g was n o t o n l y higher t h a n t h e average sacrifice r a t i o o f previous d i s i n f l a t i o n s i n t h a t c o u n t r y , b u t h i g h e r t h a n t h a t forecast b y t h e regression i n Table 1 0 . 1 . F o r Italy, o n e o f o u r n o n - t a r g e t i n g c o m p a r i s o n c o u n t r i e s , as w e l l as f o r t h e U n i t e d States, we o b t a i n t h e same p a t t e r n as f o r m o s t o f t h e i n f l a t i o n targeters, i n t h a t t h e actual sacrifice r a t i o i n t h e early 1990s is h i g h e r t h a n b o t h t h e past aver­ age a n d t h e p r e d i c t e d value. F o r A u s t r a l i a , however, t h e a c t u a l sacrifice r a t i o d u r i n g t h e latest d i s i n f l a t i o n was l o w e r t h a n forecast, a l t h o u g h h i g h e r t h a n t h e past average sacrifice r a t i o . Finally, t h e sacrifice ratios f o r G e r m a n y a n d S w i t z e r l a n d ( f r o m a n e a r l i e r p e r i o d ) are l o w e r t h a n b o t h t h e p r e d i c t e d values a n d t h e i r o w n past sacrifice ratios. D i s i n f l a t i o n u n d e r i n f l a t i o n t a r g e t i n g — o r at least t h e first d i s i n f l a t i o n u n d e r target­ i n g — d o e s n o t a p p e a r t o be less costly t h a n i t w o u l d have b e e n absent inflation targeting. T h e f i n d i n g o f n o "credibility bonus" ( i n terms o f l o w e r sacrifice ratios) f r o m i n f l a t i o n t a r g e t i n g is r e m i n i s c e n t o f r e c e n t f i n d i n g s t h a t changes i n m o n e t a r y i n s t i t u t i o n s (such as i n c r e a s e d cen­ tral bank independence) do n o t appear to generate a credibility bonus (see, f o r e x a m p l e , D e b e l l e a n d Fischer [ 1 9 9 4 ] a n d Posen [ 1 9 9 5 a ] ) . P r o b a b l y t h e m o s t c o n t r o v e r s i a l aspect o f Ball's m e t h o d o l o g y , as we have m e n t i o n e d , is t h a t a l l deviations o f o u t p u t f r o m p o t e n t i a l d u r i n g his d i s i n f l a t i o n s are b e i n g a t t r i b u t e d t o p o l i c y - i n d u c e d d e m a n d c o n t r a c ­ t i o n . I n d e e d , as K i n g a n d W a t s o n (1994) p o i n t o u t , measures o f t h e sac­ r i f i c e r a t i o are o f t e n sensitive t o t h e specific a s s u m p t i o n b y w h i c h t h e p o l i c y - i n d u c e d p a r t o f t h e o u t p u t c o n t r a c t i o n is b e i n g i d e n t i f i e d . I f , f o r e x a m p l e , some p r o d u c t i v i t y - e n h a n c i n g i n n o v a t i o n (a p o s i t i v e s u p p l y shock) o c c u r r e d d u r i n g a d i s i n f l a t i o n (as d e f i n e d a b o v e ) , Ball's mea­ sure o f o u t p u t lost d u e t o c o n t r a c t i o n a r y m o n e t a r y p o l i c y w o u l d u n d e r ­ state t h e t r u e cost o f t h e d i s i n f l a t i o n , l e a d i n g t o t o o l o w a n estimate o f

14.25% 2.05 1.67 0.98

Sacrifice Ratio Predicted Sacr Ratio Past Avg. Sacr Ratio

1.06

0.28

2.12

1.87

3.04 2.34

6.22%

4.16%

7.62%

15.38%

Change in Inflation

5.25%

89Q2-93Q1

90Q3-93Q4

86Q3-92Q4

0.55

1.95

2.19

6.48%

8.64%

90Q1-93Q4

UK.

0.93

1.32

0.53

6.43%

9.55%

90Q4-93Q1

Sweden

0.34

2.28

2.58

2.05%

6.42%

90Q2-93Q4

Italy

Sacrifice Ratios for the Latest Completed Disinflation

Disinflation

0.56

Initial Inflation

0.09 (2.06)

Length of Disinflation Adjusted R-Square

Australia

-0.01 (0.07)

Change in Inflation

Canada

-0.17 (2.98)

Initial Inflation

New Zealand

2.16 (2.80)

Constant

1.52

2.99

3.77

2.43%

5.13%

90Q1-94Q4

U.S.

4.46

3.19

2.47

5.75%

5.87%

80Q4-87Q1

Germany

2.34

2.78

2.15

4.82%

5.93%

82Q1-87Q1

Switzerland

Results from regressing a sample of 25 sacrifice ratios (3 for each country except for Germany and Switzerland) on a constant, inflation at the beginning of the disinflation, change in inflation during the disinflation, and the length (in quarters) of the disinflation. T statistics in paren­ theses.

T A B L E 10.1 Sacrifice Ratios and T h e i r Determinants

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259

t h e sacrifice r a t i o . A p o t e n t i a l avenue f o r a v o i d i n g this p r o b l e m , w h e n a s k i n g w h e t h e r t a r g e t a d o p t i o n has c h a n g e d t h e t e r m s o f t h e o u t p u t i n f l a t i o n tradeoff, is t o c o n s i d e r forecasts o f i n f l a t i o n , a n d t h e n t o c o m ­ p a r e t h e i n f l a t i o n rates r e a l i z e d f o l l o w i n g t a r g e t a d o p t i o n t o t h e rates t h a t w o u l d be e x p e c t e d based o n i n f o r m a t i o n available p r i o r t o t a r g e t a d o p t i o n . T h i s is t h e a p p r o a c h t h a t we c o n s i d e r n e x t .

Inflation Forecasts from Estimated Phillips Curves To d e t e r m i n e w h e t h e r i n f l a t i o n - t a r g e t i n g c o u n t r i e s saw i n f l a t i o n d r o p m o r e t h a n m a c r o e c o n o m i c c o n d i t i o n s w o u l d have p r e d i c t e d , we f o r e ­ cast i n f l a t i o n f o r e a c h c o u n t r y f r o m a n e s t i m a t e d P h i l l i p s c u r v e , i n t h e m a n n e r o f G o r d o n (1985) a n d F u h r e r ( 1 9 9 5 ) . Specifically, f o r each c o u n ­ t r y i n o u r sample, we regress q u a r t e r l y i n f l a t i o n o n lags o f itself, a mea­ sure o f resource u t i l i z a t i o n , a n d t w o measures o f p r i c e pressures f r o m supply-side factors: t h e l a g g e d c h a n g e i n t h e n o m i n a l effective e x c h a n g e rate, a n d t h e l a g g e d c h a n g e i n a U.S. d o l l a r - d e n o m i n a t e d c o m m o d i t y p r i c e i n d e x . T h e measures o f s u p p l y pressures were i n c l u d e d o n l y i f t h e y i m p r o v e d t h e fit, as m e a s u r e d b y t h e adjusted R . U s i n g these regres­ sions, w h i c h are e s t i m a t e d u s i n g data u p t o t h e date o f t a r g e t a d o p t i o n , we c o n s t r u c t 8-quarter forecasts o f i n f l a t i o n . T h i s exercise is i n t e n d e d t o determine whether inflation i n the inflation-targeting countries d r o p p e d b e y o n d t h e e x t e n t we w o u l d a t t r i b u t e t o n o r m a l cyclical factors, domes­ tic a n d i n t e r n a t i o n a l . As a b y p r o d u c t , t h e regression m a y also h e l p us j u d g e w h e t h e r i n t r o d u c i n g i n f l a t i o n targeting i n d u c e d observable changes i n wage- a n d p r i c e - s e t t i n g s t r u c t u r e s . 2

6

7

T h e regression is e s t i m a t e d over t h e p e r i o d 1971:2 ( t h e s e c o n d quar­ ter o f 1971) t o t h e t i m e o f t a r g e t a d o p t i o n f o r each o f t h e f o u r i n f l a t i o n targeters i n o u r sample. F o r A u s t r a l i a , t h e sample f o r t h e e s t i m a t i o n is t h e same as t h a t f o r N e w Z e a l a n d . ( N o t e t h a t even t h e out-of-sample forecasts f o r A u s t r a l i a e n d b e f o r e its a d o p t i o n o f i n f l a t i o n t a r g e t i n g , b y o u r d a t i n g , so t h a t A u s t r a l i a m a y be t r e a t e d as a c o n t r o l c o u n t r y ) . F o r Italy, t h e sample p e r i o d is t h e same as f o r t h e U n i t e d K i n g d o m ; t h a t is, u n t i l t h e lira's e x i t f r o m t h e E R M i n t h e t h i r d q u a r t e r o f 1992. F o r t h e U n i t e d States, G e r m a n y , a n d S w i t z e r l a n d , t h e regression is e s t i m a t e d u p to G e r m a n e c o n o m i c r é u n i f i c a t i o n i n 1990:2, a l l o w i n g c o m p a r i s o n w i t h t h e p u t a t i v e l y c r e d i b l e c o m m i t m e n t t o l o w i n f l a t i o n i n t h e U n i t e d States as w e l l as w i t h n o m i n a l targeters o f l o n g s t a n d i n g . Table 10.2 r e p o r t s results f r o m t h e regressions a n d t h e i n f l a t i o n f o r e ­ casts. As a c h e c k o f t h e robustness o f t h e results w i t h respect t o t h e n u m -

T A B L E 10.2 Forecasting Inflation from Phillips Curves Results from regressing quarterly inflation (annualized) on its own lags, a utilization mea­ sure, changes in the nominal effective exchange rate and in commodity prices prior to the adoption of inflation targets (prior to 1990Q3 for the U.S., Germany and Switzerland; prior to 1990Q1 for Australia; prior to 1992Q4 for Italy), and from forecasting inflation out of sample over 8 quarters following target adoption (or equivalent). New Zealand

Canada

Australia

U.K.

Utilization Measure

Unemp Rate

Unemp Rate

Unemp Rate

Unemp Rate

Sample

71Q2-89Q4

71Q2-90Q4

71Q2-89Q4

71Q2-92Q3

Forecast Horizon

90Q1-91Q4

91Q1-92Q4

90Q1-91Q4

92Q4-94Q3

A. Basic Specification, Four Lags of Each Variable Included AdjR Square

0.66

0.62

0.63

0.56

Sum of coefficients on all lags (joint significance of all lags) of variable: Inflation

0.60 (8.57)*

0.90 (24.02)*

0.83 (25.54)*

0.63 (7.41)*

Utilization Measure

-0.08 (3.12)*

-0.06 (2.33)

-0.06 (1.88)

-0.14 (3.84)*

Exchange Rate

-0.08 (4.16)*

Commodity Prices

0.01 (0.98)

Parameter Stability (5% Critical Value)

0.44 (1.73)

1.63 (1.67)

0.40 (1.70)

0.35 (1.74)

Avg Forecast Error

0.69

-0.84

0.87

1.89

0L64

Ö53

B. Parsimonious Specification Adj R Square

(X65

Ö63

Sum of coefficients on all lags (joint significance of all lags) of variable: Inflation

0.53 (4, 7.78)*

Utilization Measure

-0.11 (4, 3.32)* -0.07 (3, 4.96)* -0.06 (1, 4.49)* -0.17 (1, 13.75)*

0.88 (3, 33.76)* 0.75 (1,109.95)* 0.48 (1, 26.79)*

Exchange Rate

-0.01 (3, 4.63)*

Commodity Prices Parameter Stability (5% Critical Value)

0.39 (1.73)

1.67* (1.66)

0.42 (1.70)

0.46 (1.74)

Avg Forecast Error

0.25

-0.51

2.81

2.39

Table 10.2 continued

Sweden

Italy

U.S.

Germany

Switzerland

Output Gap

Unemp Rate

Unemp Rate

Unemp Rate

Output Gap

71Q2-92Q4

71Q2-92Q3

71Q2-90Q2

71Q2-90Q2

71Q2-90Q2

93Q1-94Q4

92Q4-94Q3

90Q3-92Q2

90Q3-92Q2

90Q3-92Q2

0.23

0.71

0.67

0.57

0.42

0.66 (5.50)*

0.78 (18.22)*

0.92 (21.43)*

-0.01 (0.24)

0.49 (3.61)*

0.11 (1.61)

-0.13 (4.22)*

-0.07 (2.89)*

-0.14 (6.24)*

0.13 (5.64)*

0.02 (3.25)*

-0.01 (3.29)*

-0.15 (3.00)*

0.01 (2.47)

0.08 (2.50)

0.01 (0.77)

0.03 (1.70)

0.04 (3.24)*

1.01 (1.80)

0.48 (1.89)

0.68 (1.69)

0.72 (1.69)

0.52 (1.68)

0.12

0.29

-0.54

-1.78

-0.11

0.68

0.64

0.58

0.40

0.39 (3, 3.47)*

0.65 (1, 57.31)* 0.89 (3, 29.06)* -0.15 (2, 9.99)*

-0.09 (2, 4.29)*

-0.14 (3, 30.91)* 0.15 (4, 5.49)*

-0.05 (4, 4.87)*

0.01 (2,6.43)*

-0.15 (4, 3.65)* 0.01 (3, 3.86)*

0.02 (1, 3.55)*

0.04 (4, 3.31)*

0.57 (1.88)

0.51 (1.69)

0.73 (1.69)

0.57 (1.68)

2.88

0.13

-1.78

-0.14

262

CHAPTER

10

b e r o f lags i n c l u d e d , f o r each c o u n t r y we r e p o r t results f r o m two d i f f e r e n t specifications. T h e first specification i n c l u d e s f o u r lags o f each variable i n o r d e r t o guarantee a reasonably g o o d fit. T h e second specification is m o r e p a r s i m o n i o u s : We o b t a i n t h e l a g s t r u c t u r e i n this case by sequentially re­ d u c i n g t h e n u m b e r o f lags o f each variable u n t i l t h e t statistic o f t h e last l a g i n c l u d e d was significant at t h e 5% level. T h e adjusted R 's i n d i c a t e a g o o d fit o f b o t h regressions f o r a l l c o u n t r i e s except Sweden. Also, f o r Swe­ d e n t h e lags o f t h e o u t p u t gap are j o i n d y insignificant, w h i c h is w h y we d o n o t r e p o r t a p a r s i m o n i o u s specification f o r t h a t c o u n t r y . F o r each regres­ s i o n a n d f o r each o f t h e variables i n c l u d e d i n t h e regression, we r e p o r t t h e s u m o f the coefficients o n a l l lags o f t h a t variable, as w e l l as t h e i r j o i n t significance ( t h a t is, t h e F-statistic f r o m testing the e x c l u s i o n o f a l l lags o f t h a t variable; 5% c r i t i c a l values are b e t w e e n 2.50 a n d 2.53). T h e s u m o f t h e coefficients captures t h e c u m u l a t i v e response o f i n f l a t i o n t o a u n i t c h a n g e i n t h e variable c o n s i d e r e d . 8

2

T h e fact t h a t t h e n o m i n a l e x c h a n g e r a t e a n d c o m m o d i t y p r i c e i n f l a ­ t i o n a p p a r e n t l y d o n o t have a s i g n i f i c a n t i m p a c t o n i n f l a t i o n i n a n u m ­ b e r o f c o u n t r i e s is r a t h e r s u r p r i s i n g , p a r t i c u l a r l y f o r o p e n e c o n o m i e s w i t h sizeable r a w m a t e r i a l s p r o d u c t i o n , s u c h as C a n a d a a n d A u s t r a l i a . T h e e x c h a n g e r a t e appears s i g n i f i c a n t i n h a l f o f t h e regressions; c o m ­ m o d i t y - p r i c e i n f l a t i o n appears s i g n i f i c a n t i n o n l y t w o o u t o f e i g h t . A pe­ c u l i a r r e s u l t f r o m t h e G e r m a n regression is t h e i n s i g n i f i c a n t i m p a c t o f past i n f l a t i o n o n t h e c u r r e n t rate o f i n f l a t i o n . T h i s last result, however, is n o t r o b u s t w i t h respect t o t h e c h o i c e o f u t i l i z a t i o n m e a s u r e . 9

O u r m a i n i n t e r e s t i n these P h i l l i p s c u r v e regressions, however, is i n i d e n t i f y i n g possible changes i n t h e r e l a t i o n s h i p b e t w e e n i n f l a t i o n a n d u n e m p l o y m e n t o r o u t p u t f o l l o w i n g t h e a d o p t i o n o f i n f l a t i o n targets. T o h e l p d o this, we t u r n n o w t o p a r a m e t e r i n s t a b i l i t y tests a n d out-of-sample forecasts g e n e r a t e d f r o m t h e P h i l l i p s curves. I n T a b l e 10.2, we r e p o r t results f r o m r e - e s t i m a t i n g t h e regressions f r o m 1971:2 t h r o u g h 1 9 9 6 : 4 a n d t e s t i n g f o r p a r a m e t e r i n s t a b i l i t y ; i f t h e a d o p t i o n o f i n f l a t i o n targets i n d u c e s changes i n wage-setting a n d p r i c e s e t t i n g behavior, t h e n we s h o u l d observe i n s t a b i l i t y i n t h e P h i l l i p s c u r v e a r o u n d the time o f target a d o p t i o n . For three o f the f o u r inflation targeters, t h e hypothesis o f p a r a m e t e r stability i n t h e P h i l l i p s c u r v e at t h e t i m e o f t a r g e t a d o p t i o n is n e v e r r e j e c t e d at t h e 5% l e v e l — t h a t is, i t does n o t a p p e a r t h a t t h e P h i l l i p s c u r v e was m a t e r i a l l y s h i f t e d b y t h e i n ­ t r o d u c t i o n o f i n f l a t i o n t a r g e t i n g i n these c o u n t r i e s . O n l y f o r C a n a d a d o we find some evidence o f p a r a m e t e r instability. F o r n e i t h e r G e r m a n y n o r S w i t z e r l a n d , t h e t w o targeters o f l o n g s t a n d i n g , n o r f o r t h e o t h e r c o m p a r i s o n c o u n t r i e s i n o u r sample, is t h e r e evidence o f p a r a m e t e r i n 10

INFLATION T A R G E T I N G : HOW S U C C E S S F U L HAS I T BEEN?

263

stability a r o u n d t h i s t i m e . T h e results f r o m these tests f o r p a r a m e t e r i n ­ stability f o r a l l n i n e c o u n t r i e s are r o b u s t w i t h respect t o t h e c h o i c e o f utilization measure a n d the choice o f lag length. A l t h o u g h , w i t h t h e e x c e p t i o n o f Canada, t h e r e is n o e v i d e n c e f o r pa­ r a m e t e r i n s t a b i l i t y f o l l o w i n g t a r g e t a d o p t i o n , i t is nevertheless interest­ i n g t o ask w h e t h e r i n f l a t i o n was b e l o w t h e values p r e d i c t e d b y t h e P h i l l i p s c u r v e d u r i n g t h i s p e r i o d . T o d o so, we p e r f o r m out-of-sample forecasts o f i n f l a t i o n over a h o r i z o n o f e i g h t q u a r t e r s , u s i n g a c t u a l values o f a l l variables e x c e p t i n f l a t i o n itself, f o r w h i c h we use past forecasted values. We i n t e r p r e t t h e r e s u l t i n g forecasts as r e p r e s e n t i n g t h e course i n f l a t i o n w o u l d have b e e n e x p e c t e d t o take i n each c o u n t r y , g i v e n t h e a c t u a l r e a l ­ i z e d values o f a l l o t h e r variables d u r i n g t h e forecast h o r i z o n . T h e s e c o u n t e r f a c t u a l p a t h s o f i n f l a t i o n c a n b e c o m p a r e d t o t h e a c t u a l paths, to h e l p us assess t h e d e g r e e t o w h i c h i n f l a t i o n t a r g e t i n g m a d e a differ­ ence. A t e c h n i c a l issue t h a t m u s t b e addressed is h o w to j u d g e w h e t h e r dif­ ferences b e t w e e n a c t u a l values a n d forecast values o f i n f l a t i o n are d u e to c h a n c e , o r i n s t e a d are l a r g e e n o u g h t o b e statistically a n d e c o n o m i ­ cally m e a n i n g f u l . A n s w e r i n g t h i s q u e s t i o n r e q u i r e s a n analysis o f t h e dis­ t r i b u t i o n o f t h e forecast e r r o r s f o r i n f l a t i o n . Since t h e forecasts are o u t of-sample, t h e d i s t r i b u t i o n o f t h e forecast e r r o r s is a n o n l i n e a r f u n c t i o n o f t h e e s t i m a t e d p a r a m e t e r s . A l s o , because t h e forecasts are c o n d i t i o n a l ones, t h e i r d i s t r i b u t i o n s also d e p e n d o n t h e a c t u a l values o f t h e r e m a i n ­ i n g variables i n t h e regression. 11

We address t h e m e a s u r e m e n t o f t h e d i s t r i b u t i o n o f forecast e r r o r s as follows. W e n e e d t o c o n s t r u c t a n a p p r o x i m a t e estimate o f t h e u n c e r ­ t a i n t y s u r r o u n d i n g t h e forecast at each q u a r t e r l y h o r i z o n f r o m 1 t o 8. T o d o so, we c o m p u t e 15 forecasts o f e i g h t q u a r t e r s ' l e n g t h f o r each c o u n ­ try, b e g i n n i n g at dates at least e i g h t q u a r t e r s p r i o r t o t h e a d o p t i o n o f i n f l a t i o n targets (so as n o t t o o v e r l a p w i t h t h e p o s t - a d o p t i o n p e r i o d ) . W e use these p r e - a d o p t i o n forecasts o n l y f o r e s t i m a t i n g t h e s t a n d a r d devia­ t i o n o f t h e forecast e r r o r . I n p a r t i c u l a r , we first estimate t h e P h i l l i p s c u r v e regression f o r each c o u n t r y i n t h e sample e n d i n g 23 q u a r t e r s p r i o r t o a d o p t i o n , t h e n forecast i n f l a t i o n o v e r t h e p e r i o d f r o m a d o p t i o n m i n u s 22 q u a r t e r s t o a d o p t i o n m i n u s 15 q u a r t e r s . N e x t we estimate t h e P h i l l i p s c u r v e u n t i l a d o p t i o n m i n u s 22 q u a r t e r s ; t h e n we forecast i n f l a t i o n f r o m a d o p t i o n m i n u s 21 q u a r t e r s t o a d o p t i o n m i n u s 14 q u a r t e r s ; a n d so o n . I n t h i s f a s h i o n we c o n s t r u c t e d 15 d i f f e r e n t forecasts. W e t h e n estimate t h e r o o t m e a n s q u a r e d e r r o r ( R M S E ) at each q u a r t e r l y h o r i z o n , 1-8, as t h e e m p i r i c a l s t a n d a r d d e v i a t i o n o f t h e 15 d i f f e r e n t forecast e r r o r s at each c o r r e s p o n d i n g h o r i z o n . 1 2

264

C H A P T E R 10

T h e results o f these forecasts are s h o w n g r a p h i c a l l y i n F i g u r e 1 0 . 1 , w h e r e t h e v e r t i c a l l i n e represents t h e onset o f forecasting, t h e d a s h e d l i n e is t h e forecast o f i n f l a t i o n , t h e t w o b o l d lines are o n e - R M S E b a n d s g e n e r a t e d as d e s c r i b e d , a n d t h e s i m p l e l i n e is t h e a c t u a l course o f i n f l a ­ t i o n . I n Table 10.2 we r e p o r t t h e average forecast e r r o r f r o m forecast­ i n g i n f l a t i o n over 8 quarters f o l l o w i n g target a d o p t i o n , expressed i n p o i n t s o f a n n u a l i n f l a t i o n . (Likewise, i n F i g u r e 10.1 q u a r t e r l y i n f l a t i o n has b e e n expressed at a n n u a l i z e d rates o n t h e axes t o facilitate i n t e r p r e t a t i o n ) . A positive forecast e r r o r i m p l i e s t h a t a c t u a l i n f l a t i o n was, o n average, be­ l o w w h a t we w o u l d p r e d i c t f r o m t h e regression results. 1 3

F o r t h r e e o f t h e f o u r i n f l a t i o n targeters, a c t u a l i n f l a t i o n d u r i n g t h e e i g h t q u a r t e r s f o l l o w i n g t a r g e t a d o p t i o n shows n o sign o f p e r s i s t e n t de­ v i a t i o n s f r o m t h e forecast, a n d stays w e l l w i t h i n t h e o n e - R M S E b a n d . T h e average o v e r - p r e d i c t i o n f o r N e w Z e a l a n d is 0.69, a n d t h a t f o r Swe­ d e n 0.12, w h i l e f o r C a n a d a a c t u a l i n f l a t i o n exceeds t h e forecast o n aver­ age b y 0.84%. F o r t h e U n i t e d K i n g d o m , however, t h e r e is s t r o n g e r evi­ d e n c e t h a t i n f l a t i o n is l o w e r t h a n w o u l d be e x p e c t e d , b e i n g b e l o w f o r e ­ cast i n 7 o u t o f 8 q u a r t e r s , a n d o u t s i d e t h e e r r o r b a n d i n 3 o u t o f 8 q u a r t e r s . O n average, a c t u a l i n f l a t i o n is b e l o w forecast by 1.9%. C o n s i s t e n t w i t h t h e results f r o m t h e p a r a m e t e r i n s t a b i l i t y tests, f o r n o n e o f t h e o t h e r five c o u n t r i e s is t h e r e m u c h e v i d e n c e o f a c h a n g e i n the behavior o f inflation, c o n d i t i o n a l o n the behavior o f o t h e r macroe c o n o m i c variables, after t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g . I n A u s ­ t r a l i a , i n f l a t i o n is a l m o s t c o n s i s t e n t l y b e l o w forecast ( 0 . 8 7 % o n aver­ a g e ) , b u t m o s t l y i n s i d e t h e e r r o r b a n d . I n Italy, i n f l a t i o n is m o r e o f t e n b e l o w t h a n above t h e forecast ( 0 . 2 9 % o n average), b u t a g a i n m o s t l y w i t h i n t h e e r r o r b a n d . I n f l a t i o n i n t h e U n i t e d States is w e l l above f o r e ­ cast i n t h e t h i r d q u a r t e r o f 1990. T h e r e a f t e r , a c t u a l i n f l a t i o n is always i n s i d e t h e e r r o r b a n d a n d v e r y close t o its forecast, l e a d i n g t o a n u n d e r - p r e d i c t i o n b y 0 . 5 4 % o n average. A f t e r t h e d e m a n d s h o c k o f eco­ n o m i c r e u n i f i c a t i o n i n G e r m a n y , i n f l a t i o n exceeds t h e p r e d i c t e d val­ ues i n a l l b u t o n e q u a r t e r , t w i c e ( i n t h e t h i r d q u a r t e r s o f 1990 a n d 1991) b y f a r m o r e t h a n o n e R M S E , r e s u l t i n g i n a n u n d e r - p r e d i c t i o n o f a c t u a l i n f l a t i o n o f 1.78% o n average. Yet, by t h e e n d o f t h e forecast h o r i z o n , G e r m a n i n f l a t i o n has r e t u r n e d t o its p r e d i c t e d v a l u e , w h i c h we i n t e r p r e t as b e i n g c o n s i s t e n t w i t h a successful p r i c e - s t a b i l i t y c o m ­ m i t m e n t based o n t a r g e t i n g o f a n o m i n a l a n c h o r . L i k e w i s e , t h e u p ­ surge o f i n f l a t i o n i n S w i t z e r l a n d d u r i n g 1989-90 was r e v e r s e d d u r i n g t h e n e x t t w o years, a l m o s t e x a c t l y i n l i n e w i t h t h e p r e d i c t i o n s . O n aver­ age, i n f l a t i o n exceeds t h e forecast b y o n l y 0 . 1 1 % . 1 4

New

Zealand,

Forecast f r o m

1990

Q1 UK,

Forecast from

1992

Q4

US, F o r e c a s t

from

1990

Q3

266 CHAPTER

Summary

io

O u r Phillips-curve a n d sacrifice-ratio results together suggest t h a t the adop­ t i o n o f inflation targeting i n the four inflation-targeting countries studied h e r e d i d n o t s i g n i f i c a n t l y a l t e r t h e r e a l e c o n o m i c costs o f a c h i e v i n g d i s i n f l a t i o n . T h e r e f o r e we p r e s u m e t h a t t h e u n d e r l y i n g wage- a n d p r i c e s e t t i n g structures d i d n o t c h a n g e either. G i v e n t h e i r desire t o m o v e infla­ t i o n d o w n , t h e i n f l a t i o n targeters g o t o n l y small, i f any, e x t r a disinflationary effect b e y o n d t h e business cycle they e x p e r i e n c e d ( o r i n d u c e d ) or, f o r t h a t matter, b e y o n d t h e d i s i n f l a t i o n e x p e r i e n c e d by c o u n t r i e s w i t h o u t i n ­ flation targets. Based o n t h e G e r m a n a n d Swiss experiences, m o r e o v e r , i t seems t h a t even a c r e d i b l e targeter o f l o n g s t a n d i n g does n o t see these benefits. I n o t h e r words, i t appears, u n f o r t u n a t e l y , t h a t t h e o n l y way t o achieve d i s i n f l a t i o n is t h e h a r d way: by a c c e p t i n g possibly s i g n i f i c a n t shortran losses i n o u t p u t ( a n d e m p l o y m e n t ) i n exchange f o r t h e l o n g e r - r u n e c o n o m i c benefits o f p r i c e stability. T h e use o f i n f l a t i o n t a r g e t i n g as a f r a m e w o r k f o r m o n e t a r y p o l i c y does n o t change t h a t basic fact.

Does Adoption of Inflation Targeting Reduce Inflation Expectations? T h e second k i n d o f evidence relevant t o assessing t h e effect o f i n f l a t i o n t a r g e t i n g concerns t h e p u b l i c ' s i n f l a t i o n expectations. T o see w h e t h e r t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g caused a d e c l i n e i n e x p e c t e d i n f l a t i o n , we l o o k b o t h at consensus forecasts o f i n f l a t i o n i n each c o u n t r y a n d at changes i n i n t e r e s t differentials relative t o t h e U n i t e d States o r G e r m a n y at b o t h a l o n g a n d s h o r t m a t u r i t y . T h e questions o f interest are w h e t h e r a d o p t i o n o f a n i n f l a t i o n target confers greater c r e d i b i l i t y i n t h e f o r m o f e i t h e r less u n c e r t a i n t y a b o u t p o l i c y o r l o w e r risk p r e m i u m s o n g o v e r n m e n t d e b t . E v e n i f t h e structures i n t h e e c o n o m y t h a t d e t e r m i n e t h e response o f i n ­ flation to t h e business cycle (wage-setting i n s t i t u t i o n s , f o r e x a m p l e ) are i n i t i a l l y unresponsive t o t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g , as t h e evi­ d e n c e described i n t h e first p a r t o f t h e c h a p t e r suggests, i t still m i g h t be t h e case t h a t expectations o f f u t u r e i n f l a t i o n (as reflected, f o r e x a m p l e , i n financial markets) w o u l d c h a n g e w h e n t h e p o l i c y r e g i m e changes.

Evidence from Surveys ofExpectations T h e panels o f F i g u r e 10.2 show a c t u a l C P I i n f l a t i o n rates f o r each c o u n ­ try, as w e l l as consensus private-sector forecasts f o r i n f l a t i o n b y t h e e n d o f each year since 1 9 9 0 .

15

A square d e n o t e s t h e consensus forecast o f

ri .2 CM

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F i g u r e 10.6 shows t h e results f o r G e r m a n y , S w i t z e r l a n d , a n d t h e States. As s h o u l d b e e x p e c t e d , t h e s i m u l a t e d v a r i a b l e s t e n d t o out" over time, m o v i n g t o w a r d t h e i r sample means o r t o w a r d t r e n d ; t h i s is t h e r e s u l t o f t h e a b s e n c e o f n e w shocks i n t h e tion.

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Figures 10.4 a n d 10.5 show t h a t , f o r a l l f o u r i n f l a t i o n - t a r g e t e r s c o n s i d ­ e r e d , a c t u a l i n f l a t i o n tends t o be l o w e r t h a n forecast, especially d u r i n g t h e p e r i o d a year o r m o r e after a d o p t i o n . A c t u a l i n f l a t i o n i n t h e target­ i n g c o u n t r i e s also e x h i b i t s a m i l d d o w n w a r d t r e n d , as o p p o s e d t o t h e s l i g h t u p w a r d t r e n d typically seen i n t h e s i m u l a t i o n s . I m p o r t a n t l y , h o w ­ ever, i n a l l f o u r c o u n t r i e s e x c e p t Sweden t h e l o w e r - t h a n - e x p e c t e d i n f l a ­ t i o n rates are a c c o m p a n i e d b y substantial shortfalls i n G D P g r o w t h over t h e t w o years f o l l o w i n g t a r g e t a d o p t i o n , as c o m p a r e d to t h e forecasted values. T h i s p a t t e r n is a n o t h e r c o n f i r m a t i o n o f o u r e a r l i e r r e s u l t t h a t t h e r e is n o evidence o f a n i m p r o v e m e n t i n t h e o u t p u t - i n f l a t i o n t r a d e o f f i n the i m m e d i a t e aftermath o f target a d o p t i o n ; instead, the i n i t i a l d i s i n f l a t i o n is a c h i e v e d o n l y at t h e expense o f s h o r t - r u n losses i n o u t p u t . T h e r e a f t e r , however, G D P g r o w t h rates i n a l l f o u r targeters e x c e e d t h e p r o j e c t i o n s , w h i l e i n f l a t i o n a n d s h o r t - t e r m i n t e r e s t rates r e m a i n at levels w e l l b e l o w t h e forecasted values. I n t h e n o n - t a r g e t i n g c o u n t r i e s i n c l u d e d f o r c o m p a r i s o n , t h e results are m i x e d . L i k e N e w Z e a l a n d a n d C a n a d a (its c o m p a r i s o n c o u n t r i e s ) , A u s t r a l i a e x h i b i t s i n f l a t i o n b e l o w its o u t - o f - s a m p l e f o r e c a s t ( F i g u r e 1 0 . 4 ) . A p p a r e n t l y , however, t h i s d i s i n f l a t i o n c a m e o n l y at t h e cost o f a substantial, entirely u n p r e d i c t e d shortfall i n G D P g r o w t h over the first t w o years f r o m t h e start o f t h e s i m u l a t i o n . T h e r e a f t e r , t h e results ex­ h i b i t t h e same p a t t e r n as i n t h e c o m p a r i s o n c o u n t r i e s , w i t h G D P g r o w t h o n t r a c k , b u t w i t h i n f l a t i o n a n d i n t e r e s t rates at new, l o w e r levels. T h u s , i n A u s t r a l i a we see t h e effects o f a d i s i n f l a t i o n w i t h o u t f o r m a l targets. I n contrast to all the o t h e r countries, Italy experienced i n f l a t i o n t h a t was i n i t i a l l y above t h e forecast, f a l l i n g b e l o w t h e forecast o n l y f r o m 1994 o n w a r d ( F i g u r e 1 0 . 5 ) . M e a n w h i l e , I t a l i a n G D P g r o w t h f e l l substan­ t i a l l y s h o r t o f t h e p r o j e c t i o n u n t i l late 1994. Towards t h e e n d o f t h e f o r e ­ cast h o r i z o n , w h i l e i n f l a t i o n a n d i n t e r e s t rates r e m a i n l o w e r t h a n p r e ­ d i c t e d , G D P g r o w t h i n I t a l y is b e l o w its forecast as w e l l . T h e o v e r a l l macr o e c o n o m i c p e r f o r m a n c e o f Italy t h e r e f o r e seems less g o o d t h a n t h a t o f the other European countries. I n t h e U n i t e d States ( F i g u r e 1 0 . 6 ) , b o t h t h e s p i k e i n i n f l a t i o n i n l a t e 1990 a n d t h e 1990-91 recession w e r e l a r g e l y u n p r e d i c t e d b y o u r s i m p l e statistical m o d e l . B y 1992, however, G D P g r o w t h h a d r e t u r n e d t o its

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t r e n d l e v e l , w h i l e i n f l a t i o n a n d s h o r t - t e r m i n t e r e s t rates r e m a i n e d b e l o w t h e i r p r e d i c t e d levels f o r t h e rest o f t h e f o r e c a s t h o r i z o n . T h e results f r o m o u r s i m u l a t i o n s f o r t h e U n i t e d States t h e r e f o r e f o l l o w t h e basic p a t t e r n o b s e r v e d i n t h e f o u r i n f l a t i o n t a r g e t e r s a n d A u s t r a ­ lia. T h e results f o r t h e o t h e r t w o b a s e l i n e c o u n t r i e s , G e r m a n y a n d Swit­ z e r l a n d , are b y c o n t r a s t m a r k e d l y d i f f e r e n t f r o m t h o s e f o r t h e target­ i n g c o u n t r i e s , o r f o r t h e U n i t e d States, f o r t h a t m a t t e r ( F i g u r e 1 0 . 6 ) . T h e s i m u l a t i o n s f o r G e r m a n y c l e a r l y r e f l e c t t h e effects o f m o n e t a r y reunification, w i t h b o t h inflation and the monetary-policy instrument above t h e i r p r o j e c t i o n s u n t i l e a r l y 1994. L i k e w i s e , f o l l o w i n g t h e u p ­ surge i n i n f l a t i o n i n S w i t z e r l a n d d u r i n g 1989-90, a c t u a l i n f l a t i o n was above its p r o j e c t i o n u n t i l t h e e n d o f 1992; t h e Swiss i n t e r e s t r a t e also rose above its p r o j e c t i o n , a n d r e m a i n e d t h e r e f o r t w o years l o n g e r af­ t e r i n f l a t i o n h a d r e t u r n e d t o its e x p e c t e d l e v e l . G D P g r o w t h i n b o t h Germany a n d Switzerland exceeded the projections i n the early part o f t h e f o r e c a s t i n g p e r i o d , p r o b a b l y as a r e s u l t o f e x p a n d e d a g g r e g a t e de­ m a n d ; however, b y 1992 a n d 1993 t h e effects o f t h e i n c r e a s i n g l y re­ s t r i c t i v e m o n e t a r y p o l i c y — a s seen i n i n t e r e s t rates w e l l a b o v e t h o s e forecast i n t o the second h a l f o f 1 9 9 4 — f o r c e d o u t p u t g r o w t h b e l o w its p r o j e c t e d t r e n d . W e i n t e r p r e t t h e r e t u r n o v e r t i m e o f i n f l a t i o n a n d t h e m o n e t a r y - p o l i c y i n s t r u m e n t t o t h e i r p r o j e c t e d levels after a s u r p r i s e d e m a n d s h o c k o f g r e a t m a g n i t u d e as c h a r a c t e r i s t i c o f a suc­ cessful t a r g e t i n g r e g i m e . Yet we also see t h a t e v e n a p u t a t i v e l y c r e d ­ i b l e m o n e t a r y p o l i c y m u s t t i g h t e n i n response t o shocks t o such shocks, a n d t h a t t h a t p o l i c y t i g h t n e s s has r e a l effects. To assess the robustness o f the results r e p o r t e d h e r e , we also p e r f o r m e d t h e s i m u l a t i o n s based o n VARs e s t i m a t e d f r o m 1980 o n . O n e reason f o r d o i n g so is t h a t m o s t o f t h e c o u n t r i e s i n o u r sample c o n d u c t e d m o n ­ etary p o l i c y d u r i n g t h e 1970s m u c h d i f f e r e n t l y f r o m t h e way t h e y h a d after t h e s e c o n d o i l shock a n d t h e i n t e l l e c t u a l a n d p o l i t i c a l d e v e l o p m e n t s t h a t f o l l o w e d i t . A n o t h e r reason is t h a t since t h e forecasts f l a t t e n o u t t o t h e i r sample means, i f we were t o i n c l u d e t h e i n f l a t i o n a r y 1970s i n t h e sample, we m i g h t bias t h e results a n d find i n f l a t i o n c o m i n g i n b e l o w forecast. W h i l e t h e r e are o n l y m i n o r changes i n t h e forecasts f o r G D P g r o w t h a n d s h o r t - t e r m interest rates w h e n we use t h e s h o r t e r data sample, i n t h e a l t e r n a t i v e s i m u l a t i o n s t h e forecasts o f i n f l a t i o n are l o w e r i n e i g h t o u t o f n i n e c o u n t r i e s . I n f l a t i o n still comes i n consistently b e l o w forecast, however, f o r any o f t h e i n f l a t i o n targeters a n d t h e U n i t e d States. F o r A u s t r a l i a , t h e i n f l a t i o n forecast is h i g h e r , l e a d i n g t o a l a r g e r over-predic­ t i o n o f actual inflation. 2 0

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Summary F o r t h e i n f l a t i o n - t a r g e t i n g c o u n t r i e s , t h e f o r e c a s t i n g exercises d e s c r i b e d i n this s e c t i o n i n d i c a t e t h a t i n f l a t i o n rates after t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g are l o w e r t h a n o t h e r w i s e w o u l d have b e e n e x p e c t e d . T h e s e d i s i n f l a t i o n s are n o t costless, b e i n g a c c o m p a n i e d b y declines i n o u t p u t g r o w t h (relative t o p r e d i c t i o n ) , suggesting o n c e a g a i n t h a t a d o p t i o n o f i n f l a t i o n t a r g e t i n g does n o t e l i m i n a t e t h e costs o f r e d u c i n g i n f l a t i o n . O n t h e o t h e r h a n d , o n c e d i s i n f l a t i o n has b e e n achieved, i n f l a t i o n - t a r ­ g e t i n g c o u n t r i e s a p p e a r t o have b e t t e r i n f l a t i o n p e r f o r m a n c e t h a n m i g h t have b e e n e x p e c t e d f r o m t h e i r past e x p e r i e n c e , w h i l e o u t p u t g r o w t h b o u n c e s b a c k a n d f o r a s h o r t p e r i o d m a y even e x c e e d w h a t w o u l d have been expected. Further, i n the inflation-targeting countries, inflation rises less t h a n w o u l d b e e x p e c t e d d u r i n g t h e s u b s e q u e n t p e r i o d o f re­ n e w e d o u t p u t g r o w t h , a f i n d i n g consistent w i t h o u r evidence t h a t i n f l a ­ t i o n e x p e c t a t i o n s i n these c o u n t r i e s r e m a i n relatively t a m e i n t h e face o f s t r o n g business-cycle u p t u r n s . T h e evidence f r o m t h e r e m a i n i n g five c o u n t r i e s suggests t w o i m p o r ­ t a n t q u a l i f i c a t i o n s t o these c o n c l u s i o n s . First, as t h e results f o r A u s t r a l i a ( p r i o r t o its t a r g e t a d o p t i o n ) a n d f o r t h e U n i t e d States show, b e t t e r - t h a n e x p e c t e d i n f l a t i o n p e r f o r m a n c e is n o t c o n f i n e d t o c o u n t r i e s o p e r a t i n g u n d e r e x p l i c i t l y a n n o u n c e d targets. P u t differently, i n f l a t i o n targets are n o t a necessary c o n d i t i o n f o r s u s t a i n i n g l o w i n f l a t i o n . S e c o n d , t h e re­ sults f o r G e r m a n y a n d S w i t z e r l a n d b r i n g h o m e t h e p o i n t t h a t even f o r countries with a l o n g record o f credible targeting, reducing inflation comes at t h e p r i c e o f s i g n i f i c a n t o u t p u t r e d u c t i o n s i n t h e s h o r t r u n .

The Effectiveness of Inflation Targeting: A Preliminary Assessment A l l t h i n g s c o n s i d e r e d , t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g as t h e f r a m e ­ w o r k f o r m o n e t a r y p o l i c y i n t h e c o u n t r i e s e x a m i n e d h e r e appears t o have b e e n a success. W h i l e we c a n n o t k n o w precisely w h a t w o u l d have h a p p e n e d h a d they n o t a d o p t e d i n f l a t i o n t a r g e t i n g , these c o u n t r i e s have seen i n f l a t i o n levels a n d i n f l a t i o n e x p e c t a t i o n s f a l l below, a n d r e m a i n below, w h a t w o u l d have b e e n e x p e c t e d based o n e x t r a p o l a t i o n s o f t h e past. O n t h e o t h e r h a n d , t h e h o p e s o f some a d o p t i n g c o u n t r i e s ( C a n a d a a n d N e w Z e a l a n d w e r e p a r t i c u l a r l y e x p l i c i t o n this p o i n t ) t h a t t h e costs o f d i s i n f l a t i o n w o u l d d e c l i n e as a r e s u l t o f i n f l a t i o n t a r g e t i n g w e r e n o t

INFLATION T A R G E T I N G : HOW S U C C E S S F U L HAS I T BEEN?

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f u l f i l l e d d u r i n g t h e first p o s t - a d o p t i o n d i s i n f l a t i o n s . I t is d i f f i c u l t t o say w h e t h e r this s h o u l d b e seen as a f a i l u r e o f i n f l a t i o n t a r g e t i n g t o create c r e d i b i l i t y , o r s i m p l y as a c o n f i r m a t i o n o f t h e finding o f m u c h p r e v i o u s research t h a t changes i n t h e s t r u c t u r e o f m o n e t a r y p o l i c y have l i t t l e ef­ fect o n t h e i n f l a t i o n - o u t p u t t r a d e o f f i n t h e s h o r t r u n . T h e comparison o f the a d o p t i n g countries' inflation r e c o r d w i t h that o f t h e respective " c o n t r o l " c o u n t r i e s , A u s t r a l i a a n d Italy, u n d e r s c o r e s t h e f a v o r a b l e — a l b e i t delayed—effect o f i n f l a t i o n t a r g e t i n g o n i n f l a t i o n e x p e c t a t i o n s . O v e r a l l , t h o u g h , we m u s t a d m i t t h a t t h e e c o n o m i c p e r f o r ­ m a n c e o f t h e non-targeters over t h e p e r i o d c o n s i d e r e d is n o t a p p r e c i a ­ bly d i f f e r e n t f r o m t h a t o f t h e i n f l a t i o n targeters. W h i l e i n a l l t h e i n f l a ­ t i o n - t a r g e t i n g c o u n t r i e s , i n f l a t i o n r e m a i n s u n e x p e c t e d l y l o w as G D P g r o w t h r e t u r n s t o its p r e d i c t e d p a t h , t h e same is t r u e f o r A u s t r a l i a a n d t h e U n i t e d States. A c o m p a r i s o n o f t h e effect o f i n f l a t i o n t a r g e t i n g i n t h e s a m p l e c o u n ­ tries t o w h a t l o n g s t a n d i n g targeters G e r m a n y a n d S w i t z e r l a n d have ex­ p e r i e n c e d b r i n g s h o m e t w o c r u c i a l p o i n t s . First, o n t h e negative side, i t m a y j u s t be t o o m u c h t o e x p e c t m o n e t a r y r e g i m e s , even h i g h l y c r e d i b l e ones, t o a l t e r t h e t e r m s o f t h e o u t p u t - i n f l a t i o n tradeoff. So, perhaps, o u r findings f o r t h e i n f l a t i o n targeters s h o u l d n o t c o m e as a g r e a t surprise. S e c o n d , a n d m o r e positively, t h e r e appears t o be some e v i d e n c e t h a t a c r e d i b l e a n d t r a n s p a r e n t t a r g e t i n g r e g i m e is able t o " l o c k i n " l o w expec­ tations o f m e d i u m - t e r m a n d l o n g - t e r m i n f l a t i o n i n t h e face o f t e m p o ­ r a r y shocks t o t h e p r i c e level. T h u s we find a sort o f asymmetry: T h e s t r e n g t h o f a n o m i n a l t a r g e t i n g r e g i m e (i.e., o f e i t h e r m o n e y g r o w t h o r i n f l a t i o n ) m a y b e its a b i l i t y t o c o p e w i t h a n d c o n t a i n adverse i n f l a t i o n a r y d e v e l o p m e n t s , even t h o u g h a p o l i c y o f active d i s i n f l a t i o n r e m a i n s costly. T h u s , w h i l e i n f l a t i o n t a r g e t i n g m a y n o t r e d u c e t h e costs o f t h e t r a n s i t i o n to l o w i n f l a t i o n , i t m a y h e l p c e n t r a l banks sustain p r i c e stability i n t h e longer r u n by increasing the transparency o f policy a n d the accountabil­ ity o f t h e m o n e t a r y p o l i c y - m a k e r s .

11 What Have We Learned?

W E HAVE r e v i e w e d t h e e x p e r i e n c e w i t h i n f l a t i o n t a r g e t i n g o f a n u m b e r o f c o u n t r i e s a r o u n d t h e w o r l d , a n d we have r e p o r t e d t h e results o f o u r attempts t o m e a s u r e t h e effects o f this a p p r o a c h t o m o n e t a r y p o l i c y sta­ tistically. N o w i t is t i m e t o s u m m a r i z e w h a t we have l e a r n e d . T h e evidence we have r e p o r t e d m a y h e l p us t o answer several i m p o r ­ t a n t questions a b o u t the w o r k i n g s o f a n i n f l a t i o n - t a r g e t i n g r e g i m e . T h r e e sets o f questions s t a n d o u t : First are questions r e l a t i n g t o design, i m p l e m e n t a t i o n , a n d o p e r a t i o n : A s s u m i n g t h a t a c o u n t r y decides t o a d o p t i n f l a t i o n t a r g e t i n g , h o w s h o u l d i t structure the p o l i c y regime? F o r e x a m p l e , w h o s h o u l d be responsible f o r setting the i n f l a t i o n target, f o r m e e t i n g the target, a n d f o r e x p l a i n i n g p o l i c y goals a n d actions t o the public? H o w s h o u l d the policy-makers re­ s p o n d to various shocks that t h r e a t e n price stability o r o t h e r e c o n o m i c ob­ jectives? Is there a best time ( o r set o f e c o n o m i c a n d p o l i t i c a l circumstances) to i n t r o d u c e i n f l a t i o n targeting? Is there a consensus o n w h a t constitutes "best practice" i n the day-to-day i m p l e m e n t a t i o n o f i n f l a t i o n targeting? Second, h o w successful has i n f l a t i o n t a r g e t i n g been? W h a t are the b e n ­ efits o f this approach? W h a t are the costs? T o w h a t degree d o the advan­ tages a n d disadvantages o f i n f l a t i o n t a r g e t i n g d e p e n d o n the details o f i m p l e m e n t a t i o n , the p o l i t i c a l e n v i r o n m e n t , a n d the state o f the economy? T h i r d , are t h e advantages o f i n f l a t i o n t a r g e t i n g u n i q u e t o t h a t ap­ p r o a c h , o r m i g h t a l t e r n a t i v e a p p r o a c h e s t o m o n e t a r y p o l i c y w o r k as w e l l o r better? T h i s c h a p t e r addresses each set o f questions. T h e r e a d e r w i l l n o t be s u r p r i s e d t o l e a r n t h a t we believe t h a t a w e l l - s t r u c t u r e d i n f l a t i o n - t a r g e t ­ i n g r e g i m e — t h o u g h n e i t h e r a panacea n o r a substitute f o r i n t e l l i g e n t p o l i c y - m a k i n g — w i l l p r o v i d e a useful f r a m e w o r k f o r t h e m a k i n g o f m o n ­ etary p o l i c y i n m o d e r n e c o n o m i e s .

The Design and Operation of an Inflation-Targeting Regime T o p a r a p h r a s e T h o m a s E d i s o n , g o o d p o l i c y - m a k i n g is o n e p e r c e n t c o n c e p t u a l i z a t i o n a n d n i n e t y - n i n e p e r c e n t e x e c u t i o n . I n f l a t i o n target-

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i n g provides a useful c o n c e p t u a l f r a m e w o r k f o r t h i n k i n g a b o u t a n d i m p l e ­ m e n t i n g m o n e t a r y policy. B u t t h e e x p e r i e n c e o f c o u n t r i e s t h a t have t a k e n t h i s a p p r o a c h suggests t h a t a g r e a t d e a l d e p e n d s o n t h e details o f i m p l e ­ m e n t a t i o n , i n c l u d i n g t h e c h o i c e o f target, t h e m e a n s o f c o m m u n i c a t i n g w i t h the public, the i n s t i t u t i o n a l arrangements that ensure central b a n k a c c o u n t a b i l i t y , a n d so o n . O u r case studies suggest t h a t a substantial d e g r e e o f c o n v e r g e n c e has t a k e n place a m o n g t h e m a j o r i n f l a t i o n - t a r g e t i n g c o u n t r i e s i n t h e d e s i g n o f t h e i r p o l i c y r e g i m e s . T h e r e seems i n d e e d t o be a n e m e r g i n g c o n s e n ­ sus o n h o w t o answer m a n y o f t h e o p e r a t i o n a l questions p o s e d i n C h a p ­ t e r 3, a n d thus o n w h a t constitutes "best p r a c t i c e " i n t h e i m p l e m e n t a ­ t i o n o f i n f l a t i o n t a r g e t i n g . M a n y o f t h e details o f i m p l e m e n t a t i o n have d i f f e r e d f r o m c o u n t r y t o c o u n t r y , a n d s u c h differences c a n p r o v i d e us w i t h insight i n t o what works a n d what doesn't w i t h i n the inflation-target­ i n g f r a m e w o r k . W e n o w c o n s i d e r a n u m b e r o f t h e key d e s i g n a n d o p e r a ­ t i o n a l issues a n d some o f t h e lessons t h a t t h e i n t e r n a t i o n a l e x p e r i e n c e w i t h inflation targeting provides.

Introduction of the Inflation Target W h e n is t h e best t i m e t o i n t r o d u c e i n f l a t i o n targeting? Generally, m a j o r changes i n m o n e t a r y p o l i c y r e g i m e s o c c u r o n l y u n d e r duress, a n d so i t m i g h t seem t h a t t h e best t i m e t o start t a r g e t i n g i n f l a t i o n w o u l d be w h e n i n f l a t i o n is t h r e a t e n i n g t o get o u t o f c o n t r o l . Yet m o s t i n f l a t i o n - t a r g e t i n g c o u n t r i e s have c h o s e n t o a d o p t t h e n e w r e g i m e o n l y after h a v i n g h a d s o m e i n i t i a l success i n l o w e r i n g i n f l a t i o n f r o m p r e v i o u s l y h i g h levels. T h i s t i m i n g has usually r e f l e c t e d a t a c t i c a l p o l i t i c a l d e c i s i o n t h a t , i n o r d e r t o g a i n c r e d i b i l i t y f o r t h e n e w r e g i m e , i t is i m p o r t a n t t o b e able t o m e e t t h e i n i t i a l i n f l a t i o n targets w i t h h i g h p r o b a b i l i t y . I t also reflects t h e fact t h a t o n e o f t h e m a i n benefits o f i n f l a t i o n targets is t h a t t h e y m a y h e l p t o " l o c k i n " e a r l i e r d i s i n f l a t i o n a r y gains, p a r t i c u l a r l y i n t h e face o f o n e - t i m e i n f l a t i o n a r y shocks. W e saw this effect, f o r e x a m p l e , f o l l o w i n g t h e exits o f t h e U n i t e d K i n g d o m a n d Sweden f r o m t h e E u r o p e a n Ex­ c h a n g e Rate M e c h a n i s m a n d after Canada's 1991 i m p o s i t i o n o f t h e Goods a n d Services Tax. I n each case, t h e r e - i g n i t i n g o f i n f l a t i o n seems t o have b e e n a v o i d e d b y t h e a n n o u n c e m e n t o f i n f l a t i o n targets t h a t h e l p e d t o a n c h o r t h e p u b l i c ' s i n f l a t i o n e x p e c t a t i o n s a n d t o give a n e x p l i c i t p l a n f o r a n d d i r e c t i o n t o m o n e t a r y policy. T h e specific i m p e t u s f o r t h e i n t r o d u c t i o n o f i n f l a t i o n t a r g e t i n g has v a r i e d substantially. I n some cases t h e i n t r o d u c t i o n o f t h e n e w a p p r o a c h

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f o l l o w e d a discrete event, s u c h as t h e collapse o f a n exchange-rate p e g i n t h e U n i t e d K i n g d o m o r Sweden, o r t h e a d o p t i o n o f a m u c h b r o a d e r package o f e c o n o m i c r e f o r m s , as i n N e w Z e a l a n d . I n o t h e r cases, t h e new a p p r o a c h t o m o n e t a r y p o l i c y has e v o l v e d gradually, i n response t o v a r i o u s dissatisfactions w i t h t h e e x i s t i n g r e g i m e ; we saw t h i s p a t t e r n i n Canada, Israel, a n d A u s t r a l i a . T h e c e n t r a l b a n k has usually p l a y e d a key r o l e i n t h e m o v e t o w a r d i n f l a t i o n targets, b u t t h e g o v e r n m e n t has also t a k e n t h e i n i t i a t i v e i n some c o u n t r i e s , s u c h as t h e U n i t e d K i n g d o m a n d S p a i n . F o r m a l legislative changes have p l a y e d a r o l e i n o n l y a few cases. W h a t e v e r t h e o r i g i n s o f t h e n e w policy, best results seem t o be o b t a i n e d w h e n t h e i n f l a t i o n targets are i n t r o d u c e d w i t h some fanfare, i n a way t h a t makes clear t o t h e p u b l i c t h a t a d i s t i n c t l y n e w a p p r o a c h is b e i n g a d o p t e d , r a t h e r t h a n b e i n g q u i e t l y p h a s e d i n . A clear s i g n a l t h a t t h e n e w a p p r o a c h is s u p p o r t e d by, a n d is t h e j o i n t r e s p o n s i b i l i t y of, b o t h t h e gov­ e r n m e n t a n d t h e c e n t r a l b a n k is also c o n d u c i v e t o t h e f r a m e w o r k ' s even­ t u a l success.

Choosing and Defining the Target D e s p i t e t h e r h e t o r i c a b o u t p u r s u i n g " p r i c e stability", a l l t h e c o u n t r i e s s t u d i e d h e r e have c h o s e n t o t a r g e t t h e i n f l a t i o n r a t e — t h a t is, t h e rate at w h i c h prices are c h a n g i n g o v e r t i m e — r a t h e r t h a n t h e level o f prices per se. T h e reason is t h a t p o l i c y - m a k e r s are c o n c e r n e d a b o u t t h e effect a price-level t a r g e t m i g h t have o n s h o r t - r u n m a c r o e c o n o m i c stability. I f they t a r g e t e d a specific level o f prices, a n d t h a t t a r g e t w e r e overshot, t h e r e w o u l d have t o be a p e r i o d o f f a l l i n g p r i c e s — t h a t is, d e f l a t i o n — a s t h e p r i c e level was b r o u g h t b a c k t o t h e target. As we saw i n C h a p t e r 3, t h e r e are g o o d reasons t o fear d e f l a t i o n , i n c l u d i n g t h e p o s s i b i l i t y t h a t i t m i g h t e n d a n g e r t h e financial system a n d p r e c i p i t a t e a n e c o n o m i c c o n ­ t r a c t i o n . I n d e e d , d e f l a t i o n has o f t e n b e e n associated w i t h d e e p reces­ sions o r even depressions, as i n t h e 1930s. T h u s p o l i c y - m a k e r s i n t h e c o u n t r i e s we have s t u d i e d have c o n c l u d e d t h a t a price-level target, w h i c h w o u l d l i k e l y r e q u i r e p e r i o d s o f d e f l a t i o n , m i g h t create u n a c c e p t a b l e costs i n t e r m s o f lost o u t p u t a n d e m p l o y m e n t . F o r t u n a t e l y , t h e e x p e r i e n c e o f i n f l a t i o n - t a r g e t i n g c o u n t r i e s indicates t h a t a f u l l reversal o f t a r g e t misses, as w o u l d be r e q u i r e d b y a price-level target, does n o t a p p e a r t o be neces­ sary f o r t h e m a i n t e n a n c e o f l o w i n f l a t i o n o r p o l i c y c r e d i b i l i t y . F o r r e l a t e d reasons, n o t a r g e t i n g c o u n t r y so far has c h o s e n a zero m i d p o i n t f o r its i n f l a t i o n t a r g e t r a n g e , as w o u l d be r e q u i r e d b y a l i t e r a l a p p l i c a t i o n o f t h e phrase " p r i c e stability." E v e n t h e B u n d e s b a n k , o n e o f

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t h e w o r l d ' s m o s t r e s o l u t e o p p o n e n t s o f i n f l a t i o n , chose as its n o r m a t i v e i n f l a t i o n t a r g e t 2 % per annum f o r m a n y years ( n o w 1.5% t o 2 % ) , above m o s t estimates o f possible u p w a r d bias i n officiai measures o f i n f l a t i o n . A key r a t i o n a l e , a g a i n , is c o n c e r n a b o u t possible d e f l a t i o n : T a r g e t i n g values f o r i n f l a t i o n g r e a t e r t h a n zero makes p e r i o d s o f a c c i d e n t a l defla­ t i o n less likely. A l s o , m a n y e c o n o m i s t s believe ( t h o u g h i t r e m a i n s c o n ­ troversial) t h a t t h e benefits o f l o w i n f l a t i o n m a y be f u l l y r e a l i z e d w h e n i n f l a t i o n reaches t h e 2 % t o 3% r a n g e , a n d t h a t still l o w e r rates c o u l d i m p e d e t h e f u n c t i o n i n g o f t h e r e a l e c o n o m y . I n any case, t h e e v i d e n c e suggests t h a t m a i n t a i n i n g a t a r g e t f o r i n f l a t i o n t h a t is above ( b u t n o t t o o far above) zero f o r a n e x t e n d e d p e r i o d , as even t h e B u n d e s b a n k has d o n e , does n o t l e a d t o i n s t a b i l i t y i n t h e p u b l i c ' s i n f l a t i o n e x p e c t a t i o n s o r t o a d e c l i n e i n t h e c e n t r a l bank's c r e d i b i l i t y . A l t h o u g h t a r g e t i n g c o u n t r i e s agree t h a t i n f l a t i o n , n o t t h e p r i c e level, s h o u l d be t h e target, a n d t h a t t h e o p t i m a l target is n o t zero b u t a s m a l l positive rate o f i n f l a t i o n , t h e y e x h i b i t i m p o r t a n t differences i n t h e spe­ cific ways t h e y choose t o d e f i n e t h e i r targets o p e r a t i o n a l l y . Perhaps m o s t s t r i k i n g a m o n g these is t h a t t h e r e is n o clear consensus o n w h a t m e a s u r e o f i n f l a t i o n s h o u l d be t a r g e t e d . Some c o u n t r i e s use t h e " h e a d l i n e " , o r all-items, C P I , p r e s u m a b l y because i t is t h e m o s t f a m i l i a r t o t h e p u b l i c . O t h e r s use a C P I i n f l a t i o n m e a s u r e f r o m w h i c h t h e prices o f c e r t a i n i t e m s ( f o o d a n d energy, f o r e x a m p l e ) are e x c l u d e d , i n o r d e r t o a v o i d r e a c t i n g t o t h e first-round effects ( t h e d i r e c t effects o n i n f l a t i o n ) o f t r a n ­ sient s u p p l y shocks. O t h e r s use b o t h types o f measures. W e see h e r e a m a n i f e s t a t i o n o f a c e n t r a l issue i n t h e d e s i g n o f i n f l a ­ t i o n targets: t h e s h o r t - r u n t r a d e o f f b e t w e e n t r a n s p a r e n c y (as p r o m o t e d , f o r e x a m p l e , b y t h e use o f a s i m p l e , w e l l - k n o w n m e a s u r e o f i n f l a t i o n ) a n d p o l i c y flexibility ( w h i c h , i n this case, is e n h a n c e d by t h e use o f i n f l a ­ t i o n i n d e x e s t h a t o m i t t h e first-round effects o f s u p p l y shocks). T h e t y p i ­ cal c o m p r o m i s e has b e e n t o choose relatively s i m p l e a n d w e l l - k n o w n indexes for defining the inflation target b u t to resort to c o m p l i c a t e d e x p l a n a t i o n s o f d e v i a t i o n s f r o m t h a t target. T h e r e are e x c e p t i o n s : N e w Z e a l a n d , f o r e x a m p l e , uses a n i n f l a t i o n t a r g e t t h a t e x p l i c i t l y excludes a variety o f prices l i n k e d t o s u p p l y shocks. T h a t c h o i c e p r o m o t e s p o l i c y flexibility b u t at some cost t o transparency, since t h e p u b l i c m a y find i t d i f f i c u l t t o u n d e r s t a n d t h e a l t e r n a t i v e i n d e x , p a r t i c u l a r l y i f its d e f i n i t i o n is n o t consistent over t i m e (as has b e e n t h e case i n N e w Z e a l a n d ) . Over­ a l l , however, so l o n g as t h e t a r g e t i n f l a t i o n measure is n o t c h a n g e d t o o o f t e n a n d does n o t deviate t o o w i d e l y f r o m " h e a d l i n e " measures o f i n f l a ­ t i o n , i t seems t h a t t h e m e a s u r e c h o s e n is n o t c r i t i c a l t o t h e success o f t h e targeting program.

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T h e t r a d e o f f b e t w e e n t r a n s p a r e n c y a n d flexibility is also a n issue i n d e c i d i n g w h i c h agency w i l l be r e s p o n s i b l e f o r m e a s u r i n g i n f l a t i o n . N e w Z e a l a n d has m a d e t h e Reserve B a n k a c c o u n t a b l e f o r m e e t i n g t h e targets a n d also f o r m e a s u r i n g ( a n d a d j u s t i n g ) t h e o f f i c i a l i n f l a t i o n n u m b e r s ; presumably, g i v i n g t h e Reserve B a n k some d i s c r e t i o n i n a d j u s t i n g t h e i n f l a t i o n m e a s u r e is i n t e n d e d t o increase t h e flexibility o f p o l i c y t o d e a l w i t h u n f o r e s e e n events. I n contrast, t h e o t h e r c o u n t r i e s we have e x a m ­ i n e d have chosen t o separate responsibility f o r m e e t i n g t h e targets (vested i n t h e c e n t r a l b a n k ) f r o m r e s p o n s i b i l i t y f o r m e a s u r i n g t h e target v a r i ­ able (vested i n a separate statistical a g e n c y ) . A l t h o u g h a l l o w i n g t h e cen­ t r a l b a n k t o m e a s u r e a n d adjust t h e t a r g e t variable m a y t e n d t o h e i g h t e n flexibility, i t decreases transparency a n d erodes t h e p u b l i c ' s c o n f i d e n c e i n the integrity o f the regime. Assigning the measurement o f inflation a n d t h e p u r s u i t o f t h e i n f l a t i o n target t o separate agencies seems t o be t h e wiser course.

Short-run Policy Flexibility and Multiple Objectives F o c u s i n g m o n e t a r y p o l i c y o n i n f l a t i o n does n o t i m p l y t h a t t r a d i t i o n a l s t a b i l i z a t i o n goals are i g n o r e d ; t h e n o t i o n t h a t m o n e t a r y p o l i c y - m a k ­ ers u n d e r i n f l a t i o n t a r g e t i n g are i n d i f f e r e n t t o t h e p e r f o r m a n c e o f t h e r e a l e c o n o m y is s i m p l y i n c o r r e c t . C e n t r a l b a n k e r s r e s p o n s i b l e f o r i n ­ f l a t i o n t a r g e t i n g c o n t i n u e t o be c o n c e r n e d a b o u t fluctuations i n o u t ­ p u t a n d e m p l o y m e n t , a n d i n a l l t h e c o u n t r i e s we have s t u d i e d , t h e a b i l i t y t o a c c o m m o d a t e s h o r t - r u n s t a b i l i z a t i o n goals is, t o s o m e d e g r e e , b u i l t i n t o the inflation-targeting regime. Evidence that o u t p u t a n d em­ p l o y m e n t r e m a i n c o n c e r n s o f p o l i c y - m a k e r s after t h e s w i t c h t o i n f l a ­ t i o n t a r g e t i n g c a n be seen i n t h e fact t h a t a l l t h e t a r g e t i n g c o u n t r i e s have u n d e r t a k e n d i s i n f l a t i o n o n l y g r a d u a l l y , t o a v o i d p u t t i n g u n d u e pressure o n the real economy. For example, a n u m b e r o f countries, i n c l u d i n g C a n a d a a n d S w e d e n , set t h e i r i n i t i a l i n f l a t i o n targets t o take effect o n l y w i t h s u b s t a n t i a l delay, so as n o t t o i m p o s e u n n e c e s s a r y s h o r t r u n costs i n t e r m s o f lost o u t p u t o r e m p l o y m e n t . A c o m m o n p r a c t i c e has b e e n t o d i s t i n g u i s h b e t w e e n t h e l o n g - r u n i n f l a t i o n g o a l a n d s h o r t r u n i n f l a t i o n targets, w i t h t h e l a t t e r set t o c o n v e r g e g r a d u a l l y w i t h t h e former. By adjusting the speed o f convergence w i t h the l o n g - r u n goal (or, n e a r l y e q u i v a l e n t l y , t h e t a r g e t h o r i z o n ) , t h e p o l i c y - m a k e r s c a n m o d e r a t e t h e r e a l costs o f r e d u c i n g i n f l a t i o n , a n d also r e d u c e o u t p u t fluctuations, while still m a i n t a i n i n g a strong c o m m i t m e n t to l o n g - r u n price stability. 1

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T h e s e t t i n g o f a floor as w e l l as a c e i l i n g f o r t h e acceptable i n f l a t i o n r a t e , w h e t h e r e x p l i c i t l y ( t h r o u g h t a r g e t ranges) o r i m p l i c i t l y , also shows a c o n c e r n f o r m a c r o e c o n o m i c s t a b i l i z a t i o n . T h i s p o i n t has b e e n e m p h a ­ sized m o s t b y t h e B a n k o f C a n a d a , w h i c h has a r g u e d t h a t i n f l a t i o n tar­ g e t i n g t h a t sets a floor as w e l l as a c e i l i n g c a n h e l p p r o t e c t t h e r e a l e c o n o m y f r o m shocks t o aggregate s p e n d i n g . I n p a r t i c u l a r , d e c l i n e s i n aggregate d e m a n d t h a t cause t h e i n f l a t i o n rate t o f a l l b e l o w t h e l o w e r b o u n d o f the target range will automatically stimulate the central b a n k to l o o s e n m o n e t a r y p o l i c y w i t h o u t f e a r i n g t h a t its a c t i o n w i l l t r i g g e r a rise i n i n f l a t i o n e x p e c t a t i o n s . T h u s i n f l a t i o n t a r g e t i n g increases t h e flex­ i b i l i t y o f t h e c e n t r a l b a n k i n r e s p o n d i n g t o declines i n aggregate s p e n d ­ i n g . I n s o f a r as aggregate d e m a n d shocks are t h e d o m i n a n t source o f cycles i n a g i v e n c o u n t r y , t h i s a p p r o a c h i m p a r t s a c o u n t e r c y c l i c a l t e n ­ d e n c y t o m o n e t a r y policy, i n c o n t r a s t t o t h e d e s t a b i l i z i n g p r o c y c l i c a l b e h a v i o r o f m o n e t a r y p o l i c y seen i n m a n y c o u n t r i e s i n t h e past. W h a t a b o u t a g g r e g a t e s u p p l y shocks? U n l i k e a g g r e g a t e d e m a n d shocks, aggregate s u p p l y shocks are n o t a u t o m a t i c a l l y h a n d l e d b y t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k . H o w e v e r , i n a l l t h e c o u n t r i e s we have ex­ a m i n e d , the monetary-policy authorities routinely allow deviations f r o m i n f l a t i o n targets i n response t o s u p p l y shocks. F o l l o w i n g ( o r i n a n t i c i p a ­ t i o n o f ) a s u p p l y shock, s u c h as, f o r e x a m p l e , a c h a n g e i n v a l u e - a d d e d taxes, t h e n o r m a l p r o c e d u r e is f o r t h e c e n t r a l b a n k first t o deviate f r o m its p l a n n e d p o l i c i e s as n e e d e d a n d t h e n t o e x p l a i n t h e reasons f o r its a c t i o n t o t h e p u b l i c . A m o n g t h e c o u n t r i e s we have c o n s i d e r e d , o n l y i n N e w Z e a l a n d has a n e x p l i c i t "escape clause" b e e n i n v o k e d to j u s t i f y s u c h actions, a l t h o u g h t h e Reserve B a n k o f N e w Z e a l a n d has also p e r m i t t e d t a r g e t d e v i a t i o n s t h a t can b e j u s t i f i e d o n l y o n a m o r e ad hoc basis. T h e a b i l i t y t o p e r m i t s h o r t - r u n d e v i a t i o n s f r o m t h e i n f l a t i o n t a r g e t is b e n e f i ­ c i a l i f (1) t h e y c a n be p l a u s i b l y r a t i o n a l i z e d f o r t h e p u b l i c , a n d (2) t h e y d o n o t t h r e a t e n l o n g e r - r u n i n f l a t i o n goals. T h e capacity t o deviate f r o m t h e t a r g e t i f necessary allows t h e c e n t r a l b a n k a s i g n i f i c a n t d e g r e e o f flexibility i n t r y i n g to stabilize t h e e c o n o m y i n t h e s h o r t r u n w i t h o u t s a c r i f i c i n g t h e benefits o f l o w i n f l a t i o n a n d l o w i n f l a t i o n e x p e c t a t i o n s i n the l o n g r u n . A f u r t h e r source o f p o l i c y flexibility lies i n t h e p o w e r o f t h e m o n e t a r y a u t h o r i t i e s t o adjust t h e i n f l a t i o n targets themselves (as o p p o s e d t o devi­ a t i n g f r o m established targets). A l l t h e t a r g e t i n g c o u n t r i e s have a d j u s t e d t h e o f f i c i a l i n f l a t i o n targets o r t a r g e t ranges g r a d u a l l y o v e r t i m e , b o t h u p w a r d (as i n t h e case o f G e r m a n y after t h e 1979 o i l s h o c k a n d N e w Z e a l a n d after t h e 1996 e l e c t i o n ) a n d d o w n w a r d (as i n a l l t h e c o u n t r i e s we have e x a m i n e d , as t h e i r i n i t i a l d i s i n f l a t i o n s p r o c e e d e d ) . So l o n g as

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v a r i a t i o n s i n t h e t a r g e t p a t h are a n n o u n c e d far e n o u g h i n advance t h a t t h e y d o n o t a p p e a r t o be m e r e l y a n ex post r a t i o n a l i z a t i o n o f a c t u a l i n f l a ­ t i o n o u t c o m e s , changes i n t h e t a r g e t p a t h are g e n e r a l l y p e r c e i v e d b y t h e p u b l i c t o be a reasonable way o f a d a p t i n g t o e c o n o m i c c o n d i t i o n s . I n particular, w i t h adequate explanation f r o m the central bank, the p u b l i c seems able t o d i s t i n g u i s h a one-time, t e m p o r a r y shock t o i n f l a t i o n — w h i c h m a y b e a c c o m m o d a t e d b y a t r a n s i t o r y increase i n t h e i n f l a t i o n t a r g e t — f r o m a c h a n g e i n t r e n d i n f l a t i o n , w h i c h t h e i n f l a t i o n targets usually are ( a n d s h o u l d b e ) set t o resist. T h i s is a substantial b e n e f i t , since c o n t a i n ­ m e n t o f i n f l a t i o n a r y e x p e c t a t i o n s is t h e o n l y m e a n s available, o t h e r t h a n the painful solution o f slowing the economy, for keeping inflation u n ­ der control.

Information Variables and Intermediate Targets I n f l a t i o n - t a r g e t i n g c e n t r a l banks g e n e r a l l y d o n o t tie themselves t o spe­ cific i n t e r m e d i a t e targets, s u c h as t h e g r o w t h rate o f t h e m o n e y stock o r t h e e x c h a n g e rate ( a l t h o u g h i n some c o u n t r i e s t h e e x c h a n g e rate has p r o v i d e d a s e c o n d a r y objective f o r m o n e t a r y p o l i c y ) . T o t h e e x t e n t t h a t i n t e r m e d i a t e targets are used, as i n t h e h y b r i d r e g i m e s o f G e r m a n y a n d Switzerland, conflicts between the intermediate target a n d the i n f l a t i o n g o a l are a l m o s t always resolved i n favor o f t h e i n f l a t i o n g o a l . W h i l e t h e use o f i n t e r m e d i a t e targets ( o t h e r t h a n t h e forecast o f f u ­ t u r e i n f l a t i o n itself, as e m p h a s i z e d b y Svensson [ 1 9 9 7 a ] ) does n o t f i t comfortably with inflation targeting, many inflation-targeting central banks have e m p h a s i z e d p a r t i c u l a r m a c r o e c o n o m i c i n d i c a t o r s as i n f o r ­ m a t i o n variables, i.e., variables t h a t c o n t a i n i n f o r m a t i o n a b o u t t h e f u ­ t u r e course o f t h e e c o n o m y b u t w h i c h are n o t themselves t a r g e t e d . Ex­ amples i n c l u d e the m o n e t a r y conditions i n d e x i n N e w Zealand a n d C a n a d a a n d t h e b r o a d m o n e y aggregate A L P i n S p a i n . C o n s i d e r a b l e a t t e n t i o n has b e e n p a i d by some c e n t r a l banks t o surveys t h a t a t t e m p t t o m e a s u r e t h e p u b l i c ' s e x p e c t a t i o n s o f i n f l a t i o n , as w e l l as estimates o f i n f l a t i o n e x p e c t a t i o n s i n f e r r e d f r o m b o n d yields. S t r u c t u r a l m o d e l s o f t h e e c o n o m y p l a y a n i m p o r t a n t r o l e i n m a n y c o u n t r i e s . H o w e v e r , al­ t h o u g h the targeting countries differ i n the degree to w h i c h they em­ phasize p a r t i c u l a r i n d i c a t o r s o f i n f l a t i o n i n t h e i r d e c i s i o n - m a k i n g , a l l r e l y o n a v a r i e t y o f sources o f i n f o r m a t i o n w h e n d e c i d i n g o n policy. T h e r e s u l t is a p o l i c y r e g i m e t h a t e x h i b i t s w h a t we have c a l l e d " c o n s t r a i n e d d i s c r e t i o n , " a style o f p o l i c y - m a k i n g very d i f f e r e n t f r o m t h e " a u t o m a t i c p i l o t " a p p r o a c h advocated, f o r e x a m p l e , b y some m o n e t a r i s t s . I n par-

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ticular, because i t frees t h e c e n t r a l b a n k f r o m m e c h a n i c a l rules a n d per­ m i t s a d i s t i n c t i o n b e t w e e n s h o r t - r u n a n d l o n g - r u n p o l i c y objectives, c o n ­ s t r a i n e d d i s c r e t i o n allows f o r objectives o t h e r t h a n i n f l a t i o n t o e n t e r i n t o decisions a b o u t m o n e t a r y policy.

Point Target versus Target Range A design d e c i s i o n t h a t affects t h e s h o r t - r u n flexibility o f p o l i c y is w h e t h e r t o set the i n f l a t i o n target as a single p o i n t (as, f o r e x a m p l e , i n Switzerland's m o n e t a r y t a r g e t i n g since 1975 a n d i n the U n i t e d K i n g d o m since 1995) o r as a range o f acceptable o u t c o m e s . T h e advantage o f a range is t h a t i t provides m o r e e x p l i c i t flexibility t o t h e t a r g e t i n g r e g i m e a n d also conveys t o t h e p u b l i c t h e i m p o r t a n t message t h a t c o n t r o l o f i n f l a t i o n is i m p e r ­ fect. H o w e v e r , t h e use o f a r a n g e has c e r t a i n drawbacks. As we saw i n t h e case studies o f c o u n t r i e s t h a t use a t a r g e t r a n g e , a n d as we k n o w f r o m e x p e r i e n c e w i t h exchange-rate t a r g e t i n g w i t h i n a b a n d , t h e r a n g e m a y "take o n a life o f its o w n . " W i t h t a r g e t ranges i n place, p o l i t i c i a n s , finan­ cial m a r k e t s , a n d t h e p u b l i c o f t e n focus o n w h e t h e r i n f l a t i o n is j u s t o u t ­ side o r j u s t i n s i d e t h e edge o f t h e r a n g e , r a t h e r t h a n o n t h e m a g n i t u d e o f t h e d e v i a t i o n f r o m t h e m i d p o i n t o f t h e range. F u r t h e r m o r e , given t h e u n c e r t a i n t y o f i n f l a t i o n forecasts, even w i t h e n t i r e l y a p p r o p r i a t e m o n e t a r y p o l i c y i n place, the i n f l a t i o n rate may fall outside t h e target range. M i s s i n g a n e n t i r e range may be p e r c e i v e d by t h e p u b l i c as a m o r e serious f a i l u r e o f p o l i c y t h a n m i s s i n g a p o i n t ( w h i c h h a p p e n s a l m o s t i n e v i t a b l y ) , lead­ i n g t o a possible loss o f c r e d i b i l i t y f o r t h e i n f l a t i o n - t a r g e t i n g r e g i m e . A n o t h e r p r o b l e m w i t h t h e use o f t a r g e t ranges is t h a t misses are par­ t i c u l a r l y l i k e l y t o o c c u r i f t h e t a r g e t h o r i z o n is s h o r t , o n t h e o r d e r o f a year. I n t h a t case, " f i r m " t a r g e t ranges f o r i n f l a t i o n m a y l e a d t o t h e socalled i n s t r u m e n t instability p r o b l e m , i n w h i c h the vigorous attempts o f p o l i c y - m a k e r s t o k e e p i n f l a t i o n w i t h i n t h e target r a n g e cause t h e p o l i c y i n s t r u m e n t s — s u c h as s h o r t - t e r m i n t e r e s t rates o r t h e e x c h a n g e r a t e — t o u n d e r g o u n d e s i r a b l y l a r g e fluctuations. T h e p r o b l e m s o f c o n t r o l e r r o r s i n i n f l a t i o n a n d i n s t r u m e n t i n s t a b i l i t y have b e e n p a r t i c u l a r l y severe i n N e w Z e a l a n d , b u t t h e y have n o t b e e n u n k n o w n i n o t h e r i n f l a t i o n - t a r g e t ­ i n g countries. O n e s o l u t i o n t o these p r o b l e m s is t o w i d e n t h e t a r g e t r a n g e , as N e w Z e a l a n d d i d i n N o v e m b e r 1996. I f t h e r a n g e is m a d e w i d e e n o u g h t o significantly reduce the i n s t r u m e n t instability a n d c o n t r o l problems, however, t h e t a r g e t i n g r e g i m e m a y lose c r e d i b i l i t y . T h a t is p a r t i c u l a r l y l i k e l y i f t h e p u b l i c focuses o n t h e edges o f t h e r a n g e r a t h e r t h a n o n t h e

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m i d p o i n t , a n d i f t h e r a n g e is m a d e so w i d e t h a t its u p p e r l i m i t seems u n r e a s o n a b l y h i g h . I n d e e d , t h e act o f w i d e n i n g t h e r a n g e (as d i s t i n c t f r o m m o v i n g t h e m i d p o i n t o f t h e r a n g e i n response t o events) m i g h t be seen as a s i g n t h a t t h e m o n e t a r y a u t h o r i t i e s have w e a k e n e d t h e i r re­ solve, r a t h e r t h a n as a n i n d i c a t i o n t h a t t h e y are t r y i n g t o i m p r o v e t h e f u n c t i o n i n g o f t h e system. T h e a l t e r n a t i v e t o u s i n g a t a r g e t r a n g e is t o set a p o i n t t a r g e t f o r i n f l a ­ t i o n . I n o r d e r t o a v o i d c o n t r o l p r o b l e m s a n d i n s t r u m e n t instability, h o w ­ ever, i t is i m p e r a t i v e t h a t t h e p u b l i c be m a d e aware t h a t , because o f u n ­ avoidable u n c e r t a i n t i e s , even t h e best p o l i c i e s are u n l i k e l y t o h o l d i n f l a ­ t i o n consistently w i t h i n a s m a l l t o l e r a n c e a r o u n d t h e p o i n t target. T h i s n e e d imposes a g r e a t e r b u r d e n o n t h e c e n t r a l b a n k t o m a k e its e x p l a n a ­ t i o n s persuasive. B u t , so l o n g as t h e p u b l i c believes t h e c e n t r a l b a n k ' s e x p l a n a t i o n s , t h e b a n k has g r e a t e r flexibility t o c o p e w i t h t a r g e t misses w i t h o u t d a m a g i n g its c r e d i b i l i t y . W i t h a p o i n t target, success is n o l o n g e r d e f i n e d as h i t t i n g t h e t a r g e t exactly ( o r as w h e t h e r i n f l a t i o n has f a l l e n j u s t i n s i d e o r o u t s i d e t h e b o u n d a r i e s o f t h e t a r g e t r a n g e ) . Rather, i t is d e f i n e d as t h e bank's a b i l i t y t o k e e p i n f l a t i o n reasonably close t o t h e target over l o n g p e r i o d s .

Transparency A stress o n " t r a n s p a r e n t " p o l i c y — p o l i c y t h a t is clear, s i m p l e , a n d u n d e r ­ s t a n d a b l e — a n d o n r e g u l a r c o m m u n i c a t i o n w i t h t h e p u b l i c character­ izes ( t o a greater o r lesser d e g r e e ) a l l t h e i n f l a t i o n - t a r g e t i n g r e g i m e s we have c o n s i d e r e d . T h e c e n t r a l banks i n i n f l a t i o n - t a r g e t i n g c o u n t r i e s c o m ­ m u n i c a t e i n a v a r i e t y o f ways. T h e y have f r e q u e n t c o m m u n i c a t i o n s w i t h t h e g o v e r n m e n t , some m a n d a t e d by law a n d some i n response t o i n f o r ­ m a l i n q u i r i e s , a n d t h e i r officials m a k e p u b l i c speeches o n p o l i c y a n d t h e e c o n o m y . B o t h c h a n n e l s are c o m m o n l y used i n c o u n t r i e s t h a t have n o t a d o p t e d i n f l a t i o n t a r g e t i n g , o f course. I n f l a t i o n - t a r g e t i n g c e n t r a l b a n k s take p u b l i c o u t r e a c h a step f u r t h e r , however, t h r o u g h v a r i o u s types o f i n f o r m a t i o n a l campaigns a n d t h r o u g h the p u b l i c a t i o n o f regular "infla­ t i o n r e p o r t s . " I n f l a t i o n r e p o r t s , first seen i n t h e U n i t e d K i n g d o m b u t n o w issued by v i r t u a l l y a l l i n f l a t i o n - t a r g e t i n g c e n t r a l banks, p r o v i d e c o m ­ p r e h e n s i v e i n f o r m a t i o n o n i n f l a t i o n prospects a n d t h e c e n t r a l b a n k ' s plans a n d objectives, typically p r e s e n t e d i n a p e d a g o g i c a l l y clear a n d accessible style. T h r o u g h these c h a n n e l s o f c o m m u n i c a t i o n , c e n t r a l banks t r y t o ex­ p l a i n t o b o t h t h e g e n e r a l p u b l i c a n d to n a r r o w e r c o n s t i t u e n c i e s ( s u c h as

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p a r t i c i p a n t s i n financial m a r k e t s ) (1) t h e goals a n d l i m i t a t i o n s o f m o n ­ etary policy, i n c l u d i n g t h e r a t i o n a l e f o r i n f l a t i o n targets; (2) t h e n u m e r i ­ cal values o f t h e i n f l a t i o n targets a n d h o w t h e y were d e t e r m i n e d ; ( 3 ) h o w t h e i n f l a t i o n targets are t o be a c h i e v e d , g i v e n c u r r e n t e c o n o m i c c o n d i t i o n s ; a n d (4) reasons f o r any d e v i a t i o n s f r o m t h e targets. E v e n t h e i n d e p e n d e n t B u n d e s b a n k , w i t h its s t r o n g p u b l i c s u p p o r t , makes g r e a t efforts a l o n g these l i n e s . W h y s p e n d so m u c h e f f o r t o n c l a r i t y a n d c o m m u n i c a t i o n ? T h e efforts by t h e i n f l a t i o n - t a r g e t i n g c e n t r a l banks t o i m p r o v e t r a n s p a r e n c y a n d c o m m u n i c a t i o n have b e e n c r u c i a l t o the success o f t h e t a r g e t i n g r e g i m e s . T h e y have i m p r o v e d private-sector p l a n n i n g b y r e d u c i n g u n c e r t a i n t y a b o u t m o n e t a r y policy, i n t e r e s t rates, a n d i n f l a t i o n ; t h e y have p r o m o t e d useful p u b l i c d e b a t e o f m o n e t a r y policy, i n p a r t b y e d u c a t i n g t h e p u b l i c a b o u t w h a t a c e n t r a l b a n k c a n a n d c a n n o t achieve; t h e y have i n c r e a s e d the central banks' f r e e d o m o f action i n the longer r u n , for example by m a k i n g t e m p o r a r y d e v i a t i o n s f r o m t a r g e t possible w i t h o u t adverse ef­ fects o n i n f l a t i o n e x p e c t a t i o n s ; a n d t h e y have h e l p e d clarify t h e r e s p o n ­ sibilities o f t h e c e n t r a l b a n k a n d o f p o l i t i c i a n s i n t h e c o n d u c t o f m o n ­ etary p o l i c y . T r a n s p a r e n c y a n d c o m m u n i c a t i o n t o g e t h e r e n h a n c e ac­ countability.

Accountability A d i s t i n c t i v e feature o f a l l t h e t a r g e t i n g r e g i m e s discussed h e r e is t h e tendency toward increased accountability o f the central bank. T h e most e x t r e m e case is N e w Z e a l a n d , w h e r e t h e g o v e r n m e n t a n d t h e c e n t r a l b a n k s i g n a f o r m a l a g r e e m e n t s e t t i n g o u t t h e objectives o f policy, a n d t h e g o v e r n m e n t has t h e r i g h t t o dismiss t h e Reserve B a n k ' s g o v e r n o r i f t h e i n f l a t i o n targets are b r e a c h e d . I n o t h e r t a r g e t i n g c o u n t r i e s , t h e cen­ t r a l b a n k ' s a c c o u n t a b i l i t y is u s u a l l y less f o r m a l i z e d . Still, t r a n s p a r e n c y o f p o l i c y associated w i t h i n f l a t i o n t a r g e t i n g has t e n d e d t o m a k e t h e c e n t r a l b a n k highly accountable to b o t h the p u b l i c a n d the government. T h a t h i g h level o f a c c o u n t a b i l i t y has b e e n e v i d e n t i n t h e m a j o r i t y o f t h e i n f l a ­ tion-targeting countries studied here. A c c o u n t a b i l i t y has a n u m b e r o f advantages, b o t h o p e r a t i o n a l a n d p o l i t i c a l . W e have seen t h r o u g h o u t t h e case studies t h a t sustained suc­ cess i n t h e c o n d u c t o f m o n e t a r y policy, as m e a s u r e d against a pre-ann o u n c e d a n d w e l l - d e f i n e d baseline ( s u c h as a p a t h o f i n f l a t i o n t a r g e t s ) , can be i n s t r u m e n t a l i n b u i l d i n g p u b l i c support for a central bank's inde­ p e n d e n c e a n d f o r its p o l i c i e s . T h i s b u i l d i n g o f p u b l i c s u p p o r t a n d ac-

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e o u n t a b i l i t y occurs even i n t h e absence o f a r i g i d l y d e f i n e d a n d legalistic s t a n d a r d o f p e r f o r m a n c e e v a l u a t i o n , as c a n b e seen i n t h e e x p e r i e n c e o f t h e B u n d e s b a n k a n d Swiss N a t i o n a l B a n k , a m o n g o t h e r s . A c e n t r a l b a n k t h a t has t h e p u b l i c ' s t r u s t a n d s u p p o r t w i l l be able t o m a k e p o l i c y w i t h greater i n d e p e n d e n c e a n d a l o n g e r - r u n perspective, w h i c h generally leads t o b e t t e r e c o n o m i c o u t c o m e s . A t r u s t e d c e n t r a l b a n k m a y also p r o v i d e a counterweight to the short-run influences affecting o t h e r dimensions o f e c o n o m i c policy, s u c h as fiscal policy. W e have seen m o r e t h a n o n e ex­ a m p l e w h e r e t h e prestige a n d respect a f f o r d e d t h e c e n t r a l b a n k b y t h e public allowed i t to exert a m o d e r a t i n g influence o n government b u d ­ getary decisions that t h r e a t e n e d the achievement o f the i n f l a t i o n ob­ jective. P u r e l y e c o n o m i c c o n s i d e r a t i o n s aside, i n f l a t i o n t a r g e t i n g also has t h e virtue o f b e i n g fully consistent w i t h the role o f a central b a n k i n a demo­ cratic society. T h o u g h a c e n t r a l b a n k s h o u l d be i n s u l a t e d f r o m shortt e r m p o l i t i c a l pressures o n interest-rate decisions, o v e r t h e l o n g e r t e r m , i t s h o u l d be a c c o u n t a b l e t o t h e p o l i t i c a l process f o r a c h i e v i n g its estab­ l i s h e d goals. I n o t h e r w o r d s , t h e c e n t r a l b a n k s h o u l d be i n s t r u m e n t - i n ­ d e p e n d e n t , b u t n o t g o a l - i n d e p e n d e n t . W h e n t h e goals o f m o n e t a r y policy, a n d t h e c e n t r a l b a n k ' s r e c o r d i n a c h i e v i n g t h e m , are l a i d o u t c l e a r l y f o r t h e p u b l i c , i t b e c o m e s d i f f i c u l t f o r t h e c e n t r a l b a n k t o p u r s u e f o r any e x t e n d e d p e r i o d p o l i c i e s t h a t are i n c o n s i s t e n t w i t h t h e interests o f soci­ ety at large.

Macroeconomic Performance under Inflation Targeting: The International Record H o w d o economies respond to the a d o p t i o n o f i n f l a t i o n targeting? T h e clearest finding f r o m t h e i n t e r n a t i o n a l e x p e r i e n c e is t h a t i n f l a t i o n - t a r ­ g e t i n g does i n d e e d l e a d t o l o w e r i n f l a t i o n . I n a l l t h e cases we have stud­ i e d , c o u n t r i e s u s i n g i n f l a t i o n targets s i g n i f i c a n t l y r e d u c e d b o t h t h e rate o f i n f l a t i o n a n d the public's i n f l a t i o n expectations relative to t h e i r previ­ ous e x p e r i e n c e a n d , p r o b a b l y , relative t o w h a t t h e y w o u l d have b e e n i n t h e absence o f i n f l a t i o n targets. F u r t h e r m o r e , o n c e i n f l a t i o n is d o w n , i t stays d o w n : F o l l o w i n g d i s i n f l a t i o n s , t h e i n f l a t i o n rate i n t a r g e t i n g c o u n ­ tries has n o t b o u n c e d b a c k u p d u r i n g s u b s e q u e n t cyclical e x p a n s i o n s o f t h e e c o n o m y . I n f l a t i o n t a r g e t i n g does h e l p p o l i c y - m a k e r s m o d e r a t e a n d control inflation. E c o n o m i c t h e o r y a n d evidence b o t h s u p p o r t t h e i d e a t h a t l o w a n d stable i n f l a t i o n p r o m o t e s e c o n o m i c g r o w t h a n d efficiency i n t h e l o n g

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r u n . T h u s i n f l a t i o n t a r g e t i n g , perhaps t o g e t h e r w i t h o t h e r fiscal a n d struc­ t u r a l r e f o r m s , c a n h e l p create a n e n v i r o n m e n t i n w h i c h t h e e c o n o m y c a n prosper. N o r is t h e m o d e r a t i o n o f i n f l a t i o n t h e o n l y b e n e f i t o f tar­ geting. T h e ability o f a p r o p e r l y operated inflation-targeting regime to a v o i d d e f l a t i o n is e q u a l l y i m p o r t a n t , since d e f l a t i o n appears t o be ex­ t r e m e l y d a n g e r o u s t o t h e h e a l t h o f t h e financial system a n d o f t h e e c o n o m y i n g e n e r a l . Finally, t h e f o r w a r d - l o o k i n g (as o p p o s e d t o reac­ t i v e ) n a t u r e o f i n f l a t i o n t a r g e t i n g has l i k e l y r e d u c e d t h e e x t e n t o f p r o c y c l i c a l , "stop-go" m o n e t a r y p o l i c i e s . "Stop-go" p o l i c i e s ( t h a t is, m o n ­ etary p o l i c i e s t h a t react t o i n f l a t i o n o n l y after i t has b e c o m e a p r o b l e m , t h e n t i g h t e n sharply) have b e e n a n i m p o r t a n t source o f cycles o f b o o m a n d bust i n a n u m b e r o f i n d u s t r i a l c o u n t r i e s , i n c l u d i n g t h e U n i t e d States. W h i l e t h e l o n g - r u n e c o n o m i c benefits o f l o w e r a n d m o r e stable i n f l a ­ t i o n are clear, t h e balance o f e c o n o m i c costs a n d benefits o f i n f l a t i o n t a r g e t i n g i n t h e s h o r t r u n is m o r e a m b i g u o u s . M u c h e c o n o m i c t h e o r i z ­ i n g suggests t h a t c o m m i t m e n t by a c e n t r a l b a n k t o a p l a n f o r r e d u c i n g i n f l a t i o n s h o u l d i m p r o v e its c r e d i b i l i t y a n d t h e r e b y r e d u c e b o t h i n f l a ­ t i o n e x p e c t a t i o n s a n d t h e o u t p u t losses associated w i t h d i s i n f l a t i o n . Ex­ p e r i e n c e ( a n d t h e e c o n o m e t r i c e v i d e n c e p r e s e n t e d i n C h a p t e r 10) does n o t s u p p o r t this p r e d i c t i o n , however. I n f l a t i o n e x p e c t a t i o n s , so far as we c a n m e a s u r e t h e m , d o n o t i m m e d i a t e l y adjust d o w n w a r d f o l l o w i n g t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g . I n s t e a d , t h e y r e s p o n d o n l y after a l a g f o l l o w i n g declines i n i n f l a t i o n . I n o t h e r w o r d s , t h e p u b l i c seems t o take a n " I ' l l believe i t w h e n I see i t " a t t i t u d e t o w a r d i n f l a t i o n r e d u c t i o n . So i t appears t h a t t h e o n l y way f o r a c e n t r a l b a n k t o achieve c r e d i b i l i t y is b y e a r n i n g i t t h e h a r d way, b y d e m o n s t r a t i n g t h a t i t c a n , i n fact, achieve disinflation. Consistent w i t h t h e finding t h a t i n f l a t i o n expectations r e s p o n d slowly, t h e r e appears t o be l i t t l e i f any r e d u c t i o n i n t h e o u t p u t loss associated w i t h d i s i n f l a t i o n — t h e so-called "sacrifice r a t i o " — a m o n g c o u n t r i e s adopt­ i n g i n f l a t i o n t a r g e t i n g (see C h a p t e r 1 0 ) . O f course, t h e r e is always t h e h o p e t h a t as i n f l a t i o n - t a r g e t i n g p o l i c i e s p r o d u c e a c o n t i n u i n g r e c o r d o f success i n r e d u c i n g i n f l a t i o n , b o t h t h e p i o n e e r s a n d t h e l a t e r a d o p t e r s o f this a p p r o a c h w i l l b e g i n t o enjoy a " c r e d i b i l i t y b o n u s " i n t h e f o r m o f a l o w e r r e a l cost o f a c h i e v i n g any g i v e n r e d u c t i o n i n i n f l a t i o n . 2

A l t h o u g h d i s i n f l a t i o n r e m a i n s costly u n d e r i n f l a t i o n t a r g e t i n g , t h e r e does seem t o be evidence t h a t t h e effects o f i n f l a t i o n a r y shocks are some­ w h a t m u t e d u n d e r this a p p r o a c h . F o r e x a m p l e , s h o r t l y after a d o p t i n g i n f l a t i o n targets i n F e b r u a r y 1 9 9 1 , t h e B a n k o f C a n a d a was faced w i t h a large increase i n i n d i r e c t taxes, a n adverse s u p p l y s h o c k t h a t i n e a r l i e r p e r i o d s m i g h t have l e d t o a r a t c h e t i n g u p o f i n f l a t i o n . I n s t e a d , t h e tax

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increase l e d t o o n l y a o n e - t i m e increase i n t h e p r i c e level; i t d i d n o t g e n e r a t e second- a n d t h i r d - r o u n d rises i n wages a n d prices, t h e r e b y cre­ a t i n g a persistent increase i n t h e i n f l a t i o n rate. T w o o t h e r key e x a m p l e s are t h e e x p e r i e n c e s o f G r e a t B r i t a i n a n d Sweden f o l l o w i n g t h e i r depar­ tures f r o m exchange-rate pegs i n 1992. T h e n o r m a l e x p e c t a t i o n is t h a t d e v a l u a t i o n s h o u l d have s t i m u l a t e d i n f l a t i o n i n those c o u n t r i e s , reflect­ i n g b o t h t h e first-round d i r e c t effects o f h i g h e r i m p o r t prices a n d t h e s u b s e q u e n t effects o n wage- a n d p r i c e - s e t t i n g behavior. H o w e v e r , i n t h e event, t h e r e was l i t t l e i n f l a t i o n a r y i m p a c t o f these t w o d e v a l u a t i o n s , a h a p p y o u t c o m e t h a t i t seems reasonable t o a t t r i b u t e t o t h e a d o p t i o n o f i n f l a t i o n targets. T h e targets h e l p e d t o focus p u b l i c a t t e n t i o n o n t h e t e m p o r a r y n a t u r e o f t h e d e v a l u a t i o n shocks, w h i l e i n d i c a t i n g t h e cen­ t r a l b a n k s ' u n w i l l i n g n e s s t o a c c o m m o d a t e t h e shocks i n t h e m e d i u m t e r m . B o t h factors t e n d e d t o s h o r t - c i r c u i t t h e second- a n d l a t e r - r o u n d effects o f t h e i n i t i a l i n f l a t i o n a r y shocks. A c o m m o n c o n c e r n raised a b o u t i n f l a t i o n t a r g e t i n g is t h a t t h e p o l i c y ­ m a k e r s ' "excessive" a t t e n t i o n t o i n f l a t i o n w i l l l e a d t o l o w a n d u n s t a b l e g r o w t h i n o u t p u t a n d e m p l o y m e n t . T h e evidence we have p r e s e n t e d — b o t h statistical a n d i n t h e case studies—speaks q u i t e c l e a r l y t o this p o i n t . I n f l a t i o n r e d u c t i o n is associated w i t h b e l o w - n o r m a l o u t p u t d u r i n g t h e i n i t i a l , d i s i n f l a t i o n a r y phase o f a n i n f l a t i o n - t a r g e t i n g r e g i m e . However, o n c e l o w i n f l a t i o n levels have b e e n achieved, o u t p u t a n d e m p l o y m e n t r e t u r n t o levels at least as h i g h as t h e y w e r e previously. A conservative c o n c l u s i o n is t h a t , o n c e l o w i n f l a t i o n is achieved, i n f l a t i o n t a r g e t i n g is n o t h a r m f u l to the real economy. Indeed, given the strong economic g r o w t h d u r i n g t h e l a t t e r p a r t o f t h e 1990s i n m a n y c o u n t r i e s t h a t have a d o p t e d i n f l a t i o n targets, a case m a y be m a d e t h a t i n f l a t i o n t a r g e t i n g promotes real growth i n a d d i t i o n to c o n t r o l l i n g inflation.

Once Again: A Framework, Not a Rule A p r i n c i p a l t h e m e o f this b o o k is t h a t i n f l a t i o n t a r g e t i n g does n o t fit w i t h i n t h e "rules-versus-discretion" d i c h o t o m y o f t r a d i t i o n a l m o n e t a r y theory. A c c o r d i n g t o t h a t view, m o n e t a r y p o l i c y m u s t b e e i t h e r p u r e l y m e c h a n i c a l ("allow t h e m o n e y stock t o g r o w b y precisely 1 % each quar­ t e r " ) o r a n exercise i n u n b r i d l e d d i s c r e t i o n o n t h e p a r t o f policy-makers. Some e c o n o m i s t s have c h a r a c t e r i z e d i n f l a t i o n t a r g e t i n g as j u s t a n o t h e r type o f p o l i c y r u l e . T h e y have t h e n c i t e d t h e stock c r i t i c i s m o f rules, w h i c h is t h a t t h e y place excessively t i g h t l i m i t s o n t h e a b i l i t y o f p o l i c y ­ m a k e r s t o r e s p o n d t o u n f o r e s e e n circumstances.

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H o w e v e r , t o r e i t e r a t e , i n f l a t i o n t a r g e t i n g as actually practiced b y m o d ­ e r n c e n t r a l banks is i n n o sense a r i g i d p o l i c y r u l e . First, u n l i k e classical m o n e t a r y p o l i c y rules ( s u c h as t h e g o l d s t a n d a r d ) , i n f l a t i o n t a r g e t i n g does n o t give t h e c e n t r a l b a n k s i m p l e , m e c h a n i c a l i n s t r u c t i o n s o n h o w t o c o n d u c t m o n e t a r y policy. Rather, i n f l a t i o n t a r g e t i n g r e q u i r e s t h e cen­ t r a l b a n k t o use a l l available i n f o r m a t i o n i n d e t e r m i n i n g w h a t actions t o take i n o r d e r t o achieve t h e i n f l a t i o n target. U n l i k e p o l i c y rules, w h i c h typically d i r e c t t h e c e n t r a l bank's a t t e n t i o n t o a single key i n d i c a t o r ( s u c h as t h e m o n e t a r y g r o w t h rate o r t h e e x c h a n g e r a t e ) , i n f l a t i o n t a r g e t i n g never encourages the central b a n k to i g n o r e p e r t i n e n t i n f o r m a t i o n i n its p o l i c y - m a k i n g . M o r e o v e r , as we saw i n t h e case studies, i n f l a t i o n t a r g e t i n g fosters a substantial d e g r e e o f p o l i c y d i s c r e t i o n , w h i c h p e r m i t s t h e c e n t r a l b a n k t o r e s p o n d t o e c o n o m i c d e v e l o p m e n t s q u i t e flexibly so l o n g as i t r e m a i n s w i t h i n t h e c o n s t r a i n t s o f l o n g - r u n p r i c e stability. F o r e x a m p l e , as we m e n t i o n e d above, t h e r e are a v a r i e t y o f m e c h a n i s m s b y w h i c h n e a r - t e r m i n f l a t i o n targets c a n b e m o d i f i e d i n response t o c h a n g i n g e c o n o m i c cir­ cumstances, w i t h o u t a b a n d o n i n g t h e l o n g - r u n i n f l a t i o n g o a l . C r i t i c i s m s o f i n f l a t i o n t a r g e t i n g based o n t h e p r e m i s e t h a t i t imposes t o o r i g i d a s t r u c t u r e o n m o n e t a r y p o l i c y are t h e r e f o r e q u i t e u n f o u n d e d . I n f l a t i o n t a r g e t i n g is n o t a r u l e . Rather, i t is a f r a m e w o r k t h a t allows f o r t h e exer­ cise o f " c o n s t r a i n e d d i s c r e t i o n . " I n f l a t i o n t a r g e t i n g , c o n c e i v e d as a s n u g - f i t t i n g g a r m e n t b u t n o t as a straightjacket f o r m o n e t a r y policy, c o m b i n e s a n u m b e r o f t h e advantages t r a d i t i o n a l l y ascribed e i t h e r t o rules o r t o d i s c r e t i o n . L i k e rules, t h e i n ­ flation-targeting framework enhances policy transparency—the clarity w i t h w h i c h p o l i c y objectives a n d p l a n n e d actions are c o m m u n i c a t e d t o t h e p u b l i c . I n f l a t i o n targets are r e a d i l y u n d e r s t o o d b y t h e p u b l i c a n d h e l p k e e p t h e g o a l o f p r i c e stability steadily i n view. T h e i n f l a t i o n - t a r g e t ­ i n g f r a m e w o r k also creates a " n o m i n a l a n c h o r " f o r t h e e c o n o m y , c o n ­ v i n c i n g t h e p u b l i c t h a t l o w a n d stable i n f l a t i o n is t h e n o r m a l o u t c o m e a n d t h a t deviations are l i k e l y t o be transitory. I n c r e a s e d transparency, i n t u r n , increases t h e a c c o u n t a b i l i t y o f m o n e t a r y p o l i c y - m a k e r s t o t h e p u b ­ l i c , t h u s m a k i n g t h e m less l i k e l y t o engage i n o p p o r t u n i s t i c b e h a v i o r i n t h e s h o r t r u n ( f o r e x a m p l e , t r y i n g t o create u n s u s t a i n a b l e e m p l o y m e n t gains, p e r h a p s t o s u p p o r t i n c u m b e n t p o l i t i c i a n s ) . M o r e o v e r , i n f l a t i o n t a r g e t i n g h e l p s focus t h e p o l i t i c a l d e b a t e o n w h a t a central b a n k can d o — c o n t r o l i n f l a t i o n — r a t h e r t h a n o n what i t c a n n o t do—raise e c o n o m i c g r o w t h p e r m a n e n t l y by p u r s u i n g e x p a n s i o n a r y p o l i ­ cies. W e m e n t i o n e d a r e m a r k a b l e e x a m p l e o f t h e salutary effects o f i n ­ flation t a r g e t i n g o n p u b l i c d e b a t e i n o u r c h a p t e r o n Canada: I n 1996,

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the president o f the Canadian E c o n o m i c Association criticized the B a n k o f C a n a d a f o r p u r s u i n g m o n e t a r y p o l i c y t h a t h e c l a i m e d was t o o c o n t r a c t i o n a r y . H i s c r i t i c i s m s p a r k e d w i d e s p r e a d d e b a t e . S u c h debates o f t e n d e g e n e r a t e i n t o calls f o r t h e i m m e d i a t e e x p a n s i o n o r c o n t r a c t i o n o f t h e e c o n o m y w i t h l i t t l e r e f e r e n c e t o t h e l o n g - r u n consequences o f such p o l i c y changes. I n this case, however, t h e very existence o f t h e i n f l a ­ t i o n t a r g e t h e l p e d c h a n n e l t h e debate i n t o a substantive discussion over w h a t s h o u l d be t h e a p p r o p r i a t e t a r g e t level f o r i n f l a t i o n , w i t h b o t h t h e B a n k a n d its critics o b l i g e d t o m a k e e x p l i c i t t h e i r assumptions a n d esti­ mates o f t h e costs a n d benefits o f v a r i o u s levels o f i n f l a t i o n . I n t h e e n d , the debate l e d to increased support for the B a n k o f Canada, a n d the c o n d u c t o f m o n e t a r y p o l i c y d i d n o t e m e r g e as a m a j o r issue i n t h e 1997 elections, as i t h a d i n t h e elections f o u r years earlier. A l t h o u g h i n f l a t i o n t a r g e t i n g is far m o r e flexible t h a n a s i m p l e p o l i c y r u l e , i t does n o t p e r m i t t h e exercise o f u n b r i d l e d d i s c r e t i o n b y t h e cen­ t r a l b a n k . T h e strategy o f h i t t i n g a n i n f l a t i o n target, b y its very n a t u r e , forces p o l i c y - m a k e r s t o be f o r w a r d - l o o k i n g r a t h e r t h a n n a r r o w l y f o c u s e d o n c u r r e n t e c o n o m i c c o n d i t i o n s . F u r t h e r , t h r o u g h its transparency, a n i n f l a t i o n - t a r g e t i n g r e g i m e increases t h e c e n t r a l b a n k ' s a c c o u n t a b i l i t y , w h i c h i n t u r n creates p o l i t i c a l pressures t h a t p r e v e n t t h e c e n t r a l b a n k f r o m i g n o r i n g , even briefly, t h e l o n g - r u n consequences o f its actions.

Alternatives to Inflation Targeting We have a r g u e d t h a t i n f l a t i o n t a r g e t i n g p r o v i d e s b o t h a n o m i n a l a n c h o r for m o n e t a r y policy a n d a framework w i t h i n w h i c h policy-makers can exercise " c o n s t r a i n e d d i s c r e t i o n . " However, t h e r e are o t h e r m o n e t a r y regimes t h a t i n p r i n c i p l e c o u l d p r o v i d e s i m i l a r advantages. W e discuss b r i e f l y s o m e advantages a n d disadvantages o f t h e m a j o r alternatives t o inflation targeting. 3

Pegging the Exchange Rate F o r any g i v e n c o u n t r y , p a r t i c u l a r l y a s m a l l c o u n t r y , o n e strategy f o r m o n ­ etary p o l i c y is t o fix t h e e x c h a n g e rate o f its c u r r e n c y t o t h a t o f a large, l o w - i n f l a t i o n c o u n t r y (usually a m a j o r t r a d i n g p a r t n e r ) . I f t h e e x c h a n g e rate is m a i n t a i n e d at a fixed value, t h e n e v e n t u a l l y t h e d o m e s t i c i n f l a ­ t i o n rate s h o u l d a p p r o a c h t h a t o f t h e o t h e r c o u n t r y , a s s u m i n g t h a t m o v e ­ m e n t s i n t h e r e a l e x c h a n g e rate ( t h a t is, t h e relative prices o f g o o d s

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p r o d u c e d i n t h e d o m e s t i c a n d f o r e i g n e c o n o m i e s ) are n o t t o o l a r g e . Alternatively, t h e e x c h a n g e rate m i g h t be a l l o w e d t o depreciate at a fixed, p r e d e t e r m i n e d r a t e (a " c r a w l i n g p e g " ) , w h i c h w o u l d p e r m i t t h e domes­ tic i n f l a t i o n rate t o be h i g h e r t h a n t h a t o f t h e l a r g e r c o u n t r y . A n exchange-rate p e g has some advantages, p a r t i c u l a r l y i f t h e a u t h o r i ­ ties' c o m m i t m e n t t o i t is reasonably c r e d i b l e . ( A large stock o f i n t e r n a ­ t i o n a l reserves is a g o o d i n d i c a t o r o f a c r e d i b l e peg, b u t the c e n t r a l bank's d e m o n s t r a t e d w i l l i n g n e s s t o s u b o r d i n a t e d o m e s t i c p o l i c y goals t o t h e m a i n t e n a n c e o f t h e p e g is e q u a l l y i m p o r t a n t . ) A n exchange-rate p e g s i g n i f i c a n t l y constrains s h o r t - r u n o p p o r t u n i s m o n t h e p a r t o f t h e c e n t r a l b a n k , a n d h e n c e , i n p r i n c i p l e , m a y r e d u c e t h e i n f l a t i o n a r y bias o f p u r e l y d i s c r e t i o n a r y m o n e t a r y policy. A n o t h e r i m p o r t a n t advantage o f a n ex­ change-rate p e g is its s i m p l i c i t y a n d clarity; t h e p u b l i c easily u n d e r s t a n d s , a n d typically supports, policies t h a t p r o m o t e a "strong" n a t i o n a l currency. F o r e x a m p l e , t h e B a n q u e de F r a n c e has f r e q u e n t l y c i t e d t h e i m p o r t a n c e o f t h e franc fort i n j u s t i f y i n g its t i g h t m o n e t a r y p o l i c i e s . Exchange-rate pegs have h e l p e d even large c o u n t r i e s t o r e d u c e t h e i r i n f l a t i o n rates. F o r e x a m p l e , w h a t e v e r o t h e r c o n c e r n s m i g h t be raised a b o u t t h e franc fort, i t has s u c c e e d e d i n k e e p i n g F r e n c h i n f l a t i o n low, a n d at a b o u t t h e same level as t h a t o f its G e r m a n p a r t n e r . Similarly, after p e g g i n g t o t h e G e r m a n m a r k i n 1990, t h e U n i t e d K i n g d o m was able t o l o w e r its i n f l a t i o n r a t e f r o m 1 0 % t o 3% i n j u s t t w o years. ( H o w e v e r , as we m e n t i o n e d earlier, i n 1992 t h e U n i t e d K i n g d o m was f o r c e d t o a b a n d o n t h e p e g w h e n t h e J o h n M a j o r g o v e r n m e n t p r o v e d u n w i l l i n g t o raise i n ­ terest rates h i g h e n o u g h t o s t e m a speculative attack o n t h e p o u n d . ) A p a r t i c u l a r l y s t r o n g f o r m o f exchange-rate p e g is t h e so-called cur­ r e n c y b o a r d , d e s i g n e d i n t h e n i n e t e e n t h c e n t u r y as a m e a n s o f c o n t r o l ­ l i n g m o n e t a r y p o l i c y i n c o l o n i e s . I n a c u r r e n c y b o a r d system, t h e n o t e i s s u i n g a u t h o r i t y a n n o u n c e s b o t h a fixed e x c h a n g e rate w i t h a p a r t i c u l a r f o r e i g n c u r r e n c y a n d its w i l l i n g n e s s t o t r a d e t h e f o r e i g n a n d d o m e s t i c c u r r e n c i e s at t h a t rate i n u n l i m i t e d a m o u n t s . I n o r d e r t o m a k e this p r o m ­ ise c r e d i b l e , t h e a u t h o r i t i e s m u s t m a i n t a i n h i g h levels o f reserves o f t h e f o r e i g n currency, s o m e t i m e s e x c e e d i n g 100% o f t h e d o m e s t i c c u r r e n c y issue. A c u r r e n c y b o a r d was successfully i m p l e m e n t e d b y A r g e n t i n a i n 1990. U n d e r t h e so-called " c o n v e r t i b i l i t y p l a n , " A r g e n t i n a ' s c e n t r a l b a n k was legally r e q u i r e d t o e x c h a n g e A r g e n t i n e pesos a n d U . S . d o l l a r s at a r a t i o o f o n e t o o n e . T h i s strategy h e l p e d A r g e n t i n a t o b r i n g i n f l a t i o n d o w n f r o m h y p e r i n f l a t i o n a r y levels i n 1989 a n d 1990 t o rates close t o those o f t h e U n i t e d States by t h e m i d - n i n e t i e s . C u r r e n t l y , a n u m b e r o f c o u n t r i e s ( i n c l u d i n g several Eastern E u r o p e a n t r a n s i t i o n e c o n o m i e s ) are e x p e r i m e n t i n g w i t h t h e c u r r e n c y b o a r d c o n c e p t .

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Exchange-rate pegs have serious disadvantages, however. M a i n t e n a n c e o f t h e p e g imposes severe constraints o n t h e a b i l i t y o f t h e d o m e s t i c m o n ­ etary a u t h o r i t i e s t o use m o n e t a r y p o l i c y f o r o t h e r purposes, such as shortr u n d o m e s t i c s t a b i l i z a t i o n , especially i f t h e d o m e s t i c business cycle is " o u t o f sync" w i t h t h a t o f t h e n a t i o n ' s t r a d i n g p a r t n e r s . T h e c o n s t r a i n t s o n p o l i c y c a n be p a r t i c u l a r l y o n e r o u s i f t h e p e g is i m p e r f e c t l y c r e d i b l e , since t h e l a c k o f c r e d i b i l i t y w i l l r e q u i r e d o m e s t i c i n t e r e s t rates t o be k e p t even h i g h e r t h a n t h e i n t e r e s t rates o f t h e c o u n t r y t o w h i c h t h e c u r r e n c y is p e g g e d . T h e s t r e n g t h e n i n g o f t h e d o m e s t i c c u r r e n c y relative t o t h a t o f t r a d i n g p a r t n e r s , w h i c h o f t e n occurs f o l l o w i n g a successful p e g , also tends t o depress d o m e s t i c e c o n o m i c activity, since i t makes t h e c o u n t r y ' s e x p o r t s less c o m p e t i t i v e i n w o r l d m a r k e t s . I n a d d i t i o n , w i t h a fixed ex­ c h a n g e rate, shocks t h a t strike t h e a n c h o r c o u n t r y are q u i c k l y t r a n s m i t ­ t e d t o t h e p e g g i n g c o u n t r y . F o r e x a m p l e , i n response t o e c o n o m i c p r o b ­ lems e n g e n d e r e d by t h e u n i f i c a t i o n process i n 1990, G e r m a n y t i g h t e n e d m o n e t a r y p o l i c y a n d eased fiscal policy, actions t h a t l e d t o s h a r p l y h i g h e r i n t e r e s t rates. T h o s e rates were t r a n s m i t t e d , t h r o u g h t h e m e d i u m o f ex­ c h a n g e rates p e g g e d t o t h e m a r k , t o m e m b e r s o f t h e E x c h a n g e Rate M e c h a n i s m ( E R M ) ; t h e r e s u l t was a s i g n i f i c a n t s l o w i n g o f g r o w t h i n sev­ e r a l o f those c o u n t r i e s . A n o t h e r disadvantage o f exchange-rate pegs, as O b s t f e l d a n d R o g o f f (1995) a n d o t h e r s have e m p h a s i z e d , is that, i n a w o r l d o f h i g h l y m o b i l e capital, a speculative attack o n t h e p e g g e d c u r r e n c y is always a possibil­ ity. I n d e e d , t h e a f t e r m a t h o f G e r m a n r e u n i f i c a t i o n was a crisis a m o n g m e m b e r s o f t h e E R M i n 1992. Since t h e n , several o t h e r exchange-rate crises have o c c u r r e d , i n c l u d i n g t h a t o f M e x i c o i n 1994 a n d t h e w i d e ­ spread attacks o n East A s i a n c u r r e n c i e s i n 1997. 4

C o n c e r t e d speculative attacks o n t h e c u r r e n c y o f a c o u n t r y leave t h a t c o u n t r y ' s c e n t r a l b a n k n o attractive o p t i o n s : E i t h e r i t c a n v i g o r o u s l y de­ f e n d t h e p e g , usually b y r a i s i n g i n t e r e s t rates sharply, o r i t c a n c a p i t u l a t e a n d devalue ( o r f l o a t ) t h e c u r r e n c y . T h e f o r m e r strategy c a n be h i g h l y d a m a g i n g t o t h e d o m e s t i c e c o n o m y , a n d m a y cost h u g e sums i n i n t e r n a ­ t i o n a l reserves. A b a n d o n i n g t h e p e g m a y also be d e s t a b i l i z i n g , by, f o r e x a m p l e , l e a d i n g t o a surge i n i n f l a t i o n a n d i n c r e a s i n g t h e d o m e s t i c value o f debts d e n o m i n a t e d i n f o r e i g n c u r r e n c i e s (a s i t u a t i o n t h a t arose b o t h i n M e x i c o a n d i n East Asia) . F u r t h e r , a b a n d o n m e n t o f t h e p e g leaves m o n e t a r y p o l i c y w i t h o u t t h e n o m i n a l a n c h o r n e e d e d t o m a i n t a i n stable prices i n t h e l o n g e r r u n . 5

A m o r e g e n e r a l s h o r t c o m i n g o f exchange-rate pegs is t h a t t h e y d o n o t solve t h e p r o b l e m o f m a i n t a i n i n g p r i c e stability. Rather, t h e y shift t h e p r o b l e m t o a n o t h e r c o u n t r y ( o r t o some i n t e r n a t i o n a l a u t h o r i t y ) .

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E v e n i n a w e l l - f u n c t i o n i n g system o f fixed e x c h a n g e rates, t h e r e m u s t b e a n o m i n a l a n c h o r f o r t h e system as a w h o l e . U n d e r t h e g o l d s t a n d a r d , t h a t a n c h o r was p r o v i d e d b y t h e w o r l d s u p p l y o f m o n e t a r y g o l d ; u n f o r ­ tunately, shocks t o t h e s u p p l y o f o r d e m a n d f o r g o l d c o u l d , a n d o f t e n d i d , l e a d t o i n s t a b i l i t y i n t h e w o r l d p r i c e level. T h e B r e t t o n W o o d s sys­ t e m o f fixed e x c h a n g e rates, w h i c h e m e r g e d after t h e S e c o n d W o r l d W a r a n d s u r v i v e d u n t i l 1971, was a " d o l l a r s t a n d a r d " w h i c h t i e d t h e m o n ­ etary p o l i c i e s o f p a r t i c i p a n t s t o t h a t o f t h e U n i t e d States. T h a t system c o l l a p s e d w h e n t h e m o n e t a r y - p o l i c y objectives o f t h e U n i t e d States be­ g a n t o d i f f e r r a d i c a l l y f r o m those o f G e r m a n y a n d o t h e r c o u n t r i e s , j u s t as t h e E R M came u n d e r e x t r e m e pressure i n 1992 a n d 1993 w h e n Ger­ m a n m o n e t a r y - p o l i c y goals d i v e r g e d f r o m those o f o t h e r m e m b e r s . F i ­ nally, t h e p r o p o s e d single E u r o p e a n c u r r e n c y w o u l d r e q u i r e s o m e type o f system-wide n o m i n a l a n c h o r ( i n f l a t i o n t a r g e t i n g b e i n g at least o n e m a j o r p o s s i b i l i t y ) . U s i n g t h e e x c h a n g e rate as a n o m i n a l a n c h o r is n o t a n o p t i o n f o r t h e system as a w h o l e .

Targeting Money A strategy f o r m o n e t a r y p o l i c y t h a t was p o p u l a r f r o m t h e mid-1970s ( f o l ­ l o w i n g t h e collapse o f t h e B r e t t o n W o o d s system) u n t i l t h e e a r l y 1980s was t a r g e t i n g a m o n e t a r y aggregate. B o t h n a r r o w measures o f t h e m o n e y stock ( t h e m o n e t a r y base, M l ) a n d b r o a d e r measures ( M 2 , M 3 ) have been targeted i n various countries. T h e intellectual roots o f m o n e t a r y t a r g e t i n g l i e i n M i l t o n F r i e d m a n ' s m o n e t a r i s m , especially his ( 1 9 5 9 ) rec­ o m m e n d a t i o n t h a t t h e c e n t r a l b a n k s h o u l d m a i n t a i n a c o n s t a n t rate o f m o n e y g r o w t h . I n p r a c t i c e , however, n o c e n t r a l b a n k has ever a d o p t e d a r i g i d rule for d e t e r m i n i n g m o n e y growth (Bernanke a n d M i s h k i n , 1992). As we have seen, even t h e m o s t d e d i c a t e d money-targeters ( s u c h as Ger­ m a n y a n d S w i t z e r l a n d ) have d e m o n s t r a t e d t h e i r w i l l i n g n e s s t o deviate f r o m t h e i r a n n o u n c e d m o n e t a r y targets i n o r d e r t o m e e t o t h e r s h o r t t e r m objectives, s u c h as s t a b i l i z a t i o n o f o u t p u t o r t h e e x c h a n g e rate. F u r t h e r , t h e m o n e t a r y targets themselves have b e e n adjusted f r o m year to year t o r e f l e c t e c o n o m i c c o n d i t i o n s a n d c o m p e t i n g objectives o f t h e central bank. C o m p a r e d w i t h exchange-rate p e g g i n g , m o n e t a r y t a r g e t i n g p e r m i t s a c e n t r a l b a n k greater f r e e d o m t o adjust m o n e t a r y p o l i c y t o d o m e s t i c c o n ­ d i t i o n s , t h o u g h at t h e same t i m e i t m a y i m p o s e less d i s c i p l i n e o n t h e c e n t r a l b a n k . M o n e t a r y t a r g e t i n g has o t h e r p o s i t i v e features as w e l l : M o n e t a r y aggregates c a n be m e a s u r e d accurately a n d w i t h o u t t o o l o n g a

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lag, a n d the ability o f the eentral b a n k to c o n t r o l the rate o f m o n e y g r o w t h is f a i r l y g o o d , at least f o r n a r r o w m o n e t a r y aggregates. T h e fact t h a t d e v i a t i o n s o f a c t u a l m o n e y g r o w t h f r o m t a r g e t e d rates are f a i r l y q u i c k l y d e t e c t e d s h o u l d , i n p r i n c i p l e , have h e l p e d t o b u i l d t h e c r e d i b i l i t y a n d a c c o u n t a b i l i t y o f c e n t r a l banks t h a t engage i n m o n e t a r y targeting. U l t i m a t e l y , i t appears t h a t t a r g e t i n g m o n e y is a useful strategy only i f t h e r e is a r e l i a b l e r e l a t i o n s h i p b e t w e e n m o n e y g r o w t h a n d g o a l variables such as i n f l a t i o n o r t h e g r o w t h rate o f n o m i n a l GDP. D e s p i t e early claims t h a t v e l o c i t y ( t h e r a t i o o f n o m i n a l G D P t o t h e m o n e y stock) is constant, o r at least p r e d i c t a b l e , i n m o s t c o u n t r i e s , t h e r e l a t i o n s h i p b e t w e e n m o n e y a n d t h e e c o n o m y has p r o v e n t o b e h i g h l y u n s t a b l e , as is e v i d e n t f r o m m a n y o f o u r case studies h e r e . T h e reasons are n o t c o m p l e t e l y u n d e r ­ s t o o d . Some observers have a t t r i b u t e d v e l o c i t y i n s t a b i l i t y t o financial i n ­ n o v a t i o n a n d o t h e r changes i n b a n k i n g systems. O t h e r s have suggested t h a t t h e v e r y a t t e m p t t o t a r g e t m o n e y caused h i s t o r i c a l r e l a t i o n s h i p s t o b r e a k d o w n . W h a t e v e r t h e reason, i f t h e stock o f m o n e y c a n n o t be r e l i ­ ably l i n k e d t o t h e b e h a v i o r o f g o a l variables s u c h as i n f l a t i o n , t h e n i t is useless as a g u i d e t o m o n e t a r y policy. I n p a r t i c u l a r , g i v e n t h e f r e q u e n c y o f velocity shifts, a m o n e y - t a r g e t i n g c e n t r a l b a n k m u s t e i t h e r c o n s t a n t l y revise o r miss its targets ( t h e r e b y s a c r i f i c i n g any advantages o f transpar­ ency, d i s c i p l i n e , o r a c c o u n t a b i l i t y ) , or, alternatively, i t m u s t accept ex­ t r e m e l y p o o r o u t c o m e s f o r its g o a l variables. T h i s d i l e m m a e x p l a i n s w h y t h e m a j o r i t y o f m o n e t a r y targeters aban­ d o n e d this strategy i n t h e 1980s; a n d w h y even those few c o u n t r i e s t h a t c o n t i n u e t o a d h e r e t o i t d o so i n a n e x t r e m e l y " f l e x i b l e " a n d ad hoc m a n ­ ner. I t also e x p l a i n s , n o t so i n c i d e n t a l l y , t h e u p s u r g e o f i n t e r e s t i n i n f l a ­ t i o n t a r g e t i n g . U n d e r i n f l a t i o n t a r g e t i n g , t h e i n f l a t i o n rate is b o t h t h e o p e r a t i n g t a r g e t a n d t h e u l t i m a t e g o a l v a r i a b l e , so t h e i n f l a t i o n - t a r g e t ­ i n g c e n t r a l b a n k never faces t h e c o n f l i c t b e t w e e n s h o r t - t e r m t a r g e t a n d l o n g e r - t e r m objective r o u t i n e l y e x p e r i e n c e d b y t h e m o n e y - t a r g e t i n g cen­ tral bank. 6

Targeting Nominal GDP As a n alternative t o i n f l a t i o n t a r g e t i n g , several economists have p r o p o s e d t h a t c e n t r a l banks s h o u l d t a r g e t t h e g r o w t h rate o f n o m i n a l G D P (see, f o r e x a m p l e , T a y l o r [ 1 9 8 5 ] ; H a l l a n d M a n k i w [ 1 9 9 4 ] ) . Relative t o i n f l a ­ t i o n , n o m i n a l G D P as a t a r g e t has t h e advantage t h a t i t p u t s some w e i g h t o n o u t p u t as w e l l as o n prices i n t h e p o l i c y - m a k i n g process ( a l t h o u g h , as

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H a l l a n d M a n k i w [ 1 9 9 4 ] p o i n t e d o u t , t h e r e is n o reason t h a t t h e one-toone w e i g h t i n g o f o u t p u t a n d inflation i m p l i c i t i n a n o m i n a l G D P target has t o be t h e socially o p t i m a l o n e ) . W i t h a n o m i n a l G D P target, a de­ cline i n projected real o u t p u t g r o w t h w o u l d automatically i m p l y an i n ­ crease i n t h e c e n t r a l b a n k ' s i n f l a t i o n target, w h i c h w o u l d t e n d t o b e sta­ b i l i z i n g because i t w o u l d a u t o m a t i c a l l y l e a d t o a n easier m o n e t a r y policy. C e c c h e t t i (1995) has p r o d u c e d s i m u l a t i o n s suggesting t h a t a t t e m p t i n g t o stabilize n o m i n a l G D P g r o w t h s h o u l d give b e t t e r o v e r a l l e c o n o m i c o u t c o m e s t h a n t a r g e t i n g i n f l a t i o n w o u l d , i n p a r t because o f t h e d i f f i ­ culty o f forecasting inflation. N o m i n a l G D P t a r g e t i n g is close i n s p i r i t t o i n f l a t i o n t a r g e t i n g a n d m i g h t p r o v i d e a reasonable a l t e r n a t i v e . T h e r e are f o u r reasons w h y i n ­ flation t a r g e t i n g is p r e f e r a b l e t o n o m i n a l G D P t a r g e t i n g , however. First, h a v i n g a n o m i n a l G D P t a r g e t forces t h e g o v e r n m e n t t o m a k e p u b l i c its estimate o f p o t e n t i a l r e a l G D P g r o w t h . S u c h a n a n n o u n c e ­ m e n t raises d i f f i c u l t t e c h n i c a l issues because estimates o f p o t e n t i a l G D P g r o w t h are far f r o m precise, even i n retrospect. F r o m a p o l i t i c a l perspec­ tive, a n n o u n c i n g a value f o r e x p e c t e d g r o w t h i n p o t e n t i a l r e a l G D P is also p r o b l e m a t i c : A conservative estimate m a y l e a d t o t h e a c c u s a t i o n t h a t t h e g o v e r n m e n t o r t h e c e n t r a l b a n k is excessively pessimistic a n d i n t e n d s t o p r e v e n t t h e e c o n o m y f r o m r e a c h i n g its m a x i m u m p o t e n t i a l ; whereas a h i g h estimate o f p o t e n t i a l g r o w t h , i f i t b e c o m e s v i e w e d as a n o f f i c i a l target, c a n l e a d t o excessively i n f l a t i o n a r y p o l i c i e s . S e c o n d , i n f o r m a t i o n o n prices is m o r e t i m e l y a n d m o r e f r e q u e n t l y r e p o r t e d t h a n data o n n o m i n a l G D P ( a n d c o u l d be m a d e even m o r e s o ) — a p r a c t i c a l c o n s i d e r a t i o n t h a t offsets some o f t h e t h e o r e t i c a l ap­ p e a l o f n o m i n a l G D P as a target. A l t h o u g h c o l l e c t i o n o f d a t a o n n o m i ­ n a l G D P also c o u l d be i m p r o v e d , m e a s u r e m e n t o f n o m i n a l G D P r e q u i r e s d a t a o n c u r r e n t q u a n t i t i e s as w e l l as c u r r e n t prices a n d t h u s is p e r h a p s intrinsically m o r e difficult to accomplish i n a timely manner. T h i r d , as we have a r g u e d i n some d e t a i l , i n f l a t i o n t a r g e t i n g as i t is a c t u a l l y p r a c t i c e d allows c o n s i d e r a b l e flexibility f o r p o l i c y i n t h e s h o r t r u n . T h u s i t is d o u b t f u l that, i n p r a c t i c e , n o m i n a l G D P t a r g e t i n g w o u l d be m o r e effective t h a n i n f l a t i o n t a r g e t i n g i n a c h i e v i n g s h o r t - r u n stabili­ zation. Finally, a n d p e r h a p s m o s t i m p o r t a n t l y , t h e c o n c e p t o f i n f l a t i o n i n c o n ­ s u m e r prices is p r o b a b l y b e t t e r u n d e r s t o o d by t h e p u b l i c t h a n is t h e c o n c e p t o f n o m i n a l GDP, w h i c h c a n easily be c o n f u s e d w i t h r e a l GDP. ( A g a i n , o n e can i m a g i n e a p o l i t i c i a n c r i t i c i z i n g a l o w t a r g e t f o r n o m i n a l G D P g r o w t h as b e i n g " a n t i - g r o w t h " w h e n i n fact t h e objective is t o b r i n g i n a l o w rate o f i n f l a t i o n . ) C o n s e q u e n t l y , i t seems l i k e l y t h a t c o m m u n i c a -

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t i o n w i t h t h e p u b l i c a n d a c c o u n t a b i l i t y w o u l d be b e t t e r served b y u s i n g a n i n f l a t i o n t a r g e t r a t h e r t h a n a n o m i n a l G D P g r o w t h target. W h i l e a s i g n i f i c a n t n u m b e r o f c e n t r a l banks have a d o p t e d i n f l a t i o n t a r g e t i n g , n o n e t o o u r k n o w l e d g e has seriously c o n s i d e r e d a d o p t i n g a n o m i n a l G D P target.

Just Do It: Preemptive Monetary Policy Without Explicit Targets I n r e c e n t years, t h e U n i t e d States has achieved e x c e l l e n t m a c r o e c o n o m i c p e r f o r m a n c e ( i n c l u d i n g l o w a n d stable i n f l a t i o n ) w i t h o u t u s i n g a n ex­ p l i c i t n o m i n a l a n c h o r (such as a t a r g e t f o r t h e e x c h a n g e rate, a m o n ­ etary aggregate, o r t h e p r i c e l e v e l ) . A l t h o u g h i n t h e U . S . case, n o ex­ p l i c i t p o l i c y f r a m e w o r k has b e e n a r t i c u l a t e d , a c o h e r e n t strategy f o r m o n e t a r y p o l i c y does exist. T h a t strategy consists o f c a r e f u l m o n i t o r i n g f o r signs o f f u t u r e i n f l a t i o n , c o u p l e d w i t h p e r i o d i c " p r e e m p t i v e strikes" by m o n e t a r y p o l i c y against t h e t h r e a t o f i n f l a t i o n . G i v e n t h e l o n g l a g b e t w e e n m o n e t a r y - p o l i c y actions a n d t h e i r effects, as e m p h a s i z e d by F r i e d m a n , t h e p r e e m p t i v e strike strategy seems a sen­ sible o n e . I f t h e c e n t r a l b a n k w a i t e d u n t i l o v e r t signs o f i n f l a t i o n ap­ p e a r e d , i t w o u l d already be t o o late t o m a i n t a i n stable prices, at least n o t w i t h o u t a severe t i g h t e n i n g o f policy. I n d e e d , t h e r e is some evidence t h a t i n f l a t i o n b e c o m e s m u c h h a r d e r t o c o n t r o l o n c e i t has b e e n a l l o w e d t o g a t h e r m o m e n t u m , i n t h e sense t h a t h i g h e r i n f l a t i o n e x p e c t a t i o n s b e c o m e i n g r a i n e d i n various types o f contracts a n d p r i c i n g agreements. T h e m a i n a r g u m e n t f o r t h e "just d o i t " strategy is, simply, its d e m o n ­ strated success. I n t h e U n i t e d States, t h e i n f l a t i o n rate f e l l s i g n i f i c a n t l y over t h e decade o f t h e 1980s, to a r o u n d 3% by t h e e n d o f 1 9 9 1 ; since t h e n , i n f l a t i o n has b e e n stable at a b o u t t h a t level o r a b i t b e l o w i t . A l ­ t h o u g h t h e r e was a m i l d recession i n 1990-91, t h e s u b s e q u e n t l e n g t h y e x p a n s i o n has b r o u g h t u n e m p l o y m e n t rates d o w n t o levels n o t seen since t h e 1960s, a n d t h e o v e r a l l g r o w t h rate has b e e n g o o d . Evidently, t h i s strategy has h e l p e d t h e F e d e r a l Reserve t o a n c h o r e x p e c t a t i o n s b y c o n ­ v i n c i n g t h e p u b l i c t h a t i t is c o n c e r n e d a b o u t f u t u r e as w e l l as c u r r e n t i n f l a t i o n , w h i l e at t h e same t i m e r e t a i n i n g some d i s c r e t i o n t o d e a l w i t h u n f o r e s e e n events i n t h e e c o n o m y . T h e r e are, however, some i m p o r t a n t p r o b l e m s w i t h t h e "just d o i t " a p p r o a c h t h a t w o u l d be a m e l i o r a t e d by t h e relatively m o d e s t c h a n g e t o i n f l a t i o n t a r g e t i n g . We leave t h e discussion o f w h y i n f l a t i o n t a r g e t i n g i m p r o v e s o n t h e "just d o i t " strategy, a n d o f w h y we t h i n k t h a t i n f l a t i o n t a r g e t i n g s h o u l d be a d o p t e d i n t h e U n i t e d States, t o t h e n e x t chapter.

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Conclusions O u r analysis suggests t h a t t a r g e t i n g i n f l a t i o n , w h e t h e r directly, as i n N e w Z e a l a n d , Canada, t h e U n i t e d K i n g d o m , Sweden, A u s t r a l i a , S p a i n , a n d Israel; o r as t h e basis f o r a m o n e t a r y t a r g e t i n g r e g i m e , as i n G e r m a n y a n d S w i t z e r l a n d , is a useful strategy f o r t h e c o n d u c t o f m o n e t a r y policy. (Since t h e d e f i n i n g f e a t u r e o f b o t h t h e G e r m a n a n d t h e o t h e r m o n e t a r y f r a m e w o r k s we have e x a m i n e d is a p u b l i c l y a n n o u n c e d n u m e r i c a l t a r g e t f o r m e d i u m - t e r m i n f l a t i o n , we d o n o t d r a w as great a d i s t i n c t i o n be­ t w e e n these t a r g e t i n g r e g i m e s as m a n y d o i n m o r e t h e o r e t i c a l l y o r i e n t e d discussions.) T r a n s p a r e n c y a n d flexibility, p r o p e r l y b a l a n c e d i n o p e r a ­ t i o n a l d e s i g n , a p p e a r t o be t h e f o u n d a t i o n s o f a m o n e t a r y - p o l i c y strat­ egy t h a t w i l l achieve b o t h o u t p u t stability i n t h e s h o r t r u n a n d p r i c e stability i n t h e l o n g r u n w i t h o u t i m p o s i n g a straitjacket o n policy. I n f l a ­ t i o n targeting demonstrably improves the accountability o f central bank­ ers t o t h e p u b l i c a n d t o e l e c t e d officials a n d fosters c o m m u n i c a t i o n be­ tween the policy-makers a n d the p u b l i c . I n f l a t i o n t a r g e t i n g is n o panacea, however. I n p a r t i c u l a r , i t does n o t enable countries to w r i n g inflation o u t o f their economies w i t h o u t i n ­ c u r r i n g costs i n lost o u t p u t a n d e m p l o y m e n t ; n o r is c r e d i b i l i t y f o r t h e c e n t r a l b a n k a c h i e v e d i m m e d i a t e l y o n a d o p t i o n o f a n i n f l a t i o n target. I n d e e d , evidence suggests t h a t t h e o n l y way f o r c e n t r a l banks t o e a r n c r e d i b i l i t y is t h e h a r d way: b y d e m o n s t r a t i n g t h a t t h e y have t h e m e a n s a n d the will to reduce inflation a n d to keep i t low for a p e r i o d o f time. A l t h o u g h this a p p r o a c h does n o t a v o i d t h e costs o f a c h i e v i n g d i s i n f l a t i o n , we have seen t h a t i n f l a t i o n t a r g e t i n g has b e e n h i g h l y successful i n h e l p ­ i n g C a n a d a , N e w Z e a l a n d , t h e U n i t e d K i n g d o m , Sweden, S p a i n , A u s t r a ­ lia, a n d o t h e r s t o achieve a n d m a i n t a i n l o w i n f l a t i o n rates, s o m e t h i n g t h e y w e r e n o t always able t o d o i n t h e past. Finally, t h e a d o p t i o n o f i n f l a t i o n targets has n o t f o r c e d c e n t r a l banks to a b a n d o n t h e i r c o n c e r n s a b o u t o t h e r i m p o r t a n t e c o n o m i c o u t c o m e s , s u c h as t h e level o f t h e e x c h a n g e r a t e o r t h e rate o f e c o n o m i c g r o w t h , i n o r d e r t o achieve l o w i n f l a t i o n rates. I n d e e d , t h e r e is n o evidence t h a t i n f l a t i o n t a r g e t i n g has p r o d u c e d h a r m f u l effects o n t h e r e a l e c o n o m y i n t h e l o n g r u n ; m o r e likely, l o w i n f l a t i o n rates have i m p r o v e d t h e pros­ pects f o r sustained l o n g - t e r m g r o w t h . We c o n c l u d e t h a t i n f l a t i o n target­ i n g is a h i g h l y p r o m i s i n g strategy f o r m o n e t a r y policy, a n d we p r e d i c t t h a t i t w i l l b e c o m e t h e s t a n d a r d a p p r o a c h as m o r e a n d m o r e c e n t r a l banks a n d g o v e r n m e n t s c o m e t o a p p r e c i a t e its usefulness.

12 Inflation Targeting for the United States and the European Monetary Union

W E HAVE described h o w i n f l a t i o n t a r g e t i n g has w o r k e d i n practice a n d have i n d i c a t e d w h y we believe t h a t i t deserves c o n s i d e r a t i o n as a strategy f o r m o n e t a r y policy. T o date, however, t h e U n i t e d States has c h o s e n n o t t o j o i n the ranks o f t h e i n f l a t i o n - t a r g e t i n g countries. Instead i t has f o l l o w e d t h e "just d o i t " a p p r o a c h described i n the p r e c e d i n g chapter. G r a n t e d , the U n i t e d States has recently enjoyed e x c e l l e n t e c o n o m i c p e r f o r m a n c e w i t h o u t b e n e f i t o f e x p l i c i t i n f l a t i o n targets. W i l l this s t r o n g p e r f o r m a n c e necessarily c o n t i n u e ? O r m i g h t t h e a d o p t i o n o f i n f l a t i o n targets p r o m o t e even b e t t e r m o n e t a r y - p o l i c y o u t c o m e s f o r the U n i t e d States i n t h e future? T h e M a a s t r i c h t Treaty, w h i c h establishes t h e g r o u n d w o r k f o r t h e E u ­ r o p e a n M o n e t a r y U n i o n ( E M U ) a n d t h e E u r o p e a n System o f C e n t r a l Banks ( E S C B ) , sets p r i c e stability as t h e p r i m a r y g o a l o f m o n e t a r y policy. W h a t has n o t b e e n d e c i d e d is precisely h o w t h e E u r o p e a n C e n t r a l B a n k , s u p p o r t e d b y t h e n a t i o n a l c e n t r a l b a n k s t h a t m a k e u p t h e ESCB, is t o achieve t h a t g o a l . C u r r e n t l y , b o t h m o n e t a r y t a r g e t i n g a n d i n f l a t i o n tar­ g e t i n g are u n d e r c o n s i d e r a t i o n as p o l i c y strategies f o r t h e E M U . S h o u l d t h e E u r o p e a n C e n t r a l B a n k f o l l o w t h e B u n d e s b a n k a n d choose m o n ­ etary t a r g e t i n g as its m o n e t a r y - p o l i c y strategy? O r w o u l d i n f l a t i o n target­ i n g d o a b e t t e r j o b o f p r o m o t i n g p r i c e stability i n t h e n e w E u r o p e a n context? O u r analysis o f t h e i n t e r n a t i o n a l e x p e r i e n c e leads us t o t h e c o n c l u ­ s i o n t h a t i n f l a t i o n t a r g e t i n g w o u l d be t h e b e t t e r c h o i c e f o r m o n e t a r y p o l i c y i n b o t h t h e U n i t e d States a n d E u r o p e . I n p o l i c y - m a k i n g , as i n l i f e , however, t h e " d e v i l is i n t h e details." So, i n this final chapter, we use w h a t we have l e a r n e d a b o u t h o w i n f l a t i o n t a r g e t i n g has w o r k e d i n p r a c t i c e t o o u t l i n e specific proposals f o r t h e i m p l e m e n t a t i o n o f i n f l a t i o n t a r g e t i n g i n b o t h t h e U n i t e d States a n d t h e E u r o p e a n M o n e t a r y U n i o n .

Inflation Targeting in the United States F r i e d m a n a n d K u t t n e r (1996) p o i n t o u t t h a t U . S . m o n e t a r y p o l i c y has pe: f o r m e d q u i t e w e l l i n t h e r e c e n t past w i t h o u t b e n e f i t o f a f o r m a l r u l e

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o r f r a m e w o r k . T h e q u e s t i o n arises, " I f i t a i n ' t b r o k e , w h y fix it?" Perhaps we s h o u l d b e satisfied w i t h t h e f l e x i b i l i t y o f o u r c u r r e n t p o l i c y process, since we c a n n o t k n o w w h a t challenges w i l l c o n f r o n t m o n e t a r y p o l i c y i n the future. M o n e t a r y p o l i c y i n t h e U n i t e d States as o f t h e l a t t e r p a r t o f t h e 1990s is n o t " b r o k e " t o any serious degree, we agree. S t i l l , i t c o u l d surely be i m p r o v e d . M o r e o v e r , t h e e x p e r i e n c e o f o t h e r c o u n t r i e s suggests t h a t n o w is t h e i d e a l t i m e t o m a k e t h e r e q u i s i t e changes t o ensure t h a t t h e g o o d p e r f o r m a n c e o f m o n e t a r y p o l i c y i n t h e U n i t e d States w i l l c o n t i n u e w h e n t h e c u r r e n t F e d e r a l Reserve l e a d e r s h i p passes f r o m t h e scene.

If It Ain't Broke, Why Fix It? W h y t i n k e r w i t h a p o l i c y f r a m e w o r k t h a t is p e r f o r m i n g so well? W e offer several answers t o this q u e s t i o n . First, i n o u r view, a m a j o r r e a s o n f o r t h e success o f t h e V o l c k e r G r e e n s p a n F e d e r a l Reserve is t h a t i t has e m p l o y e d a p o l i c y - m a k i n g p h i ­ losophy, o r f r a m e w o r k , t h a t is i n m a n y ways q u i t e s i m i l a r t o i n f l a t i o n t a r g e t i n g . T h e F e d e r a l Reserve has expressed a s t r o n g p r e f e r e n c e f o r low, stable i n f l a t i o n ; a n d p o l i c y discussions a b o u t s h o r t - r u n s t a b i l i z a t i o n ( b o t h w i t h i n t h e F e d e r a l Reserve a n d b e t w e e n t h e F e d e r a l Reserve a n d t h e legislative a n d executive b r a n c h e s ) have f e a t u r e d c o n s i d e r a t i o n o f t h e l o n g - t e r m i n f l a t i o n i m p l i c a t i o n s o f c u r r e n t actions. So, a l o n g c e r t a i n d i m e n s i o n s , a d o p t i o n o f i n f l a t i o n t a r g e t i n g w o u l d n o t be a m a j o r depar­ t u r e f r o m w h a t t h e F e d e r a l Reserve has actually b e e n d o i n g i n r e c e n t years. Rather, i t w o u l d serve t o a l a r g e d e g r e e t o f o r m a l i z e , a n d t h u s ( i t m a y be p r e s u m e d ) t o p e r p e t u a t e , some o f t h e positive features o f cur­ r e n t practice. S e c o n d , f o r m a l a d o p t i o n o f i n f l a t i o n t a r g e t i n g w o u l d increase t h e t r a n s p a r e n c y o f t h e Fed's p o l i c y m a k i n g . I n this respect, i t w o u l d b u i l d o n a n u m b e r o f r e c e n t steps t a k e n b y t h e F e d , such as s h o r t e n i n g t h e time before the minutes o f Federal O p e n M a r k e t C o m m i t t e e ( F O M C ) m e e t i n g s are released a n d t h e d e c i s i o n t o a n n o u n c e i m m e d i a t e l y after the F O M C meeting the Committee's decision about whether to change t h e t a r g e t f o r t h e f e d e r a l f u n d s rate. G r e a t e r t r a n s p a r e n c y w o u l d p r o ­ m o t e b e t t e r p u b l i c u n d e r s t a n d i n g o f t h e Fed's strategy a n d tactics. T h a t b e t t e r u n d e r s t a n d i n g w o u l d l e a d i n t u r n t o a m o r e i n f o r m e d p u b l i c de­ bate a n d , u l t i m a t e l y , t o b e t t e r p o l i c y o u t c o m e s . O u r case studies have s h o w n t h a t i n f l a t i o n t a r g e t i n g e n c o u r a g e s b o t h p u b l i c a n d p o l i t i c i a n s t o focus o n w h a t m o n e t a r y p o l i c y c a n d o ( m a i n -

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t a i n l o n g - r u n p r i c e s t a b i l i t y ) , r a t h e r t h a n o n w h a t i t c a n n o t d o (create p e r m a n e n t increases i n o u t p u t a n d e m p l o y m e n t t h r o u g h e x p a n s i o n a r y p o l i c i e s ) . E x p a n s i o n a r y m o n e t a r y policies have l o n g b e e n seen as a " q u i c k fix" f o r t h e e c o n o m y , because they create m o r e o u t p u t a n d m o r e j o b s i n t h e s h o r t r u n . H o w e v e r , b o t h e x p e r i e n c e a n d extensive research show t h a t e x p a n s i o n a r y p o l i c i e s c a n n o t sustain s u c h increases f o r l o n g . O n the contrary, they may eventually lead to h i g h e r inflation, w i t h h a r m f u l consequences f o r t h e e c o n o m y i n t h e l o n g r u n . I n t h e c o u n t r i e s we have s t u d i e d , t h e existence o f a n i n f l a t i o n - t a r g e t i n g f r a m e w o r k has m o r e t h a n o n c e n u d g e d t h e p o l i t i c a l debate t o w a r d a l o n g e r - r u n perspective, i n w h i c h t h e benefits o f p r i c e stability are r e c o g n i z e d . T h e r e s u l t has b e e n less pressure o n t h e m o n e t a r y a u t h o r i t i e s t o p u r s u e ill-advised p o l i c i e s t h a t p r o v i d e some t e m p o r a r y s t i m u l u s , b u t at t h e cost o f h i g h e r i n f l a t i o n and i m p a i r e d economic performance i n the longer t e r m . T h e contrast between m o r e a n d less transparent p o l i c y regimes is n i c e l y i l l u s t r a t e d b y events d u r i n g t h e s p r i n g o f 1997 i n t h e U n i t e d States a n d t h e U n i t e d K i n g d o m . A t t h a t t i m e , f o l l o w i n g several p r e v i o u s r e d u c t i o n s o f t h e f e d e r a l f u n d s rate, t h e F e d e r a l Reserve reversed its p o l i c y a n d h i k e d t h e t a r g e t f o r t h e f u n d s rate b y 25 basis p o i n t s ( o n e - q u a r t e r o f a percentage p o i n t ) . A l t h o u g h t h a t rise was q u i t e modest, p a r t i c u l a r l y g i v e n t h e r a p i d g r o w t h o f t h e U.S. e c o n o m y a n d t h e t i g h t l a b o r m a r k e t at t h e t i m e , i t p r o v o k e d a s t o r m o f c r i t i c i s m i n Congress a n d elsewhere. Yet at a b o u t t h e same t i m e , increases i n interest rates e n g i n e e r e d by t h e B a n k o f E n g l a n d , a n established inflation-targe ter, were received q u i t e calmly by t h e B r i t i s h p u b l i c . T h e difference, we suggest, lies i n the use o f i n f l a t i o n t a r g e t i n g i n B r i t a i n . Because o f this a p p r o a c h , t h e B r i t i s h p u b l i c h a d a b e t t e r u n d e r s t a n d i n g o f t h e l o n g - r u n objectives b e i n g p u r s u e d by t h e i r m o n e t a r y authorities, a n d h e n c e o f the reason f o r t h e i r p o l i c y a c t i o n , t h a n d i d the U.S. p u b l i c . T h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g i n t h e U n i t e d States m i g h t reduce the a t t e n t i o n p a i d to i n d i v i d u a l Federal Reserve p o l i c y moves a n d focus the p u b l i c debate instead o n w h e t h e r t h e F e d e r a l Re­ serve has a s o u n d l o n g - r u n strategy f o r the c o n d u c t o f m o n e t a r y policy. I n c r e a s e d transparency w o u l d also r e d u c e t h e f i n a n c i a l a n d e c o n o m i c u n c e r t a i n t y associated w i t h t h e Fed's c u r r e n t p r o c e d u r e s b y g i v i n g t h e m a r k e t s m o r e i n f o r m a t i o n a b o u t w h a t f u t u r e m o n e t a r y p o l i c i e s are l i k e l y to be. T h a t w o u l d r e d u c e substantially t h e costs i n c u r r e d by financial analysts t r y i n g t o guess w h a t t h e F e d e r a l Reserve w i l l d o n e x t a n d w o u l d m a k e i t easier f o r businesses a n d c o n s u m e r s t o p l a n f o r t h e f u t u r e , t h u s p r o m o t i n g e c o n o m i c efficiency. T h i r d , F e d e r a l Reserve a d o p t i o n o f i n f l a t i o n t a r g e t i n g w o u l d h e l p t o d e p e r s o n a l i z e U.S. m o n e t a r y policy. T r u e , m o n e t a r y p o l i c y has b e e n ex-

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c e l l e n t i n r e c e n t years u n d e r t h e l e a d e r s h i p o f c h a i r m e n V o l c k e r a n d G r e e n s p a n . M o r e o v e r , t h e c u r r e n t m e m b e r s o f t h e F O M C have d e m o n ­ s t r a t e d t h a t t h e y are c o n v i n c e d o f t h e value o f f o r w a r d - l o o k i n g m o n ­ etary p o l i c y t h a t focuses o n p r i c e stability. T h i s state o f affairs has n o t always p r e v a i l e d , however, a n d m a y n o t always exist i n t h e f u t u r e . M o n ­ etary p o l i c y - m a k e r s are q u i t e capable o f f a l l i n g o f f t h e ( a n t i - i n f l a t i o n ­ ary) w a g o n , as t h e e x p e r i e n c e o f t h e 1970s illustrates. A d o p t i o n o f i n f l a ­ t i o n targeting w o u l d strengthen the central bank's c o m m i t m e n t to the l o n g - r u n g o a l o f p r i c e stability a n d w o u l d m a k e t h e a c h i e v e m e n t o f l o w i n f l a t i o n less d e p e n d e n t o n t h e c o m p e t e n c e o r t h e c o n v i c t i o n s o f a few individuals. F o u r t h , a n i n f l a t i o n - t a r g e t i n g f r a m e w o r k seems m o r e c o n s i s t e n t t h a n t h e c u r r e n t p r a c t i c e w i t h d e m o c r a t i c p r i n c i p l e s . C e r t a i n l y t h e r e are g o o d reasons, n o t a b l y i n s u l a t i o n f r o m s h o r t - t e r m pressures, f o r t h e c e n t r a l b a n k t o have some d e g r e e o f i n d e p e n d e n c e , as t h e F e d e r a l Reserve cur­ r e n t l y does. I n d e e d , t h e evidence is t h a t e c o n o m i e s w i t h i n d e p e n d e n t c e n t r a l b a n k s enjoy l o w e r rates o f i n f l a t i o n t h a n o t h e r c o u n t r i e s , w i t h n o h i g h e r v o l a t i l i t y i n e m p l o y m e n t a n d o u t p u t . Yet t h e p r a c t i c a l e c o n o m i c a r g u m e n t s f o r c e n t r a l b a n k i n d e p e n d e n c e co-exist uneasily w i t h t h e p r e ­ s u m p t i o n t h a t g o v e r n m e n t policies s h o u l d be m a d e democratically, r a t h e r t h a n b y a n e l i t e g r o u p . I n d e e d , r e c e n t c r i t i c i s m o f t h e F e d e r a l Reserve m a y have b e e n p r o m p t e d b y t h e i m p r e s s i o n t h a t t h e F e d , a n d p a r t i c u ­ l a r l y its c h a i r m a n , has b e c o m e t o o p o w e r f u l . A p o l i t i c a l b a c k l a s h against a " h i g h h a n d e d " F e d e r a l Reserve c o u l d have adverse consequences f o r the quality o f U.S. m o n e t a r y policy i n the future. T o resolve t h e a p p a r e n t c o n f l i c t b e t w e e n t h e n e e d f o r c e n t r a l b a n k independence o n one h a n d a n d the regard for democratic principles o n t h e other, i t is useful t o i n v o k e o n c e a g a i n t h e d i s t i n c t i o n m a d e b y D e b e l l e a n d Fischer ( 1 9 9 4 ) a n d Fischer (1994) b e t w e e n g o a l i n d e p e n ­ dence a n d i n s t r u m e n t independence for the central bank. I n brief, a g o a l - i n d e p e n d e n t c e n t r a l b a n k is o n e t h a t is free t o set t h e objectives o f m o n e t a r y policy. A n i n s t r u m e n t - i n d e p e n d e n t c e n t r a l b a n k is o n e t h a t is free t o set t h e i n s t r u m e n t s o f m o n e t a r y policy, s u c h as t h e i n t e r e s t rate. Because u l t i m a t e l y p o l i c y objectives i n a d e m o c r a c y m u s t r e f l e c t t h e p o p u l a r w i l l , t h e y s h o u l d be set b y e l e c t e d officials. Consequently, i n a democracy, t h e c e n t r a l b a n k s h o u l d n o t exercise g o a l i n d e p e n d e n c e . H o w e v e r , because t h e c e n t r a l b a n k has t h e best i n f o r m a t i o n a n d exper­ tise o n h o w t o go a b o u t a c h i e v i n g p o l i c y objectives, i t s h o u l d be free t o choose t h e settings o f t h e i n s t r u m e n t s n e e d e d t o d o t h e j o b . T h a t is, f o r efficient a n d accountable policy-making, the central b a n k s h o u l d enjoy instrument independence.

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I n f l a t i o n t a r g e t i n g is consistent w i t h , a n d i n d e e d p r o m o t e s , this way o f o r g a n i z i n g r e s p o n s i b i l i t y f o r m o n e t a r y policy. I n t h e s t a n d a r d i n f l a ­ t i o n - t a r g e t i n g f r a m e w o r k , t h e c e n t r a l b a n k is f u l l y a c c o u n t a b l e t o e l e c t e d officials, w h o i n t u r n typically have p r i m a r y r e s p o n s i b i l i t y f o r s e t t i n g t h e goals f o r m o n e t a r y p o l i c y a n d t h e n m o n i t o r i n g t h e e c o n o m i c o u t c o m e s . A t t h e same t i m e , t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k ensures t h a t t h e objectives set b y t h e g o v e r n m e n t are feasible a n d t h a t t h e y are c o n s i d ­ e r e d w i t h i n t h e a p p r o p r i a t e l o n g - r u n perspective. So, f o r e x a m p l e , this f r a m e w o r k r e q u i r e s t h e g o v e r n m e n t t o choose objectives f o r t h e l o n g r u n i n f l a t i o n rate ( w h i c h is p o t e n t i a l l y u n d e r t h e c o n t r o l o f t h e c e n t r a l b a n k ) r a t h e r t h a n for, say, t h e l o n g - r u n u n e m p l o y m e n t r a t e ( w h i c h is n o t a feasible objective f o r t h e c e n t r a l b a n k ) . Finally, u n d e r i n f l a t i o n t a r g e t i n g as i t has g e n e r a l l y b e e n p r a c t i c e d , s h o r t - t e r m o p e r a t i o n a l d e c i ­ sions b e l o n g solely t o t h e c e n t r a l b a n k , as m u s t b e t h e case i f i t is t o be a c c o u n t a b l e f o r a c h i e v i n g its assigned objectives. T h u s , i n f l a t i o n target­ ing promotes instrument independence for the central bank. A n i n s t r u c t i v e e x a m p l e o f h o w i n f l a t i o n t a r g e t i n g serves t o r e d u c e t h e tensions b e t w e e n c e n t r a l - b a n k i n d e p e n d e n c e a n d d e m o c r a t i c policy­ m a k i n g is b r o u g h t t o l i g h t i n o u r case study o f t h e U n i t e d K i n g d o m . P r i o r t o 1997, m o n e t a r y - p o l i c y decisions i n t h e U n i t e d K i n g d o m w e r e m a d e b y t h e executive b r a n c h ( t h e C h a n c e l l o r o f t h e E x c h e q u e r ) r a t h e r t h a n b y t h e B a n k o f E n g l a n d . T h e n , o n M a y 6, 1997, t h e C h a n c e l l o r o f the Exchequer, G o r d o n B r o w n , granted independence to the Bank o f E n g l a n d , g i v i n g i t t h e p o w e r t o set t h e o v e r n i g h t i n t e r e s t rate. B r o w n m a d e i t clear t h a t ( i n his view) his a c t i o n h a d b e e n m a d e possible b y t h e a d o p t i o n o f a n i n f l a t i o n - t a r g e t i n g r e g i m e , w h i c h h a d i n c r e a s e d t h e trans­ parency o f policy a n d the accountability o f the B a n k for achieving policy objectives. H e p o i n t e d o u t t h a t t h e i n f l a t i o n - t a r g e t i n g a p p r o a c h w o u l d e n a b l e t h e g o v e r n m e n t t o c o n t i n u e t o set t h e goals o f m o n e t a r y policy, as is a p p r o p r i a t e i n a d e m o c r a t i c society, a n d w o u l d also e n s u r e t h e B a n k t h e d i s c r e t i o n i t needs t o achieve those goals. F i f t h , t h e a d o p t i o n o f i n f l a t i o n t a r g e t i n g w o u l d e n h a n c e t h e Fed's a b i l i t y t o d e a l w i t h shocks t o t h e e c o n o m y , s u c h as a n u n a n t i c i p a t e d c o n ­ t r a c t i o n i n aggregate d e m a n d o r i n s t a b i l i t y i n financial m a r k e t s . As we saw i n C h a p t e r 6, f o r e x a m p l e , t h e B a n k o f C a n a d a has c l a i m e d t h a t t h e use o f i n f l a t i o n targets has i m p r o v e d its a b i l i t y t o d e a l w i t h shocks t o aggregate d e m a n d . Because a d e c l i n e i n aggregate d e m a n d usually leads to l o w e r - t h a n - e x p e c t e d i n f l a t i o n also, t h e B a n k is able t o r e s p o n d w i t h a m o n e t a r y easing, w i t h o u t c a u s i n g t h e p u b l i c t o q u e s t i o n its a n t i - i n f l a ­ t i o n a r y resolve. Shocks t o aggregate supply, as we have seen, c a n b e h a n d l e d t h r o u g h v a r i o u s devices, s u c h as t h e e x c l u s i o n o f c e r t a i n vola-

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t i l e prices f r o m t h e t a r g e t e d i n d e x . T h e use o f i n f l a t i o n targets also ap­ pears t o r e d u c e t h e risk t h a t s u p p l y shocks w i l l create l o n g - t e r m increases i n t h e rate o f i n f l a t i o n . M o r e o v e r , w i t h i n f l a t i o n targets i n place, t h e c e n t r a l b a n k c a n react m o r e effectively t o events t h a t increase t h e risk o f f i n a n c i a l crisis. F o r e x a m p l e , f o l l o w i n g t h e f a i l u r e o f a large b a n k o r c o r p o r a t i o n t h a t rattles financial m a r k e t s , t h e F e d e r a l Reserve w o u l d be able t o i n j e c t n e e d e d l i q u i d i t y i n t o t h e financial system w i t h o u t b e i n g seen as j e o p a r d i z i n g its i n f l a t i o n goals. I n response t o p r o b l e m s i n t h e b a n k i n g sector a n d c r e d i t m a r k e t s d u r i n g t h e early 1990s, t h e F e d e r a l Reserve k e p t t h e f e d e r a l f u n d s rate fixed at t h e e x t r e m e l y l o w level o f 3% ( o r a b o u t zero, i n r e a l t e r m s , since i n f l a t i o n was also at a b o u t 3 % ) f o r m o r e t h a n a year. T o r a t i o n a l i z e this policy, C h a i r m a n G r e e n s p a n r e f e r r e d t o t h e f i n a n c i a l " h e a d w i n d s " t h a t w e r e h o l d i n g b a c k t h e recovery o f t h e U . S . e c o n o m y . S t i l l , some c o n c e r n was expressed i n financial m a r k e t s t h a t t h e F e d e r a l Reserve was l o s i n g its a n t i - i n f l a t i o n a r y resolve. T h a t c o n c e r n , w h i c h m a n i ­ fested itself i n substantial increases i n l o n g b o n d rates w h e n t h e F e d e r a l Reserve b e g a n r a i s i n g t h e f e d e r a l f u n d s rate i n F e b r u a r y 1994, m i g h t have b e e n less p r o n o u n c e d h a d a n i n f l a t i o n - t a r g e t i n g r e g i m e b e e n i n place. G i v e n t h e l i k e l i h o o d t h a t U.S. m o n e t a r y policy, despite its g e n e r a l l y g o o d p e r f o r m a n c e i n r e c e n t years, c o u l d be i m p r o v e d b y t h e a d o p t i o n o f i n f l a t i o n targets, we m a y still ask, w h y now? W h y n o t w a i t u n t i l i n f l a ­ t i o n starts t o b e c o m e a p r o b l e m a g a i n b e f o r e c o n s i d e r i n g a shift i n t h e Fed's f r a m e w o r k f o r m a k i n g m o n e t a r y policy? T h e answer, as suggested by t h e case studies, is l a r g e l y p o l i t i c a l . We have seen t h a t c o u n t r i e s t h a t have a d o p t e d i n f l a t i o n t a r g e t i n g have t y p i ­ cally d o n e so n o t w h e n i n f l a t i o n is r i s i n g , b u t after t h e y have already a c h i e v e d some success i n b r i n g i n g t h e i n f l a t i o n rate d o w n . T h a t t i m i n g is advantageous because i t increases t h e l i k e l i h o o d t h a t t h e n e w r e g i m e w i l l e n d u r e as i t b u i l d s o n already-established c r e d i b i l i t y o f t h e c e n t r a l b a n k as a n i n f l a t i o n f i g h t e r . M o r e o v e r , t h e p u b l i c seems m o r e w i l l i n g t o accept i n f l a t i o n t a r g e t i n g o n c e i t recognizes t h a t l o w i n f l a t i o n c a n i n ­ d e e d be achieved, t h a t i t p r o v i d e s t a n g i b l e e c o n o m i c benefits, a n d t h a t a d d i t i o n a l s h o r t - r u n costs ( i n t e r m s o f lost o u t p u t o r e m p l o y m e n t ) t o b r i n g d o w n i n f l a t i o n m a y n o t be necessary. T h e current conditions for a d o p t i o n o f inflation targeting i n the U n i t e d States thus seem h i g h l y p r o p i t i o u s . I n d e e d , t h e p o l i t i c a l a n d eco­ n o m i c s i t u a t i o n is p r o b a b l y m o r e favorable i n t h e U n i t e d States t h a n i t has b e e n i n o t h e r c o u n t r i e s t h a t have successfully a d o p t e d i n f l a t i o n tar­ gets. A t t h e t i m e o f this w r i t i n g , i n f l a t i o n has b e e n l o w a n d stable f o r

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m o r e t h a n five years; t h e e c o n o m y has b e e n r e m a r k a b l y healthy, enjoy­ i n g a b a l a n c e d , l o n g - l i v e d e x p a n s i o n ; t h e benefits o f a l o w - i n f l a t i o n envi­ r o n m e n t have b e c o m e clear t o t h e A m e r i c a n p u b l i c ; a n d t h e success o f i n f l a t i o n t a r g e t i n g i n o t h e r i n d u s t r i a l i z e d c o u n t r i e s is b e c o m i n g increas­ i n g l y a p p a r e n t . T h u s , t h e U n i t e d States appears t o have a w i n d o w o f o p p o r t u n i t y i n w h i c h a n e w m o n e t a r y - p o l i c y a p p r o a c h c o u l d be a d o p t e d readily. W i t h l u c k , t h e n e w f r a m e w o r k c o u l d t h e n be firmly established by t h e t i m e t h e n e x t d i f f i c u l t decisions a b o u t m o n e t a r y p o l i c y have t o be made.

A Proposal for Inflation Targeting in the United States We t u r n n o w t o a specific p r o p o s a l . We first o u t l i n e t h e e l e m e n t s o f a n i n f l a t i o n - t a r g e t i n g f r a m e w o r k a p p r o p r i a t e f o r t h e U n i t e d States. We t h e n e x p l a i n h o w each e l e m e n t w o u l d w o r k i n p r a c t i c e a n d h o w i t w o u l d i m ­ p r o v e t h e p e r f o r m a n c e o f m o n e t a r y policy. 1. We r e c o m m e n d t h a t t h e l o n g - r u n i n f l a t i o n g o a l f o r t h e U n i t e d States be d e f i n e d as a rate o f i n f l a t i o n s l i g h t l y above (say o n e per­ centage p o i n t ) t h e m e a n estimate o f t h e u p w a r d m e a s u r e m e n t bias i n i n f l a t i o n . T h i s w o u l d be t h e effective d e f i n i t i o n o f " p r i c e stabil­ ity." U n d e r c u r r e n t estimates o f t h e m e a s u r e m e n t bias, t h a t sug­ gests a l o n g - r u n i n f l a t i o n g o a l o f a b o u t 2 % p e r a n n u m ( 1 % above t h e e s t i m a t e d 1 % m e a s u r e m e n t bias). T h e exact value f o r t h e l o n g r u n g o a l w o u l d n o t be specified i n the o r i g i n a l f r a m e w o r k b u t w o u l d be established as p a r t o f a n o v e r s i g h t process (see p o i n t 7 b e l o w ) . 2. A s h o r t - t e r m i n f l a t i o n t a r g e t w o u l d be set a n d a n n o u n c e d o n c e a year, at a r e g u l a r t i m e . T h i s target m i g h t vary f r o m year t o year, d e p e n d i n g o n e c o n o m i c circumstances. T h e sequence o f s h o r t - t e r m targets w o u l d be r e q u i r e d t o converge w i t h t h e l o n g - r u n i n f l a t i o n g o a l , a l t h o u g h c o n v e r g e n c e c o u l d be g r a d u a l . 3. T h e h o r i z o n f o r t h e i n f l a t i o n t a r g e t w o u l d r e f l e c t t h e l a g b e t w e e n t h e s e t t i n g o f p o l i c y a n d t h e effects o f p o l i c y o n t h e e c o n o m y . Spe­ cifically, t h e t a r g e t f o r i n f l a t i o n w o u l d be set n o t f o r t h e i m m e d i ­ ately f o l l o w i n g year, b u t f o r a year f a r t h e r i n t h e f u t u r e . F o r ex­ a m p l e , at t h e e n d o f 1998, t h e F e d e r a l Reserve m i g h t set t h e i n f l a ­ t i o n t a r g e t f o r i n f l a t i o n t o be r e a l i z e d d u r i n g t h e year 2000. 4. T h e i n f l a t i o n t a r g e t w o u l d be a p o i n t target, r a t h e r t h a n a t a r g e t r a n g e . However, t h e r e w o u l d be a p p r o p r i a t e discussion b y t h e cen-

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trai bank, for the benefit o f the government and the public, o f the i n h e r e n t r a n g e o f u n c e r t a i n t y a r o u n d this target. 5. I n f l a t i o n o u t c o m e s t h a t fall b e l o w t h e t a r g e t s h o u l d b e resisted j u s t as s t r e n u o u s l y as o u t c o m e s t h a t e x c e e d t h e target, e x c e p t w h e n p a r t i c u l a r d e v e l o p m e n t s s u c h as favorable s u p p l y shocks j u s t i f y ac­ ceptance o f l o w e r i n f l a t i o n . 6. T h e p r i c e i n d e x u s e d f o r d e f i n i n g t h e i n f l a t i o n t a r g e t w o u l d be t h e "core" C P I , f r o m w h i c h t h e prices o f f o o d , energy, a n d o t h e r espe­ cially v o l a t i l e i t e m s have b e e n e x c l u d e d . 7. T h e n u m e r i c a l value f o r t h e l o n g - r u n i n f l a t i o n g o a l w o u l d be set w i t h g o v e r n m e n t i n v o l v e m e n t , possibly b y a c o m m i s s i o n i n c l u d i n g p a r t i c i p a t i o n by t h e F e d e r a l Reserve. P e r i o d i c r e v i s i o n o f t h e l o n g r u n objective w o u l d be u n d e r t a k e n w h e n c o n d i t i o n s w a r r a n t e d . D e t e r m i n a t i o n o f t h e l o n g - r u n i n f l a t i o n g o a l s h o u l d take i n t o ac­ c o u n t biases i n m e a s u r i n g i n f l a t i o n a n d p r o v i d e safeguards against accidental deflation. 8. As m a n d a t e d b y t h e c u r r e n t H u m p h r e y - H a w k i n s l e g i s l a t i o n , t h e C h a i r m a n o f t h e B o a r d o f G o v e r n o r s o f t h e F e d e r a l Reserve w o u l d be r e q u i r e d t o testify twice a year b e f o r e Congress o n t h e F e d e r a l Reserve's p e r f o r m a n c e i n a c h i e v i n g its i n f l a t i o n targets. 9. T h e F e d e r a l Reserve w o u l d p r o d u c e a regular, c o m p r e h e n s i v e In­ flation Report. I t s h o u l d use t h i s r e p o r t , a n d any o t h e r o p p o r t u n i ­ ties available t o i t , t o o u t l i n e d e v e l o p m e n t s r e l e v a n t t o i n f l a t i o n , t h e c u r r e n t status o f m o n e t a r y policy, a n d t h e Fed's p r o p o s e d strat­ egy f o r m e e t i n g t h e i n f l a t i o n targets. We n o w l o o k at each o f these n i n e e l e m e n t s i n greater d e t a i l . 1. Price stability a n d t h e l o n g - r u n i n f l a t i o n objective A key e l e m e n t i n any i n f l a t i o n - t a r g e t i n g r e g i m e is t h e d e f i n i t i o n o f w h a t " p r i c e stability" m e a n s i n p r a c t i c e . O u r r e c o m m e n d a t i o n is t h a t p r i c e stability be d e f i n e d as a n i n f l a t i o n rate s l i g h t l y above t h e consen­ sus estimate o f t h e i n f l a t i o n m e a s u r e m e n t bias ( w h i c h c o u l d c h a n g e over t i m e ) . I f we take a figure o n t h e o r d e r o f 1 % as t h e best estimate o f t h e m e a s u r e m e n t bias, t h e n a d d a n o t h e r 1 % " m a r g i n o f safety" ( f o r reasons n o t e d b e l o w ) , we o b t a i n a r e c o m m e n d e d l o n g - r u n i n f l a t i o n t a r g e t o f a p p r o x i m a t e l y 2 % p e r year, a n u m b e r t h a t is consistent w i t h w o r l d w i d e practice.

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D e f i n i n g p r i c e stability i n t e r m s o f a t a r g e t f o r t h e l o n g - r u n i n f l a t i o n rate, r a t h e r t h a n i n t e r m s o f a p r i c e - l e v e l target, is also c o n s i s t e n t w i t h w o r l d w i d e p r a c t i c e , as we have seen t h r o u g h o u t t h e case studies. T h e advantage o f t a r g e t i n g a n i n f l a t i o n rate r a t h e r t h a n a p r i c e level is t h a t t a r g e t i n g t h e l a t t e r m i g h t r e q u i r e p e r i o d s o f d e f l a t i o n , w h i c h c o u l d be h a r m f u l t o t h e f i n a n c i a l system a n d t o t h e e c o n o m y m o r e generally. Some e c o n o m i s t s have p o i n t e d o u t t h a t a n i n f l a t i o n - r a t e t a r g e t i m p l i e s rela­ tively g r e a t e r v o l a t i l i t y a n d u n p r e d i c t a b i l i t y o f t h e p r i c e level i n t h e dis­ t a n t f u t u r e , w i t h possible adverse effects o n l o n g - t e r m p l a n n i n g ( r e t i r e ­ m e n t p l a n n i n g , f o r e x a m p l e ) . However, we believe t h a t , i n p r a c t i c e , s u c h effects w o u l d be u n l i k e l y to be l a r g e (see, f o r e x a m p l e , M c C a l l u m [ 1 9 9 6 ] f o r some i l l u s t r a t i v e c a l c u l a t i o n s ) . F e d e r a l Reserve C h a i r m a n A l a n G r e e n s p a n r e p o r t e d l y has d e f i n e d p r i c e stability as a s i t u a t i o n i n w h i c h i n f l a t i o n is n o t a c o n s i d e r a t i o n i n h o u s e h o l d o r business decisions. As we discussed i n C h a p t e r 2, measure­ m e n t e r r o r f o r C P I i n f l a t i o n i n t h e U n i t e d States is e s t i m a t e d t o b e i n t h e r a n g e o f 0.5% t o 2.0%, w i t h a m e a n value i n t h e v i c i n i t y o f 1 % . T h u s a n i n f l a t i o n g o a l o f 2 % — 1 % over t h e m e a n m e a s u r e m e n t e r r o r — i s q u i t e consistent w i t h t h e G r e e n s p a n d e f i n i t i o n o f p r i c e stability. Yet, o n e m i g h t ask, w h y w o u l d a 2 % g o a l f o r l o n g - r u n i n f l a t i o n be b e t t e r t h a n a g o a l o f zero i n f l a t i o n , w h i c h has t h e advantages o f s i m p l i c ­ ity a n d t h e p s y c h o l o g i c a l a p p e a l o f t h e "magic n u m b e r " o f zero? O r w h y n o t a 1 % l o n g - r u n i n f l a t i o n g o a l , w h i c h is consistent w i t h a " t r u e " i n f l a ­ t i o n rate o f zero, o n c e t h e e s t i m a t e d m e a s u r e m e n t e r r o r has b e e n e l i m i ­ nated? T h e reason we n e e d a m a r g i n o f safety is t h a t t h e r e are serious risks i n s e t t i n g a n i n f l a t i o n t a r g e t t o o low. T h o s e risks, w h i c h we dis­ cussed i n C h a p t e r 2, i n c l u d e t h e possibility o f r e d u c e d real-wage flexibil­ ity ( i f n o m i n a l wage cuts are n o t feasible) a n d possible f i n a n c i a l i n s t a b i l ­ ity i f e r r o r s b y t h e c e n t r a l b a n k cause t h e e c o n o m y t o slip i n t o t h e r a n g e o f negative i n f l a t i o n ( d e f l a t i o n ) . A 1 % t a r g e t f o r t r u e i n f l a t i o n p r o v i d e s some i n s u r a n c e against such risks. 2. V a r i a t i o n i n t h e i n f l a t i o n t a r g e t over t i m e A key issue i n t h e d e s i g n o f a n i n f l a t i o n - t a r g e t i n g r e g i m e is h o w flex­ i b l e t h e i n f l a t i o n targets s h o u l d be i n t h e s h o r t a n d m e d i u m t e r m s . As t h e case studies i n d i c a t e d , a l t h o u g h c e n t r a l b a n k e r s are s o m e t i m e s c r i t i ­ cized f o r f o c u s i n g t o o m u c h o n p r i c e stability, t h e y are c e r t a i n l y c o n ­ c e r n e d i n p r a c t i c e w i t h o t h e r aspects o f e c o n o m i c p e r f o r m a n c e , par­ t i c u l a r l y fluctuations i n o u t p u t , e m p l o y m e n t , a n d e x c h a n g e rates. C o n ­ sequently, i n f l a t i o n targeters, even those m o s t " h a w k i s h " o n i n f l a t i o n ,

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have a l l o w e d t h e i r targets t o vary over t i m e i n response t o shocks t o t h e e c o n o m y , o r as p a r t o f a d i s i n f l a t i o n a r y process. I n d e e d , m u c h discus­ s i o n o f i n f l a t i o n t a r g e t i n g focuses o n t h e s e t t i n g o f t w o p a r a m e t e r s : t h e l o n g - r u n i n f l a t i o n g o a l , a n d t h e l e n g t h o f t i m e a l l o w e d f o r t h e conver­ gence o f a c t u a l i n f l a t i o n w i t h t h a t g o a l f o l l o w i n g a s h o c k t o t h e e c o n o m y t h a t drives i n f l a t i o n f r o m its d e s i r e d level. By s e t t i n g paths f o r t h e s h o r t t e r m i n f l a t i o n target t h a t g r a d u a l l y a p p r o a c h t h e l o n g - r u n i n f l a t i o n g o a l , t h e c e n t r a l b a n k can h e l p ensure t h a t t h e e c o n o m y does n o t suffer u n n e c ­ essary losses i n o u t p u t a n d e m p l o y m e n t i n the p u r s u i t o f p r i c e stability. F o r e x a m p l e , suppose a j u m p i n o i l prices s u d d e n l y p u s h e d i n f l a t i o n f r o m l o w levels t o a level w e l l above t h e l o n g - r u n g o a l . I n this c i r c u m ­ stance, t h e i n f l a t i o n - t a r g e t i n g a p p r o a c h w o u l d n o t r e q u i r e a n i m m e d i ­ ate, d r a c o n i a n response. I n s t e a d , t h e s h o r t - t e r m i n f l a t i o n t a r g e t w o u l d b e t e m p o r a r i l y adjusted u p w a r d , w i t h assurances t h a t t h e t a r g e t w o u l d f o l l o w a p l a n n e d d o w n w a r d p a t h over t i m e . Such a response reflects b o t h t h e r e a l i t y t h a t a s h o r t - t e r m i n f l a t i o n b u l g e c a n n o t be i m m e d i a t e l y e l i m i ­ n a t e d (at least n o t w i t h o u t u n a c c e p t a b l e costs), a n d also t h e p r e s u m p ­ t i o n t h a t i n f l a t i o n w i l l be g r a d u a l l y r e t u r n e d t o its l o n g - r u n n o r m . D u r ­ i n g this process, t h e F e d e r a l Reserve w o u l d have t o e x p l a i n t o t h e p u b l i c t h a t its actions w e r e d e s i g n e d t o k e e p o u t p u t a n d e m p l o y m e n t losses t o a m i n i m u m , w h i l e s t i l l m a i n t a i n i n g t h e objective o f l o n g - r u n p r i c e stabil­ ity. E x p e r i e n c e suggests t h a t this strategy w o u l d h e l p t o m i t i g a t e t h e sec­ o n d - a n d t h i r d - r o u n d effects o f t h e o i l p r i c e shock, as w e l l as t h e effects o n the public's expectations o f inflation. A n o t h e r advantage o f b e i n g able t o adjust s h o r t - r u n i n f l a t i o n targets over t i m e is t h a t i t w o u l d p r o m o t e frankness a m o n g c e n t r a l b a n k e r s . L i k e t h e i r colleagues a r o u n d t h e w o r l d , some F e d e r a l Reserve officials have b e e n r e l u c t a n t t o a d m i t t h a t t h e y are c o n c e r n e d a b o u t e c o n o m i c o u t c o m e s o t h e r t h a n l o n g - r u n p r i c e stability, o r even t h a t m o n e t a r y p o l i c y c a n affect r e a l variables l i k e o u t p u t a n d e m p l o y m e n t . T h e y w a n t t o a v o i d g i v i n g t h e p u b l i c t h e i m p r e s s i o n t h a t t h e y are b e i n g "soft" o n i n f l a t i o n , an impression that m i g h t lead to h i g h e r inflation expectations. ( T h a t r e t i c e n c e a p p e a r e d t o be j u s t i f i e d b y t h e c r i t i c i s m e v o k e d b y F e d e r a l Reserve V i c e - C h a i r m a n A l a n B l i n d e r i n A u g u s t 1994, w h e n h e d a r e d t o speak f r a n k l y a b o u t t h e i n f l a t i o n - o u t p u t t r a d e o f f i n a speech at a confer­ ence i n Jackson H o l e , W y o m i n g . ) T h e a b i l i t y t o adjust t h e i n f l a t i o n tar­ g e t over t i m e ( a c c o m p a n i e d b y p u b l i c e x p l a n a t i o n s ) w o u l d e n c o u r a g e F e d e r a l Reserve officials t o d e m o n s t r a t e t h e i r c o n c e r n s a b o u t fluctua­ tions i n o u t p u t a n d e m p l o y m e n t , w i t h o u t p r o m p t i n g the charge that they were i g n o r i n g their p r i m a r y responsibility to c o n t r o l inflation i n t h e l o n g r u n . Politically, g r e a t e r frankness i n p o l i c y - m a k i n g w o u l d t e n d

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t o defuse t h e p e r c e p t i o n t h a t t h e F e d e r a l Reserve is i n d i f f e r e n t t o t h e p r o b l e m s o f t h e u n e m p l o y e d a n d o t h e r hard-pressed citizens. I n s h o r t , a t i m e - v a r y i n g i n f l a t i o n target, r a t h e r t h a n i m p e d i n g t h e b a t t l e against i n f l a t i o n , w o u l d h e l p t h e F e d e r a l Reserve t o c o m m a n d p u b l i c s u p p o r t f o r b o t h its i n d e p e n d e n c e a n d its g o a l o f s t a b i l i z i n g prices. As a n aside, we n o t e t h a t t h e r e is a t r a p i n t o w h i c h s o m e i n f l a t i o n targeters f a l l after a p e r i o d o f successful d i s i n f l a t i o n , w h e n t h e i n f l a t i o n rate is close t o its l o n g - r u n objective. I n this s i t u a t i o n , i n f l a t i o n targets may r e m a i n unchanged for a p r o l o n g e d p e r i o d o f time, giving the pub­ lic t h e i m p r e s s i o n t h a t t h e t a r g e t has b e e n f i x e d a n d w i l l n o l o n g e r vary. B u t t r a n q u i l p e r i o d s d o n o t last forever. T h u s , i n i m p l e m e n t i n g a n i n f l a ­ t i o n - t a r g e t i n g f r a m e w o r k i n t h e U n i t e d States, t h e F e d e r a l Reserve s h o u l d r e m i n d t h e p u b l i c t h a t severe shocks t o t h e e c o n o m y always r e m a i n a possibility. T o d r i v e h o m e this p o i n t , t h e F e d e r a l Reserve s h o u l d m a k e clear t h a t i t takes t h e a n n u a l r e v i e w o f t h e i n f l a t i o n t a r g e t q u i t e seri­ ously, so t h a t even a d e c i s i o n t o leave t h e t a r g e t u n c h a n g e d m u s t be carefully j u s t i f i e d . T h e flip side o f t h e c o n c e r n t h a t i n f l a t i o n targets m a y n o t be c h a n g e d o f t e n e n o u g h is t h a t they m a y be c h a n g e d t o o o f t e n a n d b y t o o m u c h . Some critics have suggested t h a t , because targets m i g h t b e c h a n g e d fre­ q u e n t l y o r o n a n ad hoc basis, t h e use o f t i m e - v a r y i n g i n f l a t i o n targets m a y i m p a i r t h e c r e d i b i l i t y o f t h e i n f l a t i o n - t a r g e t i n g f r a m e w o r k itself. By a c c o m m o d a t i n g any c h a n g e i n i n f l a t i o n b y a c h a n g e i n its "target," t h e y w a r n , a c e n t r a l b a n k o r g o v e r n m e n t m i g h t r e n d e r t h e system m e a n i n g ­ less. E x p e r i e n c e suggests, however, t h a t c r e d i b i l i t y is n o t d a m a g e d by v a r y i n g targets over t i m e , so l o n g as t h e c e n t r a l b a n k e x p l a i n s its actions a n d reaffirms its c o m m i t m e n t t o l o n g - r u n p r i c e stability. I n d e e d , because changes i n i n f l a t i o n targets are so n e w s w o r t h y a n d are so closely s c r u t i ­ n i z e d (a r e s u l t o f t h e t r a n s p a r e n c y o f this a p p r o a c h ) , g o v e r n m e n t s a n d c e n t r a l b a n k e r s p r o b a b l y c h a n g e s h o r t - t e r m i n f l a t i o n targets t o o i n f r e ­ q u e n t l y , t a k i n g a c t i o n o n l y w h e n t h e j u s t i f i c a t i o n f o r c h a n g e appears o v e r w h e l m i n g . As o u r case studies d e m o n s t r a t e , p o l i c y - m a k e r s are o f t e n r e l u c t a n t t o c h a n g e i n f l a t i o n targets even w h e n a c h a n g e i n g o v e r n m e n t occurs. 3. T h e h o r i z o n f o r w h i c h t h e i n f l a t i o n t a r g e t is set M o n e t a r y p o l i c y affects t h e e c o n o m y o n l y w i t h l o n g lags. Consequently, p o l i c y - m a k i n g m u s t be f o r w a r d - l o o k i n g , r a t h e r t h a n p u r e l y reactive. T h e d e t e r m i n a t i o n o f t h e h o r i z o n f o r i n f l a t i o n targets s h o u l d be based o n research r e g a r d i n g h o w l o n g i t takes m o n e t a r y p o l i c y t o i n f l u e n c e i n f l a ­ t i o n : I f , f o r e x a m p l e , research i n d i c a t e s t h a t t h e l a g is o n t h e o r d e r o f

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t w o years (a c o m m o n e s t i m a t e ) , t h e n t h e i n f l a t i o n t a r g e t s h o u l d b e set f o r t h e a n n u a l i n f l a t i o n rate t w o years h e n c e . S u c h a p r a c t i c e w o u l d re­ m i n d t h e p u b l i c t h a t p r i c e stability is a l o n g - r u n , r a t h e r t h a n a s h o r t - r u n , g o a l . I n Canada, f o r e x a m p l e , t h e i n f l a t i o n targets w e r e set t o a p p l y t o a p e r i o d b e g i n n i n g 22 m o n t h s after t h e i n i t i a l a n n o u n c e m e n t . H o w e v e r , some i n f l a t i o n - t a r g e t i n g c o u n t r i e s set t h e t a r g e t f o r i n f l a t i o n o n l y f o r t h e c o m i n g year, a s h o r t h o r i z o n w h i c h does n o t a d e q u a t e l y r e f l e c t t h e l a g b e t w e e n p o l i c y actions a n d t h e i r effects. I n o u r case study o f N e w Z e a l a n d , we saw t h a t a s h o r t t a r g e t h o r i z o n has r e s u l t e d i n p r o b l e m s o f c o n t r o l a n d i n s t r u m e n t instability. E v e n i n t h e case o f Canada, t h e fact t h a t t h e i n f l a t i o n t a r g e t is set a n n u a l l y a n d has r e m a i n e d essentially u n ­ c h a n g e d f o r a substantial p e r i o d o f t i m e has m a d e i t m o r e d i f f i c u l t t o k e e p t h e p u b l i c aware o f t h e fact t h a t t h e targets are s u p p o s e d t o b e f o r w a r d - l o o k i n g i n n a t u r e . E m p h a s i z i n g t h a t t h e r e is a relatively l o n g h o r i z o n f o r targets seems essential. 4. A p o i n t t a r g e t r a t h e r t h a n a t a r g e t r a n g e I n f l a t i o n targeters have m a d e d i f f e r e n t choices o n w h e t h e r a n i n f l a ­ t i o n t a r g e t s h o u l d be expressed as a single p o i n t o r as a r a n g e o f accept­ able o u t c o m e s . As we have seen, a t a r g e t r a n g e allows f o r flexibility i n r e s p o n d i n g t o shocks t o t h e e c o n o m y a n d reflects t h e u n c e r t a i n t y i n a c h i e v i n g any i n f l a t i o n target. A disadvantage o f u s i n g a t a r g e t r a n g e is that the u p p e r a n d lower bands o f the range may become the p r i n c i p a l focus o f p u b l i c a t t e n t i o n , l e a d i n g t h e c e n t r a l b a n k t o c o n c e n t r a t e t o o m u c h o n k e e p i n g i n f l a t i o n j u s t w i t h i n the bands rather t h a n t r y i n g to h i t the m i d p o i n t o f the range. For example, slight overshootings o f the up­ p e r b a n d o f t h e t a r g e t b a n d have r e c e i v e d t r e m e n d o u s a t t e n t i o n i n N e w Z e a l a n d , b u t i n f l a t i o n rates close t o t h e u p p e r e n d o f t h e r a n g e b u t n o t b r e a c h i n g i t have g o n e l a r g e l y u n r e m a r k e d . I n t h e U n i t e d K i n g d o m i n 1995, t h e i n f l a t i o n forecast e x c e e d e d t h e m i d p o i n t o f t h e t a r g e t r a n g e by m o r e t h a n o n e p e r c e n t a g e p o i n t , b u t w i t h o u t b r e a c h i n g t h e u p p e r b a n d . I n t h a t case, p r o b a b l y t o o l i t t l e a t t e n t i o n was p a i d t o t h e over­ s h o o t i n g o f t h e m i d p o i n t , a n d t h e fact t h a t i n f l a t i o n h a d n o t a c t u a l l y crossed t h e u p p e r e n d o f t h e r a n g e was used as t o j u s t i f y t h e absence o f any p o l i c y response. I t is d i f f i c u l t t o i m a g i n e p o l i c y objectives t h a t w o u l d m a k e sense o f such a s y m m e t r i c p u b l i c reactions t o i n f l a t i o n rates j u s t i n s i d e a n d j u s t o u t s i d e t h e b a n d s a n d t h e incentives t h a t such r e a c t i o n s create f o r c e n t r a l bankers. I t is also n o t clear t h a t t h e use o f a t a r g e t r a n g e is a g o o d way f o r t h e c e n t r a l b a n k t o convey h o w u n c e r t a i n i t is a b o u t its a b i l i t y t o h i t t h e i n f l a t i o n target. U n f o r t u n a t e l y , some estimates o f t h e i r r e d u c i b l e u n c e r -

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t a i n t y a r o u n d a n i n f l a t i o n t a r g e t are o n t h e o r d e r o f five t o six p e r c e n t ­ age p o i n t s (see f o r e x a m p l e , H a l d a n e a n d S a l m o n [ 1 9 9 5 ] a n d Stevens a n d Debelle [1995] ) } T h e inflation-targeting central b a n k that employs a target r a n g e thus has t h e u n a t t r a c t i v e c h o i c e o f m a k i n g t h e target r a n g e very w i d e , w h i c h is l i k e l y t o confuse t h e p u b l i c a b o u t t h e c e n t r a l b a n k ' s intentions a n d reduce the credibility o f policy; o r o f m a k i n g the range so n a r r o w t h a t misses are i n e v i t a b l e , w h i c h has its o w n consequences f o r credibility. T o a v o i d such p r o b l e m s , we r e c o m m e n d a p o i n t t a r g e t f o r i n f l a t i o n . W e f u l l y r e c o g n i z e t h a t t h e c o n t r o l o f i n f l a t i o n is i n h e r e n t l y i m p e r f e c t , a n d that the unavoidable range o f uncertainty a r o u n d the p o i n t target needs t o be a c k n o w l e d g e d i n c e n t r a l b a n k analyses. H o w e v e r , we w o u l d l i k e t o see t h e F e d e r a l Reserve take t h e a p p r o a c h o f t h e B a n k o f E n ­ g l a n d : As we discussed i n C h a p t e r 7, i n 1995 t h e B a n k o f E n g l a n d switched f r o m a target r a n g e t o a p o i n t target, a n d i t has u s e d t h e Inflation Report a n d other channels to c o m m u n i c a t e the i n h e r e n t uncertainties i n the c o n t r o l o f i n f l a t i o n t o t h e p u b l i c , r a t h e r t h a n l e a v i n g those u n c e r t a i n ­ ties t o be i n f e r r e d f r o m t h e t a r g e t r a n g e . Finally, t h e use o f a time-vary­ i n g i n f l a t i o n t a r g e t obviates t h e n e e d f o r flexibility p r o v i d e d b y t h e use o f a target range. 5. U n d e r s h o o t i n g t h e t a r g e t is j u s t as u n d e s i r a b l e as o v e r s h o o t i n g Some c e n t r a l b a n k e r s have f a l l e n i n t o t h e " y o u c a n n e v e r be t o o r i c h o r t o o t h i n " fallacy. I t m i g h t b e t r u e t h a t o n e can n e v e r be t o o r i c h — a l t h o u g h some w o u l d d i s a g r e e — b u t o n e surely c a n be t o o t h i n . L i k e ­ wise, i n f l a t i o n c a n surely be t o o low. A d e c l i n e i n i n f l a t i o n b e l o w t h e i n f l a t i o n target, unless i t arises f r o m a b e n e f i c i a l s u p p l y shock, w i l l exact a t o l l i n t e r m s o f lost o u t p u t a n d e m p l o y m e n t t h a t is g r e a t e r t h a n neces­ sary. L i t e r a l d e f l a t i o n , as we have seen, c a n be e x t r e m e l y h a r m f u l , par­ t i c u l a r l y i f i t p r e c i p i t a t e s financial i n s t a b i l i t y (see, f o r e x a m p l e , M i s h k i n [ 1 9 9 7 b ] ) . A n i m p o r t a n t advantage o f i n f l a t i o n t a r g e t i n g is t h a t i t p r o ­ vides a floor f o r i n f l a t i o n as w e l l as a c e i l i n g . 6. T a r g e t i n g " c o r e " C P I i n f l a t i o n A l t h o u g h the particular choice o f the price i n d e x used i n construct­ i n g t h e i n f l a t i o n t a r g e t is p e r h a p s n o t c r i t i c a l , we l e a n t o w a r d t h e use o f a "core" C P I m e a s u r e t h a t excludes f o o d , e n e r g y a n d o t h e r v o l a t i l e i t e m s f r o m t h e p r i c e i n d e x . T h e c o r e C P I is l i k e l y t o p r o v i d e a b e t t e r g u i d e t o m o n e t a r y p o l i c y t h a n o t h e r i n d i c e s , since i t measures t h e m o r e persis­ tent underlying inflation rather than transitory influences o n the price level. M o r e o v e r , its use i n d i c a t e s t o t h e p u b l i c t h a t t h e c e n t r a l b a n k w i l l

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r e s p o n d flexibly t o i n f l a t i o n a r y shocks a r i s i n g f r o m s u p p l y shocks ( s u c h as sharp increases i n t h e prices o f o i l o r f o o d ) . Use o f a c o r e C P I mea­ sure also helps t h e c e n t r a l b a n k t o c o m m u n i c a t e t o t h e p u b l i c t h a t n o t every s h o c k t h a t raises prices w i l l l e a d t o a p e r m a n e n t increase i n i n f l a ­ t i o n , a n d t h a t s h o r t - t e r m changes i n i n f l a t i o n r e s u l t i n g f r o m supply shocks w i l l be t r e a t e d d i f f e r e n t l y f r o m changes d r i v e n by aggregate d e m a n d . T h e a r g u m e n t f o r u s i n g t h e C P I r a t h e r t h a n some o t h e r p r i c e i n d e x (such as t h e G D P d e f l a t o r ) is t h a t i t is d i r e c t l y r e l e v a n t t o c o n s u m e r l i v i n g standards a n d is t h e p r i c e i n d e x best u n d e r s t o o d b y t h e p u b l i c a n d m o s t w i d e l y r e p o r t e d i n t h e m e d i a . I t is also c a l c u l a t e d m o r e fre­ q u e n t l y a n d w i t h less delay t h a n o t h e r m a j o r p r i c e i n d i c e s . Finally, mea­ s u r e m e n t e r r o r s i n this i n d e x are b e t t e r u n d e r s t o o d b y e c o n o m i s t s t h a n those o f a l t e r n a t i v e i n d i c e s . 7. R e s p o n s i b i l i t y f o r s e t t i n g t h e i n f l a t i o n target We have already m e n t i o n e d i n this c h a p t e r t h e useful d i s t i n c t i o n be­ tween goal independence a n d i n s t r u m e n t independence for the central b a n k . W e believe t h a t i n f l a t i o n t a r g e t i n g is m o s t effective a n d leads t o the most democratically accountable policy-making w h e n the central b a n k is i n s t r u m e n t - i n d e p e n d e n t b u t n o t f u l l y g o a l - i n d e p e n d e n t . I n f l a t i o n t a r g e t i n g , b y its very n a t u r e , r e q u i r e s t h a t t h e c e n t r a l b a n k have i n s t r u m e n t i n d e p e n d e n c e . T h e c e n t r a l b a n k c a n h a r d l y be h e l d a c c o u n t a b l e f o r m e e t i n g t h e i n f l a t i o n targets i f i t is n o t g i v e n c o n t r o l o f t h e p o l i c y i n s t r u m e n t s . I n s t r u m e n t i n d e p e n d e n c e takes advantage o f t h e c e n t r a l bank's u n d e n i a b l y g r e a t e r expertise i n t h e i m p l e m e n t a t i o n o f m o n e t a r y policy, a n d i t enables t h e policy-makers t o take i n t o a c c o u n t t h e l a g b e t w e e n p o l i c y a n d its effect w i t h o u t b e i n g h a n d i c a p p e d b y t h e myopic tendencies o f politicians. I n f l a t i o n t a r g e t i n g does n o t , however, r e q u i r e t h a t t h e c e n t r a l b a n k enjoy g o a l i n d e p e n d e n c e as w e l l . U n d e r o u r p r o p o s a l , l o n g - r u n i n f l a ­ t i o n goals w o u l d be set b y t h e g o v e r n m e n t , possibly t h r o u g h a s t a n d i n g c o m m i s s i o n t h a t i n c l u d e s t h e F e d e r a l Reserve as a n active p a r t i c i p a n t . N o t e that the commission m i g h t well decide to change the l o n g - r u n i n ­ flation g o a l at some p o i n t , because o f n e w research o n m e a s u r e m e n t bias i n t h e C P I o r o n t h e rate o f " t r u e " i n f l a t i o n t h a t best p r o m o t e s l o n g r u n e c o n o m i c g r o w t h a n d stability. T h e r e are several reasons w h y t h e g o v e r n m e n t s h o u l d have substan­ t i a l r e s p o n s i b i l i t y f o r s e t t i n g l o n g - r u n i n f l a t i o n goals. First, d e m o c r a t i c a c c o u n t a b i l i t y i n t h e s e t t i n g o f goals n o t o n l y l e g i t i m i z e s t h e p o l i c y - m a k ­ i n g process, b u t u l t i m a t e l y i t p r o t e c t s t h e c e n t r a l b a n k f r o m u n w a r r a n t e d c r i t i c i s m a n d attacks o n its o p e r a t i o n a l i n d e p e n d e n c e . S e c o n d , g o v e r n 2

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m e n t p a r t i c i p a t i o n i n s e t t i n g l o n g - r u n i n f l a t i o n goals obliges i t t o a d o p t a l o n g - r a n g e view o f t h e effects o f m o n e t a r y policy, r a t h e r t h a n f o c u s i n g solely o n c u r r e n t cyclical c o n d i t i o n s . A n o t h e r b e n e f i t o f substantial g o v e r n m e n t p a r t i c i p a t i o n i n s e t t i n g i n f l a t i o n goals, o n e t h a t has r e c e i v e d r e l a t i v e l y l i t t l e a t t e n t i o n , is t h a t i t m a y l e a d t o s o u n d e r fiscal policy. A g o v e r n m e n t t h a t has c o m m i t t e d i t ­ self t o n u m e r i c a l i n f l a t i o n goals c a n b e t t e r resist over-expansionary fis­ cal p o l i c i e s , large b u d g e t deficits, a n d excessive increases i n p u b l i c wages o n t h e g r o u n d s t h a t they are i n c o n s i s t e n t w i t h t h e g o v e r n m e n t ' s o w n i n f l a t i o n goals. F o r e x a m p l e , i n N e w Z e a l a n d , t h e s e t t i n g o f i n f l a t i o n targets b y t h e F i n a n c e M i n i s t e r seems t o have h e l p e d t h a t c o u n t r y k e e p g o v e r n m e n t s p e n d i n g u n d e r c o n t r o l . Similarly, t h e r o l e o f t h e C a n a d i a n g o v e r n m e n t i n s e t t i n g i n f l a t i o n targets m a y have h e l p e d i t t o resist salary increases i n t h e p u b l i c sector. Private-sector wage a g r e e m e n t s m a y also be m o d e r a t e d i f t h e r e is a s t r o n g g o v e r n m e n t c o m m i t m e n t t o l o w i n f l a ­ tion. Because b u d g e t deficits i n t h e U n i t e d States are c u r r e n t l y at very l o w levels ( w i t h even surpluses b e i n g p o s s i b l e ) , t h e salutary effect o f i n f l a ­ t i o n targets o n fiscal d i s c i p l i n e m a y n o t be so salient at t h e m o m e n t . However, serious fiscal i m b a l a n c e s m a y r e t u r n i n t h e f u t u r e , p a r t i c u l a r l y g i v e n t h e u n f u n d e d Social Security o b l i g a t i o n s t h a t l o o m a h e a d . A l t h o u g h t h e u l t i m a t e responsibility f o r setting l o n g - r u n i n f l a t i o n goals s h o u l d rest w i t h t h e U.S. g o v e r n m e n t , t h e F e d e r a l Reserve s h o u l d n o t be left e n t i r e l y o u t o f t h e p i c t u r e . H a v i n g t h e F e d e r a l Reserve p a r t i c i ­ pate i n d e c i d i n g t h e l o n g - r u n i n f l a t i o n g o a l has m u c h t o r e c o m m e n d i t . W i t h a research staff o f a p p r o x i m a t e l y five h u n d r e d e c o n o m i s t s , t h e Fed­ e r a l Reserve c a n p r o v i d e v a l u a b l e expertise o n t h e e c o n o m y a n d o n m o n e t a r y policy. M o r e o v e r , because t h e F e d e r a l Reserve is i n d e p e n d e n t f r o m t h e day-to-day p o l i t i c a l process, i t w o u l d b r i n g h i g h prestige a n d the reputation o f b e i n g an honest broker to the commission. O n c e a l o n g - r u n i n f l a t i o n g o a l has b e e n established, t h e n e x t step is to d e f i n e a t r a n s i t i o n p a t h o f m e d i u m - t e r m targets. I n fact, because set­ t i n g those targets w i l l i n e v i t a b l y d e m a n d t e c h n i c a l c o m p e t e n c e i n deter­ m i n i n g t h e pace at w h i c h i n f l a t i o n can be m o v e d t o w a r d t h e l o n g - r u n g o a l w i t h o u t c a u s i n g u n d u e o u t p u t fluctuations, i t m a y be best t o en­ t r u s t this task solely t o t h e F e d e r a l Reserve. I n some i n f l a t i o n - t a r g e t i n g c o u n t r i e s , m e d i u m - t e r m i n f l a t i o n targets are set j o i n t l y b y t h e c e n t r a l b a n k a n d t h e g o v e r n m e n t , as r e p r e s e n t e d ( f o r e x a m p l e ) b y t h e f i n a n c e m i n i s t e r . T h e m o s t n e a r l y analogous p r o c e d u r e f o r t h e U n i t e d States w o u l d b e t o have t h e Secretary o f t h e Treasury set t h e m e d i u m - t e r m targets i n c o n s u l t a t i o n w i t h t h e F e d e r a l Reserve. E m p o w e r i n g t h e finance

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m i n i s t r y t o establish m e d i u m - t e r m i n f l a t i o n targets i n c o n s u l t a t i o n w i t h t h e c e n t r a l b a n k m a y w o r k w e l l i n a p a r l i a m e n t a r y system o f d e m o c r a c y , i n w h i c h t h e finance m i n i s t r y represents b o t h t h e executive a n d legisla­ tive b r a n c h e s o f t h e g o v e r n m e n t . T h a t a r r a n g e m e n t m i g h t n o t be suit­ able i n t h e U n i t e d States, however, w h e r e t h e Secretary o f t h e T r e a s u r y f u n c t i o n s as t h e representative o f t h e executive b r a n c h b u t n o t t h e legis­ lative b r a n c h . T h u s , m e d i u m - t e r m i n f l a t i o n targets set b y t h e U.S. Trea­ sury m i g h t r e f l e c t t h e p o l i t i c a l views o f t h e P r e s i d e n t r a t h e r t h a n t h e views o f Congress. 8. A c c o u n t a b i l i t y A key e l e m e n t o f i n f l a t i o n t a r g e t i n g is t h e a c c o u n t a b i l i t y t o t h e p u b l i c o f t h e agency r e s p o n s i b l e f o r t h e c o n d u c t o f m o n e t a r y p o l i c y ( t h e F e d ­ e r a l Reserve, i n t h e U n i t e d States). T h e H u m p h r e y - H a w k i n s legisla­ t i o n already provides some degree o f accountability f o r the Federal Reserve by r e q u i r i n g t h e C h a i r m a n o f t h e B o a r d o f G o v e r n o r s o f t h e F e d e r a l Reserve System t o testify b e f o r e Congress t w i c e a year o n t h e p e r f o r m a n c e o f m o n e t a r y p o l i c y . T h i s t e s t i m o n y w o u l d r e m a i n a n es­ sential c o m p o n e n t o f an inflation-targeting framework. However, u n ­ d e r a n i n f l a t i o n - t a r g e t i n g r e g i m e , t h e r e q u i r e m e n t t o testify w o u l d i m p o s e g r e a t e r a c c o u n t a b i l i t y o n t h e F e d e r a l Reserve t h a n i t does at p r e s e n t , because Congress w o u l d be a b l e t o m e a s u r e t h e Fed's p e r f o r ­ m a n c e against a n u m e r i c a l b e n c h m a r k . I n f l a t i o n t a r g e t i n g s h o u l d n o t b e seen as a "free r i d e " f o r t h e c e n t r a l b a n k ; o n t h e c o n t r a r y , t h e i n ­ creased t r a n s p a r e n c y o f p o l i c y u n d e r i n f l a t i o n t a r g e t i n g w o u l d s u b j e c t t h e F e d e r a l Reserve t o m o r e i n t e n s e p u b l i c s c r u t i n y , as is a p p r o p r i a t e i n a d e m o c r a t i c society. G i v e n t h e m u l t i - y e a r h o r i z o n o f t h e m e d i u m - t e r m i n f l a t i o n targets i n o u r p r o p o s a l , t h e F e d e r a l Reserve's t e s t i m o n y w o u l d be i n t w o parts. I n t h e first p a r t , t h e C h a i r m a n w o u l d discuss c u r r e n t i n f l a t i o n p e r f o r m a n c e , i n c l u d i n g t h e F e d e r a l Reserve's success o r f a i l u r e i n a c h i e v i n g t h e i n f l a ­ t i o n t a r g e t set several years b e f o r e . Key t o this discussion w o u l d be a n a c c o u n t i n g o f h o w t h e F e d e r a l Reserve h a d set its p o l i c y i n s t r u m e n t s i n o r d e r t o achieve t h a t target, a n d a n analysis o f w h e t h e r those settings w e r e a p p r o p r i a t e g i v e n t h e i n f o r m a t i o n t h e n available. T h e C h a i r m a n w o u l d also i n d i c a t e w h y any d e v i a t i o n s f r o m t h e i n f l a t i o n t a r g e t h a d oc­ c u r r e d a n d w h e t h e r t h e y c o u l d have reasonably b e e n foreseen. A n ex­ t r e m e l y i m p o r t a n t b e n e f i t t o this discussion w o u l d be t h e o p p o r t u n i t y i t w o u l d p r o v i d e t o e d u c a t e Congress a b o u t t h e lags i n t h e effects o f t h e policy instruments o n inflation a n d the consequent need for forwardl o o k i n g m o n e t a r y policy.

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I n t h e s e c o n d p a r t o f t h e testimony, t h e C h a i r m a n w o u l d discuss f u ­ t u r e i n f l a t i o n targets a n d t h e i r i m p l i c a t i o n s f o r c u r r e n t m o n e t a r y p o l i c y a n d t h e Federal Reserve's g e n e r a l p o l i c y strategy. A g a i n , this r e p o r t w o u l d focus a t t e n t i o n o n t h e n e e d t o p l a n m o n e t a r y p o l i c y over a l o n g h o r i ­ zon. E n g a g i n g m e m b e r s o f Congress i n these discussions, w i t h t h e m e ­ d i a i n a t t e n d a n c e , w o u l d h e i g h t e n t h e p u b l i c ' s awareness a n d u n d e r ­ s t a n d i n g o f t h e goals a n d i n s t r u m e n t s o f m o n e t a r y policy. F u r t h e r , i t w o u l d p r o v i d e t h e F e d e r a l Reserve w i t h a n o p p o r t u n i t y t o e x p l a i n t o t h e p u b l i c its p o l i c y f r a m e w o r k , t h e r a t i o n a l e f o r its c u r r e n t p o l i c i e s , a n d t h e n e e d f o r a t t e n t i o n t o l o n g - r u n as w e l l as s h o r t - r u n objectives. T h e H u m p h r e y - H a w k i n s l e g i s l a t i o n n o w i n effect appears t o be suffi­ c i e n t l y b r o a d a n d non-specific t o m a k e n e w l e g i s l a t i o n unnecessary t o i m p l e m e n t t h e f r a m e w o r k we have p r o p o s e d h e r e . ( A p a r a l l e l exists w i t h t h e C a n a d i a n i m p l e m e n t a t i o n o f i n f l a t i o n targets, w h i c h w e r e i n s t i t u t e d w i t h o u t m o d i f i c a t i o n s t o t h e B a n k o f C a n a d a A c t . ) Nevertheless, some m o d i f i c a t i o n o f H u m p h r e y - H a w k i n s w o u l d p r o b a b l y b e useful. T h e A c t sets several goals f o r m o n e t a r y policy, i n c l u d i n g h i g h e c o n o m i c g r o w t h , l o w u n e m p l o y m e n t , a n d p r i c e stability; m i s s i n g , however, is any specific r e f e r e n c e t o t h e t i m e f r a m e i n w h i c h these goals are t o be r e a c h e d o r t o t h e i r o r d e r o f p r i o r i t y . O n e m i g h t argue, f o r e x a m p l e , t h a t a focus o n l o n g - r u n p r i c e stability is consistent w i t h H u m p h r e y - H a w k i n s , because p r i c e stability p r o m o t e s h i g h rates o f e c o n o m i c g r o w t h a n d e m p l o y m e n t i n t h e l o n g r u n . I t does n o t always p r o m o t e " m a x i m u m e m p l o y m e n t " i n t h e s h o r t r u n , however, w h i c h m i g h t l e a d some t o i n t e r p r e t i n f l a t i o n t a r g e t i n g as i n c o n s i s t e n t w i t h t h e A c t . I t w o u l d be desirable t o m o d i f y the H u m p h r e y - H a w k i n s legislation i n the d i r e c t i o n o f the Maastricht Treaty, w h i c h specifies t h a t p r i c e stability is t h e o v e r r i d i n g l o n g - r u n o b ­ j e c t i v e o f m o n e t a r y policy, b u t also m a n d a t e s a t t e n t i o n t o o t h e r i m p o r ­ t a n t e c o n o m i c goals, so l o n g as t h e y are consistent w i t h l o n g - r u n p r i c e stability. S u c h m o d i f i c a t i o n s w o u l d clarify t h e r o l e o f p r i c e stability i n the conduct o f monetary policy and w o u l d provide a sounder founda­ t i o n for the inflation-targeting framework. A n o t h e r p r o b l e m w i t h t h e H u m p h r e y - H a w k i n s l e g i s l a t i o n is t h a t i t r e q u i r e s t h e F e d e r a l Reserve t o set targets f o r t h e g r o w t h o f t h e m o n ­ etary aggregates a n d t h e n t o r e p o r t t o Congress o n its success i n meet­ i n g those targets. Because o f t h e b r e a k d o w n o f t h e r e l a t i o n s h i p b e t w e e n m o n e t a r y aggregates a n d n o m i n a l s p e n d i n g a n d i n f l a t i o n i n t h e 1980s, however, this focus o n m o n e t a r y t a r g e t i n g i n t h e U n i t e d States is n o w obsolete a n d is w i d e l y i g n o r e d b o t h i n s i d e a n d o u t s i d e t h e F e d e r a l Re­ serve System. I n d e e d , i n t h e H u m p h r e y - H a w k i n s t e s t i m o n y i n J u l y 1993, C h a i r m a n G r e e n s p a n i n d i c a t e d t h a t the Federal Reserve w o u l d n o l o n g e r

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use m o n e t a r y targets as guides f o r m o n e t a r y policy. T h e references t o m o n e t a r y targets s h o u l d be s t r u c k f r o m H u m p h r e y - H a w k i n s as p a r t o f an overhaul o f that legislation. 9. C o m m u n i c a t i o n T h e m o n e t a r y a u t h o r i t i e s m u s t be a c c o u n t a b l e t o t h e p u b l i c directly, as w e l l as t o t h e g o v e r n m e n t . W i t h o u t p u b l i c s u p p o r t , t h e c e n t r a l b a n k w i l l u l t i m a t e l y fail t o achieve its goals. As o u r case studies i n d i c a t e , cen­ t r a l banks i n i n f l a t i o n - t a r g e t i n g c o u n t r i e s strive m i g h t i l y t o convey t o t h e public what m o n e t a r y policy can a n d cannot d o a n d to e x p l a i n the ratio­ n a l e a n d strategy f o r t h e c o n d u c t o f m o n e t a r y policy. T h e B a n k o f E n ­ g l a n d has b e e n a l e a d e r i n this e f f o r t w i t h its Inflation Report, n o w c o p i e d by m a n y o t h e r c o u n t r i e s . Key features o f t h e Inflation Report i n B r i t a i n are clear a n d accessible w r i t i n g , t h e use o f c o l o r a n d g r a p h i c s , a n d t h e e m p l o y m e n t o f t h e best t e c h n i q u e s o f pedagogy, a l l i n a n e f f o r t t o ex­ p l a i n a n d clarify t o t h e p u b l i c h o w t h e p o l i c y f r a m e w o r k w o r k s . We sug­ gest t h a t t h e F e d e r a l Reserve devote substantial resources t o p r o d u c i n g a similar, r e g u l a r r e p o r t , as w e l l as u s i n g means s u c h as speeches, b r o ­ c h u r e s , e x h i b i t s , a n d videos t o convey its message t o t h e p u b l i c . T h e F e d e r a l Reserve is w e l l p r e p a r e d t o take u p this effort. T h e B o a r d o f G o v e r n o r s a n d t h e d i s t r i c t F e d e r a l Reserve Banks a l l have s u b s t a n t i a l p u b l i c i n f o r m a t i o n d e p a r t m e n t s a n d s i m i l a r resources already i n place. I n d e e d , t h e F e d e r a l Reserve p r o b a b l y c o u l d d o a b e t t e r j o b o f c o m m u n i ­ c a t i n g w i t h t h e p u b l i c t h a n o t h e r i n f l a t i o n - t a r g e t i n g c e n t r a l banks whose resources are far m o r e l i m i t e d .

Inflation Targeting in the European Monetary Union F o r t h e E u r o p e a n M o n e t a r y U n i o n ( E M U ) t o a d o p t i n f l a t i o n target­ i n g w o u l d n o t be a r a d i c a l step. M a n y o f t h e f u n d a m e n t a l s o f i n f l a t i o n t a r g e t i n g have b e e n c o d i f i e d i n t h e M a a s t r i c h t Treaty a n d have b e e n stated i n p o s i t i o n papers p u b l i s h e d b y t h e E u r o p e a n M o n e t a r y I n s t i t u t e , t h e p r e c u r s o r t o t h e E u r o p e a n C e n t r a l B a n k . T h e M a a s t r i c h t T r e a t y cre­ ates a n i n s t i t u t i o n a l c o m m i t m e n t t o p r i c e stability by m a n d a t i n g t h a t i t be t h e p r i m a r y l o n g - r u n objective o f m o n e t a r y policy. M o r e o v e r , t h e E u ­ r o p e a n M o n e t a r y I n s t i t u t e (1997, p . 3) has issued t h e f o l l o w i n g g u i d i n g p r i n c i p l e s f o r m o n e t a r y p o l i c y strategy: •

Effectiveness: T h e strategy s h o u l d be effective i n t h e p u r s u i t o f t h e final objective [ p r i c e s t a b i l i t y ] .

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A c c o u n t a b i l i t y : T h e strategy s h o u l d i n v o l v e t h e f o r m u l a t i o n a n d a n n o u n c e m e n t o f targets so t h a t t h e c e n t r a l b a n k c a n be h e l d ac­ c o u n t a b l e t o t h e p u b l i c f o r its actions.

•

Transparency: T h e process o f setting targets a n d o f m a k i n g deci­ sions o n t h e basis o f the strategy s h o u l d be m a d e clear t o t h e p u b l i c .

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M e d i u m - T e r m O r i e n t a t i o n : T h e strategy s h o u l d be able t o d e l i v e r its final objective over t h e m e d i u m t e r m , t h e r e b y p r o v i d i n g a n an­ c h o r t o i n f l a t i o n e x p e c t a t i o n s , b u t nevertheless p r o v i d e t h e cen­ t r a l b a n k w i t h some d i s c r e t i o n i n response t o s h o r t - t e r m d e v i a t i o n s f r o m t h e target.

•

C o n t i n u i t y : T h e strategy o f t h e E u r o p e a n System o f C e n t r a l Banks [ESCB] should b u i l d o n the experience gained by p a r t i c i p a t i n g n a t i o n a l c e n t r a l banks b e f o r e t h e start o f Stage T h r e e ( w h e n t h e E u r o p e a n M o n e t a r y U n i o n a n d t h e ESCB c o m e i n t o e x i s t e n c e ) .

•

Consistency w i t h t h e I n d e p e n d e n c e o f t h e ESCB: T h e strategy m u s t be consistent w i t h t h e i n d e p e n d e n t status g r a n t e d t o t h e ESCB by t h e treaty a n d s h o u l d s u p p o r t i t as far as possible.

A l t h o u g h these p r i n c i p l e s are f u l l y consistent w i t h i n f l a t i o n target­ i n g , t h e y are consistent w i t h o t h e r a p p r o a c h e s as w e l l , n o t a b l y m o n e t a r y t a r g e t i n g as c u r r e n t l y p r a c t i c e d i n G e r m a n y , t h e a n c h o r c o u n t r y f o r t h e E u r o p e a n E x c h a n g e Rate M e c h a n i s m ( E R M ) . I n d e e d , as t h e E u r o p e a n M o n e t a r y I n s t i t u t e has e m p h a s i z e d , "differences b e t w e e n m o n e t a r y a n d i n f l a t i o n t a r g e t i n g strategies are n o t o v e r w h e l m i n g " (Ibid., p . 6 ) . T h e d i f f e r e n c e b e t w e e n t h e two strategies, as actually p r a c t i c e d , lies p r i m a ­ r i l y i n t h e d e g r e e o f emphasis p l a c e d o n m o n e t a r y aggregates i n f o r m u ­ lating monetary policy a n d i n c o m m u n i c a t i n g w i t h the public. A l t h o u g h t h e E M I has t a k e n a b a l a n c e d p o s i t i o n o n t h e t w o strategies, we believe that the European Monetary U n i o n should adopt inflation targeting r a t h e r t h a n m o n e t a r y t a r g e t i n g . We n o w o u t l i n e a p r o p o s a l f o r i n f l a t i o n targeting i n the E M U .

A Proposal for Inflation Targeting in the European Monetary Union Because t h e stage o f d e v e l o p m e n t a n d t h e s t r u c t u r e o f m o n e y a n d capi­ tal m a r k e t s o f t h e c o u n t r i e s t h a t w i l l m a k e u p t h e E u r o p e a n M o n e t a r y

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U n i o n are s i m i l a r t o those o f t h e U n i t e d States, m o s t o f t h e r e c o m m e n ­ d a t i o n s i n t h e U . S . p r o p o s a l a p p l y t o t h e E M U as w e l l . 1. W e r e c o m m e n d a l o n g - r u n C P I i n f l a t i o n g o a l f o r t h e E M U o f slightly above (say o n e p e r c e n t a g e p o i n t ) t h e consensus estimate o f t h e u p w a r d m e a s u r e m e n t bias i n i n f l a t i o n . 2.

T h e i n f l a t i o n target s h o u l d be a n n o u n c e d o n c e a year a n d s h o u l d be a l l o w e d t o vary over t i m e . I n p a r t i c u l a r , g r a d u a l a d j u s t m e n t o f t h e s h o r t - r u n targets t o w a r d t h e l o n g - r u n g o a l s h o u l d be per­ m i t t e d t o m o d e r a t e t h e o u t p u t a n d e m p l o y m e n t effects o f d i s i n ­ flationary policies.

3.

T h e h o r i z o n f o r t h e i n f l a t i o n t a r g e t s h o u l d r e f l e c t t h e lags i n t h e effects o f m o n e t a r y policy, w h i c h m a y d i f f e r f r o m those o b ­ served i n t h e U n i t e d States. T h e l a g o f p o l i c y m a y also d e p e n d o n w h i c h c o u n t r i e s e n t e r t h e E u r o p e a n M o n e t a r y U n i o n , since t h a t w i l l d e t e r m i n e h o w l a r g e a n d o p e n t o t r a d e t h e single-cur­ r e n c y area w i l l be. T h e E u r o p e a n M o n e t a r y I n s t i t u t e is c u r r e n t l y s t u d y i n g p o l i c y lags i n t h e c o u n t r i e s t h a t are l i k e l y t o j o i n t h e E M U , as w e l l as a n a l y z i n g h o w m o n e t a r y i n t e g r a t i o n s h o u l d be e x p e c t e d t o affect those lags.

4.

T h e i n f l a t i o n target s h o u l d be a p o i n t target, r a t h e r t h a n a range, w i t h the u n c e r t a i n t y s u r r o u n d i n g such a target b e i n g clearly c o m ­ m u n i c a t e d to the public. T h e uncertainty i n p r e d i c t i n g a n d con­ t r o l l i n g i n f l a t i o n i n E u r o p e m a y d i f f e r substantially f r o m t h a t i n t h e U n i t e d States.

5.

I n f l a t i o n o u t c o m e s b e l o w t h e i n f l a t i o n target s h o u l d be c o n s i d ­ e r e d as d a m a g i n g as o u t c o m e s above t h e i n f l a t i o n target, ex­ c e p t w h e n e c o n o m i c d e v e l o p m e n t s (such as favorable s u p p l y shocks) j u s t i f y l o w e r i n f l a t i o n .

6.

T h e p r i c e i n d e x u s e d t o specify t h e i n f l a t i o n t a r g e t s h o u l d be a "core"-type C P I f r o m w h i c h t h e prices o f f o o d , energy, a n d o t h e r v o l a t i l e items w o u l d be e x c l u d e d . I n p a r t i c u l a r , t h e i n d e x s h o u l d e x c l u d e the d i r e c t effects o f variations i n m o r t g a g e i n t e r e s t rates.

7.

T h e E u r o p e a n C e n t r a l B a n k s h o u l d issue a n Inflation Report at r e g u l a r intervals a n d s h o u l d seize o n every o p p o r t u n i t y t o i n ­ f o r m t h e p u b l i c o f c u r r e n t i n f l a t i o n d e v e l o p m e n t s , t h e ease o r tightness o f c u r r e n t m o n e t a r y policy, a n d t h e Bank's l o n g e r - r u n strategy f o r m e e t i n g its i n f l a t i o n targets.

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8. I n f l a t i o n a n d i n f l a t i o n targets s h o u l d be t h e c e n t r a l consider­ a t i o n i n discussions a b o u t m o n e t a r y policy. T h e m o n e t a r y ag­ gregates s h o u l d have n o special r o l e i n f o r m u l a t i n g o r e x p l a i n ­ i n g m o n e t a r y policy. 9. As r e q u i r e d by t h e M a a s t r i c h t Treaty, t h e E u r o p e a n C e n t r a l B a n k is t o be g o a l - i n d e p e n d e n t ; t h a t is, i t is solely r e s p o n s i b l e f o r set­ t i n g i n f l a t i o n targets. H o w e v e r , s o m e m e c h a n i s m s h o u l d be de­ vised f o r c o n s u l t a t i o n w i t h g o v e r n m e n t a l b o d i e s i n s e t t i n g those targets. 10. U n d e r t h e M a a s t r i c h t Treaty, t h e P r e s i d e n t o f t h e E u r o p e a n C e n t r a l B a n k is r e q u i r e d t o testify o n c e a year t o t h e E u r o p e a n P a r l i a m e n t o n t h e B a n k ' s success o r f a i l u r e i n a c h i e v i n g i n f l a ­ t i o n targets. W e p r o p o s e t h a t representatives o f t h e E u r o p e a n C e n t r a l B a n k also a p p e a r p e r i o d i c a l l y b e f o r e t h e n a t i o n a l par­ liaments o f the E M U countries. T h e first seven e l e m e n t s o f o u r p r o p o s a l are essentially t h e same as those p r o p o s e d f o r t h e U n i t e d States. T h e last t h r e e e l e m e n t s , however, raise issues t h a t r e q u i r e f u r t h e r c o m m e n t . 8. T h e R o l e o f M o n e t a r y Aggregates M o n e t a r y t a r g e t i n g has b e e n suggested as a n a l t e r n a t i v e t o i n f l a t i o n targeting for the European Monetary U n i o n . Supporters o f monetary t a r g e t i n g p o i n t o u t t h a t G e r m a n y a n d S w i t z e r l a n d have u s e d this ap­ p r o a c h successfully t o c o n t r o l i n f l a t i o n over a substantial p e r i o d o f t i m e . T h e y a r g u e t h a t b y a d o p t i n g t h e same strategy, t h e E u r o p e a n C e n t r a l B a n k w i l l be able to i n h e r i t some o f the Bundesbank's credibility. T h i s v i e w has b e e n e x p r e s s e d b y t h e E u r o p e a n M o n e t a r y I n s t i t u t e [ 1 9 9 7 , p. 11]: the adoption o f monetary targeting i n Stage Three [ o f the unification pro­ cess] would offer the advantage o f ensuring continuity with the strategy o f the E U central bank which has performed an anchor function i n the ERM, i n view o f its long-term track record o f fighting inflation. Following a m o n ­ etary targeting strategy m i g h t therefore help the ESCB to i n h e r i t credibility from the start o f its operations. A l t h o u g h t h i s a r g u m e n t is n o t w i t h o u t m e r i t , i t d o e s n o t c o n v i n c e us t h a t m o n e t a r y t a r g e t i n g s h o u l d b e c h o s e n as t h e basic m o n e t a r y p o l i c y strategy f o r t h e E u r o p e a n C e n t r a l B a n k . T h e r e are several reasons.

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First, as we n o t e d i n t h e p r e c e d i n g chapter, m o n e t a r y aggregates are n o t a p a r t i c u l a r l y useful g u i d e f o r m o n e t a r y p o l i c y unless t h e r e l a t i o n ­ s h i p b e t w e e n m o n e t a r y aggregates a n d i n f l a t i o n is s t r o n g a n d r e l i a b l e . A stable r e l a t i o n s h i p b e t w e e n m o n e y a n d i n f l a t i o n is, i n fact, u n l i k e l y t o exist i n t h e fledgling E M U , since this r e l a t i o n s h i p has never b e e n par­ ticularly reliable i n most o f the constituent countries o f the U n i o n , i n ­ c l u d i n g G e r m a n y (Estrella a n d M i s h k i n , 1 9 9 7 ) . As we saw i n C h a p t e r 4, t h e B u n d e s b a n k has n o t b e e n u n a w a r e o f t h e i n s t a b i l i t y o f t h e m o n e y i n f l a t i o n r e l a t i o n s h i p , w h i c h helps t o e x p l a i n w h y i t has b e e n w i l l i n g t o t o l e r a t e misses o f its m o n e y - g r o w t h t a r g e t r a n g e i n m o r e t h a n h a l f o f t h e years f o r w h i c h targets have b e e n set. F u r t h e r m o r e , t h e c r e a t i o n o f t h e E u r o p e a n M o n e t a r y U n i o n a n d t h e ESCB at t h e start o f Stage T h r e e , t o g e t h e r w i t h o n g o i n g f i n a n c i a l d e r e g u l a t i o n a n d i n n o v a t i o n , w i l l cause m a j o r changes i n t h e o p e r a t i o n o f t h e E u r o p e a n f i n a n c i a l system i n c o m ­ i n g years. T h o s e changes w i l l affect m o n e y a n d asset d e m a n d s i n u n p r e ­ d i c t a b l e ways, m a k i n g i t l i k e l y t h a t t h e r e l a t i o n s h i p b e t w e e n m o n e t a r y aggregates a n d i n f l a t i o n i n t h e u n i o n as a w h o l e w i l l be even m o r e u n ­ stable t h a n i t has b e e n i n t h e i n d i v i d u a l m e m b e r c o u n t r i e s . T h e second objection to the a d o p t i o n o f monetary targeting by the E u r o p e a n M o n e t a r y U n i o n is t h a t m o n e t a r y targets are l i k e l y t o p r o v e a less effective v e h i c l e o f c o m m u n i c a t i o n f o r t h e E M U t h a n t h e y have f o r p r e - U n i o n G e r m a n y a n d S w i t z e r l a n d . I n o u r view, t h e B u n d e s b a n k a n d t h e Swiss N a t i o n a l B a n k have b u i l t t h e i r a n t i - i n f l a t i o n a r y r e p u t a t i o n s despite t h e i r use o f m o n e t a r y t a r g e t i n g . I n d e e d , t h e f r e q u e n t target misses i n those c o u n t r i e s have typically b e e n j u s t i f i e d by reference t o a n n o u n c e d i n f l a t i o n goals a n d i n f l a t i o n t r e n d s , s h o w i n g t h a t G e r m a n y a n d Switzer­ l a n d have f o l l o w e d w h a t is, f o r m o s t p r a c t i c a l purposes, a n i n f l a t i o n t a r g e t i n g strategy. M a s q u e r a d i n g t h e i r a p p r o a c h as a m o n e t a r y target­ i n g strategy has h a d some costs i n t e r m s o f r e d u c e d c o h e r e n c e a n d trans­ p a r e n c y o f policy, b u t these costs have b e e n m i t i g a t e d b y t h e c l a r i t y o f t h e e x p l a n a t i o n s e m a n a t i n g f r o m t h e B u n d e s b a n k a n d t h e Swiss N a t i o n a l B a n k , a n d by t h e fact t h a t t h e p o l i c y f r a m e w o r k i n c l u d e s a s t a t e m e n t o f t h e l o n g - r u n i n f l a t i o n g o a l a n d r e g u l a r evaluations o f t h e progress be­ ing made toward that goal. T h e ( i n c o r r e c t ) c l a i m t h a t m o n e t a r y t a r g e t i n g was t h e f u n d a m e n t a l r e a s o n f o r success i n these t w o c o u n t r i e s , however, is p r o v i n g destructive i n c u r r e n t discussions a b o u t t h e c h o i c e o f strategy f o r t h e nascent E u r o ­ p e a n C e n t r a l B a n k . M o n e t a r y t a r g e t i n g was serviceable i n G e r m a n y a n d S w i t z e r l a n d because o f p u b l i c u n d e r s t a n d i n g , a n d s t r o n g s u p p o r t for, t h e a n t i - i n f l a t i o n a r y focus o f t h e t w o c e n t r a l banks. T h e n e w E u r o p e a n C e n t r a l B a n k has n e i t h e r t h e a n t i - i n f l a t i o n c r e d i b i l i t y n o r t h e u n i f i e d

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p o l i t i c a l c o n s t i t u e n c y o f t h e B u n d e s b a n k a n d Swiss N a t i o n a l B a n k . Miss­ i n g a n n o u n c e d targets f o r m o n e y g r o w t h m a y thus b e far m o r e p r o b ­ l e m a t i c f o r t h e E u r o p e a n C e n t r a l B a n k , because t h e p u b l i c w i l l be less w i l l i n g t o accept at face value t h e ECB's e x p l a n a t i o n s f o r these misses a n d its d e c l a r a t i o n s o f a n t i - i n f l a t i o n a r y d e t e r m i n a t i o n . F u r t h e r m o r e , i n m a n y E u r o p e a n c o u n t r i e s , t h e p u b l i c w i l l have h a d n o e x p e r i e n c e w i t h a m o n e t a r y p o l i c y f o c u s e d o n m o n e t a r y aggregates, a n d t h u s m a y f i n d t h e targets h a r d e r t o u n d e r s t a n d a n d less r e l e v a n t t o t h e i r d a i l y lives t h a n targets f o r i n f l a t i o n . Because a key e l e m e n t o f any successful t a r g e t i n g strategy is t r a n s p a r e n c y a n d effective c o m m u n i c a t i o n w i t h t h e p u b l i c , t h e b e t t e r a p p r o a c h f o r t h e E C B w o u l d be t o d o w n g r a d e t h e a t t e n t i o n to m o n e t a r y aggregates a n d p u t i n f l a t i o n targets at t h e f o r e f r o n t instead. ( O f course, t o t h e e x t e n t t h a t m o n e t a r y aggregates d o p r o v e useful as i n f o r m a t i o n variables, t h e r e w o u l d be n o o b j e c t i o n t o u s i n g t h e m i n t h a t capacity.) I f t h e E C B chooses t o a d o p t a n i n f l a t i o n - t a r g e t i n g a p p r o a c h , i t m i g h t w e l l c o n c e n t r a t e o n e d u c a t i n g t h e p u b l i c t o r e c o g n i z e t h a t this a p p r o a c h is q u i t e consistent w i t h t h e m o n e t a r y t a r g e t i n g a p p r o a c h f o l l o w e d b y t h e p r e - U n i o n B u n d e s b a n k . T h e t w o a p p r o a c h e s have several characteris­ tics i n c o m m o n , i n c l u d i n g : a c o m m i t m e n t t o p r i c e stability; t h e specifi­ c a t i o n o f n u m e r i c a l i n f l a t i o n goals ( b o t h i n t h e m e d i u m t e r m a n d t h e l o n g t e r m ) ; a c c o u n t a b i l i t y o f t h e c e n t r a l b a n k f o r m e e t i n g t h e goals; transparency o f p o l i c y a n d effective c o m m u n i c a t i o n w i t h t h e p u b l i c ; a f o r w a r d - l o o k i n g a p p r o a c h t h a t takes i n t o a c c o u n t t h e lags i n h e r e n t i n m o n e t a r y p o l i c y ; a n d flexibility t o r e s p o n d t o s h o r t - r u n e c o n o m i c devel­ opments. I n short, i n practice an inflation-targeting E u r o p e a n Central B a n k w o u l d f u n c t i o n very m u c h l i k e t h e m o n e y - t a r g e t i n g B u n d e s b a n k , a n d t h e p u b l i c s h o u l d be h e l p e d t o u n d e r s t a n d this basic c o n t i n u i t y . T h e differences t h a t e x i s t — n o t a b l y , t h e de-emphasis o n m o n e y g r o w t h as a n i n f l a t i o n forecaster u n d e r i n f l a t i o n t a r g e t i n g — f a v o r t h e i n f l a t i o n targeting approach. 9. C o n s u l t a t i o n i n t h e S e t t i n g o f I n f l a t i o n Targets Because t h e M a a s t r i c h t Treaty gives t h e E u r o p e a n C e n t r a l B a n k g o a l i n d e p e n d e n c e as w e l l as i n s t r u m e n t i n d e p e n d e n c e , c o n s u l t a t i o n w i t h t h e g o v e r n m e n t is n o t a n o p t i o n f o r t h e E u r o p e a n M o n e t a r y U n i o n . Indeed, according goal independence to the E u r o p e a n Central Bank m a y have b e e n u n a v o i d a b l e , at least at t h e outset, since t h e r e l a t i o n o f the European Parliament to the parliaments i n the countries that will m a k e u p t h e E M U has n o t yet b e e n c l a r i f i e d ; thus i t is n o t clear w h a t g o v e r n m e n t a l agency, o t h e r t h a n t h e E C B itself, c o u l d be g i v e n t h e au-

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t h o r i t y t o set i n f l a t i o n targets f o r E M U . S t i l l , some m e c h a n i s m f o r c o n ­ sultation between the E C B a n d the constituent governments s h o u l d be developed. E n a b l i n g the national governments to participate i n the setting o f i n f l a t i o n targets w o u l d y i e l d several benefits. First, i t w o u l d k e e p t h e E u r o p e a n C e n t r a l B a n k f r o m b e i n g v i e w e d as a n o n - d e m o c r a t i c i n s t i t u ­ t i o n i n d i f f e r e n t t o t h e c o n c e r n s o f t h e p u b l i c , h e l p i n g t o preserve its independence i n the l o n g r u n . Second, having the governments partici­ p a t e i n s e t t i n g i n f l a t i o n targets w o u l d h e l p focus t h e p o l i t i c a l d e b a t e o n m o n e t a r y p o l i c y w i t h i n t h e u n i o n o n l o n g - r u n issues, such as p r i c e sta­ bility, rather t h a n o n the "need" for short-run m o n e t a r y stimulus, w h i c h p o l i t i c i a n s t e n d t o believe always exists. T h i r d , a l l o w i n g t h e g o v e r n m e n t s t o take p a r t i n t h e i n f l a t i o n - t a r g e t i n g process w o u l d t e n d t o sensitize t h e m t o t h e fact t h a t large increases i n p u b l i c sector wages o r u n d u l y e x p a n s i o n a r y fiscal p o l i c i e s m i g h t i n t e r f e r e w i t h t h e a c h i e v e m e n t o f t h e u n i o n ' s i n f l a t i o n targets. Because fiscal deficits i n E u r o p e are a l r e a d y l a r g e , a n d because f o r d e m o g r a p h i c reasons p u b l i c - p e n s i o n o b l i g a t i o n s are l i k e l y t o b e relatively h i g h e r i n E u r o p e i n c o m i n g years t h a n even i n t h e U n i t e d States, t h e n e e d f o r d i s c i p l i n e d fiscal p o l i c y i n t h e E M U is urgent. 10.

Accountability

W i t h i n i n d i v i d u a l c o u n t r i e s , n u m e r i c a l i n f l a t i o n targets increase t h e c e n t r a l b a n k ' s a c c o u n t a b i l i t y by p r o v i d i n g e x p l i c i t objectives t h a t m a k e i t easier t o evaluate t h e b a n k ' s p e r f o r m a n c e . H o w e v e r , a c c o u n t a b i l i t y o f t h e E u r o p e a n C e n t r a l B a n k m a y be m o r e d i f f i c u l t t o achieve because t h e statutes o f t h e E u r o p e a n System o f C e n t r a l Banks c a n n o t be c h a n g e d b y l e g i s l a t i o n , b u t o n l y by a l t e r a t i o n s i n t h e M a a s t r i c h t Treaty. M o r e o v e r , i t is n o t clear t o w h o m t h e E u r o p e a n C e n t r a l B a n k w o u l d be a c c o u n t ­ able. A l t h o u g h t h e P r e s i d e n t o f t h e E C B is r e q u i r e d t o testify o n c e a year t o t h e E u r o p e a n P a r l i a m e n t , this r e q u i r e m e n t m a y n o t g u a r a n t e e suffi­ c i e n t o v e r s i g h t o f E C B p o l i c i e s . Since t h e E u r o p e a n P a r l i a m e n t is cur­ r e n t l y less p o w e r f u l t h a n t h e n a t i o n a l p a r l i a m e n t s o f t h e c o u n t r i e s t h a t m a k e u p t h e u n i o n , s c r u t i n y by t h a t o r g a n i z a t i o n w o u l d n o t i n f l u e n c e E C B b e h a v i o r as s t r o n g l y as w o u l d o v e r s i g h t b y a m o r e p o w e r f u l body, s u c h as a c o n s o r t i u m o f n a t i o n a l p a r l i a m e n t s , o r t h e i n d i v i d u a l p a r l i a ­ m e n t s themselves. I n fact, t h e a c c o u n t a b i l i t y o f t h e E u r o p e a n C e n t r a l B a n k u n d e r t h e M a a s t r i c h t T r e a t y seems i n s u f f i c i e n t . T h e E C B s h o u l d be r e q u i r e d t o j u s t i f y its p o l i c y actions t h r o u g h p e r i o d i c testimony, n o t o n l y i n t h e E u ­ r o p e a n Parliament, b u t i n the national parliaments o f the E M U coun-

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tries as w e l l . Besides i n c r e a s i n g t h e Bank's a c c o u n t a b i l i t y a n d visibility, such t e s t i m o n y w o u l d d e m o n s t r a t e t o t h e p u b l i c i n each E M U c o u n t r y t h a t t h e E C B is a c c o u n t a b l e t o t h e m , as w e l l as t o t h e E M U as a w h o l e , w h i c h w o u l d increase p o p u l a r s u p p o r t f o r t h e B a n k ' s i n d e p e n d e n c e . T h i s t e s t i m o n y w o u l d also p r o v i d e t h e E u r o p e a n C e n t r a l B a n k w i t h a n a d d i t i o n a l p u b l i c f o r u m i n w h i c h t o e x p l a i n its p o l i c y a n d t o emphasize t h e n e e d f o r c e n t r a l b a n k e r s t o a d o p t a l o n g - r u n perspective w h e n m a k ­ i n g p o l i c y decisions. O u r case studies have d e m o n s t r a t e d t h a t t h e a c c o u n t a b i l i t y o f c e n t r a l banks t o t h e p u b l i c is as i m p o r t a n t as its a c c o u n t a b i l i t y t o g o v e r n m e n t . D e s p i t e its g o a l i n d e p e n d e n c e , t h e B u n d e s b a n k has d e v o t e d as m u c h e f f o r t t o p u b l i c o u t r e a c h as have c e n t r a l b a n k s w h o are less i n d e p e n ­ dent. I n taking u p the mantle o f the Bundesbank, the European Central B a n k s h o u l d m a k e a c o n c e r t e d effort t o c o m m u n i c a t e r e g u l a r l y a n d c o m ­ p r e h e n s i v e l y w i t h t h e p u b l i c . T h i s is w h y a n Inflation Report o r s i m i l a r d o c u m e n t s h o u l d be p r o d u c e d b y t h e E u r o p e a n C e n t r a l B a n k , a n d w h y t h e E C B s h o u l d take every o p p o r t u n i t y t o e x p l a i n its p o l i c y actions a n d t h e reasons f o r its focus o n i n f l a t i o n targets a n d p r i c e stability.

Conclusions I n this c h a p t e r we have t r i e d t o m a k e t h e case f o r t h e a d o p t i o n o f i n f l a ­ t i o n t a r g e t i n g by t h e U n i t e d States a n d by t h e E u r o p e a n M o n e t a r y U n i o n . I n f l a t i o n t a r g e t i n g w o u l d h e l p b o t h t h e p u b l i c a n d its p o l i t i c a l leaders t o focus o n w h a t m o n e t a r y p o l i c y c a n d o r a t h e r t h a n o n w h a t i t c a n n o t d o . By i n c r e a s i n g t h e t r a n s p a r e n c y o f m o n e t a r y policy, i t w o u l d also r e d u c e f i n a n c i a l a n d e c o n o m i c u n c e r t a i n t y , t h e r e b y p r o m o t i n g e c o n o m i c effi­ ciency. I t w o u l d h e l p t o d e p e r s o n a l i z e m o n e t a r y p o l i c y a n d m a k e t h e r o l e o f t h e c e n t r a l b a n k m o r e consistent w i t h t h e p r i n c i p l e s o f a d e m o ­ cratic society. Finally, i n f l a t i o n t a r g e t i n g w o u l d also e n h a n c e t h e a b i l i t y o f m o n e t a r y p o l i c y - m a k e r s t o d e a l flexibly w i t h adverse shocks t o t h e e c o n o m y , s u c h as a c o n t r a c t i o n i n aggregate d e m a n d o r a p e r i o d o f f i ­ n a n c i a l instability, w i t h o u t sacrificing t h e l o n g - r a n g e objective o f l o w a n d stable i n f l a t i o n . I n this chapter, we have also o u t l i n e d c o n c r e t e proposals f o r t h e a d o p ­ t i o n o f i n f l a t i o n targets i n t h e U n i t e d States a n d t h e E u r o p e a n M o n ­ etary U n i o n . We believe t h a t n o w is t h e best t i m e t o i m p l e m e n t these o r s i m i l a r proposals. O u r case studies show t h a t t h e p u b l i c is m o s t recep­ tive t o this a p p r o a c h o n c e t h e c e n t r a l b a n k has d e m o n s t r a t e d t h a t i t is capable o f c o n t r o l l i n g i n f l a t i o n a n d t h e p u b l i c has b e c o m e aware o f t h e

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12

benefits t h a t accrue t o a l o w - i n f l a t i o n e c o n o m y . B o t h t h e U n i t e d States a n d E u r o p e are c u r r e n t l y at t h a t p o i n t . F u r t h e r m o r e , because t h e E u r o ­ p e a n C e n t r a l B a n k is a n i n s t i t u t i o n s t a r t i n g f r o m scratch, n o w is t h e t i m e t h a t i t w i l l have t h e greatest flexibility i n c h o o s i n g w h a t m o n e t a r y p o l i c y strategy s h o u l d be p u t i n place. W e are c o n v i n c e d t h a t i n f l a t i o n target­ i n g w o u l d be a h i g h l y successful a p p r o a c h f o r m a k i n g m o n e t a r y p o l i c y i n b o t h t h e E M U a n d t h e U n i t e d States, as i t has already p r o v e d t o be i n a n u m b e r o f countries a r o u n d the w o r l d .

Notes

Chapter 1 Introduction 1. For earlier discussions of experiences with inflation targeting, see Goodhart and Viñals (1994), L e i d e r m a n and Svensson (1995), Haldane (1995), and McCallum (1996), among others. Bernanke and Mishkin (1997) discuss the idea of inflation targeting as a framework for policy, which we will emphasize here, and present some o f the arguments discussed i n more detail i n this book. 2. H.R. 2360, 105th Congress, 1st session; see the language o f Sec. 3(b) (2) (A) i n particular. I n an earlier session of Congress, Senator Connie Mack (R-Fla.) introduced a bill which, i f i t had passed, would have established price stability as the primary goal o f the Fed, effectively forcing the U.S. central bank to adopt inflation targeting [S.R. 1266, 104th Congress, 1st sess.]. 3. European Monetary Institute, 1997, p.2. See also Issing (1996). 4. Eichengreen (1992) presents a detailed account o f the rise and fall o f the gold standard, and o f the contributions o f monetary mismanagement to the Great Depression. Chapter 2 The Rationale for Inflation Targeting 1. The Phillips curve's origin was the work o f A.W. Phillips (1958), who discovered a negative relationship o f wage inflation and unemployment i n a century o f British data. Numerous authors extended Phillips's results to the U n i t e d States and other countries. 2. O f course, large transitory benefits can outweigh small permanent costs. Still, the thrust o f Friedman's conclusion is to reduce the likelihood that activist expansionary policies will be desirable. 3. Indeed, the only rate o f inflation that the public could expect at which there would be no incentive for the central bank to "cheat" by raising inflation still further would be the level of inflation at which the costs of further increases i n inflation outweigh the benefits o f the associated economic stimulus. 4. U n d e r a gold standard, i t is more precise to say that bread's price is measured i n terms o f the local currency, whose own value i n terms o f gold is fixed by the central bank. 5. I t must be admitted that the rhetoric o f some o f the proponents o f inflation targeting has encouraged t h i n k i n g o f this strategy as a rule. 6. McCallum (1995) argues that the central bank can simply choose not to behave myopically, i n which case the public's expectations will come to reflect

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its more farsighted behavior. This would appear to us to be more likely, how­ ever, under some institutional arrangements and policy strategies than others. McCallum also points out that to the extent that policy credibility is a p r o b l e m , it will affect the government as well as the central bank; we agree, for reasons that we discuss below. Chapter 3 Issues of Design and Implementation 1. Rotemberg and Woodford (1997) provide some simulation evidence i n favor o f this argument. 2. This debate is reminiscent o f controversies over the use o f "cones" or "tunnels" i n establishing ranges for money growth. "Cones," which widen over time, were associated with a targeted rate o f money growth with little offsetting of misses; "tunnels," which imply a constant forecast variance for the level o f the money stock, are associated with level money stock targets and greater offset o f target misses. 3. Technically, ensuring only that the i n f l a t i o n rate is stationary may leave a u n i t r o o t i n the price level, so that the forecast variance o f the price level at more and more distant horizons grows w i t h o u t b o u n d . This p r o b l e m is analogous to the issue o f "base d r i f t " i n monetary targeting; see Walsh (1986). 4. However, Svensson (1996) gives examples i n which price-level targeting actually reduces the volatility o f output. The practical relevance o f these ex­ amples is an open question. One factor that bears strongly o n the comparison of inflation and price-level targeting is the persistence of shocks to the economy; highly persistent shocks, which tend to induce a sequence o f target misses i n the same direction, would tend to make price-level targeting particularly costly. Persistence i n price-level measurement errors would tend to have a similar ef­ fect, favoring an inflation target over a price-level target. Chapter 4 German and Swiss Monetary Targeting: Precursors to Inflation Targeting 1. For a brief, contemporary survey o f the adoption o f monetary targets, see Bank for International Settlements (1976), pp. 32-39. Later, in-depth ac­ counts o f the operation o f monetary targeting i n a number o f countries may be found i n Meek (1983) and Bernanke and Mishkin (1992). 2. There still existed some requirement for the Bundesbank to buy curren­ cies participating i n the bloc float, a multilevel arrangement o f exchange rate bands similar to the European Monetary System, which arose some years later. 3. I n a later account, Schiltknecht states, "Before the Governing Board o f the Bank makes its final decision o n the money-stock target, the Government is informed about the intentions o f the Board. However, i t must be emphasized

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that the responsibility for establishing a money-stock target rests solely with the Governing Board." (Schiltknecht 1983, p. 73.) 4. There is no direct reference at the time or i n the reminiscences o f the participants to any exchange between Swiss and German policymakers o n these issues. Whether the conditions surrounding adoption led to roughly one optimal conclusion, or whether there was an explicit meeting o f the minds, is anyone's guess. The similarities of these countries' adoption o f targeting regimes, however, are not seen i n the respective regimes' operating procedures, as discussed below. 5. Neumann (1996) and Clarida and Gertler (1997) argue b o t h points, that the Bundesbank has multiple goals and that i t doesn't strictly target money. Von H ä g e n (1995) and Bernanke and Mihov (1997) focus o n the latter point, while F r i e d m a n (1995) a n d Estrella a n d M i s h k i n (1997) discuss why the Bundesbank m i g h t n o t want to look at M3. 6. Von H ä g e n (1989) and Bernanke and Mishkin (1992) make some sug­ gestions regarding this. 7. The resemblance between this approach and the approach called for i n the EC Council o f Ministers' statement o f October 1972 quoted i n the previous section is almost perfect. 8. See, for example, Deutsche Bundesbank (1981b, October, "Recalcula­ tion o f the Production Potential o f the Federal Republic o f Germany"). 9. The vast variety and depth o f information provided by the Bundesbank i n its Monthly Report and Annual Report w o u l d appear to be evidence that a wide range o f i n f o r m a t i o n variables, far beyond M 3 , velocity, and potential GDP, play a role i n Bundesbank decision-making (the work involved i n pro­ ducing the data and analysis makes i t unlikely that i t is merely a smokescreen or a public service). Nevertheless, monetary-policy moves are always justified with reference to M 3 a n d / o r inflation developments, rather than to these other types o f data. 10. Although, on the other hand, neither is there a disclaimer o f institu­ tional responsibility, as one typically sees o n articles written by Federal Reserve staff for official publications, for example. 11. Swiss National Bank (1994c, December, p. 272). 12. Posen (1995b) argues that German and Swiss support for central bank independence and pursuit o f price stability is consistent with a general ten­ dency for countries with politically effective financial sectors to have greater political support for low inflation. 13. The Bank's more recent response to large terms-of trade shocks will be discussed i n the following section. 14. The issue o f the susceptibility o f M l demand to changes i n exchange rate expectations is analyzed i n Rich (1985, pp. 60-69). 15. The Swiss National Bank also publishes a Monthly Report, which con­ sists largely o f data tables (mostly having to do w i t h the financial system), as well as an Annual Report o n the state o f Switzerland's banks. Except for the short-term forecasts o f SAMB growth published every three months i n the

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Monthly Report since 1991, neither o f these has served the purpose o f report­ i n g o n monetary policy since the publication o f the first issue o f Geld, Währung, und Konjunktur i n 1983. 16. However, neither the Swiss National Bank n o r the Bundesbank explic­ itly discusses private-sector inflation expectations, as many inflation-targeting central banks have done. 17. Actually, i t was the t h i r d year o f four i n a row i n which the 8.0% C B M monetary growth p o i n t target was exceeded by at least a percentage p o i n t (see Bernanke and M i s h k i n [1992, p. 201, Table 4 ] ) . 18. Two more technical developments also suggested the switch from C B M to M3 targets. The first was that m i n i m u m reserve requirements had changed substantially since 1974, so that C B M , c o m p u t e d o n the basis o f 1974 ratios, corresponded less and less to the monetary base and thus to "the extent to which the central bank has provided funds for the banks' money creation." The second was the increasing need to include, for control purposes, new components such as Euro-deposits held by domestic nonbanks, i n some broadly defined money stock. Since these components had never been subject to m i n i ­ m u m reserve requirements, the weight at which they should enter C B M was n o t clear, a p r o b l e m that does n o t exist for an extended definition o f M3. 19. "While officially the question o f the correct exchange rate was still u n ­ der discussion, the German Chancellor announced his decision o n the ex­ change rate without i n f o r m i n g Bundesbank President Karl-Otto Pohl, although they had met only a few hours before" (Hefeker, 1994, p. 383). See Marsh (1992) for a longer historical account. For most East German citizens, per­ sonal assets were converted at the rate o f 1 to 1. However, for larger holdings, a d e c l i n i n g rate o f exchange was employed. 20. We are grateful to O t m a r Issing for emphasizing this shift to us. This change c o u l d be i n t e r p r e t e d as a sign that the Bundesbank expresses greater confidence i n its ability to achieve its desired i n f l a t i o n goal. 2 1 . For two recent examples o f this repeated argument, see Issing (1996) and Schmid (1995). 22. The reason b e h i n d l o w e r i n g the m e d i u m - t e r m target from 2% to 1% was the decline i n the share i n SAMB o f banks' deposits at the Swiss N a t i o n a l Bank f r o m a r o u n d 25% p r i o r to 1988 to 9% to 1 1 % f r o m 1990 o n , as a con­ sequence o f the i n s t i t u t i o n a l changes discussed earlier. Since the i n c o m e elasticity o f banks' deposits is h i g h e r than that o f currency i n c i r c u l a t i o n , the smaller fraction o f the f o r m e r translates i n t o a smaller t r e n d g r o w t h o f SAMB. Chapter 5 New Zealand: Inflation-Targeting Pioneer 1. "The role o f monetary policy under [the new government's] approach is aimed i n the m e d i u m term at achieving suitably moderate and steady rates o f

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growth i n the major monetary aggregates. This is directed ultimately at the i n ­ flation rate, as control over the monetary aggregates is seen as a prerequisite for a lower, more stable rate o f inflation" (Reserve Bank o f New Zealand, 1985a, September, p. 513). 2. Before the passage o f the Reserve Bank o f New Zealand Act o f 1989, the Reserve Bank was ranked comparatively low i n its degree o f independence. See, for example, Alesina and Summers (1993). 3. The problem o f the treatment o f housing costs was addressed i n the beginning o f 1994, when the share o f the index based o n existing dwellings i n the CPI was largely replaced by an index o f the cost o f construction o f new houses. Similar problems i n the treatment o f housing costs were a feature o f the CPI i n the U n i t e d States before 1983. 4. Strictly speaking, the first PTA only allowed for, or required renegotia­ tion of, the Agreement while the second and t h i r d PTAs explicitly required such a response to shocks. 5. We are grateful to Governor Brash for clarifying this point. The exclu­ sion o f the effects o f taxes imposed by local authorities proved impractical given the difficulties o f identifying policy changes at that level. The effect, however, remained potentially quite large, with the movement toward "user-pays pricing" of public services being part o f the broader reforms. 6. This is not simply a matter of who guards the guardian, serious though that may be. "Because the Reserve Bank's estimate o f u n d e r l y i n g inflation re­ lies on j u d g m e n t i n its construction, its validity cannot be directly verified [by outside observers]. I n addition, there is r o o m for disagreement concerning the proper model to be used i n estimating the impact o f one-time shocks" (Spiegel, 1995). The Reserve Bank itself has made note o f this potential conflict of interest and its possible effect on its credibility i n articles i n the Bulletin. 7. Some bank documents, however, have made the contradictory claim that the move to targeting and central bank independence w o u l d be expected to have an effect o n the costs o f disinflation. For example, " i n order to i m ­ prove the prospects o f monetary policy to remain—and be seen to remain— on the track o f low inflation, and thereby help reduce the costs o f disinflation, attention t u r n e d to possible institutional arrangements that w o u l d help i m ­ prove monetary policy credibility" (Lloyd, 1992, p. 208). See Posen (1995a), Hutchison and Walsh (1996), and Chapter 10 for econometric assessments o f this effect. 8. Again, this may be contrasted to the Bundesbank's approach, which does not address the short-run real effects o f monetary policy i n public state­ ments but keeps all responsibility for the t i m i n g o f disinflation w i t h i n the Bundesbank. 9. The article cited here, while signed by Lloyd, n o t only appeared i n the Reserve Bank's Bulletin u n d e r the authoritative title, "The New Zealand A p p r o a c h to Central Bank A u t o n o m y , " b u t parts o f i t also appeared verba­ t i m i n other statements by Reserve Bank officials i n 1992 a n d 1993. Thus i t

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seems reasonable to treat this statement as reflecting the official views o f the Bank. 10. Following the i n t r o d u c t i o n o f the M C I , these assumptions w o u l d trans­ late i n t o an assumed path for the M C I over the forecast h o r i z o n . 11. Regarding financial stability, inflation targeting has an i m p o r t a n t ad­ vantage over an exchange rate peg i n that the inflation targeting approach preserves the ability o f the central bank to act as a lender o f last resort. This o p t i o n is n o t as available i n a fixed-exchange-rate regime, as the Argentinean experience d u r i n g the "tequila crisis" o f 1995 demonstrates (e.g., see M i s h k i n [1997a]). 12. A similar p o i n t about the gap between the perception and the opera­ tional realities o f monetary targeting i n Germany and Switzerland was made i n Chapter 4. 13. See, for example, New Zealand Herald (1990a). 14. See New Zealand Herald (1990b). I t is interesting that, after losing power, the Labour Party (which had instituted the inflation targets and the economic reforms more generally), announced its opposition to the 2% band for the i n ­ flation target. However, i t continued to support keeping the center o f the target atl%. 15. The b i l l rate is indicative o f the stance o f the Reserve Bank's monetary policy, b u t u n l i k e a true policy instrument, i t is n o t directly c o n t r o l l e d by the Bank. I n M a r c h 1997, the Bank discussed m o v i n g to a more directly c o n t r o l l e d instrument rate, b u t decided against such a change i n June. 16. U n t i l December 1993, the Bank's inflation forecasts assumed that the exchange rate would remain constant at the level present at the time o f the forecast. The vindication o f the statement above over the preceding two years led the Bank i n June 1994 to assume from that p o i n t o n an annual appreciation equal to the difference between the trade-weighted inflation forecasts for New Zealand's main trading partners and the m i d p o i n t o f the 0% to 2% target range from June 1994. 17. See, for example, Louisson (1994). 18. We are grateful to Governor Brash for his discussion o f these develop­ ments. 19. I n that election multi-member proportional representation, which had been approved i n a nationwide referendum, replaced majoritarian elections. Proportional representation was largely defended as a way for the public to p u t a brake o n activist programs by the government, o f either the left or right. ( U n ­ der majoritarian parliaments, New Zealand had seen major shifts, such as Labour's "Rogernomics" reforms after 1984, and presumably such shifts w o u l d be less likely i n a more fractured legislature.) The effect o f multiple parties o n inflation rates and fiscal policy (usually held by the economics literature to i n ­ crease the former and loosen the latter) does not seem to have entered the discussions.

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Chapter 6 Canada: Inflation Targets as Tools o f Communication 1. To cite two examples o f the belief i n expectational sluggishness: "There is no doubt that Canadian markets are not at all supportive o f inflationary ac­ tions nowadays. But i t does take time for such reality to have an impact o n mar­ ket behavior, and o n the costs and prices that flow from this behavior" (Crow, 1991, p. 13). A n d , " [ t ] h e lags i n the response o f the Canadian rate o f inflation to changes i n monetary policy have traditionally been long, b o t h as a result o f institutional characteristics . . . and expectational sluggishness" (Freedman, 1994a, p. 21). Moreover, Longworth and Freedman (1995) explain how back­ ward-looking expectations play a significant role i n the current Bank o f Canada forecasting model. 2. See similar statements i n Jenkins (1990), Bank of Canada (1991b, March, pp. 3-21), and Freedman (1994a). 3. The example o f New Zealand was probably n o t yet well established, and it was not acknowledged i n public statements by senior bank officials u n t i l Freed­ man (1994a). 4. Thiessen (1994a, p. 86) makes an almost identical statement o f these two points. 5. "Over longer periods o f time, the measures o f inflation based o n the total CPI and the core CPI tend to follow similar paths. I n the event o f persis­ tent differences between the trends o f the two measures, the Bank w o u l d ad­ j u s t its desired path for core CPI inflation so that total CPI inflation w o u l d come w i t h i n the target range" (Bank o f Canada, 1996c, November, p. 4 ) . 6. " I t is i m p o r t a n t to stress that the objective continues to be the con­ t r o l o f i n f l a t i o n as defined by the total consumer price i n d e x " (Thiessen, 1996b, p . 4 ) . 7. "Accommodating the initial effect o n the price level o f a tax change but n o t any o n g o i n g inflation effects was the approach set o u t with the Febru­ ary 1991 inflation-reduction targets, and restated i n the December 1993 agree­ m e n t [extending the target framework] " (Thiessen, 1994a, p. 82). O f course, unlike the assessment o f differences between core and headline CPI, the as­ sessment o f the size o f a tax increase's impact effect o n prices depends o n an analyst's assumptions. The Bank does publish its own calculations o f the price effects o f tax changes. 8. "The targets continue to be expressed as a range or a band rather than a specific inflation rate because i t is impossible to control inflation precisely" (Thiessen, 1994a, p. 86). 9. "Other sources o f unexpected price increases, which are typically less significant than the three singled out for special attention, will be handled within the one percent band around the targets for reducing inflation" (Bank o f Canada, 1991b, September, p. 4).

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10. This may be due to the fact that, more than any other inflation-targeting country, Canada has had to cope with headline inflation falling below the target or reaching the target ahead o f schedule; and, perhaps as a result, the Bank has faced greater public criticism o f the targets as harmful to the real economy. These challenges are discussed i n the next section. 11. See Thiessen (1994a, p. 89) and Freedman (1994a, p. 20) for examples. 12. This statement makes the assumption that the weakness i n the Cana­ dian economy reflects a gap between output and potential output, rather than a change i n labor or product markets that has increased the "natural" rate o f unemployment. 13. This statement is representative o f the Bank's position. See also, for ex­ ample, Bank o f Canada (1995c, May, p. 3), which states: "The ultimate objective o f Canadian monetary policy is to promote good overall economic performance. Monetary policy can contribute to this goal by preserving confidence i n the value o f money through price stability. I n other words, price stability is a means to an end, n o t an end i n itself." 14. This interpretation o f short-run flexibility was raised i n a different con­ text i n Bernanke and Mishkin (1992). I n a more recent example, i n the Bank o f Canada's Annual Report, 1994, the Bank states that "in late 1994 and early 1995, the persistent weakness o f the dollar began to undermine confidence i n the currency, and the Bank o f Canada took actions to calm and stabilize financial markets" (p. 7); the Annual Report, 1996 lists "promoting the safety and sound­ ness o f Canada's financial system" (p. 4) as the second part o f its section "Our C o m m i t m e n t to Canadians." I n short, the Bank found no inherent conflict be­ tween p r o m o t i n g (within limits) financial stability or more stable output o n one hand and the pursuit o f price stability over the long r u n o n the other. I n its attention to goals other than price stability, the Bank o f Canada is similar to all the central banks we study i n this volume, though perhaps more open about it. 15. "Real"—that is, inflation-indexed—bonds have been issued i n Canada since 1991, following the example o f the United Kingdom. One motive cited for the creation was precisely to obtain a measure o f inflation expectations, which should be closely related i n principle to the difference i n yields between indexed and non-indexed bonds. As the Bank o f Canada itself has pointed out, however, the market for real bonds to date has been relatively small and i l l i q u i d , and the experience with them has been relatively short. Thus, use o f real bonds for measuring inflation expectations is viewed as difficult i n practice. 16. This idea has been picked up since by a number o f other countries and several private-sector forecasting groups as a compact means o f expressing the relative tightness o f monetary policy i n open economies. For a more complete discussion o f the M C I , see Freedman (1994b). 17. Freedman (1995, p. 30) offers the o p i n i o n that "it may well be that [the] most important contribution [ o f the Monetary Policy Reports] will be to signal prospective inflationary pressure and the need for timely policy action, at a time when actual rates o f inflation (which are o f course a lagging indicator) are still

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relatively subdued." This scenario is premised o n Canada's starting from a situ­ ation o f "relatively subdued" inflation pressures, which was the case by 1995. 18. C i t i n g New Zealand, the U n i t e d K i n g d o m , and Sweden, Freedman (1995, pp. 29-30) notes, "These reports, which have b o t h backward-looking and forward-looking perspectives, have received considerable attention and careful scrutiny by the press, the financial markets, and parliamentary com­ mittees." See also Thiessen (1995a, p. 56), who states: "This report w i l l pro­ vide an account o f our stewardship o f monetary policy and w i l l be useful for those who want to know more about monetary policy for their own decision­ making." 19. This move may have seemed necessary after the October 1993 election was fought i n part over the Bank's monetary policy, and Crow eventually de­ cided not to be considered for a second term. The newly elected Liberal Gov­ ernment chose to extend rather than to replace the inflation targets. 20. According to Cukierman's (1992) index o f central bank independence (based o n the banks' formal legal standing), the Bank o f Canada ranks, with the Danish central bank, just below the Federal Reserve i n independence. 21. Laidler and Robson (1993, Chap.9) provide an extensive discussion o f the Bank o f Canada's practical independence and its limits t h r o u g h 1992. 2 2. See Creating Opportunity: The Liberal Plan for Canada, cited i n Crane (1993). 23. The targets were intended to define the path implied by the various actual inflation targets at eighteen-month intervals of 3% by year-end 1992, 2.5% by mid-1994, and 2% by year-end 1995 (all range midpoints). 24. For example, '"the government is betting o n its own inflation targets,' said Toronto-Dominion Bank chief economist Doug Peters, referring to Canada's target o f 2 percent inflation i n 1995" (Szep, 1991). 25. Sacrifice ratios attempt to measure the amount o f real output lost for each p o i n t o f disinflation. 26. See, for example, I p (1991). 27. The academic literature has adopted the term "hysteresis" to describe situations i n which increases i n unemployment arising from transitory causes may tend to become permanent, for reasons such as loss o f skills. Hysteresis has often been cited as a source o f the persistently high unemployment rates ob­ served for nearly two decades i n Western Europe. 28. The committee's formal title was the Standing Committee o n Finance, Subcommittee on the Bank o f Canada, o f the House o f Commons, but i t was called the Manley Committee after its chairman, J o h n Manley. See its report, The Mandate and Governance of the Bank of Canada, February 1992. 29. I t should be noted that, for all the attention central banks' written char­ ters and legal mandates attract, only a few central banks have formal mandates for price stability. N o t only have many inflation targeters—such as Canada, Swe­ den, Australia, and the U n i t e d K i n g d o m — a d o p t e d largely successful inflationtargeting regimes without revision o f their legal mission, but the Bundesbank is the only one o f the three independent central banks with a long-standing sue-

344

NOTES

cessful inflation record that has had such a clearly limited legal mandate (the Swiss National Bank and the U.S. Federal Reserve are the others). 30. The Liberal Party's campaign platform, Creating Opportunity: The Liberal Plan for Canada, included the statements: "Liberals believe that economic poli­ cies must n o t merely attack an individual problem i n isolation from its costs i n other areas.... The Conservatives' single-minded fight against inflation resulted i n deep recession, three years without growth, declining incomes, skyrocketing unemployment, a crisis i n international payments, and the highest combined set o f government deficits i n our history." See Crane (1993). 31. For a sample o f private-sector reactions, see Marotte (1993). 32. For press coverage o f Freedman's speech, see, among others, I p (1993). 33. D u r i n g the period o f an announced downward path for inflation, the emphasis i n the Bank o f Canada's discussion was on the midpoint, whereas once the range o f 1 to 3% range was reached, the emphasis shifted to the bands. We are grateful to Charles Freedman for discussion o f this point. 34. Some press observers characterized the contemporaneous developments i n transparency undertaken by the Bank as reflecting a desire to make the Bank seem more generally accountable rather than identified with a particular indi­ vidual. See, for example, Vardy (1993) and McGillivray (1994). 35. The Bank had explained beforehand that it expected only a temporary blip i n inflation i n 1995 from the depreciation o f the Canadian dollar. The fact that the depreciation d i d not lead to a persistent rise i n inflation, even without a fur­ ther tightening o f monetary conditions, helped build the Bank's credibility. 36. The body o f the Monetary Policy Report states, "Since the last Report, the Canadian economy has been weaker than expected and the degree o f slack i n labor and product markets has been correspondingly greater" (p. 3). A n d later, "Although a slowdown had been anticipated, the Bank was surprised (along with most others) by how abruptly the situation changed" (p. 6). 37. For example, "for the medium-term, a key issue is whether the t r e n d o f inflation m i g h t move below the 1 to 3 percent target range. . . . This i n t u r n would imply an easing i n the desired path o f medium-term monetary conditions" (Bank o f Canada, 1996c, May, p. 3). Governor Thiessen and other officers made similar statements to the press. 38. I n addition to citing Akerlof, Dickens, and Perry (1996), Fortin also gives prominence to James Tobin's discussion o f the macroeconomic significance o f the n o m i n a l wage floor i n his 1971 Presidential Address to the American Eco­ nomic Association (p. 779). 39. See, for example, Crane (1996) and Fortín (1996b) 40. The speech, reprinted i n Thiessen (1996a), was delivered before the Board o f Trade o f Metropolitan Toronto o n November 6, 1996. 41. "However, inflation will work as a lubricant only i f i t fools people into believing that they are better off than they really are. There is, i n fact, every reason to expect that people's behavior adapts to circumstances. I n a low-infla­ t i o n environment, employees are likely to come to understand the need for

NOTES

345

occasional downward adjustments i n wages or benefits" (Thiessen 1996a, pp. 68-9). Note that Thiessen does not assert that such wage flexibility has already occurred or is likely to arise quickly. Chapter 7 United Kingdom: The Central Bank as Counterinflationary Conscience 1. This announcement was made official by the simultaneous delivery o f a letter from the Chancellor to the Chairman o f Parliament's Treasury and Civil Service Committee. 2. Speeches by officials o f the Bank o f Canada i n the late 1980s leading up to that country's adoption o f inflation targets made the same point, and with some o f the same rhetorical spirit. 3. The Bank o f England and the Chancellor were o f course aware o f the innovations i n inflation targeting i n New Zealand and Canada but they avoided mentioning them i n public. Still, the U.K. adoption o f inflation targeting may be thought o f as part o f a larger movement. 4. I n a speech on June 14, 1995, Chancellor Kenneth Clarke (1995) an­ nounced that this objective would be extended indefinitely beyond the next gen­ eral election. Without a change i n the status of the Bank of England, however, the ruling party had no power to b i n d future governments, so the force o f Clarke's statement was unclear. I n late 1996, prior to the spring 1997 election campaign, Labour Party leaders indicated that they would continue the inflation-targeting framework (and the current targets) should they, as expected, win the election. 5. This is akin to the Swiss National Bank's rationale for its p o i n t target for monetary growth. As the Bank o f England's own research suggests, however, i f a target range were truly designed to capture some reasonable confidence inter­ val o f outcomes, given control problems, the range would be too wide for cred­ ibility with the general public. See Haldane and Salmon (1995). 6. See Clarke (1995). Note that the point target does not imply perfor­ mance assessment o n the basis o f a backward-looking average. Instead, the i n ­ flation performance relative to the p o i n t target is explained as the result o f past actions and intervening developments. We are grateful to Mervyn K i n g for clari­ fying this point. 7. The Labour Party's commitment to the inflation target and to greater operational independence for the Bank o f England was made explicit i n the party's election platform. The rapid granting o f independence—the day after Labour took office—nonetheless was a surprise to all observers. 8. The conveying o f this information i n an appropriate way to a nontechni­ cal audience has challenged the staff o f the Inflation Report. Initial efforts to depict the trend path o f inflation with probability "cones" moving out from i t were not widely understood. Recent renderings o f a probability density for fu­ ture inflation with shading from red (most likely) to p i n k (tail o f distribution) appear to have been well received.

346

NOTES

9. The statements quoted represent the Bank's official stance. I n the same issue o f the Quarterly Bulletin, the Bank's "General Assessment" echoes b o t h statements—that "the achievement o f price stability remained the u l t i ­ mate objective o f monetary policy" (p. 355), and that "had the U n i t e d King­ dom r e m a i n e d i n the ERM, i t is quite possible that price stability w o u l d have been achieved d u r i n g the next year. A l t h o u g h clearly desirable i n itself, price stability attained too quickly m i g h t have i n t e n s i f i e d the problems o f do­ mestic debt deflation. Some easing o f policy was, therefore, desirable" (p. 356). 10. A t least, so l o n g as an "optimal" contract for central bankers penaliz­ ing inflation performance alone is n o t i n force. 11. There is now some requirement for the Bank and its senior staff to give testimony to the House o f Commons Treasury Committee o n a regular basis, as opposed to the by-request (though frequent) appearances i n the past. Nonetheless, the record o f these past testimonies—as well as the lack o f i n ­ centives facing backbenchers o n the committee to deviate from respective party leaderships' lines o n monetary policy—suggests that these hearings are u n ­ likely to influence Bank policy significantly. 12. The p o i n t should not be exaggerated, however, since Italy also managed to l i m i t the pass-through effect o f its ERM exit without adopting inflation tar­ gets (see Chapter 10). 13. See, for example, Economist (1994). 14. Svensson (1997a) makes clear the benefits o f having the target o f policy be the monetary policymaker's inflation forecast. 15. The Bank assumes i n its projections that official interest rates will not change and that movements i n the exchange rate will reflect the differential between U.K. short-term interest rates and trade-weighted overseas short-term interest rates. 16. Several British press commentators observed that the May meeting was postponed u n t i l after some local elections had taken place and took this as an indication that a rate hike was coming, since Clarke would not want to imple­ ment his policy the day before the elections. While the Bank-Chancellor meet­ ings are monthly, the exact timing is not systematic, with occasional reschedulings occurring. I n this instance, there was a widespread expectation before the meet­ ing that the Chancellor would agree with the Bank's assessment; his later public overruling o f the Bank, leaving rates unchanged, might be seen as an accommo­ dation to broader Tory political reality, but one that emphasized the economic realities as well. As noted below, the U.K. press tends to look for politicization o f monetary policy. 17. See Clarke (1995). 18. See, for example, Financial Times (1996). I t should be noted that the British press tends to focus on the possibility that business and monetary cycles are governed by political and electoral developments. This is despite the fact that there is little econometric or other evidence to suggest that such cycles are

NOTES

347

operative i n the U n i t e d Kingdom, an open economy with brief election cam­ paigns on short notice.

Chapter 8 Sweden: Searching for a N o m i n a l A n c h o r 1. The Riksbank's Governing Board consists o f eight members, seven o f whom are appointed by Parliament for the duration o f the legislative period (3 years). These seven members appoint the Governor as the eighth member, but the Governor is appointed for five years and is not the Chairman. I f a vote is tied, the Chairman, not the Governor, casts the decisive vote. 2. D u r i n g the 1930s, monetary policy i n Sweden followed a rule to stabilize the price level, a precursor to the monetary-policy strategy considered i n this book. A n account o f this period may be found i n Jonung (1979). 3. The Riksbank's decision to peg the krona to the ECU was part of a broader trend. O n October 22, 1990, Norway adopted a peg to the ECU, and Finland followed suit on June 7, 1991. 4. I n its own account o f the speculative attacks and the ensuing floating o f the krona, the Riksbank mentions all these factors behind the krona's suscepti­ bility. See Sveriges Riksbank (1993a, 1, p.10). 5. The position papers referred to are those published i n Sveriges Riksbank (1992c). 6. See, for example, the discussion i n Svensson (1992), pp. 18-19. Cer­ tainly, for a small, open economy still undergoing the effects of financial liberal­ ization, any form o f monetary target was out o f the question. 7. A detailed account o f the political discussions concerning monetary policy d u r i n g 1993 and 1994 may be found i n Svensson (1995). 8. Berg and Grottheim (1997, pp. 171-175). 9. We are grateful to Claes Berg for discussion o f this point. See Bäckström (1994). 10. Svensson (1997a) argues that inflation targeting should be interpreted as meaning that the central bank is using its inflation forecast as an intermedi­ ate target. 11. The issue o f r e f o r m o f the Riksbank is discussed i n more detail i n Svensson (1995). 12. Berg and Grottheim (1997, pp. 178-180). 13. This discussion is based on, and all relevant quotes are taken from, the summary o f the Committee's report SOU 1993:20. We thank Lars Svensson for providing us with the English version o f the summary. 14. See Berg and Lundkvist (1997) for a detailed examination o f the struc­ tural adaptation o f the Swedish economy to inflation targeting. 15. T h e Riksbank, u n l i k e the Bank o f Canada, does n o t have a m o n ­ etary-conditions i n d e x that weights the effects o f exchange a n d interest

348

NOTES

rate movements i n the economy. However, the influence o f the krona's value o n the economy is never overlooked i n public discussion o f the stance of policy. 16. Sveriges Riksbank (1997b, June, pp. 8-10). I n Chapter 10 we report the results of a similar survey o f a broad sample of targeting and non-targeting coun­ tries. Household expectations o f headline CPI inflation averaged 6% to 7% an­ nually i n the 1980s i n Sweden. Since 1992, those expectations have averaged 2%. Chapter 9 Inflation Targeting in Three Small Open Economies 1. Ben-Bassat states, "About (1986), the Bank o f Israel began setting an inflation target as a basis for monetary policy, without making this public" (BenBassat, 1995, p. 38). 2. Chile also engaged i n a form o f inflation targeting when inflation was at double-digit levels, apparently quite successfully. See Morande and SchmidtHebbel (1997). 3. The economic stabilization program has received considerable academic attention. See, for example, the contributions i n Bruno et al. (1991). 4. See, for example, the results reported i n Table 1 o f Ben-Bassat (1995). 5. Bufman and Leiderman (1997), p. 33. 6. This explicit commitment l i n k i n g the choice o f inflation target to fu­ ture goals o f disinflation represents a sharp change from the initial p e r i o d o f Israeli inflation targets, i n which even government policy-makers interchanged the words "target" and "forecast" i n their discussions. We are grateful to O h a d Bar-Efrat for discussion o f this point. 7. This relationship assumes no change i n the real exchange rate. 8. Quoted i n Offenbacher (1996), p. 6 1 . 9. Bufman and Leiderman (1997), p. 7. 10. Ibid. 11. See, for example, Edey (1997), p. 62. 12. "The motivation [from 1987 to 1989] was a growing discomfort (within and outside the Bank) with the degree o f policy discretion, combined with the recognition that most other OECD countries had succeeded i n getting inflation down: Australia, with inflation n o t far short o f 10 per cent, looked out o f step, a n d there were increasing calls f o r the Bank 'to do something about i t ' " (Grenville, 1997, p. 135). 13. For example, " I n principle, systems with hard-edged bands and commit­ ments to keep inflation continuously within a specified range, as i n New Zealand, can be contrasted with systems such as those of Australia and Finland that focus o n the average rather than the permitted range; however these differences can be easily exaggerated given the presence o f caveats and exclusions i n many sys­ tems" (Edey, 1997, p. 61). 14. Stated more generally, " I n Australia, we d i d not adopt such a hard-edged band, because o f concerns that the resulting discontinuity i n the payoff fune-

NOTES

349

tion m i g h t induce instability i n the instruments o f monetary policy, and further may result i n policy-induced business cycles" (Debelle, 1997, p. 119). 15. As stated i n Laubach and Posen's (1997b) discussion o f the lessons o f Swiss and German monetary targeting (p. 43), "Severely l i m i t i n g a central bank's discretion, the so-called ' b i n d i n g o f hands,' does n o t seem to be a necessary condition for sustained low inflation." 16. "The difference between 2 or 3 per cent inflation o n average and somet h i n g only slightly lower may be non-zero, but i t is hard to believe that i t is quite so crucial. Given that there are costs to reducing inflation further, and that the size o f the additional gains is less certain, a practical course, for the time being, i n Australia is to direct policy towards maintaining the current low but still positive rates o f inflation" (Stevens and Debelle, 1995, p. 87). 17. Edey (1997),p. 62. 18. Chapter 10 discusses the Consensus Forecasts further and uses these data to study the credibility o f several inflation-targeting regimes. 19. The announcement is reprinted i n Banco de España, 1995b, January, pp. 5-13. 20. The English translation o f the Law, from which this and all other quotes are taken, is provided o n the Bank's website—http://www.bde.es 21. Almeida and Goodhart (1998), p. 12. 22. Almeida and Goodhart (1998), p. 20. 23. I n addition to the Inflation Report, the Bank publishes every three months a "Quarterly Report o n the Spanish Economy" i n the Economic Bulletin. This report analyzes recent economic developments i n great detail, b u t i t does not discuss any policy decisions or provide any other forward-looking analyses. Chapter 10 Inflation Targeting: How Successful Has It Been? 1. I n our view, Huh's (1996) apparently similar comparisons are o f apples to oranges. The focus o f his analysis is a comparison o f the experience o f the U n i t e d Kingdom to that o f France—an ERM member which at the time had an overvalued exchange rate and rising policy credibility— and o f the U n i t e d States —a country without a declared n o m i n a l anchor, a different business cycle, and a smaller degree o f openness. 2. See Svensson (1993), A m m e r and Freeman (1995), Freeman and Willis (1995), and H u h (1996). 3. Ball (1994) explores some effects o f labor-market structure o n the sacrifice ratio. Because o f data limitations, we omit this factor i n our analysis. 4. Using alternatively the percent change o f the middle m o n t h o f the quarter or the average o f the inflation rates o f the three months w i t h i n the quarter d i d n o t affect the results strongly. 5. Discrepancies between our results and those i n Ball's Table 5.1 can be due either to differences i n the t i m i n g o f disinflations, or to differences i n the measured output gap for a given episode. W h e n p e r f o r m i n g the exercise o f

350

NOTES

using Ball's episodes and changes i n inflation, our results are almost identical to his, which means that the measured output gaps are not the cause o f the dis­ crepancies. W h e n instead using Ball's episodes, but our own measure o f change i n inflation, there are discrepancies between the ratios o f the order o f magni­ tude o f 0.2 to 0.5. Finally, when we date the disinflationary episodes ourselves using Ball's criteria, we arrive at differences i n the beginning and end dates o f the order o f 1 to 3 quarters. These differences i n episodes have strong effects on the resulting sacrifice ratios. This suggests that Ball computed inflation i n a different way, and therefore identified slightly different episodes. 6. Inflation for New Zealand and Australia was computed using the two Reserve Banks' underlying CPI series; for Canada using CPI excluding food and energy, for the U.K. using RPIX; and for Sweden using CPI excluding indirect taxes and subsidies. Except for New Zealand and Australia, CPI series for all countries are from the BIS. The measure o f resource utilization was either the unemployment rate or residuals from Hodrick-Prescott filtered log GDP (meant to capture the output gap). Except for New Zealand, unemployment and real GDP are from the OECD Main Economic Indicators. Below we will report o n the robustness o f our results with respect to the choice o f resource utilization mea­ sure. The nominal effective exchange rate and the U.S. dollars denominated commodity-price index, excluding energy prices, are from the Bank for Inter­ national Settlements. (Replacing this with an index including energy prices made no difference i n the results.) 7. Since we use these regressions exclusively for obtaining inflation fore­ casts, we do not include any contemporaneous variables o n the right-hand side to avoid simultaneity issues. Neither do we impose a u n i t root o n inflation by restricting the sum o f the coefficients o n lagged inflation to equal one. This prevents us from giving the estimated parameters a structural interpretation. 8. Box-Pierce tests d i d not indicate any autocorrelation i n the residuals at one to 16 lags at the 5% level for any o f the countries, either specification, and either choice o f utilization measure. 9. The major changes to the results reported i n the last paragraphs from choosing the alternative utilization measure are as follows: For New Zealand, the exchange rate is again significant, the significance of past inflation increases, and the output gap enters insignificantly. For Canada, the output gap enters signifi­ cantly, and commodity prices are again included but insignificant. For Australia, neither the exchange rate nor commodity prices are included, and the lags of the output gap are jointly insignificant. For the United Kingdom, the exchange rate is now included i n the regression, but the four lags are jointly insignificant. For Italy, the exchange rate is included and significant, while commodity prices are excluded. For the United States, the output gap enters significantly, and commod­ ity prices are again included but insignificant. Finally, for Germany, lagged inflation enters now highly significantly, while both the output gap and commodity prices are insignificant, and the exchange rate is excluded. Since Swiss unemployment data start only i n 1983, and the Swedish unemployment rate exhibits a break i n the early 1990s, we do not report results for these two countries using unemployment.

NOTES

351

10. Estimates are t h r o u g h 1995:3 for Italy, t h r o u g h 1995:2 for Australia, and t h r o u g h 1995:1 for New Zealand, due to data availability. 11. More precisely, the forecast error o f a M i o r i z o n out-of-sample forecast is a function o f up to the k-th power o f the estimated parameters. 12. The fact that the forecasts are overlapping introduces serial correlation between the forecast error at horizon j from forecast date k and the forecast error at horizon ^-1 from forecast date ß+1 [see Hansen and H o d r i c k (1980)]. The empirical standard deviation o f the forecast errors at a specific h o r i z o n is nevertheless a consistent estimate o f the true standard deviation at this h o r i ­ zon. 13. We discuss (and Figure 10.1 shows) only the results f r o m the forecasts using the basic specification with four lags o f all variables included, since the parsimonious specifications perform less well as forecasting equations. 14. For most countries, using the output gap instead o f the unemployment rate as the utilization measure does n o t have a strong effect o n the results. For Canada, the U n i t e d Kingdom, Italy, the U n i t e d States, and Germany, the re­ spective average forecast errors become 0.38, -1.25, -1.35, -0.14, and -1.20. Ex­ cept for Italy, inflation is even less often outside the one-RMSE band than be­ fore. For Italy, inflation is above the upper band i n three out o f eight quarters. For New Zealand and Australia, using the output gap instead o f the unemploy­ ment rate leads to m u c h higher over-prediction following target adoption. I n New Zealand, inflation is below the lower band d u r i n g the last three quarters, and the average forecast error rises to 4.06%. For Australia, inflation is below the lower band d u r i n g all eight quarters, leading to an average forecast error o f 5.80. These results should be treated with caution, however, as for all countries except the U n i t e d Kingdom, Italy, the U n i t e d States, and Switzerland the out­ p u t gap enters the regression insignificantly, and thus there is effectively no Phillips curve found i n the data. 15. The data o n forecasts are from Consensus Forecasts, a monthly publica­ t i o n by London-based Consensus Economics, Inc. A t the b e g i n n i n g o f each m o n t h , Consensus Economics collects forecasts for a number o f countries for up to 15 economic variables (output, employment, prices, and interest rates, to name a few) from a number o f financial institutions and professional forecast­ ers based i n each country. The number o f institutions polled varies w i t h the size o f the economy (for example, there are 30 respondents from the U n i t e d States, 8 from Italy, and so o n ) . The forecasts for inflation that we utilize i n this section are forecasts for CPI inflation by the end o f the current year and by the end o f the following calendar year. 16. The 3-month interest rate for Germany is the 3-month FIBOR. The avail­ able treasury b i l l series for Germany is from the Bundesbank's operations i n 3m o n t h treasury bills (Bundesschatzwechsel), which were discontinued at the end o f 1995. Besides this fact, the series exhibits the pattern o f l o n g periods o f no change like the Bundesbank's discount and l o m b a r d rates, and therefore does not seem to be a good indicator o f market conditions. The 3-month FIBOR, by contrast, behaves m u c h like the overnight rate, except for a term p r e m i u m .

352

NOTES

17. A m m e r and Freeman (1995) perform a similar exercise. They interpret their results as showing below-predicted GDP growth after targeting, as well as lower inflation and interest rates. Their simulations, however, were based o n data series ending two years before the series presented here. As can be seen i n the simulation results for New Zealand and Canada, GDP growth was initially below predicted values, probably due to disinflationary policies p r i o r to target adoption. Over the whole post-target-adoption period, however, GDP growth rebounds and is at the predicted level o n average. For New Zealand, we use the discount rate rather than the overnight interest rate because i t is the only continuously available series that can be seen as re­ flecting the stance o f monetary policy. Since the late 1980s, the Reserve Bank has been keeping the discount rate 0.9% above the interbank overnight rate. For Sweden and Italy, we smooth out the spike i n their short-term interest rates i n September 1992 by interpolating neighboring values, since the forecasts would otherwise be dominated by these movements and would be meaningless for our purposes. 18. A formal test for structural breaks i n monetary-policy reaction functions has three limitations that prevent its use i n this assessment of inflation targeting's effectiveness: First, the tests would be o f extremely low power given the l i m i t e d time since adoption, even i n New Zealand. Second, the tests would require us to impose a structural model o f monetary policy-making for each country, which is beyond the scope o f this analysis. T h i r d , we are most interested i n qualitative results, while the formal test would provide only a yes/no answer. 19. Country-specific shocks are not the only potential source o f problems for this comparison. Another possible reason why inflation and interest rates c o u l d be l o w e r t h a n forecast w o u l d be the existence o f a w i d e s p r e a d disinflationary trend across many countries over this time period which drove these variables down i n targeters and non-targeters alike. For this reason, we include Australia and Italy i n our comparison. Again, treating Australia as a non-targeting country seems appropriate, given that our forecasts start almost five years p r i o r to the adoption o f an inflation target i n Australia. 20. Clarida, Gali, and Gertler (1998), for example, show that after October 1979, the Federal Reserve became m u c h more serious about fighting inflation, setting its monetary-policy instruments so that upward movements o f inflation led to a rise i n the real federal funds rate, rather than a fall as had occurred before 1979. Chapter 11 What Have We Learned? 1. See Svensson (1997b) for a theoretical demonstration that gradual ad­ j u s t m e n t o f the medium-term inflation target to the long-run goal is o p t i m a l for a policy-maker concerned about b o t h o u t p u t fluctuations and low, stable inflation.

NOTES

353

2. I t should be noted, however, that the relatively long records o f low infla­ tion compiled by Germany, Switzerland, and the U n i t e d States have n o t pro­ duced detectable declines i n the sacrifice ratios i n those countries (Posen [1995a]). 3. This section draws heavily o n Mishkin (1997a). 4. There is a debate about whether speculative attacks can be purely spon­ taneous, self-fulfilling prophecies, or whether there must be some "fundamen­ tal" problem with a country's policies before an attack occurs. The evidence is not clear as to whether countries experiencing attacks i n the past decade had bad policy fundamentals; or, to the extent they d i d , whether these problems were the cause o f the speculative attack. 5. Mishkin (1998) gives additional criticisms o f the use o f exchange-rate pegs i n emerging-market countries. 6. Or, as an official o f the Bank o f Canada reputedly p u t i t , "We d i d n ' t abandon the monetary aggregates; they abandoned us."

Chapter 12 Inflation Targeting for the United States and the European Monetary Union 1. I t is possible that the adoption o f inflation targeting, and the resulting stabilization of inflation expectations, may reduce this range of uncertainty. Clear evidence o n this p o i n t is not yet available, however. 2. I n practice, even central banks that do set inflation goals without formal government approval (Germany and Switzerland being the prime examples) are still not completely goal-independent. Even nominally goal-independent central banks know that choosing policy objectives that are inconsistent w i t h the public's wishes will eventually have serious adverse consequences, because the independence o f the central bank can be modified or taken away at any time through legislation (Posen, 1995b). Indeed, the Bundesbank, despite its reputation for being strongly committed to controlling inflation, has u n t i l re­ cently used a numerical long-run inflation goal o f 2% per year, which is the same as (for example) the m i d p o i n t o f the Canadian inflation target, j o i n t l y set by the Finance Minister and the Bank o f Canada. Thus, what appear to be very different processes for setting the long-run inflation target have led to the same quantitative result, a value for desired inflation which is low but recognizes the dangers to the real economy o f making inflation too low.

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Szep, Jason. 1991. "Canada Plans to Introduce Inflation-Indexed Bonds." Reuters Financial Service, May 28. Tait, Nikki. 1995. "NZ Bank Chief Sticks to Policy." Financial Times, May 3. . 1996. "NZ Deal Gives Rise to Faith and Doubt." Financial Times, December 20. Taylor, J o h n B. 1985. "What Would Nominal GNP Targeting Do to the Business Cycle?" Carnegie-Rochester Conference Series on Public Policy 22: 61-84. Thiessen, Gordon. 1991. "Notes for Remarks by Gordon G. Thiessen, Senior Deputy Governor o f the Bank o f Canada." Bank of Canada Review July: 15-21. . 1994a. "Further Direction for the Bank o f Canada and Monetary Policy." Bank of Canada Review Spring: 85-90. . 1994b. "Opening Statement before the Standing Senate Committee o n Banking, Trade, and Commerce." Bank of Canada Review Spring: 81-90. . 1995a. "Uncertainty and the Transmission o f Monetary Policy i n Canada." The Hermes-Gordon Lecture. Bank of Canada Review Summer: 41-58. . 1995b. "Notes for Remarks by Gordon G. Thiessen, Governor o f the Bank of Canada." Bank of Canada Review Summer: 65-70. . 1996a. "Does Canada Need More Inflation to Grease the Wheels o f the Economy?" Bank of Canada Review Winter: 47-62. .1996b. "Towards a More Transparent and More Credible Monetary Policy." Remarks delivered at the Ecole des Hautes Etudes Commerciales. Vardy, Jill. 1993. "Crow Out, Thiessen I n : New Bank o f Canada Governor W i l l Continue Inflation-Fighting Policies." Financial Post, December 23, p . l . von Hagen, J ü r g e n . 1989. "Monetary Targeting with Exchange Rate Constraints: the Bundesbank i n the 1980s." Federal Reserve Bank of St. Louis Review, 71 (5): 53-69. . 1995. "Inflation and Monetary Targeting i n Germany." I n Leonardo Leiderman and Lars E. O. Svensson, eds., Inflation Targets, L o n d o n : Centre for Economic Policy Research, 107-21. Walsh, Carl E. 1986. " I n Defense o f Base Drift." American Economic Review 76(4 ) : 692-700. Woodford, Michael. 1994. "Nonstandard Indicators for Monetary Policy: Can Their Usefulness Be Judged from Forecasting Regressions?" I n N . Gregory Mankiw, ed., Monetary Policy, Chicago: University o f Chicago Press, 95-115.

Index

accountability of central bank, 296-97; Bank of Canada, 116, 122, 130,132, 144, 344; Bank of Israel, 214, 251; Bundesbank, 61; of central bank in fixed-term targeting, 77; and inflation targeting, 283; inflation­ ary pressures of German monetary union, 74-75; New Zealand, 87, 91, 100102; proposed for EMU, 332-33; pro­ posed for inflation targeting in United States, 324-26; Reserve Bank of Austra­ lia, 219, 251; Spain, 237, 251; Sweden, 186; United Kingdom/Bank of England, 153, 159, 162-63, 169; vs. credibility in New Zealand, 114 accounting to the public, in inflation tar­ geting, 24 adjusted monetary base (AMB), 62 adoption of inflation targeting: in Austra­ lia, 218-23; in Canada, 116-20; in Israel, 205-09; in New Zealand, 87-92; in Spain, 235-40; in Sweden, 174-82; in United Kingdom, 147-53 adoption of monetary targeting, factors in Germany and Switzerland, 43 adjusted monetary base (AMB) and SAMB growth and annual targets 1980-90 in Switzerland (graph), 54 advantages of monetary targeting, 304-05 aggregate demand shocks, and inflation targeting, 292 aggregate shocks, responding to, 35 aggregate supply shocks , 24; vs. aggregate demand shocks, 292 ALP, in Spain, 236-37, 242 alternatives to inflation targeting, 301-07 AMB, see adjusted monetary base analysis of inflation targeting, control group strategy, 252-253; measures used for, 252-54; OECD countries, 252; Phillips-curve equations in, 253; sacri­ fice ratios in, 253 analysis of operational framework in Ger­ many and Switzerland, 56-57

Annual Report: in Australia, 227-228; of Bundesbank, 61, 337; in Canada, 117, 120, 127, 128, 130, 133, 135, 136, 137; in Israel, 212-13; in New Zealand, 101; in Spain, 243; of Swiss National Bank, 338 anti-inflation policy in United Kingdom, 151 approach to study, 7-8 Australia —analysis: lessons from, 250-51; Phillips curve, 226 —central bank: accountability, 251; cash and long-term interest rates i n , 230 (graph); credibility, 222; flexibility, 221; nominal effective exchange rate (graph), 230; transparency of policy in, 205, 251 — communication to public, 225; Annual Report, 227-28; Bulletin, 226-27; Quarterly Report, 227, 232 —GDP growth rates in, 229, 230 (graph), 235 —inflation targeting: adoption of, 218-23; experience under, 228-35; key features of, 203-05; operational framework for in­ flation targeting, 223-38; and price sta­ bility, 221, 222, 224-25; real-side goals in, 226; setting inflation target, 204; "thick point" target in, 204, 223, 224; underly­ ing inflation targeted, 221-22, 230 (graph) —monetary policy: compared with New Zealand, 220-21; critical episode in, 228, 229-32; fiscal consolidation, 205; mon­ etary targeting abandoned, 219 —unemployment in, 226, 229 —wage-bargaining mechanisms in, 204 —wage increases in, 234-35 balancing transparency and flexibility, 26 Ball's sacrifice ratio method, 349

368 Banco de España: and adoption of inflation targeting in Spain, 235-36; credibility of, 239; flexibility of, 240; independence of, 242; and operational framework, 239; and price stability, 204 Bank of Canada Act, 141 Bank of Canada Review, 120 Bank of Canada: accountability, 130, 344; Annual Report, 1993, 136; Annual Report, 1994, 127, 137; credibility, 344; and disinflationary policy of 1980s and early 1990s, 116-17; emphasis on floor and ceiling for inflation, 136; flexibility in, 144; and Governing Council of, 128; government, 129; independence of 134, 343; internal organization of, 128-29; and price stability, 116, 342; rationale for inflation targeting approach, 119; responsibility for meeting targets, 115; short-run goal of, 118; transparency, 344 Bank of England, 158-59; conflict with Chancellor of the Exchequer, 162, 16467, 168, 169; exchange rate index, 161; given operational independence, 169; independence of, 146; inflation forecasts of, 157; lack of goal independence, 170; responsibilities of, 145; subordinate status of, 165 Bank of Israel Law of 1954, 213 Bank of Israel: accountability, 214; credibility of, 206, 209, 217; independence of, 213-14; and inflation targeting, 348; instrument interest rate of, 210; measures of inflation expectations, 212 base drift in monetary targeting, 336 behavior of core inflation, VAR model of, 275-82 benefits of inflation targeting, 298 benefits of low inflation, 16-19 Beveridge curve, in Sweden, 198 bill rate, vs. true policy instruments, in New Zealand, 340 Black Wednesday, effects of: in Sweden, 177; in United Kingdom, 147, 152 bloc float, 336 Boletín Económico, 243 Box-Pierce tests, 350 Bretton Woods system, 304, 305

INDEX

Bretton-Woodsfixed-exchange-rateregime, 43, 51, 174, 304, 305 British Labour Party, and inflation target, 155 British monetary policy under inflation targeting, 159-71 Bulletin; i n Australia, 226-227; i n New Zealand, 89, 90, 100 Bundesbank Act of 1957: Article 3, 45; Section 13, 60; Section 18, 60-62 Bundesbank, 44-51; and 1979 oil supply shock, 70, 72-73; accountability of, 61; central bank money stock (CBM), 45; credibility of, 50, 73; free liquid reserves in, 45; growth of production potential, 58; M3 vs. CBM, 57, 59-60; monetary policy of in 1970s and 1980s, 68-69; normative judgments made by, 58-59; responsibility for monetary expansion, 60; transparency in, 61, 72-73 —and German reunification, 68, 70-72; stance on monetary union in Germany, 71 —communication with public: Federal Gazette, 60; Monthly Report, 61, 337; Annual Report, 61, 337 —price stability in, 45; unavoidable price increases, 58 — targets in: adoption of target range, 59; asymmetrical responses to target misses, 69-70; effect of monetary targeting on wage-setting behavior, 50; horizons for inflation target, 31; information variables used in, 337; problems with M3 target, 75-76; reformulation of target range by, 59; target growth rate derivation, 5759 Canada —analysis: lessons from, 144; Phillips curve, 124; bias in inflation measurement, 121; sacrifice-ratio calculations, 134 —central bank: accountability, 116, 122; credibility, 124; effect of Quebec referendum on sovereignty on interest rates, 138-139; effects of tax increase on CPI, 341; flexibility, 116, 123, 342; inflation expectations in, 126; policy transparency, 124-25, 127

INDEX

—communication to public, 122, 127; An­ nual Report, 130,133,135; Monetary Policy Report, 126, 130, 138 —inflation targeting, 115-44; compared to New Zealand, 123; core CPI in, 133, 137; critical junctures of inflation targeting framework, 132; development of, 115; first horizon for, 115; Governor Crow's views on, 118-20; headline CPI in, 137; lack of escape clauses, 123; target range, 116,123; timetable for reducing inflation in, 120; total vs. core CPI in, 341 —monetary policy, 130-43; expectational sluggishness in, 341; fiscal policy and monetary contraction in, 140; goods and services tax in, 118; inflation-indexed bonds in, 133; lags in effect of monetary policy in, 119; M l and M2 in, 125-26; monetary conditions index (MCI), 126, 342; real economy and prices, 124; realreturn bonds, 133; reducing vs. maintain­ ing inflation, 142; risk premiums in longterm interest rates, 118; under Conser­ vative Government, 134 —unemployment in, 130-32 Canadian Conservative Party, and formal targets, 117 Canadian dollar, 135, 136 Canadian Economic Association, 132, 133 Canadian economic indicators, 131 (graphs) Canadian exports, and economy, 133 Canadian GDP, stagnation of, 139 Canadian monetary policy under inflation targeting, 130-43 Canadian target distinctions, compared with Bundesbank, 118 Canadian-U.S. interest rate differential, 141 cash and long-term interest rates in Austra­ lia, 230 (graph) Cash Rate instrument, of Reserve Bank of Australia, 229, 231, 232 CBM see central bank money central bank as counterinflationary con­ science, in United Kingdom, 145-71 central bank independence: Cukierman's index of, 343; in Germany and Switzer­ land, 337; in New Zealand, 339

369 central bank: accountability of, 37-38; dis­ cussion of limited discretion, 349; effect on inflation rate, 14, 23; and inflation, 3-4; and inflation reports, 37; and goal vs. instrument independence, 38; inde­ pendent vs. subordinate, 38; opportunis­ tic behavior of, 15, 16; responsibility to communicate with public, 37 central bank money (CBM), in Germany, 45-46; 57-58; 68-69; vs. monetary base, 57 centralized wage-setting mechanisms, in Sweden,194 Chancellor of the Exchequer, conflict with the Bank of England, 162,164-67,168,169 Chicago School, 4 Chile, inflation targeting in, 348 commodity price inflation, relationship to inflation, 262 communication with public, 31, 34,42, 29596; in Australia, 225; in Bank of England, 146, 153, 157, 158-59; in Canada, 122, 127, 132, 133; in New Zealand, 89, 102; proposed for EMU, 329; proposed for United States, 326; role of in inflation targeting, 23; in Sweden, 177, 197 communications issues, 36-38 comparison of Bundesbank response to 1979 oil shock and reunification, 72-73 conclusions regarding inflation targeting, 308 cones, for establishing ranges for money growth, 336 conflict of interest, in Reserve Bank of NewZealand, 339 conflict, Bank of England and Chancellor of the Exchequer, 162, 164-67, 168, 169 consensus forecasts of inflation, 276 (graphs) Consensus Forecasts, 349, 351; in Austra­ lia, 227; as measure of inflation expecta­ tions in Canada, 126, 139 Conservative Government, in Canada, 134, 135 Conservative Party —and formal targets in Canada, 117 — i n United Kingdom, 147; effect on inter­ est rates, 162; role in adoption of infla­ tion targeting, 147, 148

370 constrained discretion policy regime, 29394, 301; and inflation targeting, 22-23 consumer price index , see CPI control group strategy, for analyzing inflation targeting, 252-53 control problems, in New Zealand, 87, 92, 112 coordination of expectations of economic agents, in Bundesbank, 50 core CPI, see CPI core inflation, 27; in Canada, 115; as price index for i n f l a t i o n target i n New Zealand, 93; in Spain, 247, 248; vector autoregression (VAR) model of behavior, 275-82; vs. headline inflation in United Kingdom, 146 cost of disinflation under inflation targeting, 254-66; at high levels, 16-17; at low to moderate levels, 18; in Canada, 142 countercyclical tendency to monetary policy, in Canada, 123 counterinflationary conscience, Bank of England as, 159 country-specific shocks, effects of, 352 CPI, 290 —actual inflation rates, 266-71 —core, in Canada, 121-22,130,131 (graph), 133,137; in Israel, 209; proposed as price index for EMU, 328; proposed as price index for inflation targeting i n the United States, 316, 321-22; vs. headline CPI, in Sweden, 183-184, 185, 202; vs. total CPI in Canada, 341 —and housing costs in New Zealand, 339 —as inflation target, 27; in Australia; in Canada, 115, 117, 121-22; 131 (graph); in Israel, 215 (graph); in Spain, 283 (graph); in Sweden, 175 (graph), 183; in Switzerland, 53 (graph) ; i n New Zealand, 87 —and unavoidable /normative inflation in Germany, 47 (graph) credibility, i n Australia, 222; Banco de España, 239; Bank of Canada, 124, 344; Bank of England, 170-71; Bank of Israel, 209, 217; and exchange rate peg, 303; and inflation targeting, 266-75; linked to transparency and flexibility, 73; of monetary policy and adoption of inflation

INDEX

targeting, 274-75; in New Zealand, 95, 112, 114; and quantitative goals, i n Canada, 124; and sacrifice ratio, 255; in Sweden, 179-81, 184-85, 195 in United Kingdom, 145, 152, 153, 155 Cukierman's index of central bank independence, 343 currency board, as exchange rate system, 302 cyclical factors in inflation forecasts, 259 de-emphasis on monetary targets in United Kingdom, 151 deflation, 29-30 demand shock vs. supply shock, 35, 72 depersonalization of U.S. monetary policy, 311-12 derivation of monetary targets in Germany and Switzerland, 63-66 deviations from target, 35-36 direct inflation targeting, 4 disadvantages of monetary targeting, 305 discount and long-term interest rates in New Zealand, 103 (graph) Discount and T-bill rates in Israel, 215 (graph) discretion vs. rules, 4 discretion-based monetary policy, 5-6 disinflation —Ball's definition of, 255 —costs of, under inflation targeting, 253, 257, 298-99; in Canada, 134; in Israel, 210, 218; in New Zealand, 90 —and inflation targeting, 254-66 disinflationary trend, effects of, 352 domestic vs. exchange-rate objectives, in Spain, 245 "dual economy," i n United Kingdom, 165 dynamic simulations of inflation, vs. actual paths of inflation (graphs), 277-79 EC, see European Community Ecole des Hautes Etudes Commerciales, 141 econometric studies of inflation, 18 Economic Bulletin, in Spain, 243, 349 economic crisis in New Zealand, effect on monetary policy, 95

INDEX

economic growth prospects in 1988, effect on Swiss National Bank, 80-81 economic performance, impermanence of, 3-4 economic stabilization program, in Israel, 206 effectiveness of inflation targeting, 282-83 effects of tax increase on CPI in Canada, 341 employment growth in Canada, 136 employment, and inflation targeting, 254, 299 EMU, see European Monetary Union ERM, 259, 271, 273, 346; and Spain, 241, 245, 248, 249 escape clause, 292; in Canada (lack of), 123; to deal with supply shocks, 24; in Israel, Australia, and Spain (lack of), 204; in New Zealand, 94; in Sweden, 182, 185; in Switzerland, 62,81-82; in United Kingdom, 168 European Central Bank, 4, 241-42, 326; goal independence of, 329; and Inflation Report, 328 European Community (EC), 43-44, 49; and Sweden, 176-77 European Exchange Rate Mechanism (ERM), see Exchange Rate Mechanism European Monetary System, 6; and Sweden, 177; tensions in, 75 European Monetary Institute, 4, 326; principles of monetary policy strategy, 32627 European Monetary Union (EMU), 274, 309, and Bundesbank, 76, 77; inflation targeting in, 326-33, 353; proposal for inflation targeting in, 327-33 European System of Central Banks (ESCB), 309 exchange rate, in Canada, 126,131 (graph); effect on future inflation in New Zealand, 98; and inflation targeting in Israel, Australia, and Spain, 203-04; as intermediate variable in Israel, 210; as policy objective in Spain, 237 exchange rate index, of Bank of England, 161 Exchange Rate Mechanism (ERM) parities, 76, 147, 327; in Spain, 236; and United

371 Kingdom, 151 exchange rate peg, advantages of, 302; as alternative to inflation targeting, 301-04; and credibility, 303; criticism of, 353; currency board as, 302; disadvantages of, 303; and ERM, 303; nominal anchor for, 304; and price stability, 303-04; in Sweden, 201 exchange-rate crises of 1992 and 1993, 6 exchange-rate targeting, in Sweden, 172 Exchequer, responsibilities of in United Kingdom, 145, 146 expansionary policies: benefits of, 14; costs of, 14 expectational sluggishness, in Canada, 341 extended money stock M3, 76 extension of inflation target, in Canada, 121 features of inflation targeting: Australia, 203-05; Canada, 115-16; Israel, 203-05; Spain, 203-05; Sweden, 172-73; United Kingdom, 145 Federal Gazette, required announcements in, 60 Federal Reserve Bank, ability to deal with shocks to the economy, 313-14 financial stability, as objective of monetary policy in New Zealand, 99 Finland, and ECU, 347 fiscal consolidation, in Israel, Australia, and Spain, 205 fiscal policy , 3; and monetary contraction in Canada, 140; under Governor Thiessen in Canada, 136 fixed exchange rate as nominal anchor in Sweden, 174 fixed-term inflation targeting, effect of tying to specific event, 76-77 flexibility, 26; Australia, 221, 223; Banco de España, 240; Bank of Canada, 116, 123, 129, 144, 342; Bank of Israel, 250; importance of in targeting regime, 85; in inflation targeting, 292; and monetary policy in Germany during reunification, 75; New Zealand, 92; in Riksbank inflation targeting, 184; short-run, and multiple objectives, 291-93; Spain, 250; Sweden, 172,179-80,182,184,185,197; Swiss National Bank, 84; and transpar-

372 ency, balancing, 26-27, 290-91; United Kingdom, 146, 153; United States, 31719 forecast of inflation at the target horizon, as intermediate target, 33 forecasting inflation from Phillips curves, 260-261 (table) foreign-exchange crisis of September 1992, in United Kingdom, 145 formal statistical analysis, limitations of, 7 forums for communication with public, 37 framework for inflation targeting in the United States, 315-26 framework for monetary policy, 6 franc fort, 302 free liquid reserves, in Bundesbank, 45 GDP deflator, in Canada, 121 GDP growth — i n Australia, 229, 235; in Canada, 133, 352; in New Zealand, 352; in Sweden, 174-76 —and unemployment rate: in Australia, 230 (graph); in Canada, 131 (graph); in Germany, 47 (graph) ; i n Israel, 215 (graph); in New Zealand, 103 (graph); in Spain, 238 (graph); in Sweden, 175 (graph); in Switzerland, 53 (graph); in United Kingdom, 151,160 (graph), 163, 168 GDP growth targeting, vs. inflation targeting, 306 GDR marks, conversion to deutschemarks, 71 Geld, Währung, und Konjunktur, 67, 338 German and Swiss monetary targeting, 33638 German Democratic Republic (GDR), 70 German monetary reunification, disputes over, 338; effects on inflation, 281 German monetary targeting, key features of, 42 German reunification, effects on economy in Spain, 237 Germany, lessons from 84-85; monetary targets in, 211; pursuit of price stability in, 337 goal independence, 38; vs. instrument independence, 312-13

INDEX

goal of price stability, initial definition in New Zealand, 92 gold standard, 5,19, 335; and relative marginal values, 19; and Sweden, 174 goods and services tax (GST): in Canada, 118, 132, 133; in New Zealand, 94 Governing Board of Riksbank, 347 Governing Council of Bank of Canada, 128 government policy, and economic growth, 3 government responsibility, and monetary policy, 3 gradual adjustment of medium-term inflation target, 352 Great Depression, contributions of monetary mismanagement to, 335 growth of production potential, use of by Bundesbank, 58 growth rate, and rate of inflation, 18 GST, see goods and services tax Hanson Lecture, in Canada, 119-20 headline CPI, 290; in Canada, 115, 121-22, 137; in Israel, 204, 209; as measure of inflation in Spain, 240, 247; as price index in New Zealand, 93; in Spain, 204; in Sweden, 173, 200; in Switzerland, 55 headline inflation: and core CPI, in Sweden, 183-184, 185, 202; and core inflation, in United Kingdom, 146, 151; in New Zealand, 108, 110; in Sweden, 193 high inflation, costs of, 16-17 horizons for inflation targets, 31; compared in Bundesbank and Swiss National Bank, 63; proposed for EMU, 328; proposed for United States, 315, 319-20 housing costs, and CPI in New Zealand, 339 Humphrey-Hawkins legislation, 316, 324-26 hyperinflation, 16 hysteresis, in academic literature, 343 implementation of inflation targets, 36 incomes policies, in United Kingdom, 148 independence: Banco de España, 242; Bank of Canada, 129,134, 343; Bank of Israel, 213; Federal Reserve in United States, 312; Reserve Bank of Australia, 223-24, 228; Reserve Bank of New Zealand, 8990; Swiss National Bank, 67

INDEX

indexation, complete, 18 indicator variables, 34-35 inflation, actual vs. dynamic simulations, 277-79 (graph); benefits of low, 16-19; and commodity price inflation, 262; defi­ nition of, 17; econometric studies of, 18; effects of central bank's intentions on, 23; effects of high inflation on economy, 16-17; in Germany after reunification, 70; and growth rate, 18; interactions with monetary policy and real GDP in infla­ tion targeting, 253; and nominal ex­ change rate, 262; promoting economic efficiency and growth, 16-17; public con­ fusion about, 17; rate of, 289-90; role in market-driven growth, 3; as stimulant to economy, 13; and unemployment, 11,12, 13, 130-32 Inflation and Inflation Expectations in Sweden, 186 inflation bias, 15 inflation control target, in Canada, 118, 129-30, 138 inflation expectations, and adoption of inflation targeting, 266-275; in Canada, 119, 126; and interest-rate differen­ tials, 271-274; market-based measure of, 271-74; response to inflation target­ ing, 298 inflation forecasts: from estimated Phillips curves, 259-66; from Phillips curves, 265 (graphs) inflation goal, balanced with other goals in New Zealand, 96 inflation-indexed bonds, in Canada, 133, 342; in the United Kingdom, 342 inflation rate, as macroeconomic variable, 10; and unemployment, 29; vs. price level, 30 inflation-reduction targets, in Canada, 118, 120 Inflation Report, in Spain, 243, 246; in Swe­ den, 173, 186-87, 191-92, 194, 195, 198, 200, 201; in United Kingdom, 146, 147, 155, 157-59, 161-63, 166-69, 170, 171; proposed for United States, 316 inflation reports to public, by central bank, 37 inflation scares, 20

373 inflation target, in Australia, 204, 218-223; in Canada, 121,127-28,131 (graph); and consumer price index, 27; deviations from, 35-36; in EMU, 331-32; horizons for, 31; implied vs. measured, 28; in Is­ rael, 204, 205-09, 215 (graph), 348; in New Zealand, 87,99; numerical value of, 28-30; optimal, 30; as point or range, 32; in Spain, 240, 241; in Sweden, 174-82; timing of introduction, 288; too high or too low, 28-30; in United Kingdom, 146, 149; in United States, 317-19; varying over time, 31; when to implement, 36 inflation targeting, 4-8, 287, 308 —alternatives to, 301-07 — i n Australia, and exchange rate, 203-04; key features of, 203-05; operational framework for, 223-28 —benefits of, 6, 26, 298 — i n Canada, 115-44, 341-44; adoption of, 116-20; critical junctures of framework, 132; features of, 115-16; monetary policy under, 130-43 — in Chile, 348 —as a conceptual framework for monetary policy, 4,21-25,287-88,299-301,335; con­ sensus on operational questions, 288; ra­ tionale for, 10-25 —design, implementation, and operation of, 26-38, 287-97 —effects on economy: behavior of infla­ tion, 275-82; disinflation vs. economic cost in, 253; effect of tying fixed term to specific event, 76-77; employment, 254, 299; inflation expectations, 266-275; in­ ternational macroeconomic perfor­ mance of, 297-99; macroeconomic stabil­ ity, 292; other macroeconomic variables, 35, 253; output, 299; price stability, 254; private-sector inflation expectations in, 253, 254; real costs, 22, 266; real output, 254; supply shocks, 24; wage- and pricesetting, 275; —features of: reduction of inflation, 254, 275; accountability, 24, 295-96; advan­ tages of, 26; combining elements of rules and discretion, 6; credibility, 26675, 282-83; information variables, 29394; forestalling rise in inflationary ex-

374 pectations, 91; interaction among infla­ tion, GDP growth, and short-term inter­ est rates, 276; intermediate targets, 29394 ; nominal anchor, 6, 20; policy-maker accountability in, 6; short-run policy flexibility, 291-93; transparency, 23, 283, 295-96 — i n Israel, 214-18; and exchange rate, 20304; key features of, 203-05 — i n New Zealand, 114, 339-340; adoption of, 87-92; key features of, 86; and Policy Targets Agreements (PTAs), 92-95 —public involvement in, 6, 24; communi­ cation with public, 4, 34, 295-96 — i n Spain, 244-50; adoption of, 235-40; and exchange rate, 203-04; key features of, 203-05 — i n Sweden, objectives of, 180; monetary policy under, 189-200 — i n the European Monetary Union (EMU), 326-33, 353 — i n the United Kingdom, 145-71, 345-46; adoption, 147-53; monetary policy under, 159-71; reasons for, 145 — i n the United States, 309-26, 353; and democratic principles, 312; proposal for, 315-26 —risks of: circularity, 34; disinflation, 25466; problems with exclusive focus on, 21; self-fulfilling prophecies, 34; tradeoffs in, 26 —vs. exchange-rate targeting, 250 inflationary expectations, and inflation tar­ geting, 91 information: to be used for policy-mak­ ing, 32-35; to communicate to public, 36-37 information variables 34-35; of Bundesbank, 337; in Canada, 125; and intermediate tar­ gets, 293-94; of Riksbank, 185 instrument independence, 38; vs. goal in­ dependence, 312-13, 322-23 instrument instability, in New Zealand, 87; with target ranges, 294 interest-rate differentials, 272 (graphs) ; and inflation expectations, 271-74 interest rates, in Canada, 131 (graph); cash and long-term in Australia, 230 (graph) ; effect on future inflation in New Zealand,

INDEX

98; marginal and long-term, in Sweden, 175 (graph); and MCI in Canada, 126 intermediate target, 33; conflict with price stability in the United Kingdom, 149; forecast of inflation as, 33; money growth as, 33; in New Zealand, 99; in Spain, 236 intermediate target variable, CBM as, 45 intervention and long-term interest rates, in Spain (graph), 238 introduction of inflation target, timing of, 288 inverted yield curve, 69, 74 IPSEBENE series, in Spain, 247, 248 Israel —analysis: lessons from, 250-51 —central bank: accountability i n , 251; disinflation and recession in, 218; eco­ nomic stabilization program in, 206; flex­ ibility in, 250; transparency in, 205, 251 —communication to public: "Recent Eco­ nomic Developments" report, 212 —inflation targeting: adoption of, 205-09; CPI inflation target, 205-06; experience under, 214-18; inflation target and disinflation, 348; inflation targets and CPI inflation, 215 (graph); key features of, 203-05; operational framework under, 209-14; price stability, 217; relationship with exchange-rate target, 207-08, 212, 216; responsibility for setting, 204; target range in, 210; use of headline CPI, 204; wage-bargaining mechanisms in, 204 —monetary policy: discount and T-bill rates in, 215 (graph); exchange-rate target, 206; fiscal consolidation in, 205 —GDP growth and unemployment rate (graph), 215 Israeli monetary policy, compared to Ger­ man policy, 211-12 key features of inflation targeting: in New Zealand, 86; i n Sweden, 172-73; i n United Kingdom, 145 key lessons: from Australia, 250-51; from Is­ rael, 250-51, from Spain, 250-51; from Sweden, 201-02; from United Kingdom, 171 Kohl, Chancellor Helmut, accountability for inflationary pressures, 74-75

INDEX

krona: depreciation of, 181; influence on economy in Sweden, 347 Labour Party: in New Zealand, 86, 88, 91, 110, 111, 340; and inflation targeting in United Kingdom, 345 lags, in effect of monetary policy, 119 Law on the Banco de España, 235, 242, 24344 lessons: from Australia, 250-51; from Canada, 144; from Germany and Switzerland, 84-85; from Israel; from New Zealand, 113-114; from Spain, 250-51; from Sweden, 201-02; from United Kingdom, 171 Liberal Government, in Canada, 121-22, 132, 135, 136, 343, 344 limitations of test for structural breaks in monetary-policy reaction functions, 352 Lombard credit, in Bundesbank, 46; after German reunification, 71-72, 73, 74, 75 long-run inflation, effect on monetary policy, 23; goal proposed for United States, 315, 316-17 long-run price stability, as a nominal anchor, 20 long-run vs. short-run inflation targets, 291 long-term interest rates: in Canada, 131 (graph); in Spain, 238 (graph); in Sweden, 175 (graph); in United Kingdom, 160 (graph) low inflation, benefits of, 16-19; and economic growth in Canada, 143; and nominal interest rates, 29; permanent and transitional costs of, 141; vs. targeting framework in Canada, 134 M0, in United Kingdom, 149, 155, 158 M l money stock, 23; in Canada, 125; in Israel, 210; in Switzerland, 52, 62, 79; susceptibility to changes in exchange rate expectations, 337 M2, in Canada, 125-26 M3, definition of, 57; effect of monetary unification on in Germany, 71-72; as monetary target in Germany, 57; problems with i n Bundesbank, 75-76; i n United Kingdom, 148, 149 M4, in United Kingdom, 155, 158

375 Maastricht Treaty, 4, 204, 236, 239-40, 241, 247, 248, 309, 326, 329, 331, 332 macroeconomic developments i n New Zealand, 102, 103 (graph) macroeconomic performance under inflation targeting, international, 297-99 macroeconomic policy, goals of, 10 macroeconomic significance of nominal wage floor in Canada, 344 macroeconomic variable, inflation rate as, 10; and inflation targeting, 253 majoritarian elections vs. multi-member proportional representation i n New Zealand, 340 Manley Committee, in Canadian House of Commons, 134, 343 marginal and long-term interest rates in Sweden, 175 (graph) Marginal Rate, in Sweden, 176, 178, 190; replaced by repo rate i n Sweden, 191 market-based measure of inflation expectations, 271-274 market-driven growth, 3 MCI, see monetary conditions index measure of inflation in inflation targeting, 290 measurement of distribution of forecast errors in analysis of inflation targeting, 263-64 measures of capacity utilization, in Sweden, 191 Medium Term Financial Strategy, in United Kingdom, 149 medium-term forecast, i n United Kingdom, 164 medium-term growth path for SAMB, in Switzerland, 63, 83-84 m e d i u m - t e r m monetary c o n d i t i o n s and target range i n Canada, 121-22, 344 medium-term nominal framework, i n United Kingdom, 152 medium-term projections for inflation in New Zealand, 98-99 Mexican crisis, in Spain, 245 midpoint of inflation target range, 289-90; in Canada, 116 minimum reserve requirements, in Switzerland, 52

376

INDEX

moderate inflation rate, and economic ef­ monetary reunification in Germany, 338; effects on inflation, 281 ficiency, 10 monetary targeting, 4 monetarism, 12 monetarism, effect on Bundesbank, 49- monetary targets: and outcomes in Ger­ many, 48 (graph); abandoned in United 50 Kingdom, 151; de-emphasis on in United monetary aggregates, in New Zealand, 339; Kingdom, 151 proposed role of in EMU, 329-31 money growth, "cones" or tunnels for, monetary base, use of in Switzerland, 66 336 monetary conditions index (MCI), 226; in Canada, 116, 126,138, 139, 342; in New money growth, as intermediate target in Spain, 236 Zealand, 98, 100, 340 money growth, as intermediate target, 33 monetary contraction, and fiscal policy in monetary rule, 5 Canada, 140 monetary targeting, 41-85; as alternative to Monetary Policy Committee, of Bank of inflation targeting, 304-05; definition of, England, 159, 170 41; flexibility in, 304-305; lessons from, monetary policy 84-85; underlying conflict of, 74 — i n New Zealand: during 1970s and 1980s, 88; and monetary conditions index, 98; — i n Germany, 336-38; adoption, 43; and monetary policy, 68-77 need for clarification of, 89; and real economy, 97 — i n Switzerland, 336-38; adoption, 43, 51; and monetary policy in Switzerland, 77— i n Sweden: from adoption to May 1994, 84 189-91; from January 1996 to December 1997,189,193-200; from May 1994 to De­ — i n EMU: vs. inflation targeting, 327, 32931 cember 1995, 189, 191-93 —monetary policy in United Kingdom un­ monetary targets, as frameworks for mon­ der inflation targeting, 146 etary policy, 68; predictive ability of in Switzerland, 82; use of in United King­ Monetary Policy Report, in Canada, 126, 127, dom, 150 128, 129, 130, 138, 342, 344 Monetary Policy Statement, in New Zealand, Monthly Report: of Bundesbank, 61, 76, 337; of Swiss National Bank, 338 93-94, 100, 102, 104, 105, 106, 107 monetary policy, activist, 11; in Canada, 124- multi-member proportional representa­ tion vs. majoritarian elections in New 25, 130-43; case study approach to, 7-8; Zealand, 340 critical episode in Australia, 228, 229-32; multi-year horizon, used in Switzerland, 63 effects on output and employment, 15; and flexibility in Germany during reuni­ fication, 75; as government responsibil­ narrow monetary aggregate, use of in Swit­ zerland, 62 ity, 3; and inflation, 3; limitations of in National Debt Office, in Sweden, 178 Sweden, 197-98; linked to medium- and long-term horizons, 24; and medium- National Party, in New Zealand, 104, 10607 term stabilization, 3; and nominal an­ chor, 11, 20; over-manipulation of, 13; as New Zealand First Party, 110, 111 political issue in New Zealand, 109; price New Zealand Herald, 340 New Zealand stability in, 10; principles of European Monetary Institute, 326-27; and public —analysis: lessons from, 113-14 expectations, 12; and short-run fluctua­ —central bank: accountability, 114; control problems in, 87, 112; credibility, 95, 112 tions in the economy, 10; in Sweden, (lack of) ; flexibility, 92; independence of, 189-200; i n United Kingdom, 159-71; 339; transparency in, 95 without explicit targets, 307; and unem­ ployment, 11 —communication to public: 102

INDEX

—GDP growth and unemployment rate in (graph), 103 —inflation targeting, 86-114, 339-40; adop­ tion of 87-92; inflation as sole interme­ diate target, 99; initial goal of price sta­ bility defined, 92; instrument instability in, 87; Labour Party and, 110, 111; mon­ etary conditions index in, 98; National Party and, 104, 106-07; open-ended tar­ gets in, 96; price index for inflation tar­ get, 93; reasons for narrow price stabil­ ity focus, 96; target range established in, 92; underlying and headline inflation and targets in, 103 (graph); use of nar­ row target range in, 87; zero inflation vs. low, positive inflation in, 113 —monetary policy: balancing inflation goal with other goals, 96; discounted and long-term interest rates in, 103 (graph); economic reform in, 86; effect of eco­ nomic crisis on, 95; effect of goods-andservices tax on, 94; effect of tax levies on, 95; effect of terms of trade on, 94; government control over speed of disinflation, 97; importance of exchange rates to economy, 98; inflation forecast­ ing in, 99-100; macroeconomic develop­ ments in, 102, 103 (graph); nominal ef­ fective exchange rate in, 103 (graph); relationship of monetary policy and real economy, 97; as small, open economy, 92; under inflation targeting, 102-13; under­ lying inflation in, 104 nominal anchor: in Australia, 204; i n Canada, 119; forms of, 19-20; and infla­ tion targeting, 19; in Israel, 204; and long-run price stability, 20; for monetary policy, 11; and monetary targeting, 42, 43; need for, 19-21; in Spain, 204, 236; in Sweden, 172,174; in United Kingdom, 145 nominal effective and DM/SFR exchange rate in Switzerland, 54 (graph) nominal effective exchange rate: Australia, 230 (graph); Canada, 131 (graph); Ger­ many, 48 (graph); New Zealand, 103 (graph); relationship to inflation, 262; Spain, 238 (graph); Sweden, 175 (graph); United Kingdom, 160 (graph)

377 nominal interest rates, effect of low infla­ tion on, 29 nominal targeting regime, strength of, 283 normative rate of price increase, 31 Norway, and ECU, 347 numerical goals for inflation, in Germany and Switzerland, 42 numerical value of inflation target, 28-30 objectives of inflation targeting in Sweden, 180 OECD countries: analysis of inflation tar­ geting in, 252; inflation in, 348; and Is­ rael, 210 OECD Economic Report, 102, 130 Office for National Statistics, in United Kingdom, 154 oil crisis of October 1973: and Bundesbank, 49; and Swiss National Bank, 55 oil price shock of 1991, 104 oil-price increases, concerns in Canada, 118 operational framework for inflation target­ ing: Australia, 223-228; Canada, 120-30; Israel, 209-14; New Zealand, 92-102; Spain, 240-44; Sweden, 182-89; United Kingdom, 153-59 operational framework for monetary target­ ing, in Germany, 56-62 operational framework for monetary target­ ing, in Switzerland, 62-68 operational issues in inflation targeting, 2736 operational questions of inflation targeting, consensus on, 288 optimal control method of policy-making, 12 ostmarks, conversion to deutschemarks, 71 output, and inflation targeting, 299 over-manipulation of monetary policy, 13, 23 overnight and long-term interest rates (graphs): Canada, 131; Germany, 47; Switzerland (graph), 53; United King­ dom (graph), 160 paper-money standard, unbacked, 19-20 parallel structure, of case studies, 7-8 parameter instability tests, 262-64

378 Phillips curve, 11; in analyzing inflation tar­ geting, 253; in Australia, 226; in Canada, 124; inflation forecasts from (graphs), 265; methodology of Gordon and Fuhrer, 259; origin of, 335; and Riksbank, 200 point target, 32; and credibility, 295; and flexibility, 295; proposed for EMU, 328; proposed for United States, 315-16, 32021; in United Kingdom, 146,154; in Swit­ zerland, 42, 64; vs. target range, 32, 29495, 345 policy activism, arguments against, 11-16 policy credibility problem, 14-15 policy discretion, in inflation targeting, 300 policy lags: effect on policy-making meth­ ods, 12-14; and monetary policy, 12 Policy Targets Agreement (PTA) in New Zealand, 86, 88, 91, 92-95, 97; irregular timing of, 95-96 policy transparency, in Canada, 127; goals of, 26; in Israel, Australia, and Spain, 203 policy-making framework: information used for, 32-35; and price stability, 10 political pressure, effect on monetary policy, 23 politicization of monetary policy in United Kingdom, 346 precursors to inflation targeting, 41-85 preemptive monetary policy, 307 price index for inflation targets in New Zealand, 87, 93 price index: consistent use of, 28; to be tar­ geted, 27-28 price level: establishing a nominal anchor for, 19-21; vs. inflation rate, 30 price stability, 283; in Australia, 221, 222, 224-25; in Canada, 119,121,122,124,134, 135, 342; definitions of, 28; in Germany, 45, 337; in Israel, 217; mandates for, 343; in New Zealand, 88, 89; as primary goal in monetary policy, 10; proposed as pri­ mary goal of Federal Reserve Bank, 335; in Spain, 237,239; in Sweden, 178-79,186, 188-89, 192, 347; in Switzerland, 65, 337; in United Kingdom, 146, 149152, 153, 156-57, 345-46; in United States, 316-17; and responses to inflationary shocks, 275; as target for measured inflation, 42; vs. inflation targeting, 254, 289

INDEX

price-level targeting, 336; use of in Sweden, 180 prices, and real economy in Canada, 124 private enterprise, and prosperity, 3 private-sector inflation expectations in in­ flation targeting, 253 probability cones, and communication in the United Kingdom, 345 production potential, and Bundesbank, 58 Progressive Conservative Party, in Canada, 135 proposal for inflation targeting in the Eu­ ropean Monetary Union, 327-33 prosperity, and private enterprise, 3 PTA, see Policy Targets Agreement public expectations: in inflation scares, 20; and monetary policy, 12 public involvement monetary policy, in in­ flation targeting, 24 public sector borrowing requirement (PSBR) in United Kingdom, 148 public support for monetary policy: in New Zealand, 92; in Swiss National Bank, 67 public, maintaining credibility with, 36-37 publicity, maximized in Canadian inflation targeting, 117 quantitative goals and credibility, i n Canada, 124 quantity theory of monetary targeting, 4344 Quarterly Bulletin, in United Kingdom, 157, 345-46 Quarterly Report, in Australia, 227, 232 Quebec referendum on sovereignty, and interest rates in Canada, 138-39 range, of inflation target, 32 range vs. point target, practical implications of, 32 rate of inflation, 289-90; and growth rate, 18 "rational expectations" models of inflation, in United Kingdom, 152 rationale for Canadian inflation-reduction targets, 120 reader's guide to text layout, 8-9 real bonds in Canada and the United King­ dom, 342

INDEX

real economic costs under inflation target­ ing, 266 real economy: and monetary policy in New Zealand, 97; and prices in Canada, 124 real output, and inflation targeting, 254 real-return bonds, in Canada, 133, 139 real-side costs of trading off disinflation, in United Kingdom, 156-57 real-side goals, in Australia, 226 reasons for changing U.S. policy, 310-15 "Recent Economic Developments," pub­ lished in Israel, 212 recession, as result of restrictive monetary policy, 11 relative marginal values, under gold stan­ dard, 19 repo rate: after German reunification, 7172, 73, 75; use of in Sweden as policy in­ strument, 191, 193 Reserve Bank Act of 1959, Section 10, in Australia, 219 Reserve Bank of Australia: accountability, 219; Cash Rate instrument, 229, 231, 232; flexibility, 223; independence of, 223-24, 228; "Semi-Annual Statement on Mon­ etary Policy," 228 Reserve Bank of New Zealand Act of 1989, 87-88, 96; and independence, 339 Reserve Bank of New Zealand Bulletin, 101 Reserve Bank of New Zealand: and ex­ change rates, 98; flexibility in, 87; poten­ tial conflict of interest in, 339; as rela­ tively "rule-oriented," 97 responsibility for setting inflation target, in United States, 322-324 retail price index (RPI), in United King­ dom, 148 retail price index excluding mortgage in­ terest payments (RPIX), in United King­ dom, 146 reunification of Germany, effect on mon­ etary policy, 68, 70-72 revision of commercial bank liquidity re­ quirements in Switzerland, 78-79 Riksbank Committee, report of, 188 Riksbank, 173; accountability, 186; adop­ tion of inflation target as nominal an­ chor, 174,179; commitment to price sta­ bility, 179; control of, 173; credibility,

379 195; defense of krona's exchange rate peg, 177; and ECU, 347; flexibility, 184; Governing Board of, 347; inflation fore­ cast of, 187; information variables for inflation targeting, 185; and Phillipscurve estimation, 200; relationship to Parliament, 186 risk of circularity, in inflation targeting, 34 risk of self-fulfilling prophecies in inflation targeting, 34 risk premiums in long-term Canadian in­ terest rates, 118 risks of targeting too high or too low, 28-30 RPIX, 165, 350; and RPI inflation and tar­ gets in United Kingdom, 55,146,153-54, 160 (graph), 161,162,163,164,167-168 RPIY, use of in United Kingdom, 146, 154, 162, 164 rules-versus-discretion and inflation target­ ing, 4, 21, 299-301 rules-based monetary policy, 5-6 sacrifice ratios, 254-59, 298, 343, 349-350; in analyzing inflation targeting, 253,25459; in Canada, 134; and credibility, 255; definition of, 254; and their determi­ nants, 258 (table); and inflation rate, 255; and low inflation, 353; Ball's meth­ odology for, 255-56, 257-59 SAMB, 62 in Switzerland: after changes in financial markets, 79, 82; after stockmarket crash of October 1997, 78; and medium-term growth paths, 54 (graph) ; use of by Swiss National Bank, 62 (graphs) scope of information provided to public, 3637 seasonally adjusted monetary base, see SAMB "Semi-Annual Statement on Monetary Policy," in Australia, 228 shekel, speculative attacks against, 207 short-run policy flexibility: in Canada, 342; and multiple objectives, 291-93 short-run stimuli, effect on monetary policy, 23 short-term inflation target, proposed for EMU, 328; proposed for United States, 315, 317-19

380 short-term interest rates in 1988, effect on Swiss National Bank, 80-81 Social Democrats, role in Swedish target inflation, 191-92 sources of data for analyses, 350 Spain —analysis: lessons from, 250-51 —central bank: accountability, 251; flex­ ibility in, 250; transparency in, 205, 239, 251 —communication to public: Annual Report, 243; Economic Bulletin, 243; Inflation Re­ port, 243 —GDP growth and unemployment rates in (graph), 238 —inflation targeting, 244-50; adoption of, 235-40; core inflation in, 247; CPI infla­ tion and targets in, 238 (graph); domes­ tic vs. exchange-rate objectives in, 237, 245 ;Exchange Rate Mechanism in, 236; intermediate target in, 236; key features of, 203-05; price stability in, 237; respon­ sibility for setting inflation target, 204; underlying inflation measures in, 247; use of headline CPI, 204; wage-bargain­ ing mechanisms in, 204 —monetary policy: fiscal consolidation in, 205; inflation target vs. exchange-rate tar­ get, 241; intervention and long-term in­ terest rates in, 238 (graph) Spanish Parliamentary Committee on Eco­ nomic Affairs, 242 speculative attacks, 353 Statistics New Zealand, 95 stock-market crash of October 1997, and Swiss National Bank, 78 success of inflation targeting, 349-52 success of inflation targeting, analysis of, 252-83 supply shock vs. demand shock, 72; and inflation targeting, 24; responding to, 35 Survey of Forecasters, in Canada, 139 surveys, of inflation expectations, 266-71; used to canvas public expectations in New Zealand, 100 Sweden —analysis: lessons from, 201-02; Phillipscurve estimation, 200

INDEX

—central bank: accountability, 186; and Black Wednesday, 177; credibility, 179-80, 185, 195; flexibility, 172, 179-80, 184; in­ fluence of krona on economy, 347; trans­ parency, 197 —communication to public, 197; Inflation Report, 186-187, 191-192, 194, 195, 198, 200, 201 —GDP growth and unemployment rate in (graph), 175 — inflation targeting, 172-202,347-48; adop­ tion of, 174-82; CPI inflation in, 175 (graph); features of, 172-73; headline CPI in, 173, 200, 348; headline vs. core CPI in, 183-84, 185, 202; increasing impor­ tance of trend inflation in, 173; Marginal Rate in, 190; motives for adopting, 179; nominal anchor in, 172; objectives of, 180; operational framework in, 182-89; price stability in, 347; target range in, 173 —monetary policy: abandonment of ex­ change-rate peg, 178; centralized wagesetting mechanisms in, 194; exchange-rate targeting in, 172; marginal and long-term interest rates in, 175 (graph); use of ex­ change-rate peg, 201; value-added tax, 195 —unemployment in, 198-99 Swedish monetary policy under inflation targeting, 189-200 Swiss and German monetary targeting, 33638 Swiss Economic Indicators, 52, 53 Swiss economy, effects of exchange rate on, 77-78 Swiss inflation performance through 1992, 77 Swiss Interbank Clearing (SIC), 78, 79 Swiss monetary targeting, key features of, 42 Swiss National Bank: Annual Report, 338; accountability of, 67; and adoption of monetary targeting, 51; change to me­ dium-term growth path, 83-84; changes affecting demand for SAMB, 78-79; flexibility in, 84; focus on headline CPI, 65; independence of, 67; introduction of ceiling on growth of bank credit, 52; Monthly Report, 338; and narrow mon­ etary aggregate, 62; public support for,

INDEX

67; and revision of commercial bank li­ quidity requirements, 78-79; and SAMB, 338; and stock-market crash of October 1997, 78; transparency in, 79-80; use of M l , 62; use of monetary base, 66; use of point targets, 64; use of SAMB, 62 Switzerland: 1975 recession, 55-56; lessons from, 84-85; pursuit of price stability in, 337; as small, open economy, 83-84 symmetrical responses, proposed for EMU target misses, 328; proposed for U.S. tar­ get misses, 321 T-bill rates in Israel (graph), 215 target adoption: in Canada, 117-18; in Spain, developments leading to, 236; and parameter instability, 262-63 target bands, in Australia, 348 target breach, result of in New Zealand, 87, 108, 109 target growth rate, derivation of i n Bundesbank, 57-59 target horizon, in Sweden, 184 target range, 4; in Canada, 120-21,123,13536, 144, 341; and credibility, 294-95; in Germany, 42; and instrument instability, 294; in Israel, 210; in New Zealand, 87, 92; reformulation of by Bundesbank, 59; spread of, 32; in Sweden, 172, 180, 18485; in United Kingdom, 146, 154; vs. point target, 294-95, 345 target thresholds, in United Kingdom, 146 target, choosing and defining, 289-91 targeting a point or range, 32 targeting core CPI, proposed in United States, 321-22 targeting framework, vs. low inflation in Canada, 134 targeting inflation rate vs. price level, 30 targeting money growth, 304-05 targeting nominal GDP, 305-07 tax code, change in Sweden, 176 tax levies, effect on monetary policy in New Zealand, 95 tax-related distortions, social costs of, 18 taxes, and monetary policy, 132-33 terms of trade, effects on monetary policy in New Zealand, 94, 95

381 "The Great Canadian Slump," 139, 143 The Monetary Policy of the Bundesbank, 61 "thick-point" inflation target, in Australia, 204, 223, 224 time horizon for inflation target, 31; in Australia, 222, 224; proposed for EMU, 328; proposed for United States, 315, 319-20 time inconsistency problem, 14-15 timetable for reducing inflation, in Canada, 120 total vs. core CPI in Canada, 341 tradeoff, between costs and benefits of ac­ tivist policies, 14, 15 transparency in monetary policy, 295-96; in Australia, 205, 251; in Bank of England, 170; in Bundesbank, 61; in Canada, 12425, 127, 132, 144, 344; defined, 26; and flexibility, balancing, 26-27, 290-91; im­ portance of in targeting regime, 84; and inflation targeting, 23,283; in Israel, 205, 251; in New Zealand, 95; in Spain, 205, 239, 251; in Sweden, 197; in United States, 310-11 trend inflation, and one-time shocks in Canada, 144 tunnels, for establishing ranges for money growth, 336 unavoidable price increases, i n Bundes­ bank, 58 underlying and headline inflation and tar­ gets in New Zealand (graph), 103 underlying CPI: defined i n Australia, 225; used in New Zealand and Austra­ lia, 350 underlying inflation: in New Zealand, 9394, 95, 104; measures in Spain, 247; use in Australia, 204 unemployment rate: in Australia, 226, 229, 230 (graph); in Canada, 131 (graph); and hysteresis in Canada, 343; and infla­ tion, 11, 12, 13; in Israel, 215 (graph); and monetary policy, 11; in Spain, 238 (graph); in Sweden, 174-76,175 (graph), 198-99; in United Kingdom, 160 (graph), 163, 165, 168 United Kingdom —analysis: lessons from, 171

382 —central bank: accountability, 153,159,16263; and Black Wednesday, 152; credibil­ ity, 145, 148-49, 152, 153; flexibility, 153; inflationary pressures in, 164; September 1992 foreign exchange crisis in, 152 —communication to public, 153; Inflation Report, 155, 157-59; Quarterly Bulletin, 157, 345-46 —GDP growth and unemployment rate in, 151, 160 (graph) —inflation targeting, 145-71,345-46; adop­ tion of, 147-53; and Conservative Party, 147, 148; headline inflation in, 151; key features of, 145-46; nominal anchor in, 145; operational framework in, 153-59; point target in, 154; price stability in, 152; retail price index in, 148; RPIX, 153-54; RPIX and RPI inflation and targets in, 160 (graph); RPIY, 154; target range in, 154; target range vs. point target in, 146; target thresholds in, 146; use of headline and core inflation in, 146; use of M3 as target aggregate, 148 —monetary policy: and anti-inflation policy, 151; "national interest" control over, 170; and Exchange Rate Mecha­ nism, 151; and probability cones, 345; and probability density, 345; incomes policies in, 148; Medium Term Financial Strategy in, 149; nominal effective ex­ change rate in, 160 (graph); overnight and long-term interest rates i n , 160 (graph) ; use of monetary targets in, 150; value-added tax in, 162; wage-price con­ trols in, 148 —unemployment rate in, 163 United States: depersonalization of mon­ etary policy in, 311-12; flexibility in, 31719; independence of central bank, 312;

INDEX

inflation targeting and democratic prin­ ciples, 312; inflation targeting in, 353; point target proposed for, 315-16, 32021; proposed framework for inflation tar­ geting, 315-26; transparency of policy in, 310-11 upward bias of inflation expectations in Canada, 119 USD/new shekel exchange rate (graph), 215 utilization measure, effect on analyses, 351 value-added tax (VAT) in Spain, 237-239, 240-41; in Sweden, 195; in United King­ dom, 162 variation in inflation target over time, in United States, 317-19 VAT, see value-added tax vector autoregression (VAR) model of be­ havior of core inflation, 275-82 velocity shocks, 44 volatility of relative prices, and uncertainty, 23 Volker-Greenspan Federal Reserve, 310 wage- and price-setting, and inflation tar­ geting, 275 wage-bargaining mechanisms, i n Israel, Australia, and Spain, 204; in Sweden, 187 wage flexibility, in Canada, 344 wage increases, in Australia, 234-35 wage-price controls, in United Kingdom, 148 yield curve, in New Zealand, 100, 107 zero rate of inflation, problems with, 28; risk of deflation with, 29-30; vs. low, positive inflation in New Zealand, 113