[VIEWPOINT]Inflation targeting as a strategyIn 1989, New Zealand was the first country to adopt inflation targeting as a framework for the conduct and evaluation of its monetary policy. Today, 20 central banks in industrial, emerging market and transition economies located in Asia, Africa, Europe and North and South America are practitioners. Korea joined them in 1998 in the wake of the Asian financial crisis; the framework has served Korea well. Should the central banks of the Group of Three economies ― the U.S. Federal Reserve, the European Central Bank, and the Bank of Japan ― join the Bank of Korea as inflation targeters? The short answer to this question is yes, but the reasons differ for each of the G3.
Inflation targeting generally includes four principal elements, but in practice inflation targeters do not follow a rigid, common formula. None of the four elements is unique to inflation targeting, but the combination reasonably characterizes the basic framework. This type of flexibility is one of the strengths of inflation targeting as a framework that offers constrained discretion in the implementation of monetary policy, in other words discretion to pursue maximum sustainable growth constrained by the need to maintain low inflation.
First, normally an inflation-targeting central bank has a mandate in which price stability is a principal, but not necessarily the only, goal. Second, this goal is translated into a numerical target point or range for a reasonably broad index of inflation. Third, a time horizon is often established for the achievement of the target or for a return to the target if there is departure; in practice this is the least well-defined element. Finally, an accountability procedure is established to assess whether the central bank is achieving or has achieved its target; actual procedures vary widely.
The central banks of the G3 economies all implement stability-oriented monetary policies. Each of them has substantial goal independence with ample scope to translate its mandate into practice. Each also has full instrument independence; it can employ the instruments of monetary policy to achieve its goal or goals without the agreement or interference of other political bodies. Thus, G3 central banks are well positioned to become inflation targeters, to choose inflation objectives, and to enhance further their accountability mechanisms. What is the case for them doing so?
The U.S. case for adopting inflation targeting is that it would increase Federal Reserve transparency. The framework would help promote greater consistency and reduce uncertainty about policy. In the process, the effectiveness of U.S. monetary policy would be enhanced. Economic agents, politicians, and the general public would be better able to understand what the Federal Reserve is doing and why. This would help further to anchor low expectations about U.S. inflation.
The case is stronger for the European Central Bank to adopt inflation targeting. The ECB recently clarified its monetary strategy to emphasize that its policy objective is to maintain inflation rates at less than, but close to, 2 percent over the medium term. The clarification provides greater protection against deflation, but it fails to establish a fully transparent objective. The European Union economy would be aided by specification of a symmetrical inflation target of 2 percent or preferably 2.5 percent, with a band of plus or minus 1 percent. This would help to orient ECB policy toward achieving maximum sustainable growth as well as toward limiting inflation and deflation. The ECB would be required to focus primarily on what it can do to aid the overall performance of the economy rather than on fiscal or structural policies that it does not control.
The case for the Bank of Japan’s adoption of inflation targeting is more complicated because of the deflation that has plagued the Japanese economy since 1995. Inflation targeting does not offer the Japanese authorities a magic solution, but it would provide a meaningful benchmark and an associated insurance policy. The adoption of an inflation-targeting framework for monetary policy would help the Bank of Japan to end deflation through the more aggressive implementation of a quantity-oriented, unconventional monetary policy. Under Governor Fukui, the Bank of Japan has taken additional important steps in this direction; it can and must do more. If the Bank of Japan were to adopt a non-zero inflation target of, for example, 2 percent, the Bank would be protected from doing too much for too long in implementing further unconventional policy measures.
If the central banks of the G3 economies were to follow the central banks of 20 other countries, including the Bank of Korea, and adopt inflation targeting, the international financial system would benefit. First, G3 economic performance would be improved. Second, uncertainties about G3 economic policies would be reduced. Third, as a result, the G3 would contribute to greater stability in the international financial system.
* The writer is a senior fellow at the Institute for International Economics. This article is based on a forthcoming IIE study on inflation targeting and the international financial system.
by Edwin M. Truman