The Inflation Targeting Debate

January 9, 2017

Inflation targeting has become one of the most prominent monetary regimes around the globe. Proponents argue that it reduces the dynamic inconsistency problem of monetary policy and thereby stabilises prices, which in turn promotes growth. Opponents, on the other hand, say that by focusing on price stability inflation targeting neglects other important policy objectives, such as financial stability, and thereby contributed to the built up of the global financial crisis. This roundup summarises the arguments made in the debate. It concludes that no consensus has emerged in the empirical literature about whether inflation targeting improves macroeconomic performance.

Inflation targeting has become a dominant framework for monetary policy over the last two decades. New Zealand was the first country to adopt it in 1990. It has been praised for its success in bringing down inflation and raising accountability on the side of policymakers (Bernanke and Mishkin, 1997; Ball, 2010). Its popularity is reflected in the number of 29 countries which are operating under inflation targeting (IT) at the end of 2015 (see Table).

Inflation targeting countries and adoption dates

Country

IT adoption date

Country

IT adoption date

Albania

January 2009

New Zealand

January 1990

Australia

April 1993

Norway

March 2001

Brazil

June 1999

Peru

January 2002

Canada

February 1991

Philippines

January 2002

Chile

September 1999

Poland

December 1998

Colombia

September 1999

Romania

August 2005

Czech Rep

December 1997

Serbia

September 2006

Ghana

May 2007

South Africa

February 2000

Guatemala

January 2005

Sweden

January 1993

Hungary

June 2001

Thailand

May 2000

Iceland

March 2001

Turkey

January 2006

Indonesia

July 2005

United Kingdom

December 1992

Israel

June 1997

Finland

February 1993

Korea

January 2001

Slovakia

January 2005

Mexico

January 2001

 

 

Sources: Roger (2009), National central banks.


Pros and cons of inflation targeting

As a prominent proponent of inflation targeting, Svensson (2010) describes IT as a monetary framework under which the central bank publicly announces an official numerical target or target range for the inflation rate over a specific time horizon. The monetary authority also explicitly communicates to the public that low and stable inflation is the main goal of monetary policy, bases its decisions on inflation forecasts, and enjoys a high degree of political independence. IT is typically associated with enhanced communication standards of monetary authorities with the public and aims at increasing accountability, possibly through implicit incentives or explicit contracts for central bankers. Advocates of IT argue that these features in the conduct of monetary policy make announced inflation targets of the central bank more credible. According to their view, the main advantage over alternative monetary regimes is thus that IT addresses the dynamic consistency problem and thereby anchors inflation expectations.

Following Walsh (2009), better anchored expectations are associated with reduced and more stable actual inflation according to a standard forward-looking Phillips curve. Lower inflation variability, in turn, will potentially reduce the short-run tradeoff between inflation and output and thus the impact of macroeconomic shocks. A publicly announced and credible inflation target will thus also stabilise output. Finally, Bernanke and Mishkin (1997) put forth that low and stable inflation promotes long-run economic growth. This is because lower uncertainty about future inflation supports long-term savings and investment decisions and reduces the riskiness of nominal financial and wage contracts. Especially in emerging and developing economies, nominal stability can be an important prerequisite for foreign direct investment and thereby foster growth.

While these are the arguments of the proponents of IT, the global financial crisis has dramatically changed the perception of IT in the public and academic debate. It is questioned whether after these turbulences IT can still be considered as the appropriate framework for achieving macroeconomic stability. Specifically, it is argued that IT, by focusing predominantly on inflation, contributed to the build-up of financial instability (Taylor, 2007; Frankel, 2012), led central banks to neglect other important objectives, such as employment (Stiglitz, 2008), and constrained monetary authorities in effectively dealing with deep balance sheet recessions (Borio, 2014).


No consensus in the academic literature

The opposing views about the costs and benefits of IT made in the public debate carry over to the academic literature. Since the first introduction of IT, many studies have analysed whether this monetary regime affects the economic performance of a country, but no consensus has emerged. Walsh (2009) and Ball (2010) provide excellent recent overviews of the literature. According to their summaries, the existing studies mostly find no effects of IT in developed economies, while there is some evidence of a positive effect of IT on macroeconomic outcomes in developing countries.

Focusing on advance economies, Ball and Sheridan (2004) in a seminal contribution find no significant differences between IT and non-IT countries, as measured by the behaviour of inflation, output, and interest rates in a sample of 20 OECD member states and based on a difference-in-difference approach that controls for regression to the mean. Similarly, Lin and Ye (2007) detect no effect of IT on either inflation or inflation variability in industrial countries when employing propensity score matching methods. Using OLS to study the impact of IT on disinflation periods in OECD countries, Brito (2010) concludes that inflation targeters were not able to bring inflation down at less cost than nontargeters. On the other hand, Gonçalves and Carvalho (2009) find in a sample of OECD countries that inflation targeters suffer significantly smaller output losses from disinflations than nontargeters when controlling for possible selection bias through Probit or Heckman regressions.

Studying the effects of IT in developing countries, Lin and Ye (2009) and Lin (2010) show evidence based on propensity score matching that IT does lower inflation and inflation variability. Moreover, De Mendonça and e Souza (2012) show in a large panel consisting of both developing and advance countries that IT reduces inflation and inflation variability only in the former group but not in the latter. They conclude that IT is particularly well suited for developing economies that aim at enhancing the credibility of their monetary authorities.

These diverging results on the general effectiveness of IT extend to studies which focus on the performance of IT during specific time periods. While Rose (2014), for example, finds that IT did not substantially change how a country weathered the global financial crisis, Carvalho Filho (2010) and Andersen et al. (2015) present evidence that IT countries fared significantly better than others during this episode. 


Conclusions

This roundup summarizes the debate on inflation targeting. It argues that no consensus has been reached in the academic discourse about whether inflation targeting improves macroeconomic outcomes. Given the empirical importance of this monetary regime, reflected in the number of 29 countries operating under inflation targeting, more research thus seems needed


References

Andersen, T. B., N. Malchow-Møller and J. Nordvig (2015). 'Inflation targeting and macroeconomic performance since the Great Recession', Oxford Economic Papers, vol. 67(3), pp. 598-613. Retrieved from http://oep.oxfordjournals.org/content/67/3/598.short

Ball, L. (2010). 'The Performance of Alternative Monetary Regimes', Handbook of Monetary Economics, vol. 3, pp. 1303-1343. Retrieved from http://www.nber.org/papers/w16124

Ball, L. M. and N. Sheridan (2004). 'Does inflation targeting matter?', The Inflation-Targeting Debate, pp. 249-282: University of Chicago Press. Retrieved from http://www.nber.org/chapters/c9561.pdf

Bernanke, B. S. and F. S. Mishkin (1997). 'Inflation Targeting: A New Framework for Monetary Policy?', Journal of Economic Perspectives, vol. 11(2), pp. 97-116. Retrieved from, http://www.nber.org/papers/w5893

Borio, C. (2014). 'Monetary policy and financial stability: what role in prevention and recovery?', BIS Working Papers. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2390174

Brito, R. D. (2010). 'Inflation targeting does not matter: another look at OECD sacrifice ratios', Journal of Money, Credit and Banking, vol. 42(8), pp. 1679-1688. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1538-4616.2010.00359.x/full

Carvalho Filho, I. E. (2010). 'Inflation targeting and the crisis: An empirical assessment', IMF Working Papers, pp. 1-22. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1562413

De Mendonça, H. F. and G. J. d. G. e Souza (2012). 'Is inflation targeting a good remedy to control inflation?', Journal of Development economics, vol. 98(2), pp. 178-191. Retrieved from http://www.sciencedirect.com/science/article/pii/S030438781100068X

Frankel, J. (2012). 'The death of inflation targeting', VoxEU. org, vol. 19. Retrieved from http://voxeu.org/article/inflation-targeting-dead-long-live-nominal-gdp-targeting?quicktabs_tabbed_recent_articles_block=1

Gonçalves, C. E. S. and A. Carvalho (2009). 'Inflation targeting matters: evidence from OECD economies' sacrifice ratios', Journal of Money, Credit and Banking, vol. 41(1), pp. 233-243. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1538-4616.2008.00195.x/full

Lin, S. (2010). 'On the international effects of inflation targeting', The Review of Economics and Statistics, vol. 92(1), pp. 195-199. Retrieved from http://www.mitpressjournals.org/doi/abs/10.1162/rest.2009.11553

Lin, S. and H. Ye (2007). 'Does inflation targeting really make a difference? Evaluating the treatment effect of inflation targeting in seven industrial countries', Journal of Monetary Economics, vol. 54(8), pp. 2521-2533. Retrieved from http://www.sciencedirect.com/science/article/pii/S0304393207000682

Lin, S. and H. Ye (2009). 'Does inflation targeting make a difference in developing countries?', Journal of Development economics, vol. 89(1), pp. 118-123. Retrieved from http://www.sciencedirect.com/science/article/pii/S0304387808000576

Rose, A. K. (2014). 'Surprising similarities: recent monetary regimes of small economies', Journal of International Money and Finance, vol. 49, pp. 5-27. Retrieved from http://www.sciencedirect.com/science/article/pii/S0261560614000813

Stiglitz, J. E. (2008). 'The failure of inflation targeting', Project Syndicate, vol. 13. Retrieved from https://www.economics.utoronto.ca/gindart/Stiglitz%20-%20The%20Failure%20of%20Inflation%20Targeting.pdf

Svensson, L. E. (2010). 'Inflation Targeting', Handbook of Monetary Economics, vol. 3, pp. 1237-1302.

http://link.springer.com/chapter/10.1057/9780230280854_16

Taylor, J. B. (2007). '” Housing and Monetary Policy” in Housing, Housing Finance and Monetary Policy Federal Reserve Bank of Kansas City'. Retrieved from http://www.nber.org/papers/w13682.pdf

Walsh, C. E. (2009). 'Inflation targeting: what have we learned?', International Finance, vol. 12(2), pp. 195-233. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1468-2362.2009.01236.x/full