What is monetary targeting and why did it succeed in some
countries and fail in others?
What is inflation targeting and why is it important?
Once a central bank has decided
whether it wants to hold the line (no change [Δ]), tighten
(increase i, decrease or slow the growth of MS), or ease (lower i,
increase MS), it has to figure out how best to do so. Quite a
gulf exists between the central bank’s goals (low inflation, high
employment) and its tools or instruments (OMO, discount loans,
changing rr). So it sometimes creates a target between the two,
some intermediate goal that it shoots for with its tools, with the
expectation that hitting the target’s bull’s-eye would lead to goal
satisfaction:
TOOLS→TARGET→GOAL
In the past, many central banks targeted monetary aggregates
like M1 or M2. Some, like Germany’s Bundesbank and
Switzerland’s central bank, did so successfully. Others, like the
Fed, the Bank of Japan, and the Bank of England, failed miserably.
Their failure is partly explained by what economists call the time
inconsistency problem, the inability over time to follow a
good plan consistently. (Weight-loss diets suffer from the
time inconsistency problem, too, and every form of procrastination
is essentially time inconsistent.) Basically, like a wayward dieter
or a lazy student (rare animals to be sure), they overshot their
targets time and time again, preferring pleasure now at the cost of
pain later.
Another major problem was that monetary targets did not
always equate to the central banks’ goals in any clear way. Long
lags between policy implementation and real-world effects made it
difficult to know to what degree a policy was working—or not.
Worse, the importance of specific aggregates as a determinant
of interest rates and the price level waxed and waned over time in
ways that proved difficult to predict. Finally, many central
banks experienced a disjoint between their tools or operating
instruments, which were often interest rates like the federal
funds, and their monetary targets. It turns out that one can’t
control both an interest rate and a monetary aggregate at the same
time. To see why, study Figure 17.1. Note that if the
central bank leaves the supply of money fixed, changes in the
demand for money will make the interest rate jiggle up and down. It
can only keep i fixed by changing the money supply.
Because open market operations are the easiest way to conduct
monetary policy, most central banks, as we’ve seen, eventually
changed reserves to maintain an interest rate target. With the
monetary supply moving round and round, up and down, it became
difficult to hit monetary targets.
Central banks can control i or MS, but not
both.
In response to all this, several leading central banks,
beginning with New Zealand in 1990, have adopted explicit inflation
targets. The result everywhere has been more or less the same:
lower employment and output in the short run as inflation
expectations are wrung out of the economy, followed by an extended
period of prosperity and high employment. As long as it remains
somewhat flexible, inflation targeting frees central bankers to do
whatever it takes to keep prices in check, to use all available
information and not just monetary statistics. Inflation targeting
makes them more accountable because the public can easily monitor
their success or failure. (New Zealand took this concept a step
further, enacting legislation that tied the central banker’s job to
keeping inflation within the target range.)
Stop and Think Box
What do you think of New Zealand’s law
that allows the legislature to oust a central banker who allows too
much inflation?
Well, it makes the central bank less
independent. Of course, independence is valuable to the public only
as a means of keeping inflation in check. The policy is only as
good as the legislature. If it uses the punishment only to oust
incompetent or corrupt central bankers, it should be salutary. If
it ousts good central bankers caught in a tough situation (for
example, an oil supply shock or war), the law may serve only to
keep good people from taking the job. If the central banker’s
salary is very high, the law might also induce him or her to try to
distort the official inflation figures on which his or her job
depends.
The Fed has not yet adopted explicit inflation targeting,
though a debate currently rages about whether it should. And
under Ben Bernanke, it moved to what some have called inflation
targeting-lite, with a new policy of communicating with the public
more frequently about its forecasts, which now run to three years
instead of the traditional two.“The Federal Reserve: Letting Light
In,” The Economist (17 November 2007), 88–89. As noted
above, the Fed is not very transparent, and that has the effect of
roiling the financial markets when expectations about its monetary
policy turn out to be incorrect. It also induces people to waste a
lot of time engaging in “Fed watching,” looking for clues about
monetary policy. Reporters actually used to comment on the
thickness of Greenspan’s briefcase when he went into Federal Open
Market Committee (FOMC) meetings. No
joke!www.amazon.com/Inside-Greenspans-Briefcase-Investment-Strategies/dp/007138913X
Why doesn’t the Fed, which is charged with maintaining financial
market and price stability, adopt explicit targets? It may be that
it does not want to be held accountable for its performance. It
probably wants to protect its independence, but maybe more for its
private interest (power) rather than for the public interest (low
inflation). It may also be that the Fed has found the holy
grail of monetary policy, a flexible rule that helps it to
determine the appropriate federal funds target.
key takeaways
Monetary targeting entails setting and attempting to meet
growth rates of monetary aggregates such as M1 or M2.
It succeeded in countries like Germany and Switzerland, where
the central bank was committed to keeping inflation in check.
In other countries, like the United States and the United
Kingdom, where price stability was not the paramount goal of the
central bank, the time inconsistency problem eroded the
effectiveness of the targets.
In short, like a dieter who can’t resist that extra helping at
dinner and two desserts, the central banks could not stick to a
good long-term plan day to day.
Also, the connection between increases in particular aggregates
and the price level broke down, but it took a long time for central
bankers to realize it because the lag between policy implementation
and real-world outcome was often many months and sometimes
years.
Inflation targeting entails keeping increases in the price
level within a predetermined range, e.g., 1 and 2 percent per
year.
Countries whose central banks embraced inflation targeting
often suffered a recession and high unemployment at first, but in
the long run were able to achieve both price level stability and
economic expansion and high employment.
Inflation targeting makes use of all available information, not
just monetary aggregates, and increases the accountability of
central banks and bankers. That reduces their independence but not
at the expense of higher inflation because inflation targeting, in
a sense, is a substitute for independence.