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It is widely accepted that — apart from price stability considered as the primary task of the central bank and announcement of the numerical value of the inflation target — the key elements of inflation targeting strategy are monetary policy based on extensive information and high standards of democratic control and transparency of central bank’s activities.
The last two requirements can be seen as an element reinforcing a far-reaching independence granted to central banks in recent decades, which is also considered an important determinant of monetary policy.
A history of struggles
We should recall the historical context in which the inflation targeting strategy was created. The collapse of the Bretton Woods system and the termination of the gold/USD convertibility in international settlements in the early 1970s marked the beginning of global monetary instability. At that time, many central banks pursued monetary policy that stimulated economic growth, which, combined with oil price shocks, boosted inflation expectations and led to a high inflation. In subsequent years, attempts were made to peg exchange rates again, but without a success.
In these circumstances, since the mid-1970s, major central banks have tried to stabilize the value of money by controlling monetary aggregates. However, as there was no fixed relationship between monetary aggregates and inflation as a result of, among other things, financial innovation, this monetary policy regime proved to be not sufficiently effective.
Towards the end of the 1980s, due to the growing popularity of the floating exchange rate regime and with the limited efficiency of the money supply control regime, the idea arose to ignore intermediate objectives and to use the numerically determined and publicly announced inflation target as a factor shaping inflation expectations.
Inflation targeting strategy proved extremely effective in stabilising inflation without generating high costs of anti-inflationary policy in the form of a negative impact on economic growth. This made it very popular among many central banks, both in developed and developing countries. As a result, this policy became the standard, especially among medium-sized and larger economies, and is the leading monetary policy regime in this group of countries.
At the same time, there are definitely fewer developed countries attempting to adjust the institutional settings of their central banks to adopt inflation targeting strategy in the future. This regime requires a number of conditions to be met in order for monetary policy to be credible and thus to have a sufficiently strong impact on economic processes and, as a result, to ensure that the objectives are met.
Inflation targeting strategy, however, is not a set of hard rules that must be strictly adhered to, but rather a structured way of conducting monetary policy that leaves central banks a high degree of flexibility and discretion.
Looking back, we see that the first two decades of pursuing inflation targeting strategy were a period of a significant decline in the previously heightened inflation and a relatively stable economic growth. Consequently, this period came to be known as the Great Moderation.
Although this might be due to many different factors, the expansion of the inflation targeting regime was seen as one of the elements supporting these positive macroeconomic trends. At the same time, however, financial imbalances gradually built up, which led to the outbreak of the global financial crisis in 2008. As a result, the last decade has revised the views on the effectiveness of inflation targeting strategies in ensuring the overall macroeconomic stability of economies.
The analysis of the functioning of central banks pursuing inflation targeting strategy shows that in many respects their practices are similar. This can be seen, among others, in their opting for a floating exchange rate, a public announcement of medium-term inflation and GDP forecasts, or the emphasis placed on transparency of communication.
Yet, in some respects the conduct of inflation targeting strategy differs across central banks. This concerns, in particular, the way how inflation targets are defined or how their levels are set. However, while the essential elements of the strategy have remained virtually unchanged since it was first used — which refers in particular to the key role of the numerical inflation target, the importance of macroeconomic forecasts and the focus on monetary policy communication — some aspects of the regime have evolved over time.
Learning by experience
In the initial period, adjustments of the inflation targeting strategy largely relied on the experience gained by central banks from their conduct of the monetary policy regime in particular circumstances. In many countries, the circumstances forced central banks to modify their strategies.
At the same time, the absence of a rigid framework proved to be a great advantage of inflation targeting strategy and an important factor which enabled it to be pursued by a group of diverse economies. Currently, around 40 central banks worldwide are conducting their monetary policy under the inflation targeting regime.
At the same time, the global financial crisis has shown that while this strategy — especially when used flexibly — proved to be effective in controlling inflation and supporting economic growth in the medium term, it failed to effectively account for the risks associated with the financial system.
For this reason, in the last decade the discussions among central bankers have focused on finding the solutions that could be seen as further modifying inflation targeting strategy. If this standpoint is adopted, the current discussions about the need to modify the inflation targeting regime encompass primarily such tasks as determining the role of financial stability in monetary policy decisions and the extent of the use of non-standard monetary policy instruments.
Ongoing changes may be perceived as a test of the limit of flexibility of inflation targeting strategy as a monetary policy regime. Importantly, in the past this strategy was relatively easily adapted to face new challenges.
For these reasons, supporters of this approach are still convinced that there is no better way to conduct monetary policy that could be considered an actual alternative to inflation targeting strategy.
On the other hand, opponents of this strategy argue that its pursuit caused imbalances to build up and led to the outbreak of the crisis. Therefore, central banks should look at other monetary policy regimes that could be more effective in stabilizing economies with too low rather than too high inflation.
Recent work undertaken at the US Federal Reserve Bank and the European Central Bank to revise monetary policy strategy can be seen as meeting the demand of a critical evaluation of conducting monetary policy based on the existing rules.
Neither the US Fed nor the ECB does officially call their strategies an inflation targeting strategy, but in practice their monetary policy regimes do not differ much.
The discussion between the supporters and opponents of the inflation targeting regime is still far from being over, but the state of discussion implies that one of the greatest and indisputable advantages of inflation targeting strategy is its flexibility, which once again may be a decisive factor in favour of making it a leading monetary policy regime.
It can be assumed that given current conditions central banks will have to place greater emphasis on financial stability and broaden the set of their monetary policy tools. However, these elements can become an integral part of the inflation targeting regime and there will be no need to reject this strategy in favour of other monetary policy frameworks.
Evolution through modification
For this reason, it is worth taking a close look at how inflation targeting strategy has evolved over time. This can make it easier to draw conclusions as to its future changes.
A review of past changes made to the inflation target regime — proposed in different countries in response to various problems — makes it possible to evaluate ex post how effective these changes were. The following publications prepared by Poland’s central bank, NBP, aim to assess their effectiveness: “Inflation Targeting ‒ Institutional features of the strategy in practice”, and “Three Decades of Inflation Targeting” published in November 2018 and August 2019.
These two extensive papers show that the process of modifying the way we understand and implement the inflation targeting strategy was a continuous process and can be called evolution of the strategy. This becomes clear when we look at the key modifications that shaped the current understanding of the essence of the inflation targeting regime and somehow became part of its canon.
The publications also address some of less common modifications in the strategy, which have not become widely accepted and can be treated as incidental. However, their analysis allows to see the pros and cons of specific solutions which finally decide whether they are more or less effective.
Many studies on inflation targeting strategies highlight the conclusions which can be drawn from the global financial crisis. The above publications analyse three decades of experience of virtually all central banks in pursuing this monetary policy regime.
Thus, NBP studies cover a fairly diverse range of issues which can help to understand the essence of inflation targeting strategy. They can provide answers to the questions about the most typical level of the inflation target, about the frequency of central banks publishing their projections and the length of the projection horizon as well as about the decision makers and frequency of monetary decision-making and about non-standard instruments used to address the global financial crisis.
Joanna Niedźwiedzińska is the Head of the Monetary Policy Strategy Division at the Poland’s central bank, NBP.
The views expressed in this article are the private views of the author and are not an expression of the official position of the NBP.