Inflation targeting: a view from the ECB

1. INTRODUCTION

What is the ultimate objective of monetary policy? What is the appropriate framework for conducting monetary policy? Central bankers and academics have been asking these critical questions for decades. This conference, in which I was honored to take part, was a milestone in this long-standing debate.

It is a fact that never before in the history of fiat money has there been so much consensus on the benefits of a low-inflation environment, and many central banks have achieved results consistent with this conviction. This is a tremendous achievement and one that could easily lead us to think that at last this long-standing debate has been settled once and for all.

However, I do sometimes wonder whether we are not too complacent in believing that the regime of low inflation will be with us "from here to eternity." There is always a risk that even great achievements, after a while, are taken as given and that their value is only rediscovered when they are in danger of becoming lost. In addition, recent history should tell us that the structure of the economy changes over time in a way that is difficult to anticipate and perceive in real time. This continuous mutation makes the task of monetary policy and its implementation even more challenging. It is the intrinsic nature of the economy that makes the debate on the aims of monetary policy and its appropriate framework so difficult to settle, and I believe that this debate will continue for some time to come.

In the course of the 1990s the inflation-targeting framework for the conduct of monetary policy has become popular among central banks and academics. In this paper I will highlight some of what I think are the distinguishing features and possible pitfalls of this approach. I will then draw comparisons with the European Central Bank's (ECB) monetary policy strategy, also in the light of the ECB's clarification of its strategy in May 2003.

Thus, in section 2, I would like to put the current debates on monetary policy into a historical perspective. In section 3, I will discuss what I see as the critical aspects of the inflation-targeting approach. Section 4 outlines the ECB's monetary policy approach and the ways in which it resembles and differs from the inflation-targeting framework.

2. A HISTORICAL PERSPECTIVE

Following the philosophy of "rules above authorities"--to paraphrase slightly the title of Henry Simons' famous article (1936)--one strand of research wanted the behavior of central bankers to be strictly constrained by a rule for conducting monetary policy. The most prominent advocate of this was Milton Friedman and his famous k-percent rule. The key argument in favor of the adoption of a simple strict rule was the acknowledgment of the economists' and central bankers' ignorance of the exact functioning of the economy and the long and variable time lags of monetary policy. It maintains that the actors of monetary policy know too little of the actual functioning of the economy to be able to perform activist policy and their discretionary actions would only exacerbate economic fluctuations instead of smoothing them. Strict rules prevent such problems, eliminating judgmental elements in monetary policy action and avoiding activist policy.

However, during the 1960s, few central bankers were in favor of rules, mostly because the performance of discretionary monetary policy at that time had been quite satisfactory, at least in the United States, and policymakers were increasingly confident of their ability to properly steer the performance of the economy. The 1970s marked the end of that overconfidence. In the period between the first oil shock and the early 1980s, the world's major economies experienced two recessions while inflation rose to double-digit levels. Although these events were not fully under the control of the monetary authorities, it is clear that the discretionary approach to monetary policy did make a negative contribution by not properly anchoring inflation expectations and instead allowing them to drift. (1)

One of the lessons that economists learned from their experience of the 1970s was that economic agents' expectations cannot be taken as given by policymakers when choosing their policy action. The underlying idea is simple but path-breaking and goes back to at least Marschak (1947), although the strongest case was made by Lucas (1976). In forming their expectations and taking their actions, economic agents will always try to anticipate future policy moves. This makes expectations of future policy relevant for today's consumption and investment decisions and creates the room for strategic interaction among economic agents, a cornerstone of which is the credibility of the policymaker to commit to a given set of actions. In the context of monetary policy, Kydland and Prescott (1977) and Barro and Gordon (1983) proposed models where the desire of the central bank to attain an unemployment rate below the natural rate generates surprise inflation in the economy: This is the "time consistency" problem. Economic agents properly understanding the incentives of the monetary authority and its actions would thus anticipate future inflation. In equilibrium, this would end up generating the well-known "inflation bias." A superior outcome could be achieved if monetary policy authorities took into account the effect their behavior could have on economic agents' action and properly commit not to inflate. The advantage of commitment relative to discretion crucially hinges on the credibility of the monetary authority actually sticking to its promises.

From those original contributions a large strand of literature tried to devise incentive-compatible institutional schemes capable of enforcing a rule-type behavior and thus dealing with the time inconsistency problem. General consensus has emerged that a necessary prerequisite for solving the time inconsistency problem is the establishment of an independent central bank to which the management of monetary policy is then delegated. The institutional arrangement mostly adopted to enforce the commitment accepts that monetary policy should treat the natural rate of unemployment as a given, and not try to push unemployment below its natural rate. (2)

These results square with another finding of the 1970s, namely, the absence of any long-run tradeoff between unemployment and inflation. This point was stressed by Friedman in his 1977 Nobel lecture, among others. Friedman's argument was that, while it is possible to stimulate the economy in the short run by some form of monetary illusion, workers would see through the illusion in the longer run, demanding higher wages and so bringing employment back to its natural level. Every effort to permanently push employment above its natural level is therefore self-defeating.

These arguments reinforced the original criticism of discretionary monetary policy and were the final nails in the coffin of the theory of an activist monetary policy (and the idea of a monetary policy seeking to push economic activity above its natural level). The focus of monetary policy action had to be price stability.

The awareness of the limitations of monetary policy was also coupled with a better understanding of the possible costs of inflation and the recognition that a low-inflation environment is a necessary precondition for long-run growth and an efficient allocation of resources. (3)

Taken together, the awareness of the cost of inflation, of the absence of a long-run trade-off between inflation and real activity, and of the relevance of the credibility problem of the monetary authority are some of the motivations underlying the widespread adoption of a culture of price stability among the central banks of the industrialized countries during the 1980s and 1990s. I have no doubt that this new culture has made an important contribution to the disinflation process that we have observed in many countries over the past two decades. (4)

The inflation experience of the 1970s and developments in the theory of monetary policy analysis over the past 20 years have made clear the importance of the monetary authority making a firm commitment. However, contrary to the debate of the 1960s, it is a commitment on an objective rather than on a simple rule. Once an agreement on the objective had been reached, another critical question remained: Which is the best strategy for achieving this final objective? Over the years central bankers and academics around the world have proposed a variety of strategies. Different central banks have adopted strategies that place different emphasis on the various pieces of information, or elements of their decisionmaking process, or different aspects of their communication policies.

Source: Findarticles.com

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