Does Inflation Targeting Matter?

Since it was first introduced by New Zealand and Chile in 1990, Canada in 1991, and the United Kingdom in 1992, inflation targeting (IT) has received a lot of attention in the public and academic debate over the design of monetary policy regimes. In part, this attention reflects the growing number of countries that have adopted an IT regime over the past decade. Schaechter, Stone, and Zelmer (2000) count 13 countries with IT experience as of February 2000: Australia, Brazil, Canada, Chile, the Czech Republic, Finland, Israel, New Zealand, Poland, South Africa, Spain, Sweden, and the United Kingdom. Corbo, Landerretche Moreno, and Schmidt-Hebbel (2001) add Korea and Thailand to this list. Most recently, Hungary and Switzerland have introduced inflation targets. Since the Bundesbank declared a normative target inflation rate as the principal goal of its monetary policy, Mishkin and Posen (1997), following von Hagen (1995), classify Germany as an early case of IT, although the German inflation objective was formulated for the medium run, while the short-run focus of the Bundesbank’s monetary strategy was on the annual monetary target. As early as 1994, an academic conference reviewed the experience with IT (Leiderman and Svensson, 1995). A number of more recent studies summarize the experience gained with IT over the past decade (Bernanke et al., 1999; Corbo, Landerretche Moreno, and Schmidt-Hebbel, 2001). These papers focus on a variety of questions related to the choice of monetary regimes, including the improvement in inflation performance, in monetary policy credibility, and in the sacrifice ratio, i.e., the cost of lowering inflation. The debate over IT exposes a couple of odd characteristics. One is that, despite a lot of effort, empirical studies on IT have consistently failed to show convincingly that IT has been an important factor in speeding up disinflation, achieving lower inflation rates, lowering the cost of disinflation, or raising the credibility of the central bank’s commitment to low inflation. An important challenge for IT supporters comes from the observation that the environment of the 1990s, when IT was first undertaken, was generally benign, implying that the particular strategy of IT may have done little to improve monetary policy outcomes over what any reasonable strategy could have achieved (Cecchetti and Ehrmann, 2000). We will review this literature in more detail in Section II. The other oddity is that, despite the lack of empirical evidence supporting the advantages of IT, its proponents consistently argue that the failure to adopt it jeopardizes the ability of a central bank to deliver price stability. For example, Bernanke et al., after presenting pages upon pages of rather inconclusive evidence regarding the superiority of IT, nevertheless submit a plea for the Fed to adopt IT in the end, arguing that this is critical to secure price stability in the United States in the post-Greenspan era. Similarly, Alesina et al. (2001), in a discussion of the European Central Bank’s (ECB) monetary policy, boldly claim that the ECB could improve its policy by adopting a version of IT, although they neither present supporting evidence for this claim nor even indicate where such evidence might be found. It is understandable that some academics find IT intellectually attractive for the outright declaration of central bank intentions and the increase in accountability implied by the announcement of an inflation target. Yet, others remain skeptical: Both the ECB (2001) and the Fed (Gramlich, 2001) have argued that they do not regard IT as an appropriate monetary policy framework. In this paper, we contribute to the assessment of IT in several ways. After reviewing earlier studies of IT experiences, we examine the changes of shortterm interest rates and of consumer price inflation and output gaps at different frequencies, as well as show that IT has reduced short-term variability in central bank interest rates and in headline inflation. We interpret this as evidence that IT has induced central banks to pay less attention to short-run news and noise and adopt a steadier course of monetary Manfred J.M. Neumann is a professor of economics at the University of Bonn and a member of the Academic Advisory Council of the German Federal Ministry of Economics and of the Bundesbank’s Research Advisory Council. Jürgen von Hagen is a professor of economics and director of the Center for European Integration Studies at the University of Bonn, a research fellow of CEPR, and a member of the Academic Advisory Council of the Federal Ministry of Economics, the Bundesbank’s Research Advisory Council, and the French Comité Economique de la Nation. The authors thank our discussants, Frederik Mishkin and Stephen Cecchetti, for valuable comments and suggestions.