Inflation targeting is 25 years old, but has it worked?

By Andrew Walker
BBC World Service Economics correspondent

  • Published
vegetable stallImage source, Getty Images
Image caption,
Britain's annual inflation rate slowed to a record low of 0.3% in January

Inflation targeting is 25 years old. It began in 1990 in New Zealand and the UK was one of the first to follow, two years later.

A quarter of a century after New Zealand set the ball rolling many central banks now have an inflation target, including the US Federal Reserve, the European Central Bank and the Bank of Japan.

It has been a very uneven time in terms of economic performance. It includes a large part of the period known as the 'great moderation' when inflation was substantially lower than previous years and economic growth reasonably stable. But it also includes the worst financial crisis since the 1930s.

First though how does it work?

The basic tools are the same as with most other inflation control policies. The most important of them in normal times is the central bank's interest rate policy.

The basic idea is straightforward enough. The central bank looks at its inflation forecast. If that is above the target it will raise interest rates which will usually lead to slower growth in spending and so to slower price rises. If the inflation forecast is below target it cuts rates with the opposite effect.

There's another important aspect - expectations among businesses, workers and households. If they expect inflation to be, say 2%, then they will set prices and pay deals on that basis and there's a better chance that inflation will be close to the target.

That is why you so often hear central bankers discussing how 'well-anchored' public inflation expectations are. The effectiveness of the approach depends to a significant extent on whether the public regards the inflation target and the central bank as 'credible'.

Image source, Getty Images
Image caption,
Monetarism is seen by many as the brainchild of the late US economist, Milton Friedman

Monetarism and 'shadowing'

The background to the rise of inflation targeting was the problems with alternative methods of containing rising prices.

The International Monetary Fund has described inflation targeting as "a pragmatic response to the failure of other monetary policy regimes".

There were two main earlier approaches: targets for either the money supply or exchange rates. Britain tried both in the 1980s and early 90s.

Money supply targets involve trying to ensure that some measure of money grows at a rate that's consistent with moderate inflation. It is the approach often known as monetarism, associated particularly with the Nobel Prize winning economist, the late Milton Friedman.

Germany's Bundesbank used this approach for many years.

But by the early 1990s the relationship between money supply and inflation was thought to be too erratic to be used as a guide to policy.

In 1993, the then chairman of the US Federal Reserve, Alan Greenspan told Congress:

"The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy."

In Britain, the policy was replaced with an exchange rate target. At first it was done in a less formal way by 'shadowing' the German mark. Then it became more rigid in 1990 when Britain joined the European exchange rate mechanism (the ERM) a system that kept currency fluctuations within limited 'bands'.

The basic idea with this approach is that you can only maintain the exchange rate target if your own inflation is reasonably close to that of the chosen foreign currency.

That ended dismally for Britain with the forced departure from the ERM as a result of massive speculation in the foreign currency markets.

The problem with exchange rate-based inflation policies is that they leave a country with little or no scope to use interest rates to respond to changes in their own economic circumstances.

A few weeks after the ERM debacle came the UK's adoption of inflation targeting. In the British case, the government remained in charge at first, until the responsibility for achieving the target was handed over to the Bank of England in 1997.

Image source, Getty Images
Image caption,
Central banks should be flexible in targeting inflation, says former Bank of England governor Lord King

'Inflation nutters'

In practice, central banks do not focus exclusively on getting inflation to the target level.

Those who think they should do that have been described by the former Bank of England governor Lord (Mervyn) King as "inflation nutters".

Instead what central banks have generally done is known as 'flexible inflation targeting'.

The aim as a rule has not been to keep inflation on target all the time, but to do so over what is called the medium term, which means a few years

In spite of the focus on inflation in their explicit targets, central banks do generally respond to other economic problems - notably unemployment and weak growth.

The Federal Reserve in the United States was rather late to adopt a specific inflation target (in January 2012).

Moderate inflation has long been one of its objectives, part of what is called the Fed's "dual mandate" - maximum employment and stable prices.

It is true there is a third element, moderate long term interest rates, but it is less discussed and the phrase dual mandate is very widely used.

For developed countries the target is usually around 2%. That is the figure chosen by the Bank of England and the US Federal Reserve. The European Central Bank aims at just below this target.

Image source, Getty Images
Image caption,
Critics say inflation targeting has constrained what action the Bank of England can take

Success or not?

So has it worked? In Britain there have certainly been many occasions when the target has been missed by a sufficiently large margin that the governor of the Bank of England has had to write a public letter to the chancellor of the exchequer to explain why.

The most recent case was because inflation too low, but it has usually been the result of prices rising faster than the target rate.

But over the longer term inflation has on average been much closer to the objective: 2.1% over 20 years, Lord King has said.

Prof Michael Woodford of Columbia University wrote that inflation targeting "has resulted in a high degree of stability in medium-run inflation expectations during the crisis and its aftermath, and I believe that this has improved the stability of the real economy as well".

Another challenge for the approach is the question of whether it made it harder for central banks to prevent the financial crisis. Prof Jeffrey Frankel of Harvard University argues that "in September 2008 it became clear that inflation targeting central banks had not paid enough attention to asset-price bubbles."

He says it should not have been a surprise that boom-bust cycles can happen without inflation

Prof John Quiggin of the University of Queensland Australia, another critic of inflation targets, says "central banks have failed, disastrously, and admitting this would be the first step towards a sustainable recovery".

Another complaint is that inflation targeting as in the UK - where it is the only explicit objective for monetary policy - constrained the Bank of England in the aftermath of the financial crisis.

Prof Simon Wren-Lewis of Oxford told the House of Commons Treasury Committee in 2012, that "policy is providing insufficient stimulus to the UK economy now, because of the form of the current monetary policy regime".

He suggested exploring alternatives including something akin to the US Fed's dual mandate.

Prof Karl Whelan of University College Dublin wrote "the Crisis has ruined inflation targeting's 'wonder drug' reputation".

Image source, Getty Images
Image caption,
Boom-bust cycles can happen without inflation, say critics of inflation-targeting

Needed 'more than ever'

But there are plenty of supporters. A group of 14 leading economists, published an e-book and the general conclusion - not shared by all of them - included this:

"It (inflation targeting) is needed now more than ever to keep expectations anchored while the advanced economies work their way through today's slow growth, rickety banks, and over-indebted public sectors."

For now, that seems to be the view of most central banks. There are certainly challenges to what you might call the 'inflation targeting consensus', but so far it has survived them.