Beyond Inflation Targets

EDINBURGH – Over the last three decades or so, central bankers and academics have become increasingly confident that inflation targeting is the key to preserving macroeconomic stability. But this is virtually impossible to prove, and the 2008 financial crisis suggested to many that monetary policy should focus on more than the prices of goods and services. So how should a revised mandate for central banks be structured to maintain their focus on low inflation while allowing monetary policy to address other issues when appropriate?

The contribution that inflation targeting makes to macroeconomic stability is difficult to discern for a simple reason: it is impossible to know what would happen if a country’s central bank pursued the opposite course. Unable to compare outcomes directly, researchers have employed a variety of strategies to identify the impact of inflation targeting, and have typically found it to be substantial (though the effect becomes small or even zero when countries’ starting points are taken into account).

For example, a case study of the United Kingdom for 1997-2007 – a period of full inflation targets and policy independence for the Bank of England (BoE) – indicates considerable improvement from a poor starting point. The focus on price stability was accompanied by relatively low inflation (compared to the past, as well as to other major economies), strong growth, and little output volatility.

However, over this period the UK also experienced sustained exchange-rate misalignment, which the BoE’s Monetary Policy Committee was unwilling or unable to address within its existing mandate. The MPC also failed to respond to any of the three bouts of rapid growth in house prices that preceded the financial crisis, arguing that they were structural in nature –caused by the decline in inflation and interest rates since the 1980’s – so a monetary response was not appropriate.