Design Issues in the Implementation of Inflation Targets

Part I has outlined the reasons why several countries have chosen to their monetary strategies on the targeting of inflation. It also raises a set of issues about the design of an inflation-targeting regime. Before examining in detail how inflation targeting has worked in the countries we examine here, we briefly outline the choices policymakers face in designing an inflation-targeting strategy. The fundamental question is how best to balance transparency with flexibility in operation, given the uncertainties of monetary policy and the economic environment. The simpler and tighter the constraints on policy, the easier it is for the public to understand and hold policy accountable, but the harder it is for policy to respond to events and maintain credible performance. Choices about target design are therefore critical in setting this balance appropriately. In the case studies that follow, we will see that the design choices for an inflation-targeting regime fall into four basic categories: definition and measurement of the target, transparency, flexibility, and timing. DEFINITION AND MEASUREMENT OF THE TARGET Because inflation targeting by its very nature requires a numerical value for the target, setting such a target requires explicit answers to several questions about how the target is defined and measured. What does price stability mean in practice? Inflation targeting requires a quantitative statement as to what inflation rate is consistent with the pursuit of price stability in the next few years. Because of innovation and changing tastes, all inflation measures have a net positive bias. For example, measurement error for consumer price index (CPI) inflation in the United States has been estimated to be in the range of 0.5 to 2.0 percent at an annual rate (Shapiro and Wilcox 1996; Advisory Commission to Study the Consumer Price Index 1996). Another factor to be taken into account in setting the target level of inflation is the asymmetric dangers from deflation. That is, through financial and other channels, the costs to the real economy from undershooting zero inflation outweigh the direct costs to the economy from overshooting zero inflation by a similar amount. These potential costs might warrant a price stability objective in which the inflation rate, corrected for any measurement error, might be set slightly above zero. What inflation series should be targeted and who should measure it? A target series must be defined and measured. The series needs to be considered accurate, timely, and readily understandable by the public, but it may also need to exclude from its definition individual price shocks or one-time shifts that do not affect trend inflation, which is what monetary policy can influence. Price-level or inflation target? Both price-level and inflation targets imply a targeted path for the price level. A price-level target sets the path for the price level so that if inflation is above the targeted rate in one period, it must be below the targeted rate in the next period in order to hit the price-level target. By contrast, an inflation target allows for base drift, in which bygones are bygones, and the miss on the inflation target does not need to be offset. Relative to an inflation target, a price-level target has the advantage of helping to pin down price-level expectations over very long time horizons, but it may increase the volatility of the price level over shorter time horizons. TRANSPARENCY An important rationale for inflation targeting is that it promotes transparency in monetary policy. Two questions need to be answered if transparency is to be achieved. How should inflation targets be used to communicate with the public and the markets? Inflation targets can be an effective way of increasing transparency by communicating information to the public and the markets about the stance and intentions of monetary policy. …