North American Journal of

Economics and Finance 13 (2002) 9397

Central banks and inflation targeting in perspective

Andrew F. Brimmer
Brimmer & Company, Inc. and University of Massachusetts-Amherst,
4400 MacArthur Blvd., N.W., Suite 302, Washington, DC 20007, USA
Received 19 April 2002; received in revised form 24 May 2002; accepted 24 May 2002

Abstract
Beginning over a decade ago, a number of central banks have adopted the technique of inflation
targeting in an effort to improve their performance. Under this approach, an agreement between a
nations government and its central bank commits the latter to achieve a quantitative inflation target
by a certain date. Typically, the target is specified as a low but positive rate of inflation. In 1990,
New Zealand became the first industrialized country to institute a formula regime of inflation targeting.
Next in line were Canada (1991), the United Kingdom and Israel (1992), and Australia and Sweden
(1993). Switzerland took the step in 1999. Finland and Spain adopted inflation targeting prior to joining
the European Monetary Union. The European Central Bank while not describing its basic mode of
operation as inflation targeting behaves as though this were the case. The U.S. Federal Reserve has
debated inflation targeting but has refrained from adopting it. Instead, it boasts that it has achieved its
noticeable success through relying on its traditional instruments. This article provides an over-view of
papers on inflation targeting in New Zealand, Canada, and Chile, and summarizes the discussion in
the United States. In New Zealand, inflation was brought down sharply, and the approach created an
expectations environment that made the policy credible. In Canada, the decline in actual inflation was
also striking, and expectations of forecasters, businesses, and organized labor soon began to decrease
in parallel with the target. Inflation targeting in Chile (dating back to 1990), cut the rate of inflation
markedly and strengthened the credibility of monetary policy.
2002 Elsevier Science Inc. All rights reserved.
Keywords: Central Banking; Inflation targeting

1. Introduction
Over the years, monetary economists, both in academia and in central banks, have made
numerous suggestions with respect to the best way for authorities to operate in pursuit of

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A.F. Brimmer / North American Journal of Economics and Finance 13 (2002) 9397

their monetary policy objectives. Along the way, some of these recommendations have been
adopted. They include fixing exchange rates, stabilization of the money supply, smoothing the
rate of growth of nominal income, and setting short-term interest rates through an instrument
rule. In one form or another, most of these procedures have been tried by one or more central
banks, but with uneven results.
Beginning just over a decade ago, a new mode of operation became quite popular. This
technique was labeled inflation targeting. Under it, an agreement between a nations government and its central bank commits the latter to achieve a quantitative inflation target by a
certain date. Typically, the target is specified as a lowbut positiverate of inflation, although
allowances are made for a margin of error and for unexpected price shocks.
In 1990, New Zealand became the first industrialized country to institute a formal regime of
inflation targeting. Next in line were Canada (1991), the United Kingdom and Israel (1992),
and Australia and Sweden (1993). Switzerland took the step in 1999. Both Finland and Spain
adopted inflation targeting prior to joining the European Monetary Union. The European
Central Bank (ECB)while not describing its basic mode of operation as inflation targeting
behaves as though this were the case. Its charter (the Maastricht Treaty) set the achievement
of price stability as the Banks primary goal, and the ECB does set explicit numeric targets for
inflation.
Finally, a number of developing countries (including Brazil, Chile, Turkey, and South Africa)
adopted inflation targeting as a principal guidepost for the operation of their central banks. In
fact, during the decade of the 1990s, the trend to inflation targeting accelerated. At the last
count, more than 30 countries had instituted inflation targeting regimes.
However, one leading country is not among them: the United States is conspicuous by
its absence. Although there has been much debate over the Federal Reserves decision not
to institute inflation targeting, the United States Congress has always refused to amend the
Federal Reserve Act to require it.
The papers included in this section, taken together, provide a variety of insights into the
motivations behind inflation targeting regimes, the way they have worked in practice, the
necessity to modify them, and the reasons for the results reported. The papers cover inflation
targeting in New Zealand, Canada, and Chile and examine the state of affairs in the United
States, which has not adopted inflation targeting, but whose experts have given considerable
thought to that approach.

2. Inflation targeting in New Zealand

In the paper entitled Inflation targeting: New Zealands experience over 14 years, Donald
T. Brash, Governor of the Reserve Bank of New Zealand, describes the origins and evolution
of that approach in his country and assesses the character and magnitude of the contribution it
has made in the central banks campaign to check inflation.
Inflation targeting was adopted by the Reserve Bank of New Zealand in response to a
mandate from the National Government to provide an anchor for monetary policy. The desire
to change inflation expectations was an important part of the motivation behind the adoption
of an inflation target. As a first step in adopting the new policy, Parliament voted to make price

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95

stability the Reserve Banks objective and to give the bank instrument independence, meaning
that, once Government set the policy, the central bank could decide how to achieve it.
The objective was announced in the form of a Policy Targets Agreement (PTA) between the
Minister of Finance and the Governor of the Reserve Bank. Under the arrangement, the bank
was assigned the obligation to achieve the agreed inflation target within the specified time,
while the finance ministers signature committed the New Zealand Government to cooperate
in the national effort to check inflation.
Over the years, the specification of the target has evolved considerably. At the outset, the
target was expressed as a range of 02%, subject to a provision for renegotiating the target in
the case of unusual events such as large changes in the international oil price or in indirect tax
rates, and other unanticipated developments. Gradually the time frame for achieving the target
was respecified and the renegotiation provision was dropped and replaced by a requirement that
the bank assure that CPI inflation (excluding exceptionable items) fell within the target range.
The result of inflation targeting in New Zealand was to bring inflation down sharply and to
create an expectations environment that made the policy credible.

3. Canadian experience with inflation targeting

In his paper, Governor David Dodge notes that Canada turned to targeting inflation in early
1991 almost out of desperation in an effort to check the high and variable rates of inflation
that had caused considerable damage to the Canadian economy in the 1970s and 1980s. This
experience forced the Canadian Government and the Bank of Canada to find a new approach to
check inflation. The solution was an agreement between them on explicit, quantitative targets
for inflation reduction.
The decision in 1991 to adopt inflation targeting followed two earlier disappointing experiences with monetary policies. The arrangement set a formal target initially at 3% (plus or
minus 1%), but announced a series of subsequent targets aimed at bringing the 12-month CPI
rate down to 2% (plus or minus 1%) by December 1995.
The results achieved under the inflation targeting regime in Canada have been striking. The
rate of inflation declined rapidly. After actual inflation decreased to the neighborhood of 2%,
expectations of forecasters and businesses soon began to decline in parallel with the targets.
This evidence, leads Governor Dodge to conclude that inflation targeting has made a substantial contribution in the quest for price stability in Canada.

4. Inflation targeting in Chile

Chile was the first developing country and, according to Klaus Schmidt-Hebbel and Matias
Tapia, the second country in the world to adopt inflation targeting in 1990. Since then, inflation
has declined from 27% per annum to low, stationary levels that are within the range of 24%
per year.
As in other countries, explicit inflation targets have allowed the Central Bank of
Chile to strengthen the credibility of monetary policy, thereby reducing inflationary

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expectations. Declining expectations, in turn, have facilitated the achievement of lower

realized inflation.
Inflation targeting often occurs in the context of floating rates. In developing countries,
floating rates create special problems associated with sharp surges in capital movements. These
problems were widely viewed to have instilled a fear of floating in emerging economies.
Schmidt-Hebbel and Tapia examine this issue and conclude that inflation targeting helped
reduce the fear of floating in Chile, because it helped reduce the pass-through from exchange
rate changes to inflation.

5. Reflections on inflation targeting for the United States

As indicated above, the United States central bank has not advocated the adoption of inflation
targeting. Although the Federal Reserve Board has not taken a formal position on the issue, it
clearly feels that such a policy would not be helpful in controlling inflation in this country. This
view was expressed succinctly by Alan Greenspan, Chairman of the Federal Reserve System,
in Congressional testimony in April 1999. In response to a question, he stated:
At the moment and as far into the future as I can perceive, the central bank of this country
is going to be focused on price stability, if for no other reason than the evidence is that it
contributes to a strong economy, prosperity, low unemployment, stable economic growth, and
growth in productivity. There is no doubt that price stability has very major, important, positive
elements to it.

Further, he stated that, in pursuing anti-inflation policies:

. . . We dont have specific numbers and one of the reasons, incidentally, is that you have to
put the limits on a specific price index.
As I have testified many times in the past, I have serious questions about whether the
Consumer Price Index is the ideal index by which to target monetary policy. There is no
question it has many flaws, and I have always argued that the personal consumption price
deflator is a far superior measure of true underlying inflation from a technical point of view.
Because that index is periodically revised, it muddies the waters in a certain sense as to what
we are looking at.
So I dont deny that we do have rough approximations of what the limits would be. It is just
that I would be very hesitant to apply very specific limits to the Consumer Price Index, which
itself sometimes distorts the outlook. I suspect, were we required to adhere to it even when it
is giving off wrong signals, we would end up with a policy which would be less than we would
like.1

A contrary view is expressed by Laurence H. Meyer in the paper included here. Meyer,
who was a Member of the Federal Reserve Board, begins his analysis by describing the two
types of mandates which typically govern central bank operations. In the first, a hierarchical
or dual regime casts price stability as the primary goal of monetary policy, and other potential
objectives are made subordinate to it. In the second, an explicit inflation target is established
as the single objective. Meyer argues in favor of setting an explicit numerical inflation target

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within the context of the Feds existing dual mandate, but against installing a single inflation
targeting regime that would replace the current dual mandate with a hierarchical one.
Meyer argues that an explicit inflation target would impart additional precision to an already
mandated goal of the United States central bank and would enhance the accountability and
transparency of Federal Reserve monetary policy. He believes that the establishment of an
explicit inflation target is compatible with the current Federal Reserve statute and would not
call for any significant changes in the way monetary policy is conducted in the United States.
6. Concluding observations
Although the countries studied here have had very positive experiences with inflation targeting, the overall record is probably more mixed. Nevertheless, as one scans this range of
experiences, an important conclusion stands out: inflation targeting made its greatest contribution by dampening inflation expectations. The successful operation of the regime increased the
publics confidence in the commitment of governments to fight inflation, and thereby helped
bring down actual inflation.
Note
1. The Economic Outlook and Monetary Policy, Hearing before the Joint Economic
committee, Congress of the United States, June 17, 1999.