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Does Inflation Targeting Make a Difference?


Jeremy M. Piger
Thursday, January 1, 2004

This article is based on a cover story written for the April 2004 issue of Monetary Trends, another publication from the St. Louis Fed. Over the past 15 years, an increasing number of central banks have adopted explicit inflation targeting as a framework for conducting monetary policy. Inflation targeting takes many forms, but at its heart are:

  • a statement made by the monetary authority announcing its targeted inflation rate (or range),
  • regular communication with the public on the progress being made toward hitting the target and
  • mechanisms for holding the monetary authority accountable should it miss its target.

Inflation targeting was adopted by a handful of mainly industrial countries during the early 1990s. Spurred by its perceived success, a large number of countries' including many emerging market economies' have recently adopted inflation targeting.

Despite the popularity of inflation targeting around the world and a general perception that it works, most early research studies found little evidence that the economic performance of non-inflation-targeting countries had suffered because they did not adopt inflation targeting. For example, a landmark study by Ben Bernanke, Thomas Laubach, Frederic Mishkin and Adam Posen found little difference in the macroeconomic performance of inflation targeting vs. non-inflation targeting countries.

The figure shows the inflation rates throughout the past decade in Canada and the United Kingdom—two representative inflation-targeting countries—along with the inflation rate in the United States, the most notable holdout to inflation targeting. At first glance, the figure confirms the notion that inflation targeting does not affect inflation performance because all three countries have experienced relatively low and stable inflation rates.

Inflation Chart

Digging deeper, however, recent studies have begun to unearth significant performance differences between inflation-targeting and non-inflation-targeting economies. One study by Jeremy Piger, Andrew Levin and Fabio Natalucci found that inflation targeting does affect the public's expectations about inflation. The authors found that the public's expectations about inflation-particularly at longer horizons-under an inflation-targeting regime were "anchored" by the inflation target, that is, the public's expectations about future inflation were less responsive to short-run changes in actual inflation.

The study found that Australia, Canada, New Zealand, Sweden and the United Kingdom—a group of inflation-targeting countries—had a near zero response in their inflation expectations when their countries experienced a real increase in inflation. However, the response from the euro area, Japan and the United States—a group of non-inflation-targeting economies—was much larger and statistically significant.

This is important because the public's expectations also can be self-fulfilling. When people expect higher future inflation, they usually negotiate their expectations into higher pricing schedules and labor contracts. Thus, keeping inflation expectations anchored significantly benefits a country's economy by helping to keep inflation low and stable.

Of course, the case regarding the benefits of inflation targeting is still far from being closed. For example, another recent study by Larry Ball and Niamh Sheridan used an alternative measure of inflation expectations and found smaller differences across inflation targeting and non-inflation targeting countries. There are also potential drawbacks to adopting inflation targeting that might offset any potential benefit from anchored-inflation expectations. For example, some Federal Reserve policy-makers have argued that inflation targeting removes the flexibility needed to respond to changing macroeconomic conditions, as well as unusual events.

Whether the United States would experience a net benefit from adopting inflation targeting is an active topic of debate, both inside and outside of the Federal Reserve. The outcome of this debate will be important in shaping the Federal Reserve's policy framework for the future.

This article is based on a cover story written for the April 2004 issue of Monetary Trends, another publication from the St. Louis Fed.