Monetary policy under inflation targeting
Contribution presented by Eugenio Domingo Solans, Member of the Governing Council and the Executive Board of the European Central Bank, at the Fourth Annual Conference of Banco Central de Chile, Santiago de Chile, 1 December 2000.
It is a real pleasure to be in Santiago de Chile, even if it is to discuss inflation targeting. Thank you for inviting me to participate in this really important Fourth Annual Conference of Banco Central de Chile. I would also like to congratulate Banco Central de Chile on the occasion of its 75th anniversary.
Allow me to put forward some ideas, which I am prepared to discuss with you during the questions and answers to this session.
First of all, I think that there is an excessive and useless gap between academic discussions and central banking practice concerning monetary policy strategy. When reading academic literature, one draws the conclusion that many different and even opposite approaches exist, whereas - in practice - the ways in which central banks take monetary policy decisions are not so different. All steps taken to bridge this gap between theory and practice should be welcome. Never before have central banks been more closely aligned than nowadays in the strategies they actually apply, irrespective of whether these strategies have been made explicit or not and irrespective of whether or not the central banks comply with the strategies which they have formally made explicit. In other words, there is a tendency towards "strategy standardisation" in practical terms. Even the exchange rate monetary policy strategy, formally so different from the internal strategies, is in line with the idea of "strategy standardisation" since it is intended to "import" the outcome of a foreign monetary policy strategy by pegging the exchange rate to that of another currency.
"Strategy standardisation" can be explained as the outcome of the growing interaction between monetary policies and arrangements in different economic areas which is, in turn, related to the trend towards economic globalisation. In other words, "strategy standardisation" mirrors "environment standardisation".
Terminology should be useful, as should any convention. When terminology happens to be more confusing than illuminating, it is advisable to shift the attention from terms to substance, to pay attention to the real meaning of what we do and not to how we call what we do. A sign that indicates that something is starting to go wrong with terminology is when names need additional adjectives to be meaningful and when these additional adjectives become more and more relevant, e.g. pure inflation targeting, flexible inflation targeting, full-fledged inflation targeting, forward-looking inflation targeting, etc.
Concerning flexible inflation targeting, I have nothing against flexibility except that if we are flexible enough when interpreting our strategies, we can reach a curious point where we can be doing more of less the same with different terms, in line with the idea of "strategy standardisation" that I mentioned earlier.
I have nothing against full-fledged inflation targeting either, except that being full-fledged implies the existence of a diverse set of general conditions, most of which are institutional arrangements which are not specific to inflation targeting, but can be applied to any strategy.
If we agree that our environment is marked by a high degree of complexity and if we accept that "strategies should mirror environments", we would also probably agree that monetary policy strategies cannot be simple, but need to be rather sophisticated so as to take into account the complexity of the environment. This can only be achieved by an all-encompassing strategy, i.e. a comprehensive and detailed strategy.
If we accept that our environment is characterised by the existence of uncertainty (i.e. changing and unpredictable conditions), we would probably also accept that monetary policy strategies should be flexible enough to be able to give the appropriate response to changing and unpredictable conditions.
Therefore, given the existing degree of complexity and uncertainty which characterises the economic environment, any appropriate monetary policy strategy should be all-encompassing and flexible.
A strategy should be all-encompassing in the sense that it should consider in a comprehensive and detailed way all possible relationships between variables that are of some relevance for monetary policy purposes, in accordance with present knowledge, taking into account more than one single paradigm. Being all-encompassing excludes shortcuts and quick and simple solutions. Being all-encompassing excludes paying attention only to the first and to the last steps of the complex chain which links the monetary policy objective with the instrument variable.
The strategy should also be flexible in the sense that it should be readily adaptable to changing and unpredictable conditions. This excludes any kind of mechanical approach, since mechanicism implies routine and automatism, which are unable to deal with unpredictable changes.
Does the inflation targeting strategy comply with the requirement of being all-encompassing and flexible (i.e. comprehensive, detailed and adaptable to change and to non-predictable conditions)? My answer is "no", unless we "bend" the meaning of the label "flexible inflation targeting" to a point at which it can accommodate almost any practice. If this were the case, even the stability-oriented monetary policy strategy of the Eurosystem, with the flexibility inherent in its two pillars, could be considered a flexible inflation targeting strategy. Of course, this is not the case, as I will try to explain.
The question then is how far one can "bend" the concept of inflation targeting by introducing flexibility without making it lose its meaning. In this respect, no matter how much one "bends" the concept of flexible inflation targeting, it will still have to keep some characteristics to "deserve" that name. These minimum features, characteristics or conditions are, in my opinion, at least the following:
A well-specified objective of inflation should be pre-established. Well specified implies an exact definition of the inflation index and the existence of a quantitative target with either a point target or a narrow enough range in order to be significant. Well-specified also means that the time horizon of the target should be consistent with the monetary policy lags.
It should give a prominent role to inflation forecasts published by central banks, which constitute the basis for decision. These published forecasts are to be consistent in definition and timing with the specified objective of inflation.
All available information concerning the outlook for price developments should boil down to an inflation forecast which should act as some sort of intermediate target of monetary policy.
A well-specified monetary policy reaction function should exist and policy-makers should be committed to take decisions following the inflation forecast by comparing it with the established inflation objective, irrespective of other elements which underlie inflation risks. The monetary policy reaction function should work symmetrically, reacting not only when the target is overshot, but also when it is undershot. This symmetric approach has sound doctrinal implications regarding the acceptance of a trade-off between output growth and stability. Pre-established, well-defined, built-in, formal "escape clauses" can be introduced provided that they are exceptional and with limited discretion.
Inflation targeting should be seen as a monetary policy rule, a more or less simple rule, a more or less pure rule, but nevertheless a rule. This means that applying an inflation targeting strategy implies a meaningful degree of automatism and a limited degree of discretion and judgement, as with any other rule. It goes without saying that judgement exists in a rule-based strategy, not so much when applying the rule, but rather when designing it, as a sort of built-in judgement.
Let me compare first these features of the inflation targeting strategy with the strategy applied by the European Central Bank (ECB). As you know, the ECB has a quantitative definition of price stability (any increase of the HICP below 2% for the whole euro area to be complied within a medium term perspective) and its monetary policy strategy is based on two pillars: the first gives a prominent role to money, basically signalling a reference value for the growth of a broad monetary aggregate, namely M3, and the second pillar consists of a broadly based assessment of the outlook for future price developments and the risks to price stability in the euro area as a whole.
None of the inflation targeting characteristics described before can be applied to the ECB's monetary policy strategy. A quantitative definition of stability is not an inflation target in conceptual and practical terms. It is rather a specification of the objective established in the Maastricht Treaty. In theory and in practice there could exist a central bank operating in a highly inflationary environment with both a definition of stability and an inflation targeting operating in a gradual disinflation process. The ECB is, certainly, obliged to comply with its objective in a medium term perspective, but its monetary policy decisions do not "target" it, in the sense that the ECB will not react mechanically if the HICP increase goes beyond the limit of the definition. Furthermore, the idea of symmetry when targeting the objective, which characterises inflation targeting, does not apply in any way to the definition of stability of the ECB. Avoiding deflation as well as inflation cannot be compared with the symmetric approach of inflation targeting, which implies not accepting inflation levels below the target as a policy decision to foster economic growth. The ECB's strategy has no inflation forecast which is a main and basic element of the inflation targeting approach. Certainly, the ECB has a staff macroeconomic projection, including inflation projections among other variables, to be published shortly in the December edition of the Monthly Bulletin. Nevertheless, these macroeconomic projections are far from playing a comparable role to that of inflation forecasts in the inflation targeting strategy. Macroeconomic projections by ECB staff are only one element among others (including other external projections and forecasts) in the second pillar of the strategy and it would be unthinkable that these projections could by themselves trigger an automatic monetary policy response without additional evidence. Again, projections are useful, but they are not the only element of this second pillar, not to say of the whole strategy. Understanding the limited role of macroeconomic projections by ECB staff in the decision-making process is crucial to avoid confusing and misleading interpretations of the decisions. Not being aware of the limitations of the use of published projections made by ECB staff in the decision-making process would paradoxically decrease the degree of transparency instead of increasing it, which should be its main purpose.
To conclude this part: the ECB's monetary policy strategy could only be identified with inflation targeting if we interpreted the above-mentioned conditions of an inflation targeting strategy in a too flexible way. In the other extreme, if the sole existence of a general commitment to price stability would be enough to label a central bank as an inflation targeter, then the question should be which central bank in the world does not follow an inflation targeting strategy.
Let me now explain why, in my opinion, a strategy based on the characteristics of inflation targeting as described before would not be the most appropriate in as complex and uncertain an environment as the current one.
First of all, central banks should resist the temptation to think that their models and their forecasts are so good that they do not to require additional support. Central banks must, of course, have their own models and their own forecasts, but - in order to take sensible decisions - it seems wise and prudent not to base them only on this element.
Secondly, there is no economic model robust enough to encompass all the relevant external information needed to take sensible monetary policy decisions. Therefore, it is impossible to boil down to a single forecast all the relevant information necessary to assess the outlook for future price developments.
Moreover, this relevant information could be constantly changing, in unpredictable ways in quantitative and qualitative terms. If there were a model and a forecast able to grasp all the relevant information at a certain moment, this model would need constant revision and reassessment to accommodate changes, which would, in turn, demand a high degree of discretion and judgement. The advantages of a rule in terms of simplicity, automatism, predictability, etc. disappear as soon as we are obliged to constantly change the contents of this rule.
How can the central bank be sure that its forecast is safe enough? Why not complement it with the information obtained from forecasts developed by other institutions? Why not rely on other sources of information and embody them into the strategy? Why should central banks be committed to take decisions on less safe grounds when it is possible to improve the information? What are we looking for: right decisions, or less safe decisions but yet consistent with a published forecast and therefore transparent and predictable?
Moreover, even assuming that the projections or forecasts are good enough, even perfect, the forecast inflation figure does not convey enough information to take a sound enough monetary policy decision. Should monetary policy have the same reaction if the forecast inflation is the result of an internal factor or an external one? Should monetary policy not distinguish between permanent and transitory factors affecting inflation? Should the monetary policy reaction be the same if one single forecast inflation figure is the result of a supply side shock rather than excess demand? The obvious answer to all these questions is "of course not": the monetary response to a given inflation forecast depends on the factors which underlie the forecast.
All these arguments lead to a clear conclusion: provided that we do not "bend" the flexibility beyond the point where it would lose its real meaning, inflation targeting implies a degree of simplicity, automatism, mechanicism and precommitment which makes it unsuitable to tackle a high degree of complexity and uncertainty as the one prevailing in today's world and especially in the euro area after the huge structural break produced by the introduction of the euro. Tackling the current degree of complexity and uncertainty demands a more comprehensive, detailed, flexible and discretionary strategy.
Of course, I am prepared to accept the possible advantages of inflation targeting in terms of simplicity, precommitment, predictability, transparency and accountability. Certainly, all these factors are important, but this does not necessarily mean that a monetary policy strategy is obliged to comply with these requirements to an extent which could endanger effectiveness. There are alternative institutional ways of being transparent and accountable without sacrificing the effectiveness of the strategy.
Politicians want central banks to be transparent and accountable. Market players want central banks to be transparent and fully predictable. But both politicians and market players are not fully aware of the complexities of monetary policy making. Our obligation as central bankers is to make them understand that what is even more important than transparency, accountability and predictability is honesty and that, honestly speaking, a monetary policy strategy should be above all effective. Inflation targeting is not the most effective strategy under the present circumstances, unless we interpret this label in such a flexible way that it can almost accommodate any practice.
I am really sorry for being a "killjoy" at a conference celebrating ten years of inflation targeting in Chile and in the world by reminding you that the central bank's world is not Panglossian.