Panel discussion at the conference "Inflation targeting: prospects and problems"
Professor Otmar Issing, Member of the Executive Board of the European Central Bank,Federal Reserve Bank of St. Louis,St. Louis, 17 October 2003.
What is the ultimate objective of monetary policy? What is the appropriate framework for conducting monetary policy? Central bankers and academics have been asking these critical questions for decades. This conference, in which I am honoured to take part, is a milestone in this long-standing debate. However, it is easy to foresee that the debate will be with us for still some time to come. Indeed, it is the intrinsic nature of the ultimate objective of our efforts that makes the debate difficult to settle. Once again, recent history has reinforced the perception that the structure of the economy changes over time in a way that is difficult to anticipate and perceive in real time. This continuous mutation makes the task of monetary policy and its implementation even more challenging.
The experience of the inflation of the 1970s and the developments in the theory of monetary policy analysis over the last twenty years have increased central bankers' and academics' awareness of the limitations of monetary policy actions and reinforced the criticism levelled at the adoption of a purely discretionary approach to monetary policy, or better to the idea of a monetary policy which aims to push economic activity above its natural level. This awareness is also coupled with a better understanding of the possible costs of inflation and the recognition that a low-inflation environment is a necessary condition for long-run growth and an efficient allocation of resources.
The recognition of the cost of inflation, of the absence of a long-run trade-off between inflation and real activity and of the relevance of the credibility problem of monetary authorities were some of the motivations behind the spread of a culture of price stability among the central banks of the industrialised countries during the 1980s and the 1990s. I have no doubt that this new culture has given an important contribution to the disinflation process that we have observed in many countries throughout the last two decades.
Since it has now been widely agreed that the ultimate objective of monetary policy has to be price stability, there only remains the other critical question, namely, what is the proper strategy to achieve the ultimate objective? Over the years central bankers and academics around the world have proposed a variety of strategies. Different central banks have adopted strategies which place different emphasise on the various pieces of information, or elements of their decision-making process or different aspects of their communication policies. Inflation targeting is one of those strategies.
Following the pioneering approach of the Reserve Bank of New Zealand in the early 1990s a large number of central banks have formally adopted an "inflation targeting framework" and today we can count around 20 central banks that refer to this approach. At the same time the inflation targeting framework has triggered a large amount of interesting and stimulating theoretical work as indeed this conference testifies. Looking back at the experience of those central banks there is no doubt that it has been a success. This is particularly evident in the case of countries starting from high levels of inflation. These countries needed to implement a disinflationary process, where inflation targeting served to guide inflation expectations and provide an explicit framework and direction to monetary policy. The approach has also turned out to be successful in countries with lower inflation, as, for example the positive experience of the United Kingdom, Sweden and Canada shows. In the few cases – limited to some emerging economies – where the experience has been somewhat less successful, it is quite evident that problems originated in other areas, notably, and often stemming from misguided fiscal policies.
At the same time, while not adopting an inflation targeting approach, some major central banks have nevertheless also achieved to maintain price stability, proving that visible success in the management of monetary policy is not only confined to inflation targeting central banks. This, to me, is just a confirmation of something I have always believed: there is no "unique" or even "best" way of monetary policy making, and different approaches or frameworks can lead to successful policies by adapting better to diverse institutional, economic and social environments.
Looking at the broad range of literature written on inflation targeting, the first challenge to some readers' eyes is to find out a proper definition. Different authors have propose different and in some cases conflicting definitions. The first and broadest definition of inflation targeting is simply a monetary policy framework which accords overriding importance to the maintenance of price stability, typically defined as a low and stable rate of consumer price inflation. Given the broad consensus that price stability is the appropriate goal of monetary policy – the conclusion reached in response to my initial question – the strategies pursued by most central banks including the ECB would fall under this loose definition. However, this definition suffers from two interrelated weaknesses. First, from the policy making perspective, such a vague definition offers no practical guidance for the conduct of monetary policy beyond identifying the primary objective. As such, its practical relevance is rather limited. Second, from a scientific perspective, the definition imposes few empirically testable restrictions on the implementation of monetary policy. As such, it does not allow inflation targeting strategies to be distinguished from other stability-oriented strategies and their relative merits to be evaluated. To put it more provocatively, by this definition all "successful" central banks are inflation targeters, while all "unsuccessful" central banks are not.
As an alternative to this broad definition, in the economic literature narrower definitions of inflation targeting are proposed, typically expressed in terms of a monetary policy framework based on the adoption of a monetary policy rule in which forecasts of future inflation play a central role, either in the form of the so-called instrument rules or of target rules. Here, I do not want to enter the vast debate on the different definitions and choice between instrument and target rules, many important contributors to which are present at this conference. Nor will I address many of the problematic issues identified by the literature and associated with the adoption of those rules, such as: the indeterminacy of equilibria, the issue of commitment to the rules and the important aspect concerning the measurement of key variables, for example, the output gap. Instead what I wish to discuss here are two more practical pitfalls associated with the narrower definition of inflation targeting, namely the central role of macroeconomic forecast in inflation targeting, on the one hand, and the robustness of the rules in view of the possible presence of model misspecifications on the other.
Inflation targeting is sometimes seen as a framework that makes macroeconomic forecasts the main, or even sole all-encompassing, tool of the policy-making process and of the external communication of policy decisions. In fact, in some, admittedly more extreme characterisations, inflation targeting is seen to imply a simple policy rule whereby changes in interest rates should feedback from the deviation between a conditional inflation forecast and the inflation objective at a specific time horizon, typically at around two years.
There is no doubt, that inflation forecasts, while useful, even indispensable ingredients of monetary policy strategies, do not represent sufficient statistics for the state of the economy at any horizon. The same inflation forecast figures can be associated with quite different states of the world, commanding quite different reactions on the part of the central bank. For this reason, the appropriate monetary policy for maintaining price stability should always be made conditional on the circumstances and the nature and magnitude of the threat to price stability, for example, on whether a shock is temporary or permanent, on whether it has emerged on the supply or demand side, or on whether it is of domestic or external origin.
Indeed, the horizon relevant for policy-makers will also depend on the prevailing economic circumstances. Monetary policy needs to focus on the period covering the whole transmission process, bearing in mind that this may span an uncertain and protracted period of time. Limiting attention to a specific fixed projection horizon, let us say two years, is arbitrary and may induce short-sighted or delayed reactions, the effects of which may have to be undone at a later date, with associated costs in terms of instability. To this extent let me note that some inflation targeting central banks have recently become less precise concerning their relevant horizon.
Target rules are somehow less subject to the above pitfall given that they are routinely implemented by producing forecasts of future inflation and output conditional on the path of the instrument and searching for the path, which minimises a proper loss function. Consequently, an evaluation of the target rule characterisation of inflation targeting is largely equivalent to an evaluation of the economic model employed to derive that rule and this leads us to my second set of comments concerning the robustness of rules.
The possible presence of model misspecification is something that economists and econometricians have considerable difficulty in acknowledging. However, every model we write down and estimate, contains some form of shortcut and approximation. This uncertainty is worsened since economists have not yet agreed upon a proper, commonly accepted approximating model. This implies that the appropriateness of a monetary policy strategy cannot be evaluated only within a particular class of models – rather a good strategy has to perform well across a variety of empirically plausible models.
However, most advocates of inflation targeting rely ultimately on a view of the economy the essence of which can be captured by no more than three equations. The defining characteristics of these equations are: staggered pricing; the centrality of the output gap; and, the notion that monetary impulses propagate primarily via an interest rate channel, with monetary quantities playing no role. The presence of only a market for goods and the absence of a fully spelled-out market for assets whose supply is inelastic implies, in the short run, that money has no role to play other than in facilitating the exchange of goods. Decisions concerning money holdings are not seen as part of a wider portfolio decision that at times may lead households to prefer liquidity over risky assets whose issuance might be related to investment and capital formation decision.
Along those lines, some recent studies demonstrate that instrumental rules perform quite robustly in this particular set of money-less macroeconomic models. However, this robustness does not survive a broadening of the suite of candidate models; in particular if financial markets are not free of frictions, then rules often do not prove to be robust and yield sub-optimal outcomes.
It should be clear that, from the view point of a central bank, a serious attempt should be made to construct models where shocks to velocity are treated appropriately within the context of broader portfolio shifts, possibly in the presence of (changing) risk assessments. Unless disturbances to money holdings are formalised in a way such as to reflect financial decisions, nothing can be said about the role of money in the business cycle, and very little policy advise can be drawn from analyses of models that do not properly tackle these problems. Acknowledging the fundamental relevance of this line of research the ECB is actively pursuing it.
Let me now turn to the ECB's monetary policy strategy. On October 1998 the Governing Council of the ECB announced its monetary policy strategy. The strategy designed was a novel one, suited for the special and still partially unknown characteristics of the euro area economy, and different in a number of respects from other current and past strategies. Since then almost five years have elapsed, the strategy has served all these functions to a high degree of satisfaction. The ECB has pursued its mandate of maintaining price stability with vigour and determination gaining a high level of credibility from the outset. This achievement is all the more a remarkable given that the ECB started without a track record in a very uncertain environment. To testify this success inflation expectations, as measured by survey data or by financial market indicators, have always remained consistent with our definition of price stability.
In December 2002 the ECB announced the decision to conduct a comprehensive review of its strategy. This decision was sometimes wrongly interpreted by observers as an implicit indication of dissatisfaction with the strategy – in fact the opposite was true. To ensure the continuation of a satisfactory development of the strategy in a complex and changing environment, it was only natural that, after more than four years of experience, the ECB Governing Council would want to look back and reflect in a systematic way on the past experience. The outcome of the strategy review was made public on the 8 May 2003 and it aimed primarily at addressing certain misunderstandings that have emerged in our communication with the public.
Regarding our definition of price stability, the Governing Council confirmed the explicit quantitative definition announced already in October 1998. However in continuing with the past conduct of monetary policy, the Governing Council clarified that in the pursuit of price stability it will aim to maintain inflation rates, measured by a year–on–year increase of the Harmonised Index of Consumption Price, below, but close to 2% over the medium term. This clarification emphasises the need for a sufficient safety margin against the risk of deflation and, at the same time, is also sufficient to cover the potential presence of a measurement bias in the consumer price index and the implications of lasting inflation differentials of a structural nature within the euro area.
The mandate of the ECB with maintaining price stability as the primary objective is enshrined in the Maastrich Treaty signed by all governments of the European Union and ratified by the Parliaments – it is "written in stone" if you wish. Announcing a quantitative definition of price stability implies a concrete commitment, provides a clear benchmark for accountability and serves as a tool to guide inflation expectations. This was especially important at the start of the euro and has become an indispensable element of our strategy.
Regarding the role of money in the strategy framework, the Governing Council confirmed that the two-pillar framework of the strategy is an effective tool to organise the full set of information for assessing the risks to price stability. As discussed before the economic literature confirms that the integration of the analysis of monetary aggregates with the analysis of the conditions on the goods and labour markets in a unified model remains an elusive challenge. Different types of analysis provide information relevant for price developments at different time horizons. What we labelled as economic analysis focuses on the most proximate causes of inflation, such as cost developments and demand-supply imbalances, and primarily contributes to the assessment of short to medium-term economic dynamics and the risks to price stability at that horizon. On the other hand, monetary analysis, focusing instead on the ultimate monetary determinants of inflation, primarily contains information for assessing price trends at medium to long-term horizons. The Governing Council clarified that the monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications coming from the economic analysis.
Let me emphasise the role of this cross-checking. All the information coming from different sources, such as short term conjectural indicators, quarterly macroeconomic forecasts, and analyses of assets prices and monetary aggregates, have to be compared and properly evaluated in order to come to an overall assessment of the monetary policy stance. This ensures that, while responding to economic shocks as they manifest themselves, we do not loose sight of the fact that in the longer term developments in money need to be consistent with our objective. It helps, in my view, to give a sense of direction and impart a steady course to the conduct of monetary policy.
The ECB staff macroeconomic projections are one important input in the monetary policy decision as a way of organising a large amount of information and helping to create a consistent picture of possible future developments, without making them the sole tool for the conduct of monetary policy. While forecasts cannot per se be a sufficient statistic for policy neither can they contain all relevant information because models underlying the forecast are inevitably misspecified to some extent.
There are instances that standard macroeconomic models, which by definition are constructed to replicate normal conditions and regularities in the economy, are unable to capture and incorporate. This is particularly the case when large shocks or special circumstances arise, such as episodes of financial instability or asset price bubbles, are involved. I am merely recalling the developments over the last two to three years, when we faced exceptional uncertainties and major stock market movements followed by large portfolio adjustment. How those past events can be squared with forecasts of inflation and output based on models in which financial assets do not play any active role is still an open issue both for central bankers and academics. In such occasions the need of careful judgement, of a broadening of the horizon for the conduct of policy and of the consideration of non-standard indicators and different interpretations of the evidence become especially relevant. On this point, let me add that given those difficulties, the ECB monetary policy strategy is transparent in openly acknowledging these difficulties.
Therefore, to conclude, let me say that the differences in the practices of central banks oriented to price stability are in fact relatively limited. I believe that the common set of principles and values that we share, rather than the differences in operational details, is what we should emphasise. At the same time, I also find it crucial that we keep an open mind to learn from each other's experiences and experiments.