Who Benefits from Inflation Targeting?

"[W]hat really matters for successful monetary policy is establishing a strong nominal anchor. While inflation targeting is one way to achieve this, it is not the only way."

NBER Research Associate Frederic Mishkin and co-author Klaus Schmidt-Hebbel review the pros and cons of inflation targeting in Does Inflation Targeting Make A Difference? (This work -- published in NBER Working Paper No. 12876 - was completed before Mishkin became a member of the Board of Governors of the Federal Reserve System.) Developing - or emerging - nations with high inflation benefit the most from the practice, the study finds. For mature, developed nations like the United States, the benefits are far more subtle.

Many nations are warming to the idea of inflation targeting. By 2005, for example, eight industrial economies and 13 emerging ones had adopted full-fledged inflation targeting. Many others expect to make the move soon. But the case for inflation targeting has not been open and shut.

While studies have generally established a link between the practice and improved economic performance, they haven't proven that the former causes the latter. Indeed, stable and mature non-targeting nations, including the United States, have often done just as well or better without it. "[T]he ongoing debate on whether inflation targeting matters indicates that open questions remain, particularly on the comparative macroeconomic performance in inflation targeting countries, both over time and relative to nontargeting countries," write the authors of this study. "[W]hat really matters for successful monetary policy is establishing a strong nominal anchor. While inflation targeting is one way to achieve this, it is not the only way."

By looking carefully at a broad sample of 21industrial and emerging-economy inflation-targeting countries over time, and comparing them with a control group of 13 industrial non-targeters, the authors conclude that a target does indeed improve economic performance but the effects vary dramatically depending on the type of economy that attempts it.

For example: targeters trimmed their inflation rates from an average 12.6 percent before they adopted the practice to 4.4 percent after they did. Emerging economies saw the biggest drop - to 6 percent after they began targeting inflation. Developed industrial targeters saw a smaller decline but achieved a much lower rate of inflation: an average 2.2 percent. That impressive rate was bested, however, by developed non-targeters, who have averaged 2.1 percent since 1997. So the practice seems to provide the biggest help to nations that are struggling the hardest to tame inflation, while its effects on nations with more benign price appreciation are relatively small, sometimes negligible.

Take, for instance, an economy's reaction to an outside shock, such as a spike in oil prices. Targeting helps to reduce the inflationary impact in a given country, apparently because the practice enhances the central bank's credibility and stabilizes consumer expectations. But like the drop in inflation, the benefit varies.

Targeting nations, especially emerging governments that have achieved their inflation target, see the biggest improvement, according to the study. These economies actually see less impact from oil shocks than do non-targeting nations. By contrast, non-targeting nations seem to weather better an external shock caused by a sudden change in exchange rates.

Targeting can also help emerging nations go against the flow when inflation is raging worldwide, this study finds. The results are striking: currencies were 10 times less sensitive to foreign inflation after the host country had adopted targeting. And, they saw a further decline once they had tamed inflation. Curiously, more developed nations saw an increase in the inflation vulnerability of their currencies after adopting targeting, albeit at a much lower level than emerging nations.

Finally, this study looks at whether targeting makes economies work more smoothly - with more stable inflation and growth. Again, the results vary. Emerging nations made the biggest strides once they adopted targeting. Industrial targeters saw a slight improvement, but only because they faced smaller shocks to their economies in the first place. But, developed non-targeters did even better on both measures of economic efficiency.

The benefits of inflation targeting for non-targeting countries with low inflation and efficient economies are less obvious. The lack of a target does reduce transparency and raise uncertainty. Over the long term, the lack of a target also could reduce the credibility of a central bank if it's not seen as being held accountable to a standard. While it is wrong to say that inflation targeting always helps, the authors conclude, it doesn't seem to hurt in too many cases and may help to stabilize inflationary expectations in an uncertain future.

-- Laurent Belsie

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