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A Framework for the Pursuit of Price Stability
William J. McDonough
President, Federal Reserve Bank of New York

It is often said that there is a worldwide community of central
bankers. I certainly feel that way. Central bankers in all countries share a number of concerns. Perhaps the most important
of these is the desire for price stability. While central bankers
may differ in the ways they seek to achieve price stability—
differences grounded in our respective histories, customs, and
institutions—the goal we all strive for is no less important.
Recognizing that no one country’s central bank
has a monopoly on the right answers, I would like to share
with you my views on why I believe price stability is so
important and what approaches can be taken to achieve
this goal. Before turning to these issues, we must first be
clear about what we mean by price stability and how to
recognize it when we see it.
In my view, a goal of price stability requires that
monetary policy be oriented beyond the horizon of its
immediate impact on inflation and the economy. This
immediate horizon is on the order of two to three years.
This orientation properly puts the focus of a forwardlooking policy on the time horizon over which monetary
These comments are based on remarks delivered by Mr. McDonough
before the Annual Financial Services Forum of the New York State
Bankers Association on March 21, 1996, and the Economic Club of
New York on October 2, 1996.

policy moves today will have their effect and households
and businesses will do most of their planning. This is the
horizon that is relevant for the definition of price stability
articulated by Chairman Greenspan: that price stability
exists when inflation is not a consideration in household
and business decisions.
A central bank’s commitment to price stability
over the longer term, however, does not mean that the
monetary authorities can ignore the short-term impact of
economic events. It is important to recognize that, even if
we set ourselves successfully on the path to price stability
and even if, as a result, price expectations are contained, we
still will not have eliminated all sources of potential inflationary shocks. The reality is that monetary policy can
never put the economy exactly where we want it to be.
For example, supply shocks that drive prices up
sharply and suddenly—such as the two oil shocks of the
1970s—are always possible. In such an eventuality, the
appropriate monetary policy consistent with a goal of price
stability would not be to tighten precipitously, but rather
to bring inflation down gradually over time, as the economy adjusts to the shift in relative prices. In the event of a
shock to the financial system, the appropriate monetary
policy might require a temporary reflation.

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As you can see, I believe that monetary policy
must be exercised cautiously. Why do I say this? Because
contracts, especially wage contracts, can outlast a good part
of, or even exceed, short-term shocks in duration. In the
short term, therefore, monetary policy must accept as given
the rigidities in wages and prices that these contracts
create. Abrupt shifts in policy, given these rigidities, especially a monetary tightening in the face of wages that are
unlikely to be cut, can cause unacceptable rises in unemployment and drops in output.

WHY PRICE STABILITY IS SO IMPORTANT
AND SO DESIRABLE
In my view, a key principle for monetary policy is that price
stability is a means to an end—to promote sustainable
economic growth. Price stability is both important and
desirable because a rising price level—inflation—even at
moderate rates, imposes substantial economic costs on society.
All countries incur these costs. They entail, for example:
• increased uncertainty about the outcome of business
decisions and profitability;
• negative effects on the cost of capital resulting from
the interaction of inflation with the tax system;
• reduced effectiveness of the price and market systems;
and
• in particular, distortions that create perverse incentives to engage in nonproductive activities.
Let me be even more explicit about the negative
effects of one particular type of nonproductive activity
induced by inflation’s distortion of incentives—the
overinvestment of resources in the financial sector. As a
former commercial banker, I am especially aware of the significance of this cost, and I believe that it deserves greater
attention than it often receives in economists’ lists of the
costs of inflation.
The resources in high-inflation economies
diverted from productive activities to nonproductive
financial transactions are enormous. In the hyperinflations
in Europe in the 1920s and again in various emerging market countries in the 1980s, we saw financial sectors grow

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severalfold. A number of estimates put the rise in the
financial sector share of GDP on the order of 1 percent
for every 10 percentage points of inflation up to inflation
of about 100 percent. The economies that experienced high
inflation consumed more financial transactions for an
essentially given amount of real goods and services.
If individuals must spend more time, effort, and
resources engaging in financial transactions because of the
uncertainty inflation engenders, then more of the economy’s
productive capacity is transferred to the activity of handling
transactions. Clearly, given my background, I am not
opposed to an expansion of the financial sector that stems
from growth of productivity, growth that offers benefits to
the public. Equally clearly, I see an expansion of the financial
sector that stems from an increasing number of people
employed as middlemen, where none would be needed
without the distortion of rising inflation and its attendant
uncertainty, as growth that diverts resources better
employed elsewhere. A bank branch on every corner means
a corner store on none.
In short, the costs of overinvestment in the financial
sector, like the costs of all inflation-induced nonproductive
activities—such as tax code dodges—decrease the resource
base available to the economy for growth. A move to price
stability would give these economies the necessary
incentives to shift resources back to productive uses. In the
case of the financial sector in a high-inflation economy, the
transfer of resources to productive uses could be as large as
a few percentage points of GDP. This can be serious money
indeed. And this is just one of the benefits of regaining
price stability.
Rapid moves toward price stability from high
inflation, however, do have their costs under certain
circumstances. The overdevelopment of a sector for no
reason other than the inflation rate is precisely one of those
circumstances. The removal of the distortionary incentive—
inflation—leads to a rapid transfer of resources out of that
sector, causing unemployment and business failures to
follow: what was boom, goes bust. In those very same
countries where we saw the overexpansion of the financial
sector, we have seen the sharp contraction of that sector

when inflation was finally brought down. This implies an
additional argument for price stability. Namely, in a
low-inflation environment, these boom-bust cycles created
by distortionary incentives are less likely to emerge and can
be more easily contained when they arise.
The avoidance of such unnecessary boom-bust
cycles also limits the serious social costs that inflation can
impose. For one, inflation may strain a country’s social fabric,
pitting different groups in a society against each other as
each group seeks to make certain its wages keep up with the
rising level of prices. Moreover, as we all know, inflation also
tends to fall particularly hard on the less fortunate in society,
often the last to get employment and the first to lose it.
These people do not possess the economic clout to keep their
income streams steady, or even buy necessities, when a bout
of inflation leads to a boom-bust scenario for the economy.
When the bust comes, they also suffer disproportionately.
It is important to note, however, that if we are to
set a goal for monetary policy, we must be clear as to what
we can expect monetary policy to do and what we know it
cannot do. What monetary policy can do is to anchor
inflation at low price levels over the long term and thereby
lock in inflation expectations. In addition, monetary policy
can help offset the effects of financial crises as well as prevent extreme downturns in the economy.
Over the past twenty years, there has been an
emerging consensus among policymakers and economists
that an activist monetary policy to stimulate output and
reduce unemployment beyond its sustainable level leads to
higher inflation but not to lower unemployment or higher
output. Moreover, although some countries have managed
to experience rapid growth in the presence of high inflation
rates, often with the help of extensive indexation, none has
been able to do so without encountering severe difficulties
at a later stage. It is thus widely recognized today that
there is no long-run trade-off between inflation and unemployment. As a result, we have witnessed a growing commitment among central banks throughout the world to
price stability as the primary goal of monetary policy.
One point is worth emphasizing: Allowing even a
low level of inflation to persist without a commitment to

bring that level downward toward price stability permits—and may even encourage—expectations for still
sharper price rises in the future. Such expectations provide
an opening for a demand-driven burst of inflation.
But what monetary policy cannot do, in and of
itself, is produce economic growth. Economic growth
stems from increases in the supply of capital and labor and
from the productivity with which labor and capital are used,
neither of which is directly influenced by monetary policy.
However, without doubt, monetary policy can help foster
economic growth by ensuring a stable price environment.
Some would argue that establishing price stability
as the primary goal of monetary policy means that a central
bank would no longer be concerned about output or job
growth. I would like to make clear for the record that I
believe this view to be simply wrong. A stable price and
financial environment almost certainly will enhance the
capacity of monetary policy to fight occasions of cyclical
weakness in the economy. What is important to bear in
mind is that by ensuring a stable price environment, monetary policy helps foster economic growth. This is a key
point—and is often overlooked.
In trying to determine the extent of future inflation, a central bank must look at a broad array of economic
indicators that reflect demand pressures and supply developments in the economy. Unfortunately, there is no single
summary measure that provides a reliable overall assessment of the many complex and diverse influences on inflation, which makes it more difficult within most countries
to reach a national consensus on policy at any point. Nonetheless, while its one explicit goal must be price stability,
monetary policy can and must also maintain the broad
environment for sustainable economic growth.

TARGETING FRAMEWORKS
FOR MONETARY POLICY
How have central banks sought to achieve price stability?
Some countries have begun to commit their central banks
statutorily to pursuing the objective of price stability and are
granting them a high degree of independence to do so.
Empirical research in recent years has shown that both the

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average rate of inflation and its variability tend to decline in
the presence of increased independence for central banks.
This is why so many governments, particularly among the
emerging market countries, have been providing their central
banks with increased autonomy.
Once a commitment has been made to price stability
as the goal of monetary policy—and that commitment has
been entrusted to an independent central bank—there are
several possible approaches to implementing that goal.
While the choice will depend on a country’s history, economic
conditions, and traditions, all successful approaches share
two important features: first, they focus on a long-term
time horizon and, second, they provide a transparent standard
for the assessment of policy. For many of these approaches,
what guides monetary policy is an announced target. Such
a target is one proven means of credibly conveying to the
public the commitment to price stability and thereby locking in inflation expectations.
There are a number of possible targets for monetary
policy. All have been used with success in some countries
while meeting with failure in others, depending upon the
economic context in which they have been implemented.
It is useful to step back and review briefly the advantages
and drawbacks, as I see them, of three different targeting frameworks—exchange rates, monetary aggregates,
and inflation.
Fixing the value of the domestic currency relative
to that of a low-inflation country is one approach central
banks have used to pursue price stability. The advantage
of an exchange rate target is its clarity, which makes it
easily understood by the public. In practice, it obliges the
central bank to limit money creation to levels comparable
to those of the country to whose currency it is pegged.
When credibly maintained, an exchange rate target can
lower inflation expectations to the level prevailing in the
anchor country.
Experiences with fixed exchange rates, however,
point to a number of drawbacks. A country that fixes its
exchange rate surrenders control of its domestic monetary
policy. It can neither respond to domestic shocks that are
not felt by the anchor country nor avoid shocks transmitted

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by the anchor country. Moreover, in the environment of
open, global capital markets, fixed exchange rate regimes
are subject to sudden speculative attacks when markets
perceive that domestic needs and exchange commitments
diverge. These speculative attacks can be very disruptive to
any country’s economy.
On balance, it seems that a fixed exchange rate
approach to price stability makes most sense when the
country adopting it has an economy closely tied to the
country or countries it is pegging to and is thus subject to
similar international shocks in any case. This approach
could also be worthwhile if a country is unable—for whatever
reason—to make a credible commitment to price stability
on a domestic basis alone. In either situation, the country
must have available a larger, low-inflation anchor country
to which it can peg its currency.
Targeting monetary aggregates is another
approach many central banks used in the 1970s and 1980s.
This approach has been successfully maintained by a few
prominent countries. Given a dependable relationship
between the targeted monetary aggregate and the goal of
price stability—where movement in the monetary aggregate
predicts movement in prices—this framework offers a
number of advantages. Like exchange rate targeting, an
announced monetary target is easily understood by the
public. In fact, it conveys more information than an
exchange rate target because it shows where monetary policy
is and where inflation is likely to be going. The targeting
of monetary aggregates has the additional advantage of
focusing policy on a quantity that a central bank can control
quickly, easily, and directly.
It is important to emphasize that the advantages
of a monetary aggregate target are totally dependent upon
the predictability of the relationship between the money
target and the inflation goal. If fluctuations in the velocity of
money—perhaps due to financial innovation—weaken this
relationship, this framework will not bring price stability.
In the United States, these relationships are not sufficiently stable for the monetary targeting approach to work.
A third approach to price stability is to target
inflation. This approach has been adopted by a number of

central banks over the past several years, as the following
study shows, and the initial results appear positive. The
advantage inflation targeting shares with exchange rate
and monetary targeting is its transparency to the public.
The commitment to price stability is made clear in policy
terms, and deviations from the pursuit of the inflation target
over the longer term are obvious. Like a monetary aggregate target, an inflation target also provides monetary policy
with the necessary flexibility to respond to economic needs
in the short term. Finally, targeting inflation avoids the
problem of velocity shocks because monetary policy is no
longer dependent upon the money-inflation relationship.
The main drawback of inflation targeting is that
inflation itself is not directly or even easily controllable by
the monetary authorities. Furthermore, policy moves in
pursuit of the inflation target only take effect with a lag, so
that success in hitting the target is not quickly apparent.
This is a problem that is not present in either exchange
rate or monetary aggregate targeting. These difficulties
may mean that the target cannot strictly be met at times,
which, at a minimum, could lead to a rise in inflation
expectations. Nevertheless, for countries that are unable
or unwilling to fix their exchange rate to that of another
country and cannot rely on stable relationships between
monetary aggregates and goals, the inflation target
approach offers a transparent means of commitment
over the longer term. I believe that the inflation-targeting
approach to price stability merits further study and
consideration.

WHAT A STRATEGY FOR MONETARY
POLICY REQUIRES
In my view, therefore, the challenge to monetary policy in
today’s environment is to consider how we may most
effectively build on our current low inflation by making its
permanence a credible policy goal. This goal raises a host of
important questions.
For one, even if we agree—as I believe we already
do—that price stability must be the primary long-term
goal of monetary policy, what exactly does price stability
mean in practical terms over both the intermediate and

long term? Second, what kind of institutional structure is
needed to enable the central bank to convey to the markets
and the public an explicit commitment to price stability?
A related question is how should such a policy be articulated
to the public to make the central bank accountable and to
foster a political consensus in support of this commitment?
Finally, how can an explicit policy commitment to price
stability be implemented in practice without pushing the
economy too hard in one direction or another? These are a few
of the questions we at the Federal Reserve Bank of New York
are asking ourselves as we consider the merits of our country’s
taking a step further in its conduct of monetary policy.
Let me offer two possible basic definitions whose
relevance depends on the time frame with which policymakers are concerned. One definition would apply over the
long term. In this time frame, as I stated at the outset, I
would define price stability as being reached when inflation
is not a consideration in household and business decisions.
What does this mean in practice? We know that,
as currently measured, a zero inflation rate is not the same
thing as price stability. This is because of well-known
errors in measuring inflation that stem from many factors,
including how quality improvements and new products are
valued in the consumer price index. Although there is
much research on this topic, economists and policymakers
cannot agree upon a single number for the magnitude of this
measurement error. In most studies, the error has been estimated to range from 0.5 percent to 2.0 percent. Therefore, as
a practical matter, price stability may best be thought of as
an inflation rate falling somewhere within this range.
Were we to move to a monetary policy strategy
that has a numerical inflation goal, given the problems
with measurement error, how might this goal be set? If the
inflation goal is set too high, we run the risk of allowing
the start of an upward spiral in inflation expectations and
inflation. Indeed, this is why I do not believe that price
stability is consistent with the 3 percent inflation rate we
currently have in the United States.
If, on the other hand, the inflation goal is set too
low, we run the risk of tipping the economy into a deflation in
which the true price level is actually falling. History has

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shown that deflation can be extremely harmful to the
economy in general, and to financial markets in particular.
The worst financial crises in our history have been associated
with deflationary periods.
Therefore, were we to set a numerical inflation
goal for monetary policy, I believe that an appropriate
number for this goal should be within the reasonable range
of measurement error—but in the upper end of the range
because of the dangers of deflation. Such a numerical goal
could be understood as the premium needed to prevent the
economy from being tipped toward deflation or needlessly
forgoing output.
Thus, in the long term, a numerical definition for
price stability would provide a framework for the discussion and evaluation of monetary policy. In practical terms,
this would mean that the Federal Reserve would be held
accountable to—and when successful, judged credible
by—an explicit inflation performance standard that would
ensure stable inflation expectations.
In the intermediate term, by contrast, over a
period of, say, three years—the time horizon over which
monetary policy affects inflation—the goal of monetary
policy is to put the economy on the path that moves it
toward long-term price stability, taking into account the
economic and financial pressures on the economy. At low
levels of inflation, there are substantial risks to the economy
from driving out the remaining inflation too quickly. In the
current environment, therefore, the path for monetary policy
in the intermediate term would have to be gradual.
Such an effort might require the numerical inflation
goal to sometimes be above the long-term goal for a period
of time, but then to trend downward toward the long-term
goal. In practice, this means that even though the intermediate policy goal would change, the underlying strategy and the
long-term goal of price stability would remain the same.
This gradual and forward-looking strategy is
essentially the course that the Federal Reserve has been following over the past several years. Integral to this course
have been increased efforts toward greater transparency in
the conduct of monetary policy. The announcement of
changes in policy at the conclusion of Federal Open Market
Committee (FOMC) meetings is evidence of these efforts.

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What, then, might be some of the advantages of
further increasing transparency by committing the Federal
Reserve to an explicit inflation goal? For one, were the
Federal Reserve to formalize its strategy by announcing
specific intermediate and long-term goals for price stability, it might reduce uncertainty about policy. Moreover, the
Federal Reserve could clarify why specific policy moves
were made at specific times, with reference to its numerical
intermediate-term goal.
In addition, an explicit commitment to price stability and specific numerical goals for inflation could help
lock in low inflation expectations, making future inflations
and disinflations less likely. Lastly, I believe that, were the
Federal Reserve to move to the articulation of such a strategy, public discussion and evaluation of monetary policy
would be directed to a tighter, less contentious framework
than that which currently exists. This is because the performance of the Federal Reserve in fulfilling its monetary
responsibilities would be the issue, while the goals would
be unambiguous and well established.
The institutional framework to implement such a
strategy is, of course, a question. I believe that the mandate
for price stability is of sufficient importance to society that
it should be set by the legislative process. Were such an
approach to be formalized, the Federal Reserve could
articulate its strategy as it currently does under the
Humphrey-Hawkins law, or Congress might choose to
replace the Humphrey-Hawkins law. The fundamental
point is that once numerical inflation goals were set, it
would be logical and useful to create some kind of an
institutional framework for the Federal Reserve to report
its progress in meeting its monetary policy goals.

THE NEED FOR DEBATE ON MONETARY
POLICY STRATEGY
I am pleased to share these thoughts with you, encouraged as
I am by favorable developments in monetary policy and the
credibility I believe the Federal Reserve has earned these past
several years in controlling prices while encouraging both
growth of the real economy and financial system stability. The discussion of the appropriate strategy for monetary
policy and what it might mean in practice is currently an

intellectual one, although, I hasten to add, one not confined
to ivory towers. This is why we are studying these issues at
the Federal Reserve Bank of New York.
Public debate about these issues has begun, and
certainly there are many points of view to listen to and
evaluate. My remarks and the study that follows are
intended to contribute to and help stimulate such discussions.
The perspective adopted in the following study, after a

review of a variety of experiences in other countries, is
generally favorable toward explicit inflation targets. But I
recognize that this is a difficult and complex subject, that
the value of such targets may not be the same in every
country and at all times, and that others may see benefits
in alternative approaches to monetary policy. If my remarks
and the study provoke further debate on these important
issues at the heart of monetary policy and our nation’s
economic welfare, I will consider our efforts to be a success.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

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7

Inflation Targeting: Lessons
from Four Countries
Frederic S. Mishkin and Adam S. Posen

Introduction

T

he key issue facing central banks as we approach
the end of the twentieth century is what strategy
to pursue in the conduct of monetary policy. One
choice of monetary strategy that has become increasingly
popular in recent years is inflation targeting, which
involves the public announcement of medium-term
numerical targets for inflation with a commitment by the
monetary authorities to achieve these targets. This study
examines the experience in the first three countries that
have adopted such an inflation-targeting scheme—New
Zealand, Canada, and the United Kingdom—as well as
in Germany, which adopted many elements of inflation
targeting even earlier. Through close examination of the

experience with inflation targeting, both how targeting
operates and how these economies have performed since its
adoption, we seek to obtain a perspective on what elements
of inflation targeting work as a strategy for the conduct of
monetary policy.1
Before looking in detail at the individual experiences of these countries, we first discuss the rationale for
inflation targeting and the design issues that arise in
implementing an inflation-targeting strategy. Then, after
the case studies of the individual countries, we provide
some preliminary evidence on the effectiveness of inflation
targeting in these countries and conclude with an assessment of the inflation-targeting experience.

This study is part of a larger project on inflation targeting with Ben Bernanke and Thomas Laubach. We thank Ben Bernanke, Donald Brash, Kevin
Clinton, John Crow, Peter Fisher, Charles Freedman, Andrew Haldane, Neal Hatch, Otmar Issing, Mervyn King, Thomas Laubach, William
McDonough, Michel Peytrignet, Georg Rich, and Erich Sporndli for their helpful comments. We are grateful to Laura Brookins for research assistance.
The views expressed in the study are those of the authors and not necessarily those of the Federal Reserve Bank of New York, the Federal Reserve System,
Columbia University, the National Bureau of Economic Research, or the Institute for International Economics.
Frederic S. Mishkin is Director of Research and Executive Vice President at the Federal Reserve Bank of New York, on leave from the Graduate School
of Business, Columbia University, and Research Associate at the National Bureau of Economic Research. Adam S. Posen is Research Associate at the
Institute for International Economics, on leave from the International Research Function of the Federal Reserve Bank of New York’s Research and Market
Analysis Group.

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9

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal Reserve Bank of New York in any form or
manner whatsoever.

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

Part I.

The Rationale for Inflation Targeting

T

he decision to organize a country’s monetary
strategy around the direct targeting of inflation
rests upon a number of economic arguments

about what monetary policy can and cannot do. Over the
last twenty years, a consensus has been emerging in the
economics profession that activist monetary policy to stimulate output and reduce unemployment beyond their sustainable levels leads to higher inflation but not to
persistently lower unemployment or higher output. Thus,
the commitment to price stability as the primary goal for
monetary policy has been spreading throughout the world.
Along with actual events, four intellectual developments
have led the economics profession to this consensus.

WHY PRICE STABILITY?
The first intellectual development challenging the use of
an activist monetary policy to stimulate output and reduce
unemployment is the finding, most forcefully articulated
by Milton Friedman, that the effects of monetary policy
have long and variable lags.1 The uncertainty of the timing
and the size of monetary policy effects makes it very possible that attempts to stabilize output fluctuations may not
have the desired results. In fact, activist monetary policy
can at times be counterproductive, pushing the economy
further away from equilibrium, particularly when the
stance of monetary policy is unclear to the public and even
to policymakers. This lack of clarity makes it very difficult
for policymakers to successfully design policy to reduce
output and unemployment fluctuations.2
The second development is the general acceptance
of the view that there is no long-run trade-off between
inflation and unemployment.3 The so-called Phillips curve

relationship illustrates the empirical regularity that a lower
unemployment rate or higher output can be achieved in
the short run by expansionary policy that leads to higher
inflation. As prices rise, households and businesses spend
and produce more because they temporarily believe themselves to be better off as a result of higher nominal wages
and profits, or because they perceive that demand in the
economy is growing. In the long run, however, the rise in
output or decline in unemployment cannot persist because
of capacity constraints in the economy, while the rise in
inflation can persist because it becomes embedded in price
expectations. Thus, over the long run, attempts to exploit
the short-run Phillips curve trade-off only result in higher
inflation, but have no benefit for real economic activity.
The third intellectual development calling into
question the use of an activist monetary policy to stimulate
output and reduce unemployment is commonly referred to as
the time-inconsistency problem of monetary policy.4 The
time-inconsistency problem stems from the view that
wage- and price-setting behavior is influenced by expectations of future monetary policy. A frequent starting point
for discussing policy decisions is to assume that private
sector expectations are given at the time policy is made.
With expectations fixed, policymakers know they can
boost economic output (or lower unemployment) by pursuing monetary policy that is more expansionary than
expected. As a result, policymakers who have a stronger
interest in output than in inflation performance will try to
produce monetary policy that is more expansionary than
expected. However, because workers and firms make decisions about wages and prices on the basis of their expectations about policy, they will recognize the policymakers’

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incentive for expansionary monetary policy and so will
raise their expectations of inflation. As a result, wages and
prices will rise.
The outcome, in these time-inconsistency models,
is that policymakers are actually unable to fool workers and
firms, so that on average output will not be higher under
such a strategy; unfortunately, however, inflation will be.
The time-inconsistency problem suggests that a central
bank actively pursuing output goals may end up with
a bias to high inflation with no gains in output. Consequently, even though the central bank believes itself to
be operating in an optimal manner, it ends up with a suboptimal outcome.
McCallum (1995b) points out that the timeinconsistency problem by itself does not imply that a central
bank will pursue expansionary monetary policy that leads to
inflation. Simply by recognizing the problem that forwardlooking expectations in the wage- and price-setting process
create for a strategy of pursuing unexpectedly expansionary
monetary policy, central banks can decide not to play that
game. Nonetheless, the time- inconsistency literature points
out both why there will be pressures on central banks to pursue overly expansionary monetary policy and why central
banks whose commitment to price stability is in doubt can
experience higher inflation.
A fourth intellectual development challenging the
use of an activist monetary policy to stimulate output and
reduce unemployment unduly is the recognition that price
stability promotes an economic system that functions more
efficiently and so raises living standards. If price stability
does not persist—that is, inflation occurs—the society suffers several economic costs. While these costs tend to be
much larger in economies with high rates of inflation (usually defined to be inflation in excess of 30 percent a year),
recent work shows that substantial costs arise even at low
rates of inflation.
The cost that first received the attention of economists is the so-called shoe leather cost of inflation—the cost
of economizing on the use of non-interest-bearing money
(see Bailey [1956]). The history of prewar central Europe
makes us all too familiar with the difficulties of requiring
vast and ever-rising quantities of cash to conduct daily

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transactions. Unfortunately, hyperinflations have occurred
in emerging market countries within the last decade as
well. Given conventional estimates of the interest elasticity
of money and the real interest rate when inflation is zero,
this cost is quite low for inflation rates less than 10 percent,
remaining below 0.10 percent of GDP. Only when inflation
rises to above 100 percent do these costs become appreciable, climbing above 1 percent of GDP (Fischer 1981).
Another cost of inflation related to the additional
need for transactions is the overinvestment in the financial
sector induced by inflation. At the margin, opportunities
to make profits by acting as a middleman on normal transactions, rather than investing in productive activities,
increase with instability in prices. A number of estimates
put the rise in the financial sector share of GDP on the
order of 1 percentage point for every 10 percentage points
of inflation up to an inflation rate of 100 percent (English
1996). The transfer of resources out of productive uses elsewhere in the economy can be as large as a few percentage
points of GDP and can even be seen at relatively low or
moderate rates of inflation.
The difficulties caused by inflation can also extend
to decisions about future expenditures. Higher inflation
increases uncertainty about both relative prices and the
future price level, which makes it harder to arrive at the
appropriate production decisions. For example, in labor
markets, Groshen and Schweitzer (1996) calculate that the
loss of output due to inflation of 10 percent (compared
with a level of 2 percent) is 2 percent of GDP. More
broadly, the uncertainty about relative prices induced by
inflation can distort the entire pricing mechanism. Under
inflationary conditions, the risk premia demanded on savings and the frequency with which prices are changed
increase. Inflation also alters the relative attractiveness of
real versus nominal assets for investment and short-term
versus long-term contracting.5
The most obvious costs of inflation at low to moderate levels seem to come from the interaction of the tax
system with inflation. Because tax systems are rarely
indexed for inflation, an increase in inflation substantially
raises the cost of capital, causing investment to drop below
its optimal level. In addition, higher taxation, which

results from inflation, causes a misallocation of capital to
different sectors, which in turn distorts the labor supply
and leads to inappropriate corporate financing decisions.
Fischer (1994) calculates that the social costs from the
tax-related distortions of inflation amount to 2 to 3 percent
of GDP at an inflation rate of 10 percent. In a recent paper,
Feldstein (1997) estimates this cost to be even higher: he
calculates the cost of an inflation rate of 2 percent rather
than zero to be 1 percent of GDP.
The costs of inflation outlined here decrease the
level of resources productively employed in an economy,
and thereby the base from which the economy can grow.
Mounting evidence from econometric studies shows that,
at high levels, inflation also decreases the rate of growth of
economies. While time series studies of individual countries over long periods and cross-national comparisons of
growth rates are not in total agreement, the consensus is
that, on average, a 1 percent rise in inflation can cost an
economy 0.1 to 0.5 percentage points in its rate of growth
(Fischer 1993). This result varies greatly with the level of
inflation—the effects are usually thought to be much
greater at higher levels.6 However, a recent study has presented evidence that the inflation variability usually associated with higher inflation has a significant negative effect
on growth even at low levels of inflation, in addition to and
distinct from the direct effect of inflation itself.7
The four lines of argument outlined here lead the
vast majority of central bankers and academic monetary
economists to the view that price stability should be the
primary long-term goal for monetary policy.8 Furthermore,
to avoid the tendency to an inflationary bias produced by
the time-inconsistency problem (or uncertainty about
monetary policy goals more generally), monetary policy
strategy often relies upon a nominal anchor to serve as a
target that ties the central bank’s hands so it cannot pursue
(or be pressured into pursuing) a strategy of raising output
with unexpectedly expansionary monetary policy. As we
will see, this anchor need not preclude clearly delineated
short-term reactions to financial or significant output
shocks in order to function as a constraint on inflationary
policy over the long term. A number of potential nominal
anchors for monetary strategy can serve as targets.

CHOICE OF TARGETS
One nominal anchor used by almost all central banks at
one time or another is a target growth path for a monetary aggregate such as the monetary base or M1, M2, or
M3. If velocity is either relatively constant or predictable,
a growth target of a monetary aggregate can keep nominal income on a steady growth path that leads to
long-term price stability. In such an environment,
choosing a monetary aggregate as a nominal anchor has
several advantages. First, some monetary aggregates, the
narrower the better, can be controlled both quickly and
easily by the central bank. Second, monetary aggregates
can be measured quite accurately with short lags (in the
case of the United States, for example, measures of the
monetary aggregates appear within two weeks). Third, as
pointed out in Bernanke and Mishkin (1992), because an
aggregate is known so quickly, using it as a nominal
anchor greatly increases the transparency of monetary
policy, which can have important benefits. A monetary
aggregate sends almost immediate signals to both the
public and the markets about the stance of monetary policy
and the intentions of policymakers, thereby helping to fix
inflation expectations. In addition, the transparency of a
monetary aggregate target makes the central bank more
accountable to the public to keep inflation low, which can
help reduce pressures on the central bank to pursue
expansionary monetary policy.
Although the targeting of monetary aggregates
has many important advantages in principle, in practice
these advantages come about only if the monetary aggregates have a highly predictable relationship with nominal
income. Unfortunately, in many countries, velocity fluctuations have been so large and frequent in the last fifteen
years that the relationships between monetary aggregates
and goal variables have broken down. Some observers have
gone so far as to argue that attempts to exploit these relationships have been a cause of their breakdown. As a result,
the use of monetary aggregate targets as a nominal anchor
has become highly problematic, and many countries that
adopted monetary targets in the 1970s abandoned them in
the 1980s. Not surprisingly, many policymakers have been
looking for alternative nominal anchors.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

13

Another frequently used nominal anchor entails
fixing the value of the domestic currency relative to that of
a low-inflation country, say Germany or the United States,
or, alternatively, putting the value of the domestic currency
on a predetermined path vis-à-vis the foreign currency in a
variant of this fixed exchange rate regime known as a
crawling peg. The exchange rate anchor has the advantage
of avoiding the time-inconsistency problem by precommitting a country’s central bank so that it cannot pursue an
overly expansionary monetary policy that would lead to a
devaluation of the exchange rate. In addition, an exchange rate
anchor helps reduce expectations that inflation will approach
that of the country to which its currency is pegged. Perhaps
most important, an exchange rate anchor is a monetary policy
strategy that is easily understood by the public.
As forcefully argued in Obstfeld and Rogoff
(1995), however, a fixed exchange rate regime is not without its costs and limitations. With a fixed exchange rate
regime, a country no longer exercises control over its own
monetary policy. Not only is the country unable to use
monetary policy to respond to domestic shocks, but it is
also vulnerable to shocks emanating from the country to
which its currency is pegged. Furthermore, in the current
environment of open, global capital markets, fixed
exchange rate regimes are subject to breakdowns that may
entail sharp changes in exchange rates. Such developments
can be very disruptive to a country’s economy, as recent
events in Mexico have demonstrated. Defending the
domestic currency when it is under pressure may require
substantial increases in interest rates that directly cause a
contraction in consumer and investment spending, and the
contraction in turn may lead to a recession. In addition, as
pointed out in Mishkin (1996), a sharp depreciation of the
domestic currency can produce a full-scale banking and
financial crisis that can tip a country’s economy into a
severe depression.
An inflation target (or its variant, a price-level target) clearly provides a nominal anchor for the path of the
price level, and, like a fixed exchange rate anchor, has the
important advantage of being easily understood by the
public. The resulting transparency increases the potential
for promoting low inflation expectations, which helps to

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produce a desirable inflation outcome. Also, like a fixed
exchange rate or a monetary targeting strategy, inflation
targeting reduces the pressure on the monetary authorities
to pursue short-run output gains that would lead to the
time-inconsistency problem. An inflation-targeting strategy
also avoids several of the problems arising from monetary
targeting or fixed exchange rate strategies. For example, in
contrast to a fixed exchange rate system, inflation targeting
can preserve a country’s independent monetary policy so
that the monetary authorities can cope with domestic
shocks and help insulate the domestic economy from foreign shocks. In addition, inflation targeting can avoid the
problem presented by velocity shocks because it eliminates
the need to focus on the link between a monetary aggregate
and nominal income; instead, all relevant information may
be brought to bear on forecasting inflation and choosing a
policy response to achieve a desirable inflation outcome.
Inflation targeting does have some disadvantages.
Because of the uncertain effects of monetary policy on
inflation, monetary authorities cannot easily control
inflation. Thus, it is far harder for policymakers to hit an
inflation target with precision than it is for them to fix the
exchange rate or achieve a monetary aggregate target. Furthermore, because the lags of the effect of monetary policy
on inflation are very long—typical estimates are in excess
of two years in industrialized countries—much time must
pass before a country can evaluate the success of monetary
policy in achieving its inflation target. This problem does
not arise with either a fixed exchange rate regime or a
monetary aggregate target.
Another potential disadvantage of an inflation
target is that it may be taken literally as a rule that precludes any concern with output stabilization. As we will
see in the cases later in our study, this has not occurred in
practice. An inflation target, if rigidly interpreted, might
lead to greater output variability, although it could lead to
tighter control over the inflation rate. For example, a negative supply shock that raises the inflation rate and lowers
output would induce a tightening of monetary policy to
achieve a rigidly enforced inflation target. The result, however, would add insult to injury because output would
decline even further. By contrast, in the absence of velocity

shocks, a monetary aggregate target is equivalent to a target for nominal income growth, which is the sum of real
output growth and inflation. Because the negative supply
shock reduces real output as well as raises the price level,
its effect on nominal income growth would be less than on
inflation, thus requiring less tightening of monetary policy.
The potential disadvantage of an inflation-targeting
regime that ignores output stabilization has led some
economists to advocate the use of a nominal income
growth target instead (for example, see McCallum [1995a]
and Taylor [1995]). A nominal income growth target
shares many characteristics with an inflation target; it also
has many of the same advantages and disadvantages. On
the positive side, it avoids the problems of velocity shocks
and the time-inconsistency problem and allows a country
to maintain an independent monetary policy. On the negative side, nominal income is not easily controllable by the
monetary authorities, and much time must pass before
assessment of monetary policy’s success in achieving the
nominal income target is possible. Still, a nominal growth
target is advantageous in that it explicitly includes some
weight on a real output objective and thus may lead to
smaller fluctuations in real output.9
Nonetheless, nominal income targets have two
very important disadvantages relative to inflation targets.
First, a nominal GDP target forces the central bank or the
government to announce a number for potential GDP

growth. Such an announcement is highly problematic
because estimates of potential GDP growth are far from
precise and they change over time. Announcing a specific
number for potential GDP growth may thus indicate a
certainty that policymakers may not have and may also
cause the public to mistakenly believe that this estimate is
actually a fixed target. Announcing a potential GDP
growth number is, therefore, likely to create an extra layer
of political complication—it opens policymakers to the
criticism that they are willing to settle for growth rates
that are too low. Indeed, it may lead to the accusation that
the central bank or the targeting regime is antigrowth,
when the opposite is true—that is, a low inflation rate is a
means to promote a healthy economy that can experience
high growth. In addition, if the estimate for potential
GDP growth is too high and it becomes embedded in the
public mind as a target, the classic time-inconsistency
problem—and a positive inflation bias—will arise.
The second disadvantage of a nominal GDP target
relative to an inflation target is that the concept of nominal
GDP is not readily understood by the public, thus making
it less transparent than an inflation target. No one speaks
of “headline nominal GDP growth” when discussing labor
contracts. In addition, because nominal and real GDP can
be easily confused, a nominal GDP target may lead the
public to believe that a central bank is targeting real GDP
growth, with the attendant problems mentioned above.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal Reserve Bank of New York in any form or
manner whatsoever.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

15

Part II.

P

Design Issues in the Implementation
of Inflation Targets

art I has outlined the reasons why several countries
have chosen to base their monetary strategies on
the targeting of inflation. It also raises a set of issues

about the design of an inflation-targeting regime. Before
examining in detail how inflation targeting has worked in
the countries we examine here, we briefly outline the
choices policymakers face in designing an inflation-targeting
strategy. The fundamental question is how best to balance
transparency with flexibility in operation, given the uncertainties of monetary policy and the economic environment.
The simpler and tighter the constraints on policy, the
easier it is for the public to understand and hold policy
accountable, but the harder it is for policy to respond to
events and maintain credible performance. Choices about
target design are therefore critical in setting this balance
appropriately.
In the case studies that follow, we will see that the
design choices for an inflation-targeting regime fall into
four basic categories: definition and measurement of the
target, transparency, flexibility, and timing.

DEFINITION AND MEASUREMENT
OF THE TARGET
Because inflation targeting by its very nature requires a
numerical value for the target, setting such a target
requires explicit answers to several questions about how
the target is defined and measured.
What does price stability mean in practice? Inflation targeting
requires a quantitative statement as to what inflation rate
is consistent with the pursuit of price stability in the next
few years. Because of innovation and changing tastes, all

inflation measures have a net positive bias. For example,
measurement error for consumer price index (CPI) inflation
in the United States has been estimated to be in the range
of 0.5 to 2.0 percent at an annual rate (Shapiro and Wilcox
1996; Advisory Commission to Study the Consumer Price
Index 1996). Another factor to be taken into account in
setting the target level of inflation is the asymmetric dangers from deflation. That is, through financial and other
channels, the costs to the real economy from undershooting
zero inflation outweigh the direct costs to the economy
from overshooting zero inflation by a similar amount. These
potential costs might warrant a price stability objective in
which the inflation rate, corrected for any measurement
error, might be set slightly above zero.
What inflation series should be targeted and who should measure
it? A target series must be defined and measured. The
series needs to be considered accurate, timely, and readily
understandable by the public, but it may also need to
exclude from its definition individual price shocks or onetime shifts that do not affect trend inflation, which is what
monetary policy can influence.
Price-level or inflation target? Both price-level and inflation
targets imply a targeted path for the price level. A pricelevel target sets the path for the price level so that if inflation
is above the targeted rate in one period, it must be below
the targeted rate in the next period in order to hit the
price-level target. By contrast, an inflation target allows for
“base drift,” in which bygones are bygones, and the miss on
the inflation target does not need to be offset. Relative to
an inflation target, a price-level target has the advantage of

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17

helping to pin down price-level expectations over very long
time horizons, but it may increase the volatility of the price
level over shorter time horizons.

TRANSPARENCY
An important rationale for inflation targeting is that it
promotes transparency in monetary policy. Two questions
need to be answered if transparency is to be achieved.
How should inflation targets be used to communicate with the
public and the markets? Inflation targets can be an effective
way of increasing transparency by communicating information to the public and the markets about the stance and
intentions of monetary policy. A variety of institutional
arrangements, published materials, testimony, and
speeches can help in this communication process and can
emphasize the forward-looking nature of monetary policy.
In addition, clear, regular explanations of monetary policy
by central banks can build public support for and understanding of the pursuit of price stability.
How should central banks be held accountable for target performance? Because monetary policy has such important effects
on the public, inflation targeting cannot be done without
democratic accountability. The extent to which this
accountability takes the form of structured discussion
rather than political pressure can in part be determined by
target design. Who should set the inflation target: the government, the central bank, or both together?

FLEXIBILITY
As McDonough (1996a) suggests, price stability is a means
to an end—the creation of a stable economic environment
that promotes economic growth—rather than an end in
itself. Control over inflation that is too tight might be costly
in terms of higher output variability. Thus, the design of an
inflation-targeting regime must answer questions about how
much flexibility should be built into it.
What deviations from the inflation target should be allowed in
response to shocks? As the discussion of the merits of an inflation

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target versus a nominal income growth target suggests, a
rigid inflation target may not be sufficiently flexible in
response to some shocks. Because both policymakers and
the public care about output fluctuations, and the ultimate
reason for price stability is to support a healthy real economy,
an inflation-targeting regime may need escape clauses or
some flexibility built into the target definition to deal with
supply and other types of shocks.
Should the target be a point or a range? Because of shocks to
the inflation process and uncertainty about the effects of
monetary policy, inflation outcomes will have a high
degree of uncertainty even with the best monetary policy
settings. Should an inflation target have a range to allow
for this uncertainty? Estimates of this uncertainty are quite
high (see, for example, Haldane and Salmon [1995] and
Stevens and Debelle [1995]), and so an inflation target
band would have to be quite wide—on the order of 5 or
6 percentage points—in order to allow for this uncertainty.
However, a band this wide might cause the public and the
markets to doubt the central bank’s commitment to the
inflation target. An alternative approach is a point target,
which—in order to address the uncertainties of inflation
outcomes—would be accompanied by discussion of the
shocks that might drive inflation away from the target goal.
Should inflation targets be varied over time? If there is substantial
inertia in the wage- and price-setting process and inflation is
initially very high, the monetary authorities might want to
avoid a rapid transition to the price stability goal. In this
case, they might well choose a transition path of inflation
targets that trends downward over time, toward the price
stability goal. Similarly, even if the price stability goal
were achieved, shocks to the economy might move the
economy away from this goal, again raising the issue of
whether the inflation targets should be varied over time.
Varying inflation targets over time may thus be used as
another tool to increase the flexibility of the inflationtargeting regime so that it can cope with supply and other
types of shocks to the economy.

TIMING
Two questions arise with respect to the timing of inflation
targets:
What is the appropriate time horizon for an inflation target?
Because monetary policy affects inflation with long lags,
monetary policy cannot achieve a specific inflation target
immediately, but instead achieves its goal over time. Also,
economic shocks can occur in the intervening period
between policy and effect. Monetary policymakers must
thus decide what time horizon is appropriate for meeting
the inflation target.
When is the best time to start implementing inflation targets? To
establish credibility for an inflation-targeting regime, it
may be important to have some initial successes in achieving
the inflation targets. This suggests that certain periods
may be better than others to introduce inflation targets.
Furthermore, obtaining political support for the commitment to price stability underlying an inflation-targeting
regime may be easier at certain times than at others, so
choosing the correct time to implement inflation targeting
may be an important element in its success or failure.

CASE STUDIES
We will see that these four categories of decisions about
operational design are recurring themes in the case study
discussions that follow. What is striking is the extent to
which a number of the target-adopting countries have converged on a few design choices, perhaps indicating an
emerging consensus on best practices.
The case studies are structured as follows. The first
section outlines why and under what circumstances the targeting regime was adopted. The next section describes the
operational framework of the targeting regime. The third
section describes the actual targeting experience. The final
section provides a brief summary of the key lessons to be
drawn from each country’s experience. The case studies
begin with Germany because it was one of the first countries
(along with Switzerland) to implement many of the features of
an inflation-targeting regime, even though Germany is not
an inflation targeter per se. Although Germany focuses
principally on monetary aggregates as the target variables,
there is much to learn from its experience, which has been
longer than that of the other countries discussed here. The
remaining case studies then proceed according to the order
in which the countries adopted inflation targeting: New
Zealand, then Canada, and finally the United Kingdom.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal Reserve Bank of New York in any form or
manner whatsoever.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

19

Part III. German Monetary Targeting:
A Precursor to Inflation Targeting

M

any features of the German monetary targeting regime are also key elements of inflation
targeting in the other countries examined in

this study. Indeed, as pointed out in Bernanke and Mishkin
(1997), Germany might best be thought of as a “hybrid”
inflation targeter, in that it has more in common with
inflation targeting than with a rigid application of a
monetary targeting rule. The German experience with
monetary targeting, which spans more than twenty years,
provides useful lessons for the successful operation of
inflation targeting, and this is why we study the German
experience here.
Several themes emerge from our review of Germany’s
experience with monetary targeting:1
• A numerical inflation goal is a key element in German
monetary targeting, suggesting that the differences
between monetary targeting as actually practiced by
Germany and inflation targeting as conducted by
other countries are not that great.
• German monetary targeting is quite flexible: convergence of the medium-term inflation goal to the longterm goal has often been quite gradual.
• Under the monetary targeting regime, monetary policy has been somewhat responsive in the short run to
real output growth as well as to other considerations
such as the exchange rate.
• The long-term goal of price stability has been defined
as a measured inflation rate greater than zero.
• A key element of the targeting regime is a strong
commitment to transparency and to communication
of monetary policy strategy to the general public.

THE ADOPTION OF MONETARY TARGETING
The decision to adopt monetary targeting in Germany,
though prompted by the breakdown of the Bretton Woods
fixed exchange rate regime, was a matter of choice.
Germany was not under any pressure at the time to reform
either its economy in general or its monetary regime in
particular—in fact, the breakdown of Bretton Woods was
in part due to the extreme relative credibility of the German
central bank’s commitment to price stability and the concomitant appreciation of the deutsche mark. Under these
circumstances, the loss of the exchange rate anchor was not
the sort of credibility crisis where macroeconomic effects
demanded an immediate response, as demonstrated by the
slow (two-to-three-year-long) move to the new regime.
Close analysis of the historical record suggests that
two main factors motivated the adoption of monetary targeting in Germany. The first factor was an intellectual
argument in favor of a nominal anchor for monetary policy
grounded in an underlying belief that monetary policy
should neither accommodate inflation nor pursue mediumterm output goals.2 The second factor was the perception
that medium-term inflation expectations had to be locked
in when monetary policy eased as inflation came down
after the first oil shock. The generalization over time of this
latter motivation—that monetary targeting provides a
means of transparently and credibly communicating the
relationship between current developments and mediumterm goals—was the guiding principle of the newly
adopted framework in Germany.
On December 5, 1974, the Central Bank Council
of the Deutsche Bundesbank announced that “from the

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21

present perspective it regards a growth of about 8% in the
central bank money stock over the whole of 1975 as acceptable in the light of its stability goals.”3 The Bundesbank
considered this target to “provide the requisite scope . . .
for the desired growth of the real economy,” while at the
same time the target had been chosen “in such a way that
no new inflationary strains are likely to arise as a result of
monetary developments.” Since 1973, the Bundesbank had
used the central bank money stock (CBM) as its primary
indicator of monetary developments, but never before had
it announced a target for the growth of CBM or any other
monetary aggregate.4 Although this was a unilateral
announcement on the part of the Bundesbank, the
announcement stressed that “in formulating its target for the
growth of the central bank money stock [the Bundesbank]
found itself in full agreement with the federal government.”
Although its statements at the time do not make
the point explicitly, one of the Bundesbank’s primary concerns appears to have been that public misperceptions
might entrench high inflation expectations. At the beginning of 1975, the Bundesbank faced the task of continuing
to ease monetary policy in view of the already apparent
weakness in the economy, without giving the impression
that its resolve to bring down inflation was diminishing.
Recent experience had shown that wage-setting behavior
in particular was mostly unaffected by the Bundesbank’s
efforts to reduce inflation:
Wage costs have gone up steadily in the last few
months, partly as after-effects of [earlier] settlements . . . which were excessive (not least because
management and labor obviously underestimated the
prospects of success of the stabilization policy). . . .
Despite the low level of business activity and subdued inflation expectations, even in very recent wage
negotiations two-figure rises have effectively been
agreed. (Deutsche Bundesbank 1974b, December, p. 6)
The credibility issue arose, therefore, in the context of the
Bundesbank’s desire to stop the pass-through of a onetime
shock to the price level; this concern for getting the public
to distinguish between first-round and second-round
effects of a price shock and to avoid locking in expectations
of high inflation characterizes the efforts of the inflation
targeters as well.

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From this perspective, the German monetary target seems to have been adopted, at least in part, to create a
necessary means of communication about inflation uncertainty. After CBM had grown by 6 percent during 1974,
the Bundesbank announced a target growth rate of 8 percent for 1975:
An acceleration of money growth was intended to
stimulate demand and provide the monetary scope
necessary for the desired real growth of the economy. On the other hand, the target was also
intended to show that no precipitate action
would be taken to ease monetary conditions, in
order not to jeopardize further progress towards
containing the inflationary tendencies. (Deutsche
Bundesbank 1976a, p. 5)
It is worth noting, however, that this explanation and the
statement cited in the previous paragraph were made after
the targets were announced, not contemporaneously with
the announcement.

THE OPERATIONAL FRAMEWORK
Our historical and institutional analysis in this section and
the following one (which discusses German monetary policy in the 1990s) independently confirms the impression of
German monetary policymaking raised in Bernanke and
Mishkin (1992) and argued by later econometric observers.
That is, the Bundesbank does not behave according to a
reduced-form-reaction function as though price stability
were its sole short-to-medium-term policy goal, or as
though the monetary growth–goal correlation were strong
enough to justify strictly following the targets, ignoring
wider information.5 In fact, in the following discussion we
bring out the operational reality and implications: that the
monetary targets provide a framework for the central bank
to convey its long-term commitment to price stability.
From 1975 until 1987, the Bundesbank announced
targets for the growth of central bank money (CBM). CBM
is defined as currency in circulation plus sight deposits,
time deposits with maturity under four years, and savings
deposits and savings bonds with maturity of less than four
years (the latter three components are weighted by their
respective required reserve ratios as of January 1974). CBM
is different from the monetary base in that banks’ excess

balances are excluded and the weights of deposits subject
to reserve requirements are historical, not current, ratios.
Since 1988, the Bundesbank has used growth in
M3 as its intermediate target. M3 is defined as the sum of
currency in circulation, sight deposits, time deposits with
maturity under four years, and savings deposits at three
months’ notice. Apart from not including savings deposits
with longer maturities and savings bonds, the major
difference between M3 and CBM is that the latter is a
weighted-sum aggregate, while the former is a simple sum.
By definition, therefore, CBM moves very closely with M3.
Because the weights on the three types of deposits are fairly
small,6 the only source for large divergences between the
growth of the two aggregates is significant fluctuation in
the holdings of currency as compared with deposits. This
potential divergence became critical in 1988, in the face of
shifting financial incentives, and again in 1990-91, after
German monetary unification.
The Bundesbank has always set its monetary targets
at the end of a calendar year for the next year. It derives the
monetary targets from a quantity equation, which states
that the amount of nominal transactions in an economy
within a given period of time is identically equal to the
amount of the means of payment times the velocity at which
the means of payment changes hands. In rate-of-change
form, the quantity equation states that the sum of real
output growth and the inflation rate is equal to the sum of
money growth and the change in (the appropriately
defined) velocity. The Bundesbank derives the target
growth rate of the chosen monetary aggregate (CBM or
M3) by estimating the growth of the long-run production
potential over the coming year, adding the rate of price
change it considers unavoidable (described below), and
subtracting the estimated change in trend velocity over
the year.
Two elements of this procedure deserve emphasis.
First, the Bundesbank does not employ forecasts of real
output growth over the coming year in its target derivation, but instead estimates the growth in production
potential. 7 This “potential-oriented approach” is based on
the Bundesbank’s conviction that it should not engage in
policies aimed at short-term stimulation. This approach

allows the Bundesbank not only to claim that it is not making any choice about the business cycle when it sets policy,
but also to de-emphasize any public discussion of its forecasting efforts for the real economy, further distancing monetary
policy from the course of unemployment. The transparency
of the quantity approach, therefore, gets certain items off
the monetary policy agenda (or at least moves in that
direction) by specifying the central bank’s responsibilities.
The second noteworthy element of the Bundesbank’s procedure for deriving the target growth rate of its
chosen monetary aggregate relates to the concept of
“unavoidable price increases,” where prices are measured by
the all-items consumer price index (CPI). These goals for
inflation are set prior to the monetary target each year
and specify the intended path for inflation, which in turn
motivates monetary policy.
In view of the unfavorable underlying situation, the
Bundesbank felt obliged until 1984 to include an
“unavoidable” rate of price rises in its calculation.
By so doing, it took due account of the fact that
price increases which have already entered into the
decisions of economic agents cannot be eliminated
immediately, but only step by step. On the other
hand, this tolerated rise in prices was invariably
below the current inflation rate, or the rate forecast
for the year ahead. The Bundesbank thereby made it
plain that, by adopting an unduly “gradualist”
approach to fighting inflation, it did not wish to
contribute to strengthening inflation expectations.
Once price stability was virtually achieved at the
end of 1984, the Bundesbank abandoned the
concept of “unavoidable” price increases. Instead,
it has since then included . . . a medium-term
price assumption of 2%. (Deutsche Bundesbank
1995c, pp. 80-1)
The setting of the annual unavoidable price
increase thus embodies four normative judgments by the
Bundesbank. First, a medium-term goal for inflation
motivates policy decisions. Second, convergence of the
medium-term goal to the long-term goal should be gradual since the costs of moving to the long-run goal cannot
be ignored. Third, the medium-term inflation goal has
always been defined as a number greater than zero. Fourth,
if inflation expectations remain contained, there is no need
to reverse prior price-level rises.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

23

The target for 1975 was a point target for CBM
growth from December 1974 to December 1975. Since
this target definition was susceptible to short-term fluctuations in money growth around year-end, the targets from
1976 to 1978 were formulated as point targets for the average growth of CBM over the previous year.
In 1979, two changes to the target formulation were
made. First, with the exception of 1989, all targets have
been formulated in terms of a target range of plus or minus
1 or 1.5 percent around the monetary target derived from
the quantity equation.
In view of the oil price hikes in 1974 and 1979-80,
the erratic movements in “real” exchange rates and
the weakening of traditional cyclical patterns, it
appeared advisable to grant monetary policy from
the outset limited room for discretionary maneuver
in the form of such target ranges. To ensure that
economic agents are adequately informed . . . the
central bank must be prepared to define from the
start as definitely as possible the overall economic
conditions under which it will aim at the top or
bottom end of the range. (Schlesinger 1983, p. 10)
In moving to a target range rather than a point target, the
Bundesbank believed that, by giving itself room for
response to changing developments, it could hit the target
range; in fact, the tone of its explanation suggests that it
was conferring some discretion upon itself rather than
buying room for error in a difficult control problem.
The second change made in 1979 was to reformulate the targets as growth rates of the average money stock
in the fourth quarter over the average money stock in the
previous year in order to indicate “the direction in which
monetary policy is aiming more accurately than an average
target does” (Deutsche Bundesbank 1979b, January, p. 8).
Chart 3 (p. 34) depicts quarterly growth rates of CBM
(through 1987) and M3 (thereafter) over the fourth-quarter
level of the previous year and the targets since 1979 (the
earlier targets are omitted because they were not formulated in terms of year-on-year rates).
The Bundesbank has repeatedly stressed that
situations may arise where it would consciously allow deviations from the announced target path to occur in order to
support other economic objectives. These allowances are

24

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

beyond and in addition to those implicit in the setting of a
target range and of a gradual path for movements in
unavoidable inflation. A case in point is the year 1977,
when signs of weakness in economic activity, combined
with a strong appreciation of the deutsche mark, prompted
the Bundesbank to tolerate the overshooting of the target.
As said at the time:
However, the fact that the Bundesbank deliberately
accepted the risk of a major divergence from its
quantitative monetary target does not imply that it
abandoned the more medium-term orientation
which has marked its policies since 1975. . . . There
may be periods in which the pursuit of an “intermediate target variable,” as reflected in the announced
growth rate of the central bank money stock,
cannot be given priority. (Deutsche Bundesbank
1978a, p. 22)
The main reason why CBM was initially chosen as
the target aggregate was the Bundesbank’s perception of
CBM’s advantages in terms of transparency and communication to the public. The Bundesbank explained its choice
of CBM in the following words:
[CBM] brings out the central bank’s responsibility
for monetary expansion especially clearly. The
money creation of the banking system as a whole
and the money creation of the central bank are
closely linked through currency in circulation and
the banks’ obligation to maintain a certain portion
of their deposits with the central bank. Central
bank money, which comprises these two components, can therefore readily serve as an indicator of
both. A rise by a certain rate in central bank money
shows not only the size of the money creation of the
banking system but also the extent to which the
central bank has provided funds for the banks’
money creation. (Deutsche Bundesbank 1976a, p. 12)
Although at any point in time CBM is a given
quantity from the Bundesbank’s point of view because of
the minimum reserve requirements, the choice of CBM
nevertheless also reflects the monetary policy stance in the
recent past. It is worth noting that this use of CBM to publicly track the monetary stance is consistent with the
Bundesbank’s focus on having minimum reserve requirements (as seen in the Bank’s advocacy of such requirements
for the unified European currency). The information being

conveyed by CBM in this context, however, is not so much
to prevent either the public or the central bank from making a large mistake about the unclear stance of monetary
policy (a major concern in the framework design of inflation targeters such as Canada), but to give rapid feedback
about the state of monetary conditions in general. The
mindset is that monetary control provides useful information about policy and lowers policy uncertainty.
The Bundesbank’s confidence that it can explain
target deviations and redefinitions to the public is reflected
in the design of its reporting mechanisms. There is no legal
requirement in the Bundesbank Act or in later legislation
for the Bundesbank to give a formal account of its policy to
any public body. The independence of the central bank in
Germany limits government oversight to a commitment
that “the Deutsche Bundesbank shall advise the Federal
Cabinet on monetary policy issues of major importance,
and shall furnish it with information upon request” (Act
Section 13). The only publications that the Bundesbank is
required to produce are announcements in the Federal
Gazette of the setting of interest rates, discount rates, and
the like (Act Section 33). According to Act Section 18, the
Bundesbank may at its discretion publish the monetary
and banking statistics that it collects.
The Bundesbank chooses to make heavy use of this
opportunity. On the inside front cover, the Monthly Report
is described as a response to Section 18 of the Bundesbank
Act, but it does much more than report statistics. Every
month, after a “Short Commentary” on monetary developments, securities markets, public finance, economic
conditions, and the balance of payments, there appear two to
four articles on a combination of onetime topics (for example, “The State of External Adjustment after German
Reunification”) and recurring reports (for example, “The
Profitability of German Credit Institutions” [annual] and
“The Economic Scene in Germany” [quarterly]). Each
year in January, the monetary target and its justification
are printed (between 1989 and 1992, the target and justification were available in December). The Annual Report
gives an extremely detailed retrospective of economic, not
just monetary, developments in Germany for the year, lists

all monetary policy moves, and offers commentary on the
fiscal policy of the federal government and the Länder.8
Between these two publications, and regularly updated
“special publications” such as The Monetary Policy of the
Bundesbank (an explanatory booklet), no Bundesbank policy
decision is left unexplained with respect to both its immediate impact and its short- and long-term effects.
The Bundesbank’s commitment to transparency
does not come without self-imposed limits on its accountability. Two limitations in particular provide a strong
contrast to the inflation report documents prepared by
central banks in Canada, the United Kingdom, and other
countries in recent years. First, no articles in the Monthly
Report are signed either individually or collectively by
authors, and the Annual Report has only a brief foreword
signed by the Bundesbank President (although all Council
members are listed on the pages preceding it). Speeches by
the President or other Council members are never
reprinted in either document. This depersonalization of
policy is to some extent made up for by the enormously
active speaking and publishing schedule that all Council
members (not just the President and Chief Economist) and
some senior staffers engage in, but the fact of depersonalized reports still weakens the link between the main policy
statements and the responsible individuals.
The second limitation on accountability is that the
Monthly Report and the Annual Report always deal with the
current situation or assess past performance 9 —no forecasts
of any economic variable are made public by the Bundesbank, and private sector forecasts or even expectations are
not discussed. The Bundesbank makes itself accountable on
the basis of its explanations for past performance, but it
does not leave itself open to be evaluated as a forecaster. In
fact, its ex post explanations, combined with its potential
GDP and normative inflation basis for the monetary targets,
enable the Bundesbank to shift responsibility for shortterm economic performance to other factors at any time.
Nevertheless, those same monetary targets are seen by the
Bundesbank as the main source of accountability and transparency because they commit the Bundesbank to explaining
policy with respect to a benchmark on a regular basis.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

25

GERMAN MONETARY POLICY UNDER
MONETARY TARGETING
The history of the German experience with inflation and
monetary targeting up until 1990 has been discussed
elsewhere (for example, see Bernanke and Mishkin [1992]
and Neumann and von Hagen [1993]). Rather than review
the entire history of German monetary targeting, we start
by highlighting events through the 1970s and 1980s
that are illustrative of certain themes discussed above—
particularly the treatment of the monetary targets not as
rigid rules but as a means of structured transparency for
monetary policy.
Then, the bulk of our discussion focuses on the
challenging episode of German monetary unification. In
that instance, the Bundesbank successfully handled a (by
definition) onetime inflationary shock of great magnitude
and politically sensitive developments in the real economy
through flexibility and communication. Close examination
of this episode also illustrates how the Bundesbank has
operated its monetary targeting regime in the 1990s and
provides a baseline for the three inflation targeters we
examine next. Charts 1-4 (pp. 33-4) track the path of
inflation, interest rates, monetary growth, GDP growth,
and unemployment before and after monetary union.
It is fair to generalize that in the 1970s and 1980s
the Bundesbank frequently over- and undershot its annual
monetary targets; it reversed overshootings in most but
not all cases. In addition, the Bundesbank responded to
movements in other variables besides inflation. From the
beginning of CBM targeting in 1975, the Bundesbank was
aware of the risk that “central bank money is prone to distortions caused by special movements in currency in circulation” (Deutsche Bundesbank 1976a, p. 11). In 1977, the
Bundesbank allowed CBM growth to exceed the target in
the face of an appreciating deutsche mark and weak economic activity. 10 At that early time, only two years after
the adoption of the targets, the Bundesbank relied on the
power of its explanation that “there may be periods in
which the pursuit of an ‘intermediate target variable’ . . .
cannot be given priority,” acknowledging the importance
of intervening real and foreign exchange developments in
its decision making (Deutsche Bundesbank 1978a, p. 2).

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

In 1981 and early 1982, CBM grew much more
slowly than M3 because of weakness in the deutsche mark,
leading to large-scale repatriation of deutsche mark notes
and an inverted yield curve that caused portfolio shifts out
of currency into high-yielding short-term assets. Accordingly, the monetary target for 1981 of 4 to 7 percent was
undershot (Chart 3, p. 34); since during this period the
Bundesbank was pursuing a disinflationary course, and progress was being made on the inflation front, the central bank
did not act to bring money growth up into target range.
In 1986 and 1987, the reverse situation—a strong
deutsche mark combined with historically low short-term
interest rates—led to CBM growth of 7.7 percent and
8 percent, respectively, while M3 grew at 7 percent and
6 percent during those two years, so that all measures
exceeded the target monetary growth range. The Bundesbank’s allowance of this overshooting could be seen as part
of the results of the Plaza Accord on the Group of Seven
exchange rates as well. The latter development prompted
the Bundesbank to announce a switch in 1988 to monetary
targets for the aggregate M3:
The expansion of currency in circulation is in itself
of course a significant development which the central bank plainly has to heed. This is, after all, the
most liquid form of money . . . and not least the
kind of money which the central bank issues itself
and which highlights its responsibility for the value
of money. On the other hand, especially at times
when the growth rates of currency in circulation
and deposit money are diverging strongly, there
is no reason to stress the weight of currency in
circulation unduly. (Deutsche Bundesbank 1988b,
March, “Methodological Notes on the Monetary
Target Variable ‘M3,’” pp. 18-21)
The fact that the Bundesbank changed the target
variable when CBM grew too fast, but did not do so when
it grew too slowly, can be interpreted as an indication of
the importance that the Bundesbank attaches to the communicative function of its monetary targets. Allowing the
target variable to repeatedly overshoot the target because of
special factors to which the Bundesbank did not want to
react might have led to the misperception on the part of
the public that the Bundesbank’s attitude toward monetary
control and inflation had changed. 11

An econometric argument has been made by Clarida
and Gertler (1997) that the Bundesbank has displayed an
asymmetry in reacting to target misses; that is, it usually
raises interest rates in response to an overshooting of the
target, but it does not lower interest rates in response to
an undershooting. In any event, the switch in targeted
monetary aggregates was not accompanied by any other
alterations in the monetary framework, and the perceived
need for the switch did not seem to occasion much concern.
In short, as long as the underlying inflation goal was met
over the medium term, the existence of the monetary targets rather than their precise functionality was sufficient.
As noted in the previous section’s discussion of
unavoidable price increases (later termed normative levels
of price increase) underlying the Bundesbank’s monetary
targets, the Bundesbank has tended to pursue disinflation gradually when inflationary shocks occur. The
Bundesbank’s response to the 1979 oil-induced supply
shock was very gradual and publicly stated to be so—the
Bundesbank set its level of unavoidable price inflation for
1980 at 8 percent, clearly below the then-prevailing rate,
but also clearly above the level of price inflation that was
acceptable over the longer term. The target inflation level
was brought down in stages, eventually returning to the
long-run goal of 2 percent only in 1984. Even though the
underlying intent was clear, each year’s target unavoidable
inflation level (as well as the monetary target and interest
rate policies determined by that level) was actually set only
a year ahead, allowing the Bundesbank still further flexibility
to respond to events and to rethink the pace of disinflation.
Although what turned out to be four years of marked inflation reduction is hardly an instance of the Bundesbank
going easy on inflation, it is an illustration of flexibility
and concern for the real-side economic effects of German
monetary policy.
The economic situation in the Federal Republic of
Germany during the two years prior to economic and monetary union with the German Democratic Republic (GDR)
on July 1, 1990, (“monetary union”) was characterized by
GDP growth of around 4 percent and the first significant
fall in unemployment since the late 1970s (Chart 4, p. 34).
After a prolonged period of falling inflation and histori-

cally low interest rates during the mid-1980s, inflation had
increased from -1 percent at the end of 1986 to slightly
more than 3 percent by the end of 1989. The Bundesbank
had begun tightening monetary policy in mid-1988, raising the repo rate in steps from 3.25 percent in June 1988
to 7.75 percent in early 1990. After the first M3 target of
3 to 6 percent had been overshot in 1988 by 1 percent, the
target for M3 growth of around 5 percent in 1989 was
almost exactly achieved, with M3 growing at 4.7 percent.
M3 growth was certainly not high in view of the prevailing
rate of economic growth.
In response to the uncertainties resulting from the
prospect of German reunification, long-term interest rates
had increased sharply from late 1989 until March 1990,
with ten-year bond yields rising from around 7 percent to
around 9 percent in less than half a year. Combined with a
strong deutsche mark, this rise in long-term interest rates
allowed the Bundesbank to keep official interest rates
unchanged during the months immediately preceding
monetary union. In the immediate aftermath of monetary
union it kept official interest rates unchanged as well,
despite the fact that the effects of the massively expansionary fiscal policy accompanying reunification were beginning
to propel GDP growth to record levels.
To some extent, the Bundesbank’s decision to keep
official interest rates unchanged for the first few months
following monetary union was due to the fact that the
inflationary potential resulting from the conditions under
which the GDR mark had been converted into deutsche
marks was very difficult to assess. The Bundesbank had
been opposed to the conversion rate agreed to in the treaty
on monetary union (on average about 1 to 1.8) and had
been publicly overruled on this point by the federal government. 12 The money stock M3 had increased almost
15 percent because of monetary union. The rate of conversion chosen turned out to be almost exactly right. While
GDP in the former GDR was estimated to be only around
7 percent of the Federal Republic’s once reunification took
place, with the vast government transfers to the east all of
the money was absorbed (see König and Willeke [1996]).
During the first few months following monetary union, the
Bundesbank was preoccupied as well with assessing the

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

27

portfolio shifts in east Germany in response to the introduction not only of a new currency, but also of a new financial system and a broad range of assets that had not
previously existed there.
As the east German banks were adjusting to their
new institutional structure, and velocity was destabilized
by portfolio shifts in east Germany, monetary data that
included east Germany were hard to interpret. The
Bundesbank therefore continued during the second half
of 1990 to calculate monetary aggregates separately for
east and west Germany, based on the returns of the banks
domiciled in the respective parts. Although M3 growth in
west Germany accelerated in late 1990 as a result of the
moderate growth rates during the first half of the year,
growth of M3 during 1990 of 5.6 percent was well within
the target range of 4 to 6 percent.
During the fall of 1990, the repo rate had
approached the lombard rate, which meant that banks were
increasingly using the lombard facility for their regular
liquidity needs and not as the emergency facility for which
the Bundesbank intended lombard loans to be used. On
November 2, 1990, the Bundesbank raised the lombard
rate from 8 to 8.5 percent as well as the discount rate from
6 to 6.5 percent. Within the next few weeks, however, banks
bid up the interest rate (Mengentender), and the repo rate rose
above the lombard rate, prompting the Bundesbank to
raise the lombard rate to 9 percent as of February 1, 1991.
With these measures, the Bundesbank was reacting to both
the volatile GDP growth rates and the faster M3 growth in
the last part of 1990. Inflation had until then remained
fairly steady, but it seems likely that the Bundesbank at
that point was probably expecting inflationary pressures to
develop in the near future given the fiscal expansion, the
overstretched capacities in west Germany, and the terms of
monetary union.
At the end of 1990, the Bundesbank announced a
target range for M3 growth of 4 to 6 percent for the year
1991, applying a monetary target for the first time to the
whole currency area. The target was based on the average
all-German M3 stock during the last quarter of 1990. As
this stock was still likely to be affected by ongoing portfolio
shifts in east Germany, the target was subject to unusually

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

high uncertainty. It is worth noting that neither the basic
inputs into the quantity equation that generates the
Bundesbank’s money growth targets’ normative inflation
nor the potential growth rate of the German economy was
changed.13
Following German unification, the monetary targets
set by the Bundesbank were decidedly ambitious as
they left normative inflation, on which these targets
are based, unchanged at 2% during this period,
even though it was obvious from the outset that this
rate could not be achieved in the target periods
concerned. (Issing 1995a)
This statement was one of policy—the reunification shock did not fundamentally alter the basic structures
of the German economy. Moreover, this statement communicated to the public at large that any price shifts coming
from this shock should be treated as a onetime event and
not be passed on to inflationary expectations.
This stance required faith in the public’s comprehension of, and the Bundesbank’s ability to credibly
explain, the special nature of the period. It is important to
contrast this adherence to the 2 percent medium-term
inflation goal with the Bundesbank’s response to the 1979
oil shock, when, as already noted, unavoidable inflation
was ratcheted up to 8 percent and brought down only
slowly. There are two explanations for the difference in policy response in the 1990-93 period, neither of which
excludes the other: first, the monetary unification shock
was a demand rather than a supply shock, and so the
Bundesbank was correct not to accommodate it; and second,
after several years of monetary targeting, the Bundesbank’s
transparent explanations of monetary policy had trained
the public to discern the differences between onetime pricelevel increases and persistent inflationary pressures. In any
event, the Bundesbank was clearly allowing its short-term
monetary policy to miss the targets in pursuit of the longer
term goal.
Following the Bundesbank’s target announcement
stressing its continued adherence to monetary targeting
after reunification and the lombard rate increase on February 1, long-term interest rates started falling for the first
time since 1988. In hindsight, it is apparent that this was

the beginning of a downward trend that continued until
the bond market slump in early 1994. Although the highest inflation rates were still to come, at this point financial
markets were apparently convinced that the Bundesbank
would succeed in containing, if not reducing, inflation in
the long run. By making it clear that it would not accommodate further price increases in the medium term, the
Bundesbank bought itself flexibility for short-term easing
without inviting misinterpretation. This link between
transparency and enhanced flexibility, of course, depends
upon the central bank’s commitment to price stability
being credible, but it emphasizes how even a credible central bank may gain through institutional design to increase
transparency.
Until mid-August 1991, the Bundesbank left the
discount and lombard rates unchanged, while the repo rate
steadily edged up toward the lombard rate of 9 percent.
CPI inflation in west Germany had still remained around 3
percent during the first half of 1991, while GDP growth
remained vigorous. M3 growth, by contrast, was falling
compared with its upward trend during late 1990, in part
because of faster than expected portfolio shifts into longer
term assets in east Germany.
These portfolio shifts, as well as the sharper than
expected fall in the GDR’s production potential, led the
Bundesbank for the first time ever to change its monetary
target on the occasion of its midyear review. The target for
1991 was lowered by 1 percent, to 3 to 5 percent. The fact
that monetary targets are rarely reset is critical to any
change being accepted without being perceived as a dodge
by the central bank.
In this instance, the Bundesbank was able to
invoke the implicit escape clause built into the semiannual
target review. That formalized process, which required a
clear explanation for any shift in targets, gave a framework
for the Bundesbank to justify its adjustment. The discipline of the monetary targeting framework displayed the
framework’s disadvantages as well: that is, the difficulty of
meeting short-run targets stemming from the instability of
money demand and the inability to forecast changes in the
monetary aggregate’s relationship to goal variables.

As the repo rate approached the lombard rate
again, the Bundesbank, on August 16, 1991, raised the
lombard rate from 9 to 9.25 percent and the discount rate
from 6.5 to 7.5 percent. The discount rate was raised to
reduce the subsidy character of banks’ rediscount facilities,
which the Bundesbank had tolerated as long as the east
German banks relied mostly on rediscount credit for the
provision of their liquidity.
Despite the fact that GDP growth started to
slacken during the second half of 1991, M3 growth accelerated. To some extent, the faster growth of M3 was a result
of the by-then inverted yield curve, which led to strong
growth of time deposits and prompted banks to counter
the outflow from savings deposits by offering special savings
schemes with attractive terms. This period was the first
time that the yield curve had become inverted since the
early 1980s and since the Bundesbank had been targeting
M3. In this situation, the conflict arose for the Bundesbank
that increases in interest rates were likely to foster M3
growth. This problem was all the more acute since banks’
lending to the private sector was growing unabated despite
the high interest rates, probably, to a large extent, because
loan programs were subsidized by the federal government
in connection with the restructuring of the east German
economy and housing sector.
This conundrum, of the Bundesbank’s instrument
tending to work in the “wrong” direction, brought the
underlying conflict of monetary targeting to the fore—the
target must be critically evaluated constantly in relationship to the ultimate goal variable(s). However, if the target
is cast aside regularly with reference to changes in that
relationship or to special circumstances indicating a role for
other intermediate variables, it ceases to serve as a target
rather than solely as an indicator.
Strictly defined, the use of a money growth target
means that the central bank not only treats all unexpected fluctuations in money as informative in just
this sense, but also, as a quantitative matter,
changes its instrument variable in such a way as to
restore money growth to the originally designated
path. (Friedman and Kuttner 1996, p. 94)

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

29

The acceleration in late 1991 notwithstanding, M3 grew
by 5.2 percent during 1991, close to the midpoint of the
original target and just slightly above the revised target.
On December 20, 1991, the Bundesbank raised
the lombard and discount rates by another 0.5 percent, to
9.75 percent and 8 percent, respectively, their highest levels since World War II (if the special lombard rates from
the early 1970s are disregarded).

August onward, as the Bundesbank started to ease monetary policy in response to the appreciation of the deutsche
mark and emerging tensions in the European Monetary
System; of course, the decision to ease also coincided with
the rapid slowdown in German GDP growth. The monetary targets for 1992 and 1993 would not be met, but the
challenge to German monetary policy from reunification
was over.

In the light of the sharp monetary expansion, it was
essential to prevent permanently higher inflation
expectations from arising on account of the adopted
wage and fiscal policy stance and the faster pace of
inflation—expectations which would have become
ever more difficult and costly to restrain. (Deutsche
Bundesbank 1992a, p. 43)

Thus in 1992, for example, when the money stock
overshot the target by a large margin, the Bundesbank made it clear by the interest rate policy
measures it adopted, that it took this sharp monetary expansion seriously. The fact that, for a number
of reasons, it still failed in the end to meet the
target . . . has therefore ultimately had little impact
on the Bundesbank’s credibility and its strategy.
(Issing 1995b)

The rhetoric invoked here by the Bundesbank is
important to appreciate. Both government policies and
union wage demands could be (and were) cited for their
inflationary effects, that is, their pursuit of transfers
beyond available resources. The Bundesbank may not have
been able to override Chancellor Helmut Kohl’s desired
exchange rate of ostmarks for deutsche marks, or his
“solidarity” transfers, but the Bundesbank Direktorium
was comfortable in making it clear that the Kohl government and not the Bundesbank Direktorium should be held
accountable for the inflationary pressures; the Bundesbank
Direktorium took accountability for limiting the secondround effects of these pressures.
In addition to this division of accountability, the
Bundesbank also clearly expressed some concern about the
persistence of inflationary expectations and (if necessary)
the cost of lowering them, thereby making clear its recognition of the substantial costs of disinflation even for a
credible central bank. Finally, the Bundesbank’s emphasis
on the ultimate goal—medium-term price stability and
inflation expectations—did not lead it to cite measures of
private sector expectations directly—something, as we will
see, many inflation targeters began doing at this time.
The December 20 increase in the lombard rate
proved to be the last. During the first half of 1992, the
repo rate slowly approached the lombard rate and peaked
in August at 9.7 percent before starting to fall from late

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

Monetary policy transparency was explicitly linked to flexibility during reunification, at least according to Bundesbank Chief Economist Otmar Issing, and that flexibility
was exercised to minimize the real economic and political
effects of maintaining long-term price stability.
Over the past five years or so, however, M3 has
continued to prove itself a problematic intermediate target,
even after reunification. The Bundesbank’s own explanations for the sizable fluctuations in annualized M3 growth
since 1992 (Chart 3, p. 34) suggest that demand for M3
behaves more and more like that for a financial asset rather
than that for a medium of exchange. While the Bundesbank, in justifying deviations from the M3 targets, has
begun giving greater prominence to reports on “extended
money stock M3,” a still broader aggregate that includes
some recently growing forms of money market accounts, it
has given no signs of readiness to switch target aggregates
again (see Deutsche Bundesbank [1995b, July, p. 28]).
The Bundesbank has repeatedly described itself as
“fortunate” because financial relationships have been more
stable in Germany than in other major economies that have
tried monetary aggregate targeting. It has attributed this
successful experience to the self-described earlier deregulation of financial markets in Germany and the lack of inflationary or regulatory inducement for financial firms to

pursue innovations. The targets continue as a structured
framework by which the Bundesbank can regularly explain
its monetary policy, even as the targets go unmet for
periods of several years.14
In the December 1996 Monthly Report, the
Bundesbank announced that it would set a target of 5 percent annualized growth in M3 in both 1997 and 1998.
This is the first time since Germany adopted monetary
targeting in 1975 that it has announced a multiyear monetary
target. The explicit reason given for the multiyear target is
to allow German monetary policy flexibility to respond to
expected volatility in the currency markets in the run-up
to European Monetary Union (EMU) in 1999, which
would make these the last German monetary targets.
Clearly, domestic price stability is balanced with other
goals for the next two years and beyond, and flexibility,
when viewed as publicly justifiable, is valued. Moreover,
given the lags between movements in German monetary
policy and their effects upon output and inflation, it is clear
that the only variables that the Bundesbank can reasonably
hope to influence significantly prior to EMU in 1999 are
the evolving Exchange Rate Mechanism (ERM) parities.
The target range for M3 growth in 1997 will be
3.5 to 6.5 percent; the target range for 1998 will be
announced at the end of 1997, apparently in response to the
difference between actual M3 growth in 1997 and what is
needed to achieve the 5 percent average. Bundesbank
President Hans Tietmeyer indicated at the news conference
announcing the new targets that the rate of annualized M3
growth in 1997-98 may be computed against the fourth
quarter of 1995 rather than of 1996, because “comparison
with the last quarter of 1996 can be a distortion.” In 1996,
M3 growth did exceed the Bundesbank’s target range of
4 to 7 percent, with much of the difference being attributed
to movements in narrow money in the last quarter as private
households participated in the oversubscribed purchase of
newly issued Deutsche Telecom stock. It is important to
note as well, however, that 1996 inflation was at its lowest
level in Germany since the adoption of monetary targets
(1.4 percent growth in CPI)—and that the Bundesbank cut
all three of its instrument interest rates to historical nominal
lows—even as M3 growth exceeded the stated target.

The endgame nature of the current German monetary situation illustrates a point that is relevant for all
inflation targeters with a fixed term for their targeting
regime, a point that has not been relevant for Germany
until now. When the end of the targeting regime is tied to
a specific event—such as an election or a treaty commitment—it is not clear how much discipline the target
imposes as that time approaches. A central bank could be
less strict about target adherence in the early years of
the period, making the claim that it will make up for
temporary overshootings later. Yet, when this later time
arrives, the commitment to return the targeted variable to
a level required under the targeting regime will in effect
predetermine the path of policy. The central bank is then
unable to respond to economic events as they unfold unless
it abandons the target.
In addition, the central bank may not be highly
accountable for its monetary policy if the targeting regime
is unlikely to be kept in place. If the central bank cannot be
held accountable, then how can its target commitment be
fully credible? This is not to suggest by any means that the
Bundesbank will go “soft” on inflation in the run-up to EMU,
but rather that it is best if target time horizons can be
credibly extended before their expiration. As we will see in
the case studies for both Canada and the United Kingdom,
there was a need to reassure the public that targets
would be maintained past election dates (and changes of
political power).

KEY LESSONS FROM GERMANY’S
EXPERIENCE
Germany’s twenty years of experience with monetary
targeting suggests two main lessons that are applicable
to any targeting regime in which an inflation goal plays a
prominent role. First, a targeting regime can be quite
successful in restraining inflation even when the regime
is flexible, allowing both significant overshootings and
undershootings of the target in response to other shortrun considerations. Indeed, German monetary targeting,
although successful in keeping inflation low, must be seen as
a significant departure from a rigid policy rule in which sub-

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

31

stantial target misses would not be tolerated.
Second, a key element of a successful targeting
regime is a strong commitment to transparency. The target
not only increases transparency by itself, but also serves as
a vehicle to communicate often and clearly with the pub-

lic and to promote an understanding of what the central
bank is trying to achieve. We shall see that these key elements of a successful targeting regime—flexibility and
transparency—have been present not only in the German
case, but also in successful inflation-targeting regimes in
other countries.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

32

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

ECONOMIC TIME LINE: GERMANY
Chart 1

Annual and Unavoidable (Normative) Inflation
Percent
8
German monetary
unification
(July 1990)

Annual inflation
6

Unavoidable
(normative)
inflation

4

2
Start of monetary
targeting
(January 1975)
0

-2
1971

73

75

77

79

81

83

85

87

89

91

93

95

97

Sources: Deutsche Bundesbank; Bank for International Settlements.
Notes: “Unavoidable inflation” is the rate chosen by the Bundesbank for use in its quantity equation for monetary forecasts. In 1986, the Bundesbank renamed this
rate “the rate of normative price increase.”

Chart 2

Overnight and Long-Term Interest Rates
Percent
16
Start of monetary
targeting
(January 1975)

14

German monetary
unification
(July 1990)
Overnight rate

12
10
Long-term rate
8
6
4
2
0

1971

73

75

77

79

81

83

85

87

89

91

93

95

97

Source: Bank for International Settlements.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

33

ECONOMIC TIME LINE: GERMANY (CONTINUED)
Chart 3

Monetary Growth and Targets
Percent
16
Start of monetary
targeting
(January 1975)

14

German monetary
unification
(July 1990)

12
10
8
6
4
2

Target range

0
-2
-4
1971

73

75

77

79

81

83

85

87

89

91

93

95

97

95

97

Sources: Deutsche Bundesbank; Bank for International Settlements.
Note: The shift to a dashed line indicates the change in the monetary aggregate targeted, from CBM (central bank money stock) to M3.

Chart 4

GDP Growth and Unemployment
Percent
12

German monetary
unification
(July 1990)

Start of monetary
targeting
(January 1975)

10

Unemployment
8
6
GDP growth
4
2
0
-2
-4
1971

73

75

77

79

81

83

85

87

89

91

Sources: Bank for International Settlements; Organization for Economic Cooperation and Development, Main Economic Indicators.

34

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

93

Part IV.New Zealand

N

ew Zealand was the first country to adopt
formal inflation targeting. In discussing its
experience, we stress the following design

choices and themes:
• Inflation targeting in New Zealand followed legislation
that mandated a Policy Targets Agreement (PTA)
between the elected government and the newly
independent central bank, which resulted in a jointly
decided numerical target for inflation.
• Inflation targeting was adopted only after a successful
disinflation had largely taken place.
• Rather than using the headline consumer price index
(CPI), the central bank uses a core-type price index to
construct the inflation target variable; the variable
excludes not only energy and commodity prices,
but also, in particular, the effects of consumer interest
rates as well as other prices on an ad hoc basis.
• The same entity that is accountable for achieving the
inflation target, the Reserve Bank of New Zealand,
also defines and measures the target variable when
“significant” first-round impacts from terms-of-trade
movements, government charges, and indirect taxes
arise. The ultimate long-run target variable of CPI
inflation, however, is compiled by a separate agency,
Statistics New Zealand.
• Although New Zealand’s inflation-targeting regime
is the most rigid of the inflation-targeting regimes
discussed in this study, it still allows for considerable
flexibility: as in Germany, the central bank responds
to developments in variables other than inflation,
such as real output growth.
• Accountability of the central bank is a key feature of
the inflation-targeting regime; the Governor of the
central bank is subject to possible dismissal by the
government if the target is breached.

• The inflation target is stated as a range, rather than as
a point target—with the midpoint of this range above
zero—again suggesting, as in the German case, that
the long-term goal of price stability is defined as a
measured inflation rate above zero.
• Strict adherence to the narrowness of the inflation target
range and the one-year time horizon of the target
has resulted in two related problems: 1) a control
problem—that is, the difficulty in keeping inflation
within very narrow target ranges—and 2) an instrument
instability problem—that is, wider swings in the policy
instruments, interest rates, and exchange rates than
might have been desirable.

THE ADOPTION OF INFLATION TARGETS
The present framework for the conduct of monetary policy
in New Zealand is explained by the Reserve Bank of
New Zealand Act of 1989. The Act was introduced into
Parliament by the government on May 4, 1989, was passed
by Parliament on December 15, and took effect on February 1, 1990. It assigns to the Reserve Bank the statutory
objective “to formulate and implement monetary policy
directed to the economic objective of achieving and maintaining stability in the general level of prices” (Section 8).1
Although inflation targeting was the institutional
means chosen to implement the Reserve Bank’s commitment
to price stability, the Act only put into the statute the need
for a visible nominal anchor. Section 9 of the Act requires
the Minister of Finance and the Governor of the Reserve
Bank to negotiate and make public a Policy Targets
Agreement, setting out “specific targets by which monetary
policy performance, in relation to its statutory objective,
can be assessed during the period of the Governor’s term”
(Lloyd 1992, p. 211). The first PTA, signed by the Minister

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

35

of Finance and the Governor on March 2, 1990, specified
numerical targets for inflation and the dates by which they
had to be reached.
The passage of the Act and the establishment of
numerical inflation targets have been the result of a slow
process that started in July 1984. The then newly elected
Labour Government embarked on a wide-ranging effort to
reform the government’s role in the New Zealand economy,
tackling at the same time fiscal, monetary, structural, and
external issues based on the view that these different
aspects of economic policy were interrelated and thus had
to be mutually coherent (for an overview of the reform
measures, see Brash [1996b]). There was a general sense of
crisis over New Zealand’s economic policy at the time, based
on concerns that the country’s performance had been significantly lagging that of other members of the Organization for
Economic Cooperation and Development (OECD) and that
neither of the major party’s old policies would work. As
far as monetary performance went:
New Zealand experienced double digit inflation for
most of the period since the first oil shock. Cumulative inflation (on a CPI basis) between 1974 and
1988 (inclusive) was 480 per cent. A brief, but temporary, fall in inflation to below 5 per cent occurred
in the early 1980s, but only as the result of a distortionary wage, price, dividend and interest rate
freeze. Throughout the period, monetary policy
faced multiple and varying objectives which were
seldom clearly specified, and only rarely consistent
with achievement of inflation reduction. As a result
of this experience, inflation expectations were
deeply entrenched in New Zealand society. (Nicholl
and Archer 1992, p. 118)
Although the Reserve Bank stated that “a firm monetary
policy is seen as an essential prerequisite for lower, more
stable interest rates and inflation rates over the mediumterm” (Reserve Bank of New Zealand 1985a, p. 451), at
the start of the general reform movement there was no
focused discussion of what exactly the objective(s) of monetary policy in the new economic environment should be.
Initially, there was some indication of interest in intermediate targeting of monetary aggregates, 2 but this topic was
never pursued and in recent years the Bank has stressed that
no useful link exists between these aggregates and inflation.

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

At the time of the signing of the first PTA in
March 1990, the Reserve Bank of New Zealand, backed by
the Labour Government (which had been reelected in
August 1987), had succeeded in bringing underlying inflation
down from almost 17 percent at the beginning of 1985 to
within the 5 percent range “although a number of one-off
factors meant that only limited progress [on disinflation]
was made” during 1989 (Reserve Bank of New Zealand
1990, p. 6). “The increase in GST [the goods and services
tax in July 1989] pushed up the [headline] inflation rate
and proved detrimental to inflation expectations. The GST
damage was . . . compounded by the impact of strong
commodity prices” (Reserve Bank of New Zealand 1990,
p. 7). The decision to announce inflation targets occurred
after most of the disinflation had already taken place. As
we will also see in Canada, the announcement fortuitously
was timed to cut off a rise in inflationary expectations and
the original target was easily met.

THE OPERATIONAL FRAMEWORK
Most of the operational aspects of New Zealand’s inflationtargeting framework are governed by the PTAs, since these
agreements (and the targets they set) represent the only legal
implementation of the Reserve Bank of New Zealand Act of
1989. The challenge for institutional designers in New
Zealand was twofold: to determine, first, how far institutional
change could take a very small natural-resource-based open
economy to desired macroeconomic outcomes, and second,
how to maintain appropriate public understanding of and
support for counterinflationary policies after the initial
reform impetus met with difficult developments. In general,
New Zealand has opted to build in legal and formal means
of introducing flexibility in its monetary framework. This
choice of design opens the possibility of frequently
announced changes in monetary policy variables and time
horizons—with detailed legal accountability—albeit at
some real cost in transparency to the general public. Within
the exercise of this flexibility, the Reserve Bank still has had
to balance the remaining constraints necessary for credibility
with the realities of the world economy.
From the start, the eventual goal of price stability
was defined in practice as achieving a rate of measured

annual inflation of between 0 and 2 percent in the All
Groups (that is, headline) CPI. The target was always
intended to be a true range, with both the floor and ceiling
to be taken seriously, but no special emphasis was placed on
the midpoint. For example, in September 1991, policy was
explicitly eased to avoid undershooting the range to
encourage perceptions that the bands of the range were hard
(Nicholl and Archer 1992, p. 124). Hitting the target
remains an extremely ambitious goal because of the narrowness of the range and its centering so close to zero measured
inflation—conditions that are costly to maintain in the face
of external or commodity price shocks. The result has been
that the actual inflation rate has remained near the top of the
range for much of the time since the adoption of targets,
with the public focus being on the 2 percent (ceiling) target
rather than the 1 percent midpoint (the intended target).
Unlike Switzerland, a similarly small open economy
that chose not to adopt a target range given the difficulties of controlling inflation exactly (especially so close to
zero measured), the Reserve Bank clearly did not want to
admit the likelihood of control problems, at least initially. As
noted below, at the end of 1996 the band was widened, in part
because the Reserve Bank recognized these difficulties. As a
beginning for discussion, the Bank uses the CPI
because it is the most widely known and the best
understood index. . . . The above-zero rate of
inflation specified reflects index number problems,
the survey methodology, and the difficulty of
adjusting for new goods or for improvements in
quality. Effectively, a judgment has been made that
1 percent CPI inflation is consistent with stability
in the general level of prices.” (Nicholl and Archer
1992, p. 120)
The first PTA admitted that this headline CPI “is
not an entirely suitable measure of [the prices of goods and
services currently consumed by households] since it also
incorporates prices and servicing costs of investmentrelated expenditures,” most notably prices of existing
dwellings, but the Agreement concluded that “the CPI
will, for practical purposes, be the measure used in setting
the targets” (Section 2). 3 The most difficult challenge for
the Reserve Bank of New Zealand in communicating with
the public about the target definition has arisen from the

inclusion of interest rates in the headline CPI, as that is the
main source of divergence from the target series. In the
“Underlying Inflation” section of its August 1991 Monetary
Policy Statement, the Bank stated that headline CPI “is the
basic yardstick against which the Bank should be assessed”
(Reserve Bank of New Zealand 1991, p. 17). It then
stressed its emphasis in the recent past on controlling
“underlying inflation” and continued:
Unfortunately, because the nature of such shocks
cannot be fully specified in advance, and because
the impact of shocks can often not be measured
precisely, it is not possible to specify a single, comprehensive definition of “underlying inflation.” To
some extent, interpretation of the impact and significance of the shocks is a matter of judgement,
and hence requires clear explanations by the Bank
to support any numerical estimates. (Reserve Bank
of New Zealand 1991, p. 19)
In practice, therefore, the Bank has developed a
measure of underlying inflation that it relies upon to
exclude any of these shocks. (The first-round effect of interest rate changes on prices is automatically excluded in a
series published by Statistics New Zealand, while other
adjustments are left to the Bank.) Underlying inflation has
been reported regularly alongside headline inflation by the
New Zealand press as well as by the Reserve Bank, and there
has been little confusion as the public has been educated over
time (even as the two series diverged by as much as 2 percent
in later years and have occasionally moved in opposite
directions). This need to exclude items from the CPI series
and then make sure the public understands why this action
is legitimate is a challenge that all inflation targeters face.
Even when a headline CPI series is used in inflation targeting,
there is still a need to explain why the central bank should
not respond to some deviations from the target (for
example, identifiable temporary deviations from the trend
such as hikes in the value-added tax).
It is useful to stress that this definition of underlying
inflation has its advantages for New Zealand as the classic
example of a small open economy. Without the terms-oftrade provision in the PTAs, for example, it is hard to see
how monetary policy could limit variation in inflation
to a meaningfully narrow range without causing severe

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

37

disruption in real activity. Yet the judgmental aspect of
this measure of inflation—that the Bank decides whether a
given shock has a “significant” impact on the price level—
is also potentially problematic. The most problematic
aspect is that the Bank itself is in charge of defining the
measure of inflation that determines whether the Bank has
been successful in achieving the announced targets, an
arrangement that undermines the seeming impartiality of
the mechanism meant to hold the Bank accountable for
achieving price stability.4
Another consequence of the Bank’s efforts to communicate clearly and usefully about the distinction
between headline and underlying inflation has to do with
time horizons. Since the underlying inflation measure is
not defined as a continuous series, but rather one with its
composition changing at irregular intervals, this distinction adds to the potential confusion. It is worth pointing
out, moreover, that the timing of the PTAs themselves—
and therefore of the inflation target, however defined—is
arbitrary, with the first interval lasting only six months
and the latest lasting indefinitely. In light of the shift to
open-ended targets, it is also worth noting that while the
PTAs are not necessarily tied to the electoral cycle—set to
expire with a given parliamentary majority—neither are
they themselves statutorily insulated from such a cycle, and
a new government could potentially renegotiate with the
Bank as desired. The realization of this possibility, which
occurred when the time horizon and range of the target
were reset in December 1996, is discussed below.
A final aspect of timing is that neither the government nor the Bank has targeted the price level rather than
the rate of inflation; the decision makers are letting
bygones in earlier price-level rises be bygones. Either interpretation of price stability would have been consistent with
the original Reserve Bank of New Zealand Act, as pointed
out by Bryant (1996, p. 8). Since at the conclusion of the
second PTA inflation had been within the 0 to 2 percent
range for one year, both the third and fourth PTAs required
the Bank merely to “formulate and implement monetary
policy to ensure that price stability is maintained” indefinitely.
In practice, each of the PTAs has included a list of
shocks in response to which the Bank is required to “generally

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

react . . . in a manner which prevents general inflationary
pressures emerging” (Section 3): 5 that is, the PTAs have
escape clauses to accommodate first-round effects on prices
but not to allow the passing on of these prices to a second
round. These shocks include:
• a movement in interest rates that causes a significant divergence between the change in the CPI and
the change in the CPI excluding the interest costs
component. This clause of the third PTA replaced the
earlier provision for a significant divergence between
the CPI and a price index treating housing costs on an
internationally comparable basis;
• significant changes in the terms of trade arising from
an increase or decrease in either import or export prices;
• an increase or decrease in the rate of the goods and
services tax (GST) or a significant change in other
indirect taxes;
• a crisis such as a natural disaster or a major diseaseinduced fall in livestock numbers that is expected to
have a significant impact on the price level; and
• a significant price-level impact arising from changes
to government or local authority levies.
The Bank has consistently excluded from its measure of
underlying inflation the effect of interest rate changes on
mortgage and credit charges (relying on a series from
Statistics New Zealand). It has also excluded the direct
effects of any changes in indirect taxes and government and
local authority levies when their impact on the CPI was
judged to be significant (defined as an impact of at least 0.25
percent in any twelve-month period). Of course, this
assessment of significance requires some decisions about
modeling tax effects, and the Reserve Bank has chosen only
to respond to those tax changes that were clearly driven by a
policy decision. 6 The natural disaster escape clause has so far
not been invoked. The terms-of-trade escape clause, however, has been applied in the discretionary manner allowed
for in the PTAs. Twice, in 1990-91 and in 1994, oil price
changes were excluded from the calculation of underlying
inflation, while timber prices were excluded in 1993-94.
Caveats and escape clauses are meant to balance
the Reserve Bank’s inflation goal with other goals, particularly real economic goals in the face of supply shocks:

[A] detailed examination of what has been written
about the caveats makes clear, the fundamental
rationale for the caveats is that, in certain specified
circumstances, the Reserve Bank should be paying
attention to consequences for variables such as output
and employment rather than concentrating singlemindedly on the inflation rate. (Bryant 1996, p. 24)
There was an absence of multiple stated objectives for the
Reserve Bank, with only price stability listed in the Reserve
Bank of New Zealand Act of 1989, and only supply shocks
admitted as a potential reason for deviation. There were five
reasons given for this single-minded focus: 1) monetary policy
affects inflation only in the long run, 2) because monetary
policy is only one instrument, it can deal with only one
short-run goal at a time, 3) multiple objectives allow policy
to change, which lowers credibility and raises inflationary
expectations, 4) objectives partly undertaken by other
government agencies if also pursued by the Reserve Bank
could compromise the Bank’s autonomy, and 5) multiple
objectives reduce transparency and accountability since poor
performance can then be attributed to the pursuit of the
other objective (see Lloyd [1992] for a representative discussion). The explicit escape clauses were the only exception.
Whenever an inflation goal below current levels
is to be achieved within a specified time horizon, this
path of disinflation implies a judgment about the acceptable costs for achieving the lower inflation rate within the
time frame. Because this choice affects the well-being of
the public, it is inherently a political decision. That is
why, in the New Zealand context, the choice was not left
solely to the Reserve Bank. In this spirit, both the first
and second PTAs envisaged a gradual transition to price
stability over the three years following their signing and
both called on the Bank to “publish a projected path for
inflation for each of the years until price stability is
achieved” (Section 5b).
The initial Policy Targets Agreement signed in
March 1990 called for achievement of 0-2 percent
inflation by December 1992 and maintenance of
price stability thereafter. Partly as a result of a view
that the output and employment costs of the speed
of adjustment implicit in this time frame were too
high, the new government elected in October 1990

deferred the target date by one year.7 (Nicholl and
Archer 1992, p. 120)
Clearly, the Reserve Bank of New Zealand under
the 1989 Act was designed to operate as a very rule-based
central bank. Notice the contrast between the PTA framework in New Zealand and that in Germany. Rather than
seek an agreement with the government, the Bundesbank,
when necessary, takes responsibility for setting the path of
disinflation on its own, and then justifies that path directly
to the general public.
In the time since the initial Policy Targets Agreement, the Reserve Bank has taken great pains to emphasize
that the link between the real economy and monetary policy still exists in the short run, and that determining the
speed of disinflation is the government’s choice (and not
the Bank’s).8 In the Reserve Bank’s own words:
It should be emphasized, however, that the single
price stability objective embodied in the Act does
not mean that monetary policy is divorced from
consideration of the real economy. At the technical
level, the state of the real economy is an important
component of any assessment of the strength of
inflationary pressures. More importantly, inflation/
real economy trade-offs may need to be made on
occasion, particularly in the context of a decision
about the pace of disinflation. . . . The main tradeoffs are essentially political ones, and it is appropriate
that they be made clearly at the political level. The
framework allows trade-offs in areas such as the pace
of disinflation, or the width of target inflation
ranges, to be reflected in the PTA with the Governor.
The override provision can also be used, if required,
to reflect a policy trade-off. 9 (Lloyd 1992, p. 210)
Also, the Reserve Bank admits that there is still a
short-run objective of financial stability, as all major central
banks acknowledge.10 “The Bank now has effective
independence to implement monetary policy in pursuit of
its statutory objective, without limitations on the technique
except that the choices made must ‘have regard to the
efficiency and soundness of the financial system’” (Nicholl
and Archer 1992, p. 119). The key point of this extended
discussion of the true intent and functioning of the Bank’s
escape clauses, time horizons for targets, and beliefs about
the relationship of monetary policy to goals other than

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

39

price stability is to drive home the fact that even the
Reserve Bank of New Zealand—the most extreme of all
the inflation-targeting countries in its use of formal
institutional constraints on monetary policy—is in operation
not as constrained or as single-minded in its pursuit of
price stability as some would have it.11
Since target adoption, the Reserve Bank has never
assigned intermediate target status to any variable except
the inflation target itself. It has consistently assigned low
weight to developments in monetary and credit aggregates,
reiterating that, since the beginning of the reforms in
1985, it is hard to establish any informative link between
these aggregates and inflation. Over the past six years, in
its public statements, it has paid the most attention to the
trade-weighted exchange rate and the level and slope of the
yield curve as part of an information-inclusive strategy:
In building its forecasts of inflation pressures, the
Bank has, over the last year or so, taken increasing
account of the role of interest rates. Over the years, a
better sense has emerged of the strength of the interest
rate effect on demand, and hence inflation. . . .
Short-term interest rate developments are now playing a greater role in the implementation of policy
between formal forecast reviews, alongside the
prominent role played by the exchange rate. (Reserve
Bank of New Zealand 1995, p. 8)
This analysis of the yield curve emphasizes an
interpretation of it as assessing monetary policy’s stance or
effect, rather than as a way of backing out an implicit inflation
forecast. Inflation is chosen as the target just because it is
the most practical nominal anchor available to New
Zealand at this time—there is no reason a PTA could not
be set up around another intermediate target.
The judgment to date has been that a target specified in
terms of the final inflation objective (suitably defined)
is preferable to an intermediate monetary aggregate
target, mainly because empirical work had not been
able to identify any particular money aggregate
which demonstrated a sufficiently close relationship with nominal income growth and inflation.
(Lloyd 1992, p. 213)
In June 1987, well before the announced target
adoption, the Bank started to conduct quarterly surveys of

40

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

businesses’ and households’ expectations concerning a
number of economic variables, among them inflation,
and has regularly reported on developments in inflation
expectations obtained from these as well as other surveys.
Since then, the Reserve Bank has invested a great deal of
effort and interest in the survey, which covers ten different
macroeconomic variables and draws the majority of its
respondents from the financial and business sectors. Questions
and responses from the survey are published in the Reserve
Bank of New Zealand Bulletin (discussed below). Price
uncertainty, the Bank’s greatest concern (rather than the
point estimate of private sector inflation forecasts), is measured by the standard deviation of directly observed pricerelated expectations (Fischer and Orr 1994, p. 162).
All of these inflation-related data items and forecasts are assembled for public reading. Section 15 of the
Reserve Bank of New Zealand Act of 1989 requires the
Bank to produce, at least every six months, a policy statement that reviews the monetary policy of the previous six
months and outlines how monetary policy is to be implemented over the next six months consistent with the
Bank’s stated inflation objective. These semiannual Monetary
Policy Statements must be published and submitted to
Parliament, and they may be discussed by a parliamentary select committee.
They must review the implementation of monetary
policy over the period since the last Statement, and
detail the policies and means by which monetary
policy will be directed towards price stability in the
coming periods. The reasons for adopting the specified policies must also be given. The annual report
provides a vehicle for accountability and monitoring
of the Bank as a whole (not just in terms of monetary policy). This is also tabled in Parliament. The
Governor and/or Deputy Governors are questioned
by the Parliamentary Select Committee for Finance
and Expenditure on both the Monetary Policy Statements and the annual reports. (Lloyd 1992, p. 214)
As noted, the Reserve Bank publishes an Annual Report and
the Reserve Bank of New Zealand Bulletin with topical articles, reprinted speeches, and official statements. (Since the
Reserve Bank of New Zealand Act of 1989, articles in the
Bulletin have for the most part been attributed to their

authors, encouraging more accountability and greater open
discussion rather than presenting Bank policy as deus ex
machina.) However, one major limitation remaining on the
flow of information involves the collection and reporting of
the various inflation series on a quarterly rather than
monthly basis; it is not clear whether this reflects inherent
data limitations in the New Zealand context or an intent to
further smooth out noisy shifts in the inflation rate (and
potential reactions by the markets) beyond those embodied
in the “underlying” series and the various explanations.
Despite the tendency to classify the Reserve
Bank’s legal independence as akin to that of the Bundesbank or the Federal Reserve System, the Reserve Bank of
New Zealand and its Governor actually face a much different
situation. “This is not independence as the Bundesbank
would understand it, since the target is to be set by the
government and the Bank is responsible to the government
for achieving it. The Bank is an agent, not a principal”
(Easton 1994, p. 86). Put differently, while the two central
banks share a similar goal, similarly defined, the Bundesbank’s
position is consistent with it being a trusted (and only
informally or voluntarily accountable) institution. However, the
structure of the Reserve Bank of New Zealand is consistent
with its being an agency of the government held regularly
to account. This is not a criticism of the Reserve Bank,
either by observers or by the original legislators.
The New Zealand reforms were motivated partly by
orthodox economics and the desire to apply its
precepts to government. However, they were also
influenced by the political “New Right,” which, on
philosophical grounds, sought a smaller role for
the public sector than perhaps could be justified
from conventional economic theory alone. (Easton
1994, p. 78)
In addition, tighter constraints may have been
necessary because of the past poor performance of New
Zealand’s monetary policy and the weaker public support
for low inflation. The upshot for inflation targeting in
New Zealand is that there is very little exercise of shortrun discretion except as allowed by the caveats in the PTAs;
moreover, that limited discretion must be accompanied by
formal ex post communications with the government.

Accordingly, although these statements are made public in
the Monetary Policy Statements, and in an active communication program beyond the Statements as pursued by the
Bank, in New Zealand the burden of explanation falls less
upon direct, transparent communications with the public
than it does in countries where discretion is less constrained. This means that government support, rather than
the power of the Reserve Bank’s explanations to the public,
is the source of flexibility.

NEW ZEALAND MONETARY POLICY
UNDER INFLATION TARGETING
This section summarizes the main events in New Zealand’s
monetary policy in the 1990s. It is based on the Bank’s
Monetary Policy Statements as well as on OECD Economic
Reports and various newspaper reports. 12 Charts 1-4
(pp. 49-50), which track the paths of inflation, interest
rates, the nominal effective exchange rate (henceforth the
exchange rate), GDP growth, and unemployment in New
Zealand both before and after inflation targeting, suggest
that the period since New Zealand’s adoption of inflation
targets can be usefully divided into three episodes.
The first, from target adoption in March 1990
to March 1992, is characterized by inflation falling to
within the 0 to 2 percent range, initially high interest rates
(which later fell rapidly), a gradual decline in the exchange
rate, negative GDP growth, and rising unemployment.
During the second episode, from the second quarter of
1992 through the first quarter of 1994, inflation fluctuated
within the upper half of the 0 to 2 percent range, interest
rates continued to fall, the trend in the exchange rate was
reversed, GDP growth rose sharply, and unemployment
declined at a moderate pace. The third episode spans the
last three years, when the Reserve Bank faced its greatest
challenges since target adoption, and draws most of our
attention. This situation since the second quarter of 1994
has been one of rising inflation and interest rates, continued appreciation of the exchange rate, sustained high GDP
growth rates, and rapidly falling unemployment. During
this episode, the inflation target was breached twice briefly,
and was in fact reset as a result of an election.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

41

The first episode begins with the initial Policy
Targets Agreement, signed on March 2, 1990, stipulating
that price stability, defined as annual inflation within the
0 to 2 percent range, was to be achieved by the year ending
December 1992, and that each Monetary Policy Statement
released by the Bank should contain a projected path for
inflation over the following five years. The first Monetary
Policy Statement, released in April 1990, specified that a
3 to 5 percent target range for inflation be reached by
December 1990, a 1.5 to 3.5 percent range by December
1991, and a 0 to 2 percent range by December 1992 and
thereafter. At this time, the Bank expected the economy to
continue its gradual recovery during 1990 from the 1988
recession. The December 1989 figure for underlying inflation, excluding the effects of the 2.5 percent increase in the
goods and services tax (GST) effective July 1, 1989, was
5.3 percent, and the Bank saw no need for changes in
short-term interest rates at this point to achieve the first
range in December 1990.
The two major surprises over the period through
January 1991 covered by the second and third Monetary
Policy Statements were the oil price shock in the wake of the
Iraqi invasion of Kuwait and the continued weakness of the
New Zealand economy. In August 1990, the Bank tightened
monetary policy somewhat in response to what it called the
“fiscal slippage” evident in the budget released in July. In
October, it announced that the target range for December
1990 should apply to CPI inflation excluding oil prices.
The oil price adjustments were then used as a pedagogic
occasion for the Bank to specify that in the future, targets
would apply to underlying inflation. As it turned out,
inflation including oil prices over the year to December
1990 was 4.9 percent—inside the original target range—
but by then the target ranges had been changed.
Following its victory by a large margin in the general election on October 29, 1990, the new majority
National (right) Government signed a new PTA with the
Bank on December 19, extending the disinflation process
by one year. As noted above, this extension was due to the
elected government’s belief that rapid disinflation had
already proved too costly in real terms. This view was
widely held, and the domestic financial sector was

42

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

extremely outspoken in characterizing the 0 to 2 percent
inflation target range as a dangerous “obsession.”13 Nevertheless, before the election both the Labour and the
National Parties (the two main parties in the thenmajoritarian, rather than proportional representation,
parliamentary system) supported maintaining the inflation
targets at their original level.14 These developments illustrate the many ways in which an inflation target can be
adapted without a change in the primary target definition,
with the time horizon being a critical determinant (as
explained above) of how tightly the target constrains policy.
The February 1991 Monetary Policy Statement specified the inflation target range at 2.5 to 4.5 percent by
December 1991, 1.5 to 3.5 percent by December 1992,
and 0 to 2 percent by December 1993 as the new path
toward price stability. Already in mid-November 1990,
the Bank started to allow the ninety-day bank bill rate
to fall substantially in response to lower than expected
inflationary pressure due to only modest effects of the oil
price increases, sluggish domestic growth, and what was
seen as the new government’s support of the goal of price
stability. (The bill rate is indicative of the stance of the
Reserve Bank’s monetary policy, but unlike a true policy
instrument it is not directly controlled by the Bank.15)
By mid-January 1991, the bill rate had fallen to under
11.5 percent from 14.6 percent in August 1990.
By August 1991, the Bank had expressed its surprise
at the speed at which inflation was falling. Growth in wage
settlements was low, unit labor costs were essentially
unchanged, the exchange rate was stable, and import prices
were flat, reflecting the recession in a number of major
economies. Whereas in its February 1991 Monetary Policy
Statement the Bank had expected headline inflation to be
slightly above the midpoint of the 2.5 to 4.5 percent range
by the next December, in the quarter to June it was already
down to 2.8 percent, and the Bank’s forecast for the year up
to December 1991 was 2 percent. Likewise, underlying
inflation (with mortgage interest rates, oil prices, and
indirect taxes and government charges removed) was down to
2.6 percent by June and was expected to fall below 2.5 percent
by the end of the year. The Bank stated that “this outcome will
reflect the firm policy stance maintained throughout

[1990], and some imprecision in the process of controlling
inflation” (Reserve Bank of New Zealand 1991, p. 43).
By late September, the Bank started to ease monetary policy sharply “when it became clear that, in the
absence of this action, underlying inflation for 1992 was
likely to fall below the 1.5 to 3.5% indicative range”
(Reserve Bank of New Zealand 1992a, pp. 5-6). In order
to maintain the floor on the range as part of the explicit
commitment (without seeming to be motivated by any
apparent fears of deflation), the Reserve Bank allowed the
ninety-day bank bill rate to fall to 8.8 percent over the
next three months and the exchange rate to depreciate
sharply. Already by October, the New Zealand dollar was
at its lowest level against the currencies of its trading partners in five years, but the Bank and the Prime Minister
explained to the public that the depreciation would not
imperil the achievement of future inflation targets because
of the forecast and the nature of the depreciation.16 In
December 1991, headline and underlying inflation were
down to 1 percent and 1.7 percent, respectively, roughly
1 percent below the forecasts from August. “The contraction
in the domestic economy (which itself was more marked
than anticipated) impacted on inflationary pressures to a
greater extent than had been expected” (Reserve Bank of
New Zealand 1992a, p. 10). Also, world prices had been
lower and the exchange rate held firm for longer than had
been expected. Mostly as a result of the exchange rate
depreciation, the Bank expected underlying inflation to
peak at around 3 percent by early 1993 and then to fall
back to 1.2 percent by the end of that year.
The June 1992 Monetary Policy Statement heralds
the beginning of the second episode, stating that “the
Bank is now focusing on ensuring that price stability is
consolidated, rather than on still trying to achieve significant
reductions in inflation” (Reserve Bank of New Zealand
1992b, p. 13). In the year from March 1991 to March
1992, headline and underlying inflation had fallen to 0.8
percent and 1.3 percent, respectively. The domestic economy
had entered the recovery in recent months and the Bank
therefore saw that its task now was to maintain price stability in an environment of moderate growth. The continued favorable outlook for inflation and the reduction in

inflation expectations, as documented by the Bank’s surveys, had allowed the Bank to accommodate some further
easing, with the ninety-day bank bill rate falling to
6.6 percent. The Bank’s forecasts for underlying inflation
for the end of 1992 and for 1993 were now at 2 percent and
1 percent, respectively, reflecting primarily downward revisions in expected unit labor costs and import prices. The
turning point in the exchange rate, in January 1993, was
foreshadowed by the Bank’s assessment that “over the longer
run . . . if the inflation rates of our trading partners . . .
remain higher than that in New Zealand, some appreciation of the nominal exchange rate would be entirely consistent with the maintenance of price stability” (Reserve Bank
of New Zealand 1992b, p. 35).17
Some unrest in the currency market following the
release of the December 1992 Monetary Policy Statement
prompted a moderate tightening action by the Bank,
reflected in a rise in the ninety-day bank bill rate from
6.4 percent to 7.8 percent. Apart from this brief incident,
the period from mid-1992 until the end of 1993 is best
described by the absence of any challenges to monetary
policy. The domestic economy continued its recovery without any notable inflationary pressures appearing. The
ninety-day bank bill rate fell below 5 percent in December
1993. Private sector inflation expectations remained by and
large unchanged, and the Bank’s inflation forecasts one and
two years ahead remained comfortably inside the 0 to 2 percent range. Donald Brash had been reappointed Governor
of the Reserve Bank on December 16, 1992, reflecting the
Reserve Bank’s perceived strength, while the National
Party barely survived the next election, holding on to a
one-seat majority in Parliament. At the end of 1992, a new
PTA was signed between the Bank and the National Party,
specifying that the Reserve Bank must maintain underlying
CPI within the already achieved 0 to 2 percent range.
As the most recent period in New Zealand monetary policy began, continuing domestic expansion and
appreciation of the exchange rate shifted the risks of future
inflation from external to domestic sources. With hindsight, it is clear that inflationary pressures started to
develop in early 1994. In December 1993, the Bank
noticed indications that the recovery might be stronger

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

43

than anticipated, but still considered it “premature” to
tighten policy. Its forecast of underlying inflation by the
end of 1994 and 1995 was at 0.8 percent and 1.8 percent,
respectively. One recurring topic covered in the Monetary
Policy Statements during the period since early 1994 is the
Bank’s uncertainty about the level of growth that the New
Zealand economy could sustain without creating inflation.
The structural reforms initiated since 1985, primarily the
liberalization and opening of markets to international
competition and institutional changes in the wage-setting
process, were presumed to have made it more difficult for
price and wage inflation to develop. Combined with an
assumed increase in the credibility of the monetary policy
framework, the reforms could have allowed higher growth
rates to be sustained without igniting inflation than was
the case during previous business cycles. Forecasting the
actual size of these effects proved to be difficult.
In line with the seeming thrust of these effects, the
average ninety-day bank bill rate dropped from 5.5 percent
in the December 1993 quarter to 4.9 percent in the March
1994 quarter, even as it became clear that GDP had grown
5 percent during 1993. Over the second quarter of 1994,
monetary policy started to respond to the unexpected
strength of the economy, and the average ninety-day bank
bill rate rose to 6.2 percent through June. GDP was growing at a rate of 6 percent per year with all sectors displaying rapid expansion, most notably the construction sector.
Capacity utilization had been on an upward path since late
1991, despite strong investment over the preceding years,
and employment had grown at an annual rate of 4 percent
since the beginning of the year. By midyear 1994, private
sector economists began to worry that a breach of the target range by headline CPI might give rise to increasing
inflation expectations by the public, even if underlying
CPI inflation remained on target. From June to December,
the bill rate rose from 5.5 percent to 9.5 percent. As a
result, the yield curve turned negatively sloped again. The
exchange rate had appreciated by 4.5 percent over 1994.
At this point, the Bank’s assessment was “that the
economic upturn may have peaked, and that growth may
begin to moderate over the coming year” (Reserve Bank
of New Zealand 1995). However, its forecast of underly-

44

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

ing inflation over the next two years came very close to
the 2 percent upper bound, with underlying inflation
expected to stay around 1.8 percent over all of 1995 and
headline inflation peaking at 4.2 percent in the second
quarter of 1995, mainly as a consequence of rising mortgage
rates. A number of private forecasts disagreed with the
Bank’s, predicting a target breach in mid-1995. Finance
Minister William Birch found it necessary to respond to
press questions about whether Governor Brash would in
fact be dismissed if the target were breached. His response,
unsurprisingly, was that the Reserve Bank’s forecasts did
not offer any grounds for believing that the target would
be breached.18
The Bank’s forecast for both GDP growth and
inflation in 1995 proved to have been too low. In May, the
Reserve Bank revised its forecast to predict that underlying
inflation would exceed the 2 percent target ceiling in the
second quarter of 1995. But “Mr. Brash said the Bank
remained confident the underlying inflation rate would fall
back during the third quarter of this year, and therefore
planned to take no action on a ‘temporary’ breach” (Tait
1995). Governor Brash made it clear that the overshooting
would not be reversed so long as there was no trend behind
it, but that he did not anticipate expectations to respond
unduly to a “temporary” deviation. This episode illustrates,
however, that the government’s view of the inflationtargeting framework in New Zealand consciously denies
the framework’s consistency with an “averaging” approach
(why else would the government make an immediate
request for the explanation of a 0.2 percent target breach?).
This rigidity, given the inevitability of target breaches due
to policy uncertainty, especially for a narrow target, is
problematic.
Although during the second and third quarters of
1995 there were some signs of a slowdown in economic
activity, by the end of the year the outlook had become
more mixed, with some indication that GDP growth
would pick up again, leading the Bank to forecast
GDP growth of 1.5 percent in the year to March 1996
and 3 percent in the year to March 1997. More important,
from the Bank’s point of view, measured underlying inflation did in fact rise above the 0 to 2 percent range to peak

at 2.2 percent in the second quarter, with headline inflation rising to 4.6 percent (although both remained below
the outer bounds of private sector forecasts).
Thereafter, headline inflation fell rapidly, as the
rise in mortgage rates stemming from the monetary tightening during 1994 stopped having an effect on the CPI
calculation (an effect that was excluded from the definition
of underlying inflation). Underlying inflation, by contrast,
fell to only 2 percent in the year to September 1995, and
although in June 1994 the Bank still had expected underlying inflation to return to 1.2 percent by June 1996, its
December 1995 forecast for the year to September 1996
was 1.7 percent. A major factor behind the increase in underlying inflation was the persistent construction boom, particularly in the Auckland area, in which construction costs
increased by 11.8 percent over the year to March 1995.
This concentration of inflationary pressures in the
nontraded sector made the Bank’s monetary policy less effective in slowing prices than past experience indicated
because the exchange rate channel of monetary transmission would have little impact on this sector of the economy.
As a result, keeping inflation within the tight target range
required a sharp rise in nominal interest rates (to more than
9 percent) and a sharp appreciation of the New Zealand
dollar. The required movements of interest and exchange
rates can be characterized as the result of a very small economy running an independent monetary policy when its
economic cycle is out of phase with the major world economies. In addition, these movements can be a potential
source of instrument instability, with resulting economic dislocations. 19 Nevertheless, the key accomplishment that New
Zealand observers saw was that the country had, for the
first time in decades, been through a business cycle upswing
of strong growth without a balance-of-payments or inflation
crisis at the end of it.
Governor Brash did take “full responsibility” for
the Bank’s not having acted sooner to stem inflationary
pressures, thereby allowing the target to be breached.
Citing the “temporary” nature of the breach, however, he
said that he would not resign, and Finance Minister Birch
backed him (Hall 1995). Clearly, the dismissal of the
Reserve Bank Governor for breach of the target is not auto-

matic, either in design or in practice. Rather, dismissal is
left to the judgment of the Board and the Finance Minister.
However, from the point of view of an “optimal central
banking contract”—as many have characterized the New
Zealand framework—Governor Brash was not penalized
for exceeding the specific number set in the contract.
By October 1995, inflation had subsided, but
Governor Brash was sufficiently chastened by the experience to suggest that he would rather see the Bank have an
inflation target in which the goal was in the center of the
range, given the difficulties of forecasting. “You don’t have
any room for being wrong at a rate of 1.8 to 1.9 percent”
(Montagnon 1995). The gap between how finely it is possible
for the Reserve Bank to control inflation and the narrow
range to which the Reserve Bank was committed became
the main theme for the next year. The target breach illustrated the potential for instrument instability, in which the
policy instruments need to undergo wide swings in order to
achieve inflation targets narrower than a small economy’s
monetary policy can consistently provide.
Since the inflation target goal required of the
Bank results from the PTA with the elected government—
and the response (that is, whether or not to dismiss the
Governor) to target breaches also depends upon the government’s support—monetary policy became a highly visible
political issue in the run-up to the October 1996 elections.
The primary debate centered on whether the target range
should be widened, although some minor parties considered
altering the goal of monetary policy from 1 percent measured
inflation. In December 1995, the Reserve Bank tightened
policy again. Most observers characterized this as a reaction
to tax cuts announced by the National Party meant to take
effect right before the elections nine months later; Finance
Minister Birch publicly denied this interpretation, stating
that the size and nature of the tax cuts had been discussed
with the Reserve Bank before being put through Parliament
(Birch 1996). In any event, the issue in the popular mind
had moved from one of low inflation to one of high real
interest rates. By February 1996, Governor Brash felt it
necessary to open a speech to the Auckland Manufacturers’
Association with the following remarks:

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45

Over recent weeks there have been a number of
media reports of people calling for the abolition of
the Reserve Bank, or the repeal of the Reserve Bank
Act, with the claim that the Bank is an anachronism in New Zealand’s free-market economy, that
its operations result in New Zealanders having to
pay interest rates which are among the highest in
the world in real terms, and that these interest rates
are pushing up the exchange rate to the huge detriment of exporters and those competing with
imports. There are variations around this theme,
depending upon who is mounting the case, but I
think that I accurately reflect the general case.
(Brash 1996b)
While Governor Brash’s policies had contained trend
inflation sufficiently to justify the government’s support,
the differential effects of tight money on traded and nontraded goods exacerbated the public political fallout of
having to maintain high interest rates to achieve the
required tight control. Simply meeting the contract was
not enough when the contract itself came under fire, and
even though rewriting the contract was the politicians’
responsibility and not the Bank’s, the Bank began to suffer
the consequences.
On April 19, 1996, the Board of the Reserve Bank
sent a letter to Finance Minister Birch. It had become clear
that the target ceiling would be breached again by midyear, that headline inflation would rise while underlying
inflation would only temporarily rise again, and that the
issue of dismissing the Governor would have to be dealt
with once more, even though again no one felt that policy
was too loose or that inflation expectations were slipping.
However, the fact that the Reserve Bank was running into a
control problem for the second time in a year pointed out
the difficulties of the third PTA. The Board’s letter supported
Governor Brash’s performance—carefully basing the argument mostly on the trend of underlying inflation—and
recommended that he continue in his position.
In May, however, the New Zealand First Party—a
populist party likely to become a coalition member for the
first time in the November elections once multimember
proportional representation had replaced majoritarian
elections20—advocated the addition of unemployment and
growth goals for monetary policy. Between the upcoming

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likelihood of an inflation blip and the political uncertainty
being tied to monetary policy, long-term bond yields rose,
and the spread between ten-year bond rates in New Zealand
and the United States reached 200 basis points, the highest
level since 1992. The Labour Party made a proposal of its
own to widen the band to -1 to 3 percent inflation.
In June 1996, the Reserve Bank reported that
underlying inflation did in fact breach the target ceiling of
2 percent in the first quarter, and it forecast that underlying
inflation would reach 2.6 percent in the third quarter.
When historically high real interest rates appeared to be
insufficient to maintain inflation within the target
range consistently, the feasibility of the target range was
questioned more widely. Private sector economists began
to join the opposition parties in advocating a widening of
the target range, predicting that inflation would remain
above 2 percent through March 1997. Of course, the
Reserve Bank, among others, feared that a widening of the
range might be interpreted as a weakening of anti-inflationary
resolve and would have harmful effects on credibility and
inflation expectations; as noted above, however, even
Governor Brash had come to realize that the control problems
of a 0 to 2 percent target range were too great for monetary
policy in the New Zealand economy.
Dr. Brash acknowledged that it would be tempting
to say that the 0 to 2 percent target range was both
too low and too narrow. But . . . “I don’t think it is
self-evident at all that a wider target would help the
real economy,” Dr. Brash said. “On the contrary
there are some real risks in doing that.” The dangers
were that widening the range would itself raise
inflationary expectations, and that the Reserve bank
itself would be slower to react to inflationary pressures.
The width of the target band is only one of the
features of the present monetary policy framework
to be questioned of late. (Fallow 1996)
Only successful targeters of long standing, like
Germany and Switzerland, appeared to be able to explain
frequent target range misses without changing their
ranges. Given the starting premises of the Reserve Bank of
New Zealand Act of 1989 and its inflation-targeting
framework, the need to control inflation tightly every
quarter (or to formally justify the Governor’s retaining his

position) when New Zealand’s monetary policy could only
do so much, created pressure for a more activist monetary
policy than was ever originally intended. In particular, the
interaction between domestic interest rates oriented
toward fighting inflation and the exchange rate harmed the
competitiveness of export sectors of the economy.
On October 12, 1996, New Zealand held its first
mixed-member proportional representation elections for
national Parliament; the outcome was (as expected) indecisive, with no one party getting more than 50 percent of the
vote. The New Zealand First Party clearly held the balance
in making a coalition, negotiating with both the Labour
and National Parties. On October 18, National Party (and
caretaker) Finance Minister Birch publicly indicated that
the inflation target (its width, its average level) was on the
table in negotiations with the New Zealand First Party.
The October 16 data release showed underlying inflation
remaining above target at 2.3 percent (headline inflation
was 2.4 percent), but below some private forecasts that
were as high as 2.7 percent. In the words of one New
Zealand business columnist watching the negotiations,
“the message: [despite being generally successful,] present
Reserve Bank inflation targets are not credible. They could
be changed at any time, depending on the whims of whoever wants most to drive about in a ministerial LTD. We
are back to politicized monetary policy” (Coote 1996).
Meanwhile, the Bank found itself on the horns of
its ongoing dilemma. The New Zealand dollar had risen to
an eight-year high against the yen and the U.S. dollar as
capital flowed back into New Zealand after the election.
The Bank again was confronted with difficult choices.
Despite the above-target contemporaneous inflation rate
and the need to rein in inflationary pressures on the nontraded goods side—and because of the medium-term trend
of underlying inflation and the highly unfavorable circumstances for the traded goods sector—there was good reason
not to raise interest rates further. “Unfortunately, in order to
keep overall monetary conditions consistent with maintaining price stability, it appears we have to accept rather
less interest rate pressure than might be ideal, and rather
more exchange pressure than might be ideal,” stated the
Bank on October 24 (Hall 1996a). In other words, the

Bank was admitting that its control problem of hitting the
required narrow target range forced it into short-run policy
trade-offs that it did not want, given the political constraints of the tight target.
Finally, on December 10, a parliamentary coalition
between the National and New Zealand First Parties was
agreed to for a three-year term. Their first substantive
announcement was that the inflation target would be modified. The new Policy Targets Agreement was signed by the
National Party’s Finance Minister Birch and Governor
Brash on December 10. The shift effectively underlines the
inescapably political nature of a central bank’s accountability under any democratic system: that is, that the goal by
which the monetary framework is evaluated, and in the
New Zealand case the exercise of the option to dismiss the
Governor for not attaining the goal, reflect the current
elected officials’ preferences.
On December 18, Governor Brash characterized
the widening of the inflation target from 0 to 2 percent to
0 to 3 percent as a modest change: “We previously aimed at
inflation of 1 per cent. It is now 1.5 per cent” (Hall
1996b). While Governor Brash admitted that this would
allow some easing, he stated that it was already justified by
inflation forecasts: “to the extent that increased inflationary
expectations lead to higher prices, higher wage settlements
and so on, the new inflation target gives much less scope
for an easing . . . than might perhaps be assumed” (Tait
1996). To the extent possible, the Reserve Bank was intent
on limiting any damage to its credibility.
In an address given a month later (Brash 1997),
Governor Brash summarized the meaning of the new PTA,
including the amended inflation target. He emphasized
that “price stability remains the single objective of monetary
policy and constitutes the best way in which the Reserve Bank
can contribute to New Zealand’s economic development.” He
noted that the current state of knowledge in monetary
economics left unresolved the debate between those who
advocate a “low, positive inflation” and those who argue for
zero inflation. The Governor continued,
“it is at this stage quite inappropriate to be dogmatic, and in my own view a target which involves
doing our utmost to keep measured inflation between

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

47

0 and 3 percent is certainly consistent with the intention of the legislation within which monetary policy is operated. . . . Indeed, irrespective of where the
mid-point of the target range should be, there may be
some advantage in having a slightly wider inflation
target than the original 0 to 2 percent target. A
number of observers have suggested that a target
with a width of only 2 percentage points requires an
excessive degree of activism on the part of the central bank. . . .The tension is between, on the one
hand, choosing a target range which effectively
anchors inflation expectations at a low level but
which is so narrow that it provokes excessive policy
activism and risks loss of credibility by being frequently exceeded; and on the other, a target range
which does a less effective job of anchoring inflation
expectations, but which requires less policy activism and protects credibility by being rarely
breached. (Brash 1997)

KEY LESSONS FROM NEW ZEALAND’S
EXPERIENCE
After close to seven years of inflation targeting, the Reserve
Bank of New Zealand’s experience provides several
important lessons. First, it suggests that the challenge of
bringing down trend inflation and maintaining low inflation
expectations is relatively easy compared with that of
tightly controlling the course of inflation within a narrow

range, especially for a small open economy. Furthermore,
New Zealand’s experience indicates that strict adherence to
a narrow inflation target range can lead to movements in
policy instruments that may be greater than the central
bank would like and open the potential for instrument
instability should the pressures from these movements
become too great.
In addition, the Reserve Bank has found that
excessive restrictions on the exercise of its discretion and
the manner of its explanation of policy—even if in the
name of accountability—can create unnecessary instances
in which credibility could be damaged even when underlying trend inflation is contained. This is due not only to
inflexibility, but also to the Bank’s focus on direct, formal
accountability to the government rather than a broader
accountability to the general public through transparency.
These lessons about the operation of targeting
frameworks do not negate the fact that inflation targeting
in New Zealand has been highly successful: this country,
which was prone to high and volatile inflation before the
inflation-targeting regime was implemented, has emerged
from the experience as a low-inflation country with high
rates of economic growth.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

ECONOMIC TIME LINE: NEW ZEALAND
Chart 1

Underlying Inflation, Headline Inflation, and Targets
Percent
20
Headline inflation
18
16
Start of inflation
targeting
(March 1990)

14
12
10
8
Underlying inflation

6

Target range

4
2
0
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Source: Reserve Bank of New Zealand.
Note: The I-shaped bars indicate the target range for inflation in effect before the adoption of an ongoing target range of 0 to 2 percent in March 1994; a dashed
horizontal line marks the midpoint of the ongoing target range.

Chart 2

Bank Bill and Long-Term Interest Rates
Percent
30.0
Bank bill rate
27.5
Start of inflation
targeting
(March 1990)

25.0
22.5
20.0
17.5
15.0
12.5
Long-term rate
10.0
7.5
5.0
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Source: International Monetary Fund, International Financial Statistics.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

49

ECONOMIC TIME LINE: NEW ZEALAND (CONTINUED)
Chart 3

Nominal Effective Exchange Rate
Index: 1990 = 100
170
160
Start of inflation
targeting
(March 1990)

150
140
130
120
110
100
90
80
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

94

95

96

97

Source: Bank for International Settlements.

Chart 4

GDP Growth and Unemployment
Percent
14
Start of inflation
targeting
(March 1990)

12

Unemployment

10
8
6
4
GDP growth
2
0
-2
-4
1980

81

82

83

84

85

86

87

Source: Reserve Bank of New Zealand.

50

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

88

89

90

91

92

93

Part V.

C

Canada

anada adopted inflation targeting in 1991, one
year after New Zealand. In examining its experience, we stress the following themes:

• Inflation targeting in Canada was not the result of
legislation. However, as in New Zealand, the inflation
target in Canada is jointly determined and announced
by both the government and the central bank.
• As in New Zealand, inflation targeting was adopted
after substantial disinflationary pressures were already
evident.
• In Canada, there is a clear-cut separation between
the entity that measures the inflation variable to be
targeted (Statistics Canada) and the entity that is
accountable for achieving the inflation target and
assessing past performance (the Bank of Canada).
• The consumer price index (CPI) inflation rate has
been chosen as the primary target variable because of
its “headline” quality, although a core inflation rate
that excludes energy and food prices and the effects of
indirect taxes is also used and reported in assessing
whether the trend inflation rate is on track for the
medium term.
• The Canadian inflation-targeting regime is quite
flexible in practice, as are all the regimes we study,
with real output growth and fluctuations a consideration in the conduct of monetary policy. Indeed, in
Canada, the inflation target is viewed as a way to help
dampen cyclical fluctuations in economic activity.
• In Canada, as in New Zealand and even Germany,
the chosen rate of convergence of the medium-term
inflation goal to the long-term goal has been quite
gradual.
• The Canadian inflation target is stated as a range
rather than a point target, often with greater emphasis
placed on the bands than on the midpoint.

• The midpoint of the inflation target range, 2 percent,
is above zero, as in all the cases we examine here.
• Although accountability is a central feature of the
inflation-targeting regime in Canada, the central
bank is more accountable to the public in general
than to the government directly.
• A key and increasingly important feature of Canada’s
inflation-targeting regime is a strong commitment to
transparency and the communication of monetary
policy strategy to the public.
• As an adjunct to implementing the inflation-targeting
regime, the central bank makes use of a monetary
conditions index (MCI), a weighted average of the
exchange rate and the short-term interest rate, as a
short-run operating target.

THE ADOPTION OF INFLATION TARGETS
The adoption of inflation targeting in Canada on February 26, 1991, followed a three-year campaign by the Bank
of Canada to promote price stability as the long-term
objective of monetary policy. This campaign, beginning
with then Governor John Crow’s Hanson Lecture at the
University of Alberta in January 1988, “The Work of
Canadian Monetary Policy” (Crow 1988), had spelled out
the reasons for the Bank of Canada’s disinflationary policy
of the late 1980s and early 1990s. The campaign had not,
however, spelled out the practical policy implications of
what price stability meant in terms of either inflation levels
or the time frame for reaching that goal (Thiessen 1995d;
Freedman 1994a, 1995).
On February 26, 1991, formal targets through the
end of 1995 “for reducing inflation and establishing price
stability in Canada” were announced. The announcement
was a joint statement by the Minister of Finance, Michael

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51

Wilson, of the ruling Conservative Party, and the Governor
of the Bank of Canada, John Crow. Publicity was maximized by the timing of the announcement, which occurred
on the day of the Canadian government’s release of its
budget and underscored the government’s support of the
Bank’s commitment to the goal of price stability. The
following month, the Bank released its Annual Report,
1990, which featured remarks by Governor Crow on the
appropriateness of price stability as a goal for monetary policy and an article entitled “The Benefits of Price Stability”
(Bank of Canada 1991a). The initiation of the new monetary policy commitment to inflation targeting had been
carefully planned to attract public attention and to begin
building public support.
Yet there had been no advance notice to the public
of the policy shift to inflation targeting by senior Bank of
Canada officials. Even in the same Annual Report, 1990, a
one-paragraph mention of the announcement of inflation
targets was tacked on the end of Governor Crow’s annual
statement, with no mention of the adoption earlier in the
piece. Nor was there an obvious crisis prompting an abrupt
shift in policy (such as a devaluation and exit from a fixed
exchange rate system or the sudden breakdown of a
declared intermediate target relationship). Governor Crow
had been appointed to his position four years earlier, and
the Conservative Government had been reelected in late
1988, so a change in policymakers also did not explain the
shift in policy.
Before the announcement of specific inflation targets,
the Bank’s repeated declaration of the price stability goal
by itself appeared to have made little headway against the
“momentum” in inflation expectations that had built up
(Thiessen 1991; Freedman 1994a). In fact, in the “Background Note” released at the time of the adoption of the
targets, mention is made of the “unduly pessimistic” outlook for inflation in a number of quarters (Bank of Canada
1991c, p. 11). Inflation targets were the tactic adopted to
reduce sticky expectations and to bring the stated goal of
Canadian monetary policy to fruition.
February 1991, it turns out, was seen by the Bank
of Canada as a useful opportunity to formalize its commitment to price stability. On the positive side, year-over-year

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CPI inflation had just dropped to 4.2 percent in the fourth
quarter of 1990 (versus a high of 5.5 percent in early
1989), and “the pressures from excess demand that were
pushing up prices from 1987 through 1989 finally eased
during 1990” (Thiessen 1991), with economic growth at its
cyclical trough. Because the Canadian economy had slowed—
and, although not realized at the time, had entered a deep
recession in 1990—underlying disinflationary pressures
were already becoming apparent at the time the targets
were introduced.
More important, on the negative side, large risk
premiums were being built into long-term Canadian
interest rates because of rapidly growing government and
external debt, political uncertainty, and credibility
problems for monetary policy following two decades of
inflation. Furthermore, a new goods and services tax
(GST)—an indirect tax similar to a value-added tax
(VAT)—was to take effect at the start of 1991 with an
expected effect on the headline total CPI of 1.25 percent, and there were fears of further oil price increases as
well. A failure to keep the first-round effects of the indirect
tax increase from initiating a new wage-price spiral would
only confirm the public’s high inflation expectations.
The current Governor of the Bank of Canada,
Gordon Thiessen, characterized February 1991 as period of
public uncertainty, despite the prior declarations of the
price stability goal (Thiessen 1991, 1995d). Deputy Governor Charles Freedman (1994a) also stated that one of the
Bank of Canada’s primary short-run concerns was to prevent
an upward spiral in inflation expectations in the face of
these shocks. The Bank went further and seized the opportunity to distinguish between the temporary shocks and
the intended path of inflation as an instructional precedent
for its targeting framework. As the initial announcement
explained: “These targets are designed to provide a clear
indication of the downward path for inflation over the
medium term” (Bank of Canada 1991b). To underscore this
intention, the Bank referred to them as “inflation-reduction
targets,” until the target range stopped dropping in 1995.
Of course, the targets chosen were thought to be realistically attainable, the logic being that if declarations of the
price stability goal were not enough, failure to achieve the

promised amount of progress toward that goal would
certainly be detrimental (Freedman 1995).
The Bank set the first target for twenty-two
months after the announcement of target adoption for the
stated reason that six-to-eight-quarter lags in the effect of
monetary policy made any earlier target infeasible. Canada
possibly went through a period of significant inflation
uncertainty as a result, and inflation undershot the target
range until early 1993. The targets did not appear believable to the public until later (Laubach and Posen 1997b).
In contrast, New Zealand’s and the United Kingdom’s
target ranges took effect immediately upon adoption, and
these countries experienced little problem with target
misses until their recent cyclical upswings.
The Bank of Canada’s intellectual basis for its
inflation-targeting approach—and for its goal of price
stability, rather than just low inflation—was what could be
termed a sluggishness as well as an entrenched upward bias
to inflation expectations. As articulated by Governor Crow
(1988) in his Hanson Lecture, “In my view, the notion of a
high, yet stable, rate of inflation is simply unrealistic.”
Offering the hypothetical example of a central bank tolerating 4 percent inflation, the Governor asserted that a
public that sees the central bank as unwilling to reduce
inflation from that level would view any shock that moved
inflation up (say to 5 percent) as unlikely to be reversed,
and therefore likely to be built into inflation expectations.
Inflation expectations get an entrenched bias upward when
there is no nominal anchor to keep the goal of price
stability in view.
The entrenched upward bias of these expectations
is cited repeatedly as an empirical reality of the Canadian
economy. 1 For expectations to change, Governor Crow
argued, the central bank must demonstrate its willingness
to pay the costs of disinflating: “But as lower inflation is
achieved, as people are less conditioned by fears of inflation, reducing inflation and preventing its resurgence
becomes less difficult” (Crow 1989). 2 While this belief
explains why the targets announced “provide [a path] for
gradual but progressive reductions of inflation until price
stability is reached” (Bank of Canada 1991c, emphasis
added), it begs the question why for three years the Bank

simply declared its commitment to price stability without
naming a nominal anchor. It is likely that the Bank was
waiting until the elected government was ready to support
fully its commitment to price stability (see, for example,
Laidler and Robson [1993]).
It is also possible to ascribe to the Bank simply an
extended decision-making process that culminated in the
opportunity to take advantage of the economic situation of
February 1991. The Hanson Lecture itself was ignored in
the Annual Report, 1988, despite eventually being cited
repeatedly in Bank of Canada statements and followed up
by “The Benefits of Price Stability” in the Annual Report,
1990. An appreciation for the possibilities of targeting
seemed to emerge with an even greater lag—in 1989,
Governor Crow stated in a speech reprinted in the Bank of
Canada Review, “In my experience, if [an inflation] target is
suggested it is almost invariably whatever the rate of
inflation happens to be at the time. Some target!” (Crow
1989, p. 22). 3
In any event, the decision to adopt inflationreduction targets was made to “buttress” the Bank of
Canada’s commitment to price stability and to resolve
uncertainties about it (Freedman 1994a). “The targets
[were] not meant to signal a shift in monetary policy. . . .
All we [were] doing [was] making clear to the public the
rate of progress in reducing inflation that monetary policy
[was] aiming for” (Thiessen 1991, p. 19). The Bank of
Canada did not suggest that the announcement of targets
by itself would bring an immediate payoff in terms of
reduced inflation expectations; rather, it saw the benefits
accruing over a long time horizon. Achieving these targets
over the medium term would eventually strengthen public
confidence in monetary policy, and inflation control would
be supported by the increased transparency and accountability that inflation targets brought to the conduct of
monetary policy.

THE OPERATIONAL FRAMEWORK
When announced in February 1991, the Canadian inflationtargeting scheme was a path for reducing inflation defined
by three commitments for inflation levels at later dates. (In
fact, as mentioned earlier, Bank of Canada officials originally

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

53

referred to the targets as “inflation-reduction targets.”)
The first was for 3 percent year-over-year inflation (defined
as the change in the CPI) by the end of 1992, twenty-two
months after adoption; the second was for 2.5 percent
inflation by the end of June 1994; and the third was for
2 percent inflation eighteen months after that.
The Bank stated at the outset that price stability
involved a rate of inflation below 2 percent: “A good deal
of work has already been done in Canada on what stability
in the broad level of prices means operationally. This
work suggests a rate of increase in consumer prices that is
clearly below 2 per cent” (Bank of Canada 1991c). There
was no mention, however, of targeting zero-measured
inflation or of a stable price level. The Bank wanted to
see further research before committing to a precise
operational definition of price stability. It indicated that
at the end of 1995, the goal would be a rate of measured
inflation of 2 percent, but this rate was not to be considered
equivalent to price stability. From the outset of targeting,
the Bank made a number of statements to indicate that the
correct number for price stability would be defined at a
later date, and that there would be further reductions in
the target until price stability was achieved. Later Bank
studies would estimate the positive-mean bias in inflation
measurement of the Canadian CPI to be at most 0.5 percent a year (Bank of Canada 1995, May, p. 4, footnote 1), so
more than measurement error must lie behind the Bank’s
belief in a greater-than-zero definition.
On the appointment of Governor Thiessen in
December 1993, the new Liberal Government and the
Bank extended the 1 to 3 percent inflation target from the
end of 1995 to the end of 1998. The setting of an operational definition of price stability was again put off until
more experience was gained about the performance of the
economy at low rates of inflation. The Bank specified that
it was not treating the current targets as the equivalent of
price stability.
There were two reasons for the extension—(i) given
that it has been a long time since Canada has had
such low rates of inflation, it would be helpful to
have more experience in operating under such

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

conditions before an appropriate longer-term
objective is determined; (ii) some time is needed
to enable Canadians to adjust to the improved
inflation outlook.4 (Freedman 1995)
The Bank attempted in its targets to orient its
policies, and public expectations, to forward-looking concerns
for the medium term of one to three years, but accepted
that expectations and the structures that went with them
would not be completely changed (even after three or more
years of targeting, and six years by the end of 1998).
The medium-term orientation also informed the
Bank’s choice of target series. The rate of change in the CPI
was chosen as the primary target rate of inflation because of
its “headline” quality, that is, it is the most commonly used
and understood price measure in Canada. In addition, the CPI
had the perceived advantage of coming out monthly, with
infrequent delays and without revisions (one alternative,
the GDP deflator, is often revised for multiple-observation
periods in Canada). Because of the inclusion of food and
energy prices in the CPI, however, the series is volatile; to
avoid forced responses to short-run blips, the Bank of
Canada also uses and reports core CPI, which excludes food
and energy, asserting that core CPI and CPI inflation move
together in the medium-to-long term. 5 “How we will react
[to a change in inflation] will depend on whether or not
a change in measured inflation is associated with a shift
in the momentum, or underlying trend, of inflation”
(Thiessen 1994b, p. 81).
There is no fixed rule by which the Bank is held
accountable for performance on either CPI series over a
specified time frame, but given the easy observability of
these measures, persistent deviations from the path set by
the targets would be obvious. Similarly, the Bank of Canada
takes out the first-round effects of indirect taxes when determining whether a current or future change in inflation
exceeds the target range in a manner that justifies a
response.6 Even allowing for some slow adaptation of
price expectations, the targets’ distinguishing first- and
second-round price effects of shocks are consistent with
the Bank behaving in a preemptive manner against inflationary impulses.

Deputy Governor Charles Freedman’s discussion
of price developments in 1994 illustrates how the Bank
uses this combination of factors in assessing the situation:
In particular, although the 12 month rate of
increase in the total CPI through much of 1994 was
virtually zero, the Bank focussed on the fact that the
reduction in excise taxes on cigarettes in early 1994
accounted for a decline of 1.3 per cent in the total
CPI. Operationally, therefore, the emphasis has
been placed on the CPI excluding food, energy and
the effect of indirect taxes, which has been posting a
rate of increase between 1 1/2 and 1 3/4 percent. At
mid-1994, the date of the second milestone, the
rate of increase of total CPI was at 0.0 percent while
that of the CPI excluding food, energy and the
effect of indirect taxes was at 1.8 percent, near the
bottom of the band. (Freedman 1995, pp. 24-5)
The Bank of Canada makes a strong effort to
communicate its reading of the economy and the rationale
for its decisions. In doing so, it explains the extent to
which the changes in the CPI reflect purely transitory
factors or persistent inflationary pressures. The Bank of
Canada is very concerned about conveying this message
clearly since its target series, CPI inflation, can be sensitive
to temporary factors. 7
As initially announced, inflation would be permitted to range from 1 percent above to 1 percent below each
of these targets, and then to lie between 1 percent and
3 percent from 1995 on; but the objective to be targeted
was the midpoint. In practice, the Bank never aggressively
sought to move inflation from the outer bands toward the
midpoints, even when actual inflation lingered at or below
the target floor for an extended period. In fact, “in the
revised targets more emphasis is placed on the bands than
on the midpoints” (Freedman 1995). Explicitly, the target
range is intended to allow for control problems.8 While
the Bank recognizes that a band of 2 percent width is
indeed narrower than what research has shown to be
necessary to capture all the unavoidable variation from
unexpected sources, it also felt that too wide a band would
send the wrong message (Freedman 1994a).
In general, the belief was that the band would
provide sufficient flexibility to deal with supply shocks

that were not already taken care of by exclusion of food,
energy, and the first-round effect of indirect taxes.9 No
explicit escape clauses were set up for the Bank of Canada
to invoke when larger shocks arose; accommodation of
supply shocks (beyond that of referring to core CPI, rather
than headline CPI, deviations from trend) was left to the
Bank’s discretion.
It is important to note how much looser in spirit
this target definition is than the Reserve Bank of New
Zealand’s highly specified list of exceptions, which is
dependent upon elected government approval. In many
ways, however, the Bank of Canada’s definition is a similar
operational response to the same difficulties and shocks to
which all small open economies exporting a large amount
of natural resources are subject. The definition of target
inflation in this manner has several implications. First, it
commits monetary policy in Canada to reversing shifts in
the trend inflation rate, while allowing price-level shifts in
the face of supply shocks—it is not a framework consistent
with price-level targeting. Second, it grants the Bank of
Canada the freedom to act in whatever way it can transparently justify to the public with reference to the target
bands; it does not prespecify when the Bank should deviate
from target achievement.
Another aspect of the Bank of Canada’s framework
is that it commits monetary policy to a somewhat countercyclical bent, in that the Bank must respond to aggregate
demand-driven price increases and decreases that would
take inflation out of the target range. While common to all
inflation-targeting regimes that explicitly or implicitly (in
terms of reasonable deviation from a point target) put a
floor on inflation goals, this feature has become more
prominent and explicit in the Canadian framework: 10
Some people fear that, by focusing monetary policy
tightly on inflation control, the monetary authorities may be neglecting economic activity and
employment. Nothing could be further from the
truth. By keeping inflation within a target range,
monetary policy acts as a stabilizer for the economy.
When weakening demand threatens to pull inflation
below the target range, it will be countered by
monetary easing. (Thiessen 1996d, p. 2)

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55

The link between developments in the real economy and in prices is not denied by the Bank of Canada
despite the focus on inflation goals. Governor Thiessen, in
fact, has offered an explanation for inflation distinct from
those relating solely to monetary factors:

means to the end of good economic performance rather
than as an end in itself” (Thiessen 1994a, p. 85).12 Interestingly, Governor Thiessen has gone on to extol the benefits
of transparency in monetary policy—as fostered by inflation
targeting—as a worthwhile pursuit in its own right.

Upward pressure on inflation comes about when
excessive spending demands in the economy, which
are not adequately resisted by monetary policy,
persistently exceed the capacity of the economy to
produce the goods and services that are being
sought. (Thiessen 1995d)

First, [the central bank] can try to reduce the uncertainty of the public and of financial markets about
its responses to the various shocks. It can do this by
making clear the longer-run goal of monetary policy,
the shorter-term operational targets at which it is
aiming in taking policy actions, and its own interpretation of economic developments. Moreover, by
committing itself to a longer-term goal and sticking
to it, as well as by lessening uncertainty about its
own responses to shocks, the central bank may be
able to lessen the effect of shocks on private sector
behavior. (Thiessen 1995d, p. 42)

The trade-off between output and prices—even at
times when increasing counterinflationary credibility
might be expected to reduce the cost of disinflation—
explains the gradual way the Bank moved from an initial
expected inflation rate of 5 percent at the end of 1991 to a
2 percent target by the end of 1995. Freedman (1994a)
noted that a typical augmented Phillips curve equation was
broadly able to track the decline in inflation, and that this
suggested that there was no need to resort to explanations
involving credibility and changes in expectations to
explain the pace of disinflation. However, despite the continued output gap, since that time inflation has not fallen
further, as these equations predict. One reason for this
might be that the process of expectations formation has
changed; that is, that the Bank’s target is now given
substantial weight, such that expectations have been quite
firm at about 2 percent.
In any event, the Bank repeatedly holds out the
hope in public statements that as private individuals’ and
firms’ expectations adapt, the cost and time necessary to
achieve and maintain inflation goals will drop. 11 It is fair
to ask, however, how long Canada (or any country) must
pursue credible disinflationary, and then counterinflationary,
policies before results can be expected. Clearly, in the case
of Canada, more than four years of inflation targeting,
preceded by at least three years of tightening monetary
conditions, were not enough to induce these effects.
Accordingly, the Bank of Canada’s justification
for the pursuit of inflation targets, and from there price
stability, does not rest upon credibility arguments alone.
“In other words, our objective is price stability, but as a

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

No other targeting central bank has so explicitly
made a virtue of transparency for its benefit to the economy
as well as its role in credibly reducing inflation, although
all have made efforts in this direction. Note that the benefits
Thiessen lists in this quotation can stem from any sustainable longer run goal of a central bank with a consistent
operational framework—neither price stability nor inflation
is mentioned. In this context, it is only logical to conclude
that the Bank of Canada feels comfortable dealing with
various short-run challenges without fear of compromising
its longer run goals. 13
The view of inflation as largely determined by
developments in aggregate demand and supply cited above
leads naturally to the wide range of information variables
the Bank considers when setting monetary policy. From
1982, when M1 was dropped as the Bank of Canada’s
intermediate target, until 1991, when inflation-reduction
targets were announced, the Bank had been actively searching
for a substitute among the various broader monetary and
credit aggregates, although “[they had] not found the
behavior of any one of them sufficiently reliable to shoulder
the burden of acting as a formal target for monetary policy”
(Crow 1990, p. 36). The move to targeting the goal (or
its forecast) rather than an intermediate variable clearly
represented a significant paradigm shift. “In our view,
underlying inflation is affected primarily by the level of

slack in the economy and by the expected rate of inflation,”
stated Governor Thiessen (Thiessen 1995d, p. 49). Both
slack and expectations are factors that cannot be directly
observed and that require many related variables to assess.
In practice, this has implied that:
the Bank of Canada has focussed closely on estimates of excess demand or supply (or “gaps”) in
goods and labor markets as key inputs into the
inflationary process. It also follows closely such
variables as the rate of expansion of money (especially the broader aggregate M2+ . . .), the growth
of credit, the rate of increase of total spending and
wage settlements as guides to policy action.
(Freedman 1995)
The Bank’s May 1995 Monetary Policy Report, setting the format for those that followed, discusses product
and labor markets, inflation expectations, commodity
prices, and the Canadian dollar exchange rate in the section “Factors at Work on Inflation.” Monetary aggregates
are not mentioned until later in the report, as the last of
“other indicators” listed in the “Outlook” section. For
measures of inflationary expectations, the Bank considers
results from the quarterly survey of the Conference Board
of Canada, the forecasts listed in Consensus Forecasts, and
the differential between the returns on thirty-year conventional and real bonds,14 but it does not conduct its
own surveys.
As an adjunct to the direct discussion of the
economic forecast and policy decisions, the Bank of Canada
has introduced the concept of a monetary conditions index
(MCI) as a short-run operational target.15 The change in
the MCI is defined as the weighted sum of changes in the
ninety-day commercial paper interest rate and in the
Group of Ten trade-weighted Canadian dollar exchange
rate, where the weights are three to one. The three-to-one
weighting of interest rate to exchange rate effects on the
economy came out of Bank estimates of the six-toeight-quarter total effect of changes of each upon aggregate
demand. The MCI was arbitrarily based at 100 in January
1987, and then computed backward and forward from that
point; as a result, the Bank stresses that short-run changes
in the MCI are more meaningful than levels.

The fundamental message of the MCI is to remind
the Bank and the public that there are two monetary
channels affecting aggregate demand in the open Canadian
economy at any time. The MCI is therefore a “short-run
operational target . . . most useful over a one- to two-quarter
horizon” (Bank of Canada 1996, November, p. 21). The
MCI is not a nominal anchor in itself, nor does it imply a
commitment to intervene to alter exchange rates: “Between
quarterly staff projections, the MCI provides the Bank with
a continuous reminder that exchange rate changes must be
considered when making decisions about interest rate
adjustments” (Bank of Canada 1996, November, p. 21).16
Underlining its tactical role in operations, the MCI is considered only briefly in the published semiannual Monetary
Policy Report.
The Bank of Canada’s Annual Report, 1994 was a
totally redesigned document compared with the 1993
edition. The first item discussed under the heading of
monetary policy was the planned introduction of the
Monetary Policy Report. As opposed to a densely printed,
very formal-looking document, the Annual Report, 1994
(and all those published since) was printed in large type,
with extensive use of white space and numerous pictures
and graphs. The document was consciously made more
user-friendly in tone and distribution as well as in format.
As argued in the next section, this change may be seen as
part of the Bank’s ongoing efforts at public outreach and
education, goals that gained greater attention when
Gordon Thiessen succeeded Governor Crow. Another factor in the new design may have been the switch in 1995
from “inflation-reduction” to “inflation-control” targets,
with the setting of a target inflation level to be maintained.17 By the Bank’s own description, in its Annual
Report, 1994:
The new Monetary Policy Report will be designed to
bring increased transparency and accountability to
monetary policy. It will measure our performance in
terms of the Bank’s targets for controlling inflation
and will examine how current economic circumstances and monetary conditions in Canada are
likely to affect future inflation. (Bank of Canada
1995a, p. 7)

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57

Governor Thiessen also spoke directly to the
reader in an informal manner:
In carrying out the responsibilities of the Bank, our
objective is to promote the economic and financial
welfare of Canada. I hope this description of those
activities will increase the public’s understanding
of how the Bank has fulfilled its responsibilities.
Communicating what the Bank is up to and why is
important if we are going to maintain the confidence of Canadians. This year we have changed the
Bank’s Annual Report. . . . This new style of annual
report is designed to provide more information on
what the Bank does, thereby providing a better
account of our actions. (Bank of Canada 1995a, p. 5)
This decision was a conscious effort to increase the
transparency of policy for the general public. At the time
inflation targets were originally adopted, the Bank stated:
The Bank of Canada will be reporting regularly on
progress relative to the inflation-reduction targets
and on its monetary policy actions in speeches, in
the extracts from the minutes of meetings of the
Board of Directors of the Bank of Canada and of
course in the Bank of Canada’s Annual Report to
the Minister of Finance. In addition, an analysis of
inflation developments relative to the targets will
be published periodically in the Bank of Canada
Review. (Bank of Canada 1991c, p. 15)
The Review switched from monthly to quarterly publication
in 1993, however, and the experience of other inflationtargeting countries, particularly the United Kingdom,
brought home the utility of a separate publication in
eliciting and focusing public discussion. 18
The semiannual Monetary Policy Report has varied
slightly in outline in the five issues published to date, but
all include some discussion of recent developments in inflation, progress in achieving the inflation-control targets,
and the outlook for inflation. To summarize the aim of the
Monetary Policy Report:
This report reflects the framework used by the Bank
in its conduct of policy. This framework includes:
(I) a clear policy objective; (II) a medium-term
perspective (given the long lags for the full impact
of monetary policy actions on the economy); and
(III) a recognition that monetary policy works
through both interest rates and the exchange rate.
(Bank of Canada 1995, May, p. 3)

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The Monetary Policy Report is a very user-friendly
periodical aimed at the layperson, with “technical boxes”
explaining various concepts and procedures in a cumulative
fashion (similar to the pedagogical efforts in the United
Kingdom’s Inflation Report). The format emphasizes white
space and includes summary bullet points in the margins,
and the presentation is limited to less than thirty pages
(largely consisting of charts). In addition, the Report is
made available on the internet or by calling a toll-free
number, and a four-page summary (compiling the various
summary points) is issued at the same time for those who
do not wish to read the entire document. Again, the Report
represents a major shift in tone and audience from the
reporting efforts undertaken in the initial years of inflation
targeting in Canada, when the discussion of inflation
performance remained in technical language and was bundled with other topics in less accessible publications.
Around the same time, there were some other
changes in the internal organization of the Bank of Canada.
Most prominently, as summarized in the Annual Report,
1994, “the Board of Directors established a new senior
decision-making authority within the Bank called the
‘Governing Council.’ The Council, which [the Governor
chairs], is composed of the Senior Deputy Governor and
the four Deputy Governors. A major decentralization of
decision-making is being implemented in the wake of the
Council’s establishment” (Bank of Canada 1995a, p. 8).
Since this change, all issues of the Monetary Policy Report
have carried the note “This is a report of the Governing
Council of the Bank of Canada” and listed the six individuals’
names. The movement to collective responsibility, rather
than giving the impression that the Governor embodies
the Bank, may be seen as an attempt to increase public
perceptions of accountability after Governor Crow had
become personally identified with the Bank’s policy in the
early 1990s. 19
The Bank of Canada remains a relatively independent central bank.20 In line with its responsibility for the
conduct of monetary policy, the Bank of Canada has full
operational independence in the deployment of monetary
policy instruments. Thus, the Bank alone determines the
setting of policy-controlled short-term interest rates.

Nevertheless, the Bank is subject to the “doctrine of dual
responsibility,” putting ultimate responsibility for the
thrust of monetary policy in the hands of the Minister of
Finance, and the Minister can make the Governor follow a
particular policy (or move interest rates at a specific time) by
issuing a public directive, with which the Governor and the
Bank must comply.
A conflict between the Minister and the Bank,
however, has never occurred. Because the issuance of a
public directive would imply that the Minister had lost
confidence in the ability of the Governor to carry out the
government’s monetary policy, the directive would likely
be followed by the resignation of the Governor. Obviously,
such a situation would almost certainly have serious repercussions for the government. Thus, a directive would be
used only in extraordinary circumstances, and it is not
something that can be used routinely by the government to
sway the conduct of monetary policy.
Indeed, it might be argued that the existence of
the explicit directive power has strengthened the independence of the Bank of Canada, compared with a system in
which the procedures for resolving policy conflicts are not
spelled out so explicitly. In general, relations between the
Finance Ministry and the Bank are quite close. The Minister
and the Governor meet almost weekly (though not on a
required schedule), the Deputy Minister of Finance holds a
nonvoting seat on the Bank’s Board of Directors, and there
are a number of other less formal contacts as well. 21
The Bank of Canada’s inflation-targeting framework has been an exceedingly flexible one, undergoing
constant refinement and development, with a marked
trend toward greater transparency over time (discussed in
further detail below). The targets changed from “inflation
reduction” to “inflation control” of around 2 percent CPI
inflation, without commitment to a specific long-run definition of price stability. Furthermore, additional reporting
obligations (such as the Monetary Policy Report) were undertaken as were new, more transparent operational tactics (for
example, the reference to the MCI and the mid-1994 move
to target more explicitly an overnight interest rate range of
50 basis points). At the same time, the backward-looking
assessment and the forward-looking prediction of the target

inflation series have always been nuanced by reference to
developments in core CPI, indirect taxes, and exchange
rates, without resorting to a specified rule for how and
when to judge success. Finally, the Bank of Canada has
become more directly accountable to the public and the
markets than to the government directly. In short, the similarity to the German framework 22 and the difference from
the New Zealand framework are striking—despite the
apparent closeness of the New Zealand and Canadian target
definitions and economic situations.

CANADIAN MONETARY POLICY UNDER
INFLATION TARGETING
This section summarizes briefly the main events in
Canadian monetary policy since the announcement of
inflation targets in February 1991. It is based on accounts
in the Bank’s Annual Reports and semiannual Monetary
Policy Reports (since 1995), speeches and articles printed in
the Bank of Canada Review, some academic studies, the
OECD Economic Reports, and various newspaper reports.
The paths of inflation, interest rates, the nominal
effective exchange rate (henceforth the exchange rate),
GDP growth, and unemployment in Canada depicted in
Charts 1-4 (pp. 69-70) indicate that the economic background for monetary policy under inflation targeting can
be usefully divided into two basic periods. The first—
which ran from the introduction of targets through the end
of 1993—was characterized by significant economic
adjustment by firms and workers as well as declining
inflation rates; at times, headline inflation dropped below
the floor of the announced target range. The second—
which runs from the announcement on December 22,
1993, when the inflation-targeting framework was
extended, to the present—has generally been characterized
(except in 1994) by a need to alleviate disinflationary
pressures, which have threatened to push inflation below
the target range.
One of the challenges that the Bank of Canada
faced during these periods was political, rather than economic. The Bank’s success in reducing inflation and then
maintaining it at a low level was associated by some critics
with a high cost in unemployment, although it is by no

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59

means clear that the level of unemployment reached at the
time was entirely due to monetary policy or that it would
have been entirely avoidable if monetary policy had been
different. The targeting framework for monetary policy has
received support from the public and has thus been
endorsed by the two different governments in power since
it was first adopted. However, while all central banks that
adopted inflation targets received some criticism of their
priorities from certain quarters, Canada’s critics have
probably been the most prominent and vocal in objecting
to an exclusive focus on inflation control and to the low
level of the target range.
This experience contrasts with that of New
Zealand, discussed above, where there was basic agreement that the monetary reforms, including the adoption
of inflation targets, were beneficial, but the control problems
of the central bank in meeting a tight inflation target
band near zero are what drew attention. The Canadian
experience also contrasts with that of the United Kingdom,
discussed below, where the central bank, because of its
lack of independence, did not control the setting of the
monetary policy instruments and so was not an obvious
target for public criticism. Instead, the primary challenge
for policy in the United Kingdom arose from the separation between those accountable for forecasting and assessing
inflation performance and those responsible for setting
monetary policy.
Accordingly, in this section, we focus upon three
critical junctures for the Canadian inflation-targeting
framework. The first critical period came in 1991 at the
time of the adoption of targets, when forces beyond the
Bank of Canada’s control—world oil markets and Canadian
domestic tax policy—created inflationary impulses. The
second came in late 1993 when the Liberal Party won a
victory in a federal election with a campaign platform that
decried the incumbent Conservative Party’s “singleminded fight against inflation.” 23 The third came in
mid-1996, when the then president of the Canadian
Economic Association (and critic of the Bank of Canada)
gave voice to a concern about the perceived excessive tightness of monetary policy in the face of high and rising
unemployment.

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In all three instances, the Bank of Canada
responded by directly engaging in substantive discourse
and increasing its efforts at transparency and public outreach. The Bank’s response should be seen as a success in
that the Bank managed to defend its policies without altering its basic commitment to operational price stability.
The fact that the Bank effectively won over a sufficient
number of wage- and price-setters in the first instance, the
Liberal Government in the second, and the general public
in the third, demonstrates the potential of inflation targets—and of transparent accountability more generally—
to shape and enhance the discussion of monetary policy.
With the Bank of Canada’s competence and responsibilities
clearly defined and tracked, the Bank could justify its policies within a clear structure. Meanwhile, the Bank’s critics
were forced to argue openly for looser policy on its economic merits (or lack thereof) alone.
The first major challenge to Canadian monetary
policy after the joint announcement of inflation targets by
Governor Crow and Finance Minister Wilson, on February 26,
1991, was how to cope with contemporaneous upward
pressures on the price level. Most important, the Canadian
federal government had just introduced a GST along with
other increases in indirect taxes by federal and provincial
governments. The key for the Bank of Canada’s strategy was
that these were identifiable, onetime price adjustments with
extremely predictable effects if the price rises were not
passed on by the private sector through a round of price and
wage hikes. The Bank had little incentive to raise interest
rates, given that it had been pursuing a policy of easing
monetary conditions since the spring of 1990, and growth for
1991 was expected to be minimal because of low U.S. aggregate demand and widespread debt overhang in Canada.
The Bank used the targets as a means of communicating to the public that these onetime shocks should not
be passed through to trend inflation, keeping the threat of
interest rate rises in the background. Looking back from
his perspective at the end of 1991, Governor Crow stated
in the Annual Report, 1991:
The fact that the economy was able to absorb the
GST and the other indirect tax changes without
provoking an inflationary spiral—a process of wages

chasing prices, prices increasing further as a result,
and so on—has been especially welcome. Certainly,
the Bank of Canada has sought to make absolutely
clear that monetary policy would not finance such a
destructive process. The way that the price effects of
the GST have been successfully absorbed has
become even more widely recognized with the
recent publication of the January 1992 CPI numbers.
(Bank of Canada 1992a, p. 9)
In fact, given the tight monetary conditions that
had already been established and the unexpected sluggishness of the economy, the Bank was able to ease nominal
short-term interest rates 6.5 percentage points between
spring 1990 and February 1992, a larger drop than was
seen in inflation. Once the tax effects were taken out of the
CPI in January 1992, headline CPI inflation dropped to
1.6 percent, while core inflation went from 5 percent in
December (still including the GST) to 2.9 percent in
January (Bank of Canada 1992a, p. 20).
The Bank’s own analysis of the economic situation
at year-end 1991 attributed most of the ongoing sluggishness in the Canadian economy to the global slowdown,
largely because of debt overhang in the rest of the Group of
Seven, as well as low commodity prices for Canadian
exports (Bank of Canada 1992a). In January 1992, the
Bank announced that it had come in under its expected
rate of inflation of 5 percent at the end of 1991. 24 The
target success was described in terms of core CPI (that is,
excluding food and energy prices) rather than the ultimate
target, headline CPI, although both were well below target
level (having risen 2.6 percent and 3.8 percent, respectively,
over 1991). By February 1992, inflation had already
dropped below the target level of 2 to 4 percent for
year-end 1992, with core CPI 2.8 percent higher than a
year earlier, despite a depreciating Canadian dollar.
The announcement in May 1991 introducing
inflation-indexed (real return) bonds, with payments of
interest and principal linked to the CPI, served as an additional indicator that the authorities intended to avoid
inflationary policies in the future. The announcement was
immediately seen (as intended) as an additional incentive
for the government and the Bank of Canada to meet the
announced inflation targets. 25

By October 1991, Bank of Canada researchers
suggested that Canada had already paid most of the cost of
bringing down inflation, as measured by sacrifice-ratio
calculations (Cozier and Wilkinson 1991). Some academic
economists immediately responded in the press with concern that the Bank of Canada’s estimates of the sacrifice
ratio were low—possibly by as much as 50 percent.26
Appealing to a hysteresis-type argument, but also indicating
some belief that a persistently looser monetary policy could
result in employment gains, these economists predicted
that unemployment would remain high. It is important to
note that the Bank’s response did not include an attempt to
deny that disinflation beginning before target adoption
involved a cost in terms of real activity—in fact, the release
of research on the topic of sacrifice ratios prompted this
discussion. Nevertheless, various officials did, at times,
hold out the hope that as Canadian inflation expectations
adjusted under targets, the cost of future disinflations
would drop (see the preceding section).
The debate was therefore about the Bank’s policy
priority on low inflation, rather than about the framework
of targeting itself. This debate over the relative importance
of low inflation would become a recurring theme, as we
explain below, and the existence of the inflation targets
helped to frame the discussion of monetary policy at this
general level rather than allowing a conflict over the interpretation of specific policy movements or the competency
of policymaking.
There was considerable discussion of the relationship between the Bank of Canada’s independence and its
inflation-targeting framework in 1991. The Bank of
Canada was included in the Conservative Government’s
proposals for general federal reform published in September;
the main changes recommended were to simplify the
Bank’s legal mandate to emphasize the pursuit of price
stability (from its multigoal statement) and to make
the Governor’s appointment subject to confirmation by
the (to-be-reformed) Senate. The Manley Committee
in the House of Commons 27 held hearings on the
proposals in late 1991, but the government was largely
occupied with its agenda of constitutional reforms, then
under discussion.

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61

The Bank and others testified that a focused price
stability mandate would clarify the accountability of the
Bank, whereas it would be possible to defend almost any
policy under the current vague mandate. The Committee
concluded, however, that “the problem with a mandate
narrowly focussed on price stability is that it would tend to
enhance the Bank’s accountability by reducing unduly the
Bank’s area of responsibility” (Paragraph 88). In the end, the
Manley Committee decided, “The elected government must
remain ultimately accountable for the monetary policy followed” (Paragraph 168). In the end, the system of dual
responsibility and the old legal mandate were maintained.28
By September 1992, the Canadian dollar had
fallen to 79 U.S. cents, from 89 U.S. cents a year earlier,
and most of the Bank of Canada’s activity was concentrated on exchange rate and interest rate interventions
meant to slow and smooth the downward trend of both
variables. The economy continued to stagnate without
falling into recession. The Annual Report, 1992 noted that
the Canadian recovery was much slower than the norm of
previous business cycles. Inflation did meet the target on
a headline basis, reading 2.1 percent in December, while
the 1.7 percent core inflation fell below the target range
of 2 to 4 percent. Core inflation would remain between
1.3 and 2 percent until the target path’s floor caught up
with it in late 1993.
The second critical juncture for the Bank of
Canada’s targeting framework came in the summer before
the November 1993 parliamentary election, when, in light
of the unpopularity of the ruling majority and rising
unemployment, then Prime Minister Brian Mulroney’s
Progressive Conservative Party seemed doomed to defeat
(although no one foresaw the eventual size of that defeat).
The Liberal Party included in its campaign platform a criticism of the Conservative Party’s “single-minded fight
against inflation.” 29 Although the political attack initially
focused on the Conservative Party’s goals for monetary
policy, it sparked debate over whether Governor Crow
should be appointed to a second seven-year term when the
Liberal Party took office. Market economists did warn the
Liberal Party leaders through the press that, if Crow was
not reappointed, some other measure would be necessary to

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reassure markets of the new government’s commitment to
low inflation.30
In October 1993, preceding the Liberal Party’s
victory, Deputy Governor Freedman’s speech at an academic
conference on monetary policy stated:
With the unexpected sluggishness of the economy,
the rate of inflation fell faster and further than initially anticipated, and this despite the fact that
monetary conditions were easing for most of the
period between the announcement of the targets
and the first target date, the end of 1992. . . .
[Although inflation was 2.1 percent at the end of
1992, versus a lower band of 2 percent,] it would be
inappropriate to push up the rate of inflation once it
had reached the lower band of the target range,
given that the longer-term goal was price stability. 31
(Freedman 1994a)
On the one hand, this statement underlined both
the Bank’s unwillingness to engage in fine-tuning (or perceived attempts at it), and its complementary willingness
to admit forecast errors and the limits of its control of
inflation developments. On the other hand, this stance
reaffirmed that the target bands were to be taken more
seriously than the midpoint, and it gave the impression
that, even then, inflation outcomes that erred on the side of
being too low would be accepted. 32 As we saw in the case
of New Zealand, as well as in the political pressures on the
Bank of Canada, an emphasis upon firm target bands
makes explanations of deviations of inflation from the
range more difficult to justify publicly because the central
bank appears to have already admitted and specified the
extent of its required flexibility. The commonly held view
is that the deviation must be by the central bank’s choice if
it is not due to incompetence.
Moreover, a seeming willingness to allow target
undershootings for some time even at very low rates of
inflation—a possibility also raised by the Bank of
England’s later interpretation of its target as 2.5 percent or
less, discussed in Part VI—raises potential economic difficulties resulting from the probable asymmetry of the output-inflation trade-off at very low levels of inflation. More
recent statements by the Bank of Canada (cited below),
perhaps in reaction to the economic and political experi-

ences we discuss here, emphasize the advantages for policy
of having a floor to an inflation target, which, if taken
seriously, can help to stabilize output fluctuations.
On December 22, 1993, the new government and
the Bank made a joint announcement extending the targeting framework, with the 1 to 3 percent inflation band to be
reached by year-end 1995 now extended through 1998. As
noted in the previous section, the Bank was careful to
indicate that this target remained a medium-term goal, not
the achievement of price stability, however defined. It is also
worth pointing out that the new Liberal Government saw
the need to extend the target beyond its stated endpoint
once the change of Parliamentary majority had raised fears
about the commitment to the regime. While the Liberal
Government could not ultimately guarantee the survival of
the commitment beyond the length of its own majority in
the House of Commons, it could act to push off the endpoint of the regime toward a more open-ended future, thus
removing the endgame pressures discussed earlier in the
German case with regard to the run-up to European
Monetary Union in Europe.
The Liberal Government elected in October 1993
had campaigned against the single-minded pursuit of low
inflation. John Crow chose not to be considered for a second term as Governor, and Deputy Governor Gordon
Thiessen was appointed as his successor for a seven-year
term beginning February 1, 1994. As noted, on the
appointment of Gordon Thiessen, the existing 1 to 3 percent range was extended three more years, that is, until the
end of 1998. 33
In 1994, employment finally rose, largely on the
basis of strong export performance. Exports were helped by
a declining Canadian dollar, particularly against the U.S.
dollar; the Canadian dollar had depreciated for the two
years up until the 1993 election and had only temporarily
strengthened upon the Liberal majority’s reaffirmation of
the inflation targets. Interest rates had risen, not only
because of U.S. rate increases, but also because of concerns
over the Canadian fiscal situation and the high level of
political power behind separatism in Quebec. In his last
official act as Governor, John Crow used his statement in
the Bank’s Annual Report, 1993 (released in March 1994) to

call for the reduction of government debt burdens in order
to take pressure off interest rates and exchange rates.
Governor Thiessen would make similar statements
about fiscal policy in the years that followed, albeit more
obliquely to start. In general, inflation-targeting central
banks, even independent ones, face a difficult decision in
determining what kind of public statements to issue on
government fiscal policy. On the one hand, even the most
politically neutral inflation forecast, or clear assessment of
past monetary policy and inflation performance, requires
some estimation of the concurrent fiscal stance and its
effects; on the other hand, a central bank that shifts responsibility for outcomes onto the other macroeconomic policy
lever or that takes an (actual or perceived) ideological stand
on budgetary politics could well undermine its own political
legitimacy. Like all the central banks we consider here, the
Bank of Canada tended to limit its discussion of fiscal
matters to statements about the fiscal stance broadly, its
effect on the exchange rate risk premia on interest rates, and
general encomiums to the ideals of long-run sustainability.
Over 1994, core CPI inflation had fluctuated
between 1.5 and 2 percent, well within the target band.
The headline CPI inflation rate had dropped to as low as
zero because of a tobacco excise tax reduction in early 1994.
Again, the Bank’s judicious use of core versus headline CPI
to distinguish onetime price shifts from trend largely
avoided confusion and the pass-through of first-round
effects to wage and price inflation—this time in what
would have been a negative direction. Indeed, in February
1995 headline CPI jumped from 0 to 1.8 percent after the
first-round effect of the federal and provincial tobacco tax
reductions dropped out of the calculations. Since the Bank
had already stressed the onetime nature of the preceding
price drop (and the stability of core inflation), it felt no
need to react to this rise when it occurred (see, for example,
Bank of Canada [1995, May]).
Meeting the announced target—and therefore
maintaining that target’s positive inflation rate rather than
driving it toward zero—bolstered the Bank’s standing in
two ways: it demonstrated the Bank’s competence and its
reasonableness with regard to the pursuit of price stability.
In the Annual Report, 1994, Governor Thiessen spoke of the

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63

third successive year of “maintenance of a low level of
inflation . . . after two decades of high and unpredictable
inflation” and remarked on “the progress that has been
made towards price stability” (Bank of Canada 1995a, p. 5).
When the first Monetary Policy Report was issued in
May 1995, the Bank stated in the four-page summary that
“core inflation has been consistently within the Bank’s
inflation-control targets band since early 1993.”
Year-over-year core inflation had risen to 2.7 percent by
that month (its highest level since the end of 1991) and
then declined, while headline inflation also peaked at
2.9 percent. After lowering interest rates on three occasions during the summer, the Bank tightened monetary
conditions toward the end of the year. First, it raised the
overnight interest rate in November and early December
1994 in response to rising U.S. rates and the emergence of
strong domestic economic data. Later, it raised rates five
times in January and February 1995 to try to stabilize
financial markets in the face of a rapid depreciation of the
Canadian dollar during a crisis of confidence following the
Mexican devaluation. By March 1995, monetary conditions as measured by the MCI were 2 percent tighter
because the Canadian dollar had rebounded. Demand for
exports was expected to remain strong through the end of
1995, while domestic demand declined in response to
interest rate rises and government fiscal restraint. The
Canadian economy had grown more strongly than expected
in 1994—at a rate of 5.6 percent.
Inflation remained in the upper half of the 1 to
3 percent target band through October, largely because of
the prior depreciation of the Canadian dollar. 34 The Bank
accepted the inflation performance and its future course,
and turned to other short-run concerns. “Throughout the
rest of the second quarter [1995], it became increasingly
apparent that the economy was not expanding as expected
and that an easing of monetary conditions was warranted”
(Bank of Canada 1995, November, p. 4).35 The Bank was
willing to admit a forecasting error and to link its monetary policy decisions to real economic developments as long
as the inflation target was met. It can be argued that the
Bank was able to do so having invested not only in previous credibility-building disinflations, but also in educat-

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ing the public in understanding that monetary policy is
forward-looking.
The Bank of Canada first cut interest rates 25
basis points in early May, then lowered the operational
target for interest rates twice in June, while the Canadian
dollar also depreciated. It then cut rates twice more in
July and again in August, when the dollar rose. The Bank
expected inflation to remain high within the target band
until 1996, when “added downward pressure coming
from greater-than-expected excess slack in the economy”
would bring it into the lower half of the band (Bank of
Canada 1995, November, p. 4). Interest rates were cut on
October 31, the day after the Quebec referendum on sovereignty failed to pass; in December 1995, headline
inflation declined to 1.7 percent, heading into the lower
half of the target band and prompting another cut in the
overnight interest rate.
When the output gap remained greater than the
Bank’s 2.5 percent estimate through the first two quarters
of 1996, contrary to expectations, monetary easing continued. The overnight rate was cut on January 25 and again
on January 31 following a U.S. federal funds rate reduction. Rates were cut once in March and once in April. Since
October 1995, the MCI had declined the equivalent of
200 basis points to its lowest level since 1994 (Bank of
Canada 1995, November, p. 43). Inflation expectations
were unaffected by the loosening and remained at historical
lows—the Canadian Conference Board Survey of Forecasters
and Consensus Forecasts both displayed downward trends in
two-year-ahead inflation expectations, from around 4 percent in the first half of 1990 to 2 percent in the second half
of 1995. The differential between Canadian “real bonds”
and thirty-year conventional bonds was 3.25 percent, on
par with the smallest differential recorded since the bonds
were first issued in 1991.
Most significantly, the Canadian–U.S. short-term
interest rate differential turned negative, while the
Canadian dollar remained firm, raising hopes at the Bank
that Canada’s inflation-targeting regime had become such
a sufficiently independent source of counterinflationary
credibility that the two countries’ interest rates might be
decoupling. Given the positive effects of these develop-

ments on expectations and inflation, and the pressing needs
of the real economy, the Bank began to emphasize how
seriously it took the floor on its inflation target and the
potentially stabilizing effect on real output of so doing.36
The third critical juncture for Canadian monetary
policy occurred in summer 1996, with the continuing
stagnation of Canadian GDP and employment. Criticisms
of the Bank of Canada’s policies were given more weight
because they were delivered by Pierre Fortin, the elected
president of the Canadian Economics Association. On June 1,
1996, Fortin delivered a presidential address entitled “The
Great Canadian Slump” (Fortin 1996a) to the annual meeting
of the Canadian Economics Association. In his address, he
characterized Canadian economic performance since 1990 as
a long slide in economic activity and employment . . .
[with the] accompanying employment and output
losses still accumulating, but . . . they surpass the
losses experienced by other industrial countries
since 1990. The last decade of this century will
arguably be remembered as the decade of The Great
Canadian Slump. (Fortin 1996a, p. 761)
After considering and dismissing a number of possible structural explanations for Canada’s economic performance, he forcefully argued that the depression of domestic
demand was largely attributable to interest-sensitive consumer durables and business fixed-investment demand.
“This gives us the clue to the true cause of the great slump
of the 1990s: old fashioned monetary and fiscal contraction. I argue that monetary policy has been the leader, and
that fiscal policy was induced by the monetary contraction”
(Fortin 1996a, p. 770).
In Section IV of his address, “Monetary Policy and
the Slump,” Fortin cites Bank of Canada statements affirming the Bank’s control over short-term interest rates and
then poses a question:
The only serious question is why the Bank of
Canada has kept the short-term real interest rate
differential with the United States so large for so
long in the 1990s. The answer to this question has
two parts: first, since 1989 the central bank has
focused exclusively on the goal of zero inflation;
second, contrary to expectations, achieving this
objective has forced it to impose permanently

higher unemployment through higher interest rates.
(Fortin 1996a, pp. 774-5)
The first part of Fortin’s explanation is attributed
to the Bank of Canada’s exclusive focus on inflation, its
religious zeal in doing so, and its excessive independence
from popular preferences and political control (pp. 775-7).
The second part of his explanation is based on his application of the argument of Akerlof, Dickens, and Perry (1996)
about a floor for nominal wage changes at or near zero in
the Canadian labor markets.37 If one believes that workers
resist nominal wage cuts strongly, whether for reasons of
“fairness” or other factors, Fortin argues,
the zero constraint can take a large macroeconomic
bite when the median wage change itself is around
zero, as was observed over 1992-4. . . . But if inflation is to fall to a very low level, such as the 1.4 per
cent of 1992-6 in Canada, and is to stay there, the
proportion of wage earners that are pushed against
the wall of resistance to wage cuts must increase
sharply. The long-run marginal unemployment cost
of lower inflation in this range is not zero, but is
positive and increasing. (Fortin 1996a, p. 779)
He goes on to state that the Bank of Canada not only has
misjudged the output-inflation trade-off at low inflation
rates, but also “has displayed a strong deflationary bias that
has not reflected the true state of knowledge on the benefits
of zero inflation, the true preferences of the Canadian
population, and the spirit and letter of the Bank of Canada
Act, which reflects those preferences by asking for a reasonable balance between the inflation and unemployment
objectives” (Fortin 1996a, p. 781).
Fortin acknowledges that “the Bank of Canada has
made every effort at explaining this strategy through public
speeches, appearances in Parliament, research papers,
Annual Reports, and, more recently, Monetary Policy Reports.
But it is also true that these attempts have more often been
exercises in advocacy of a controversial and extreme policy
orientation than genuine dialogue with the public” (Fortin
1996a, p. 781). His two primary policy recommendations
are to make the Bank of Canada more like the U.S. Federal
Reserve System (in his description), with five governors
holding staggered terms, and to raise the inflation target’s
midpoint 1 percent, to 3 percent (Fortin 1996a, p. 781).

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65

In the press discussion that ensued, including
Fortin’s own summary of his arguments for mass readership, permanent and transitional costs of achieving low
inflation were repeatedly confused.38 Without coming down
on either side of the argument, we note that the Canadian–
U.S. interest rate differential had dropped along with
interest rates more broadly, suggesting that the Bank of
Canada was successful in containing inflation. In addition,
this suggests that the Bank of Canada had eased monetary
conditions because the considerable slack in the real economy implied disinflationary pressures that might cause
inflation to drop below the target range. Whether the
Canadian economy had borne too great a cost in lost output
during the transition process to be justified by the benefits
of lower inflation—despite the Bank of Canada’s acknowledgments of the cost of disinflation and conscious gradualism documented above—is an issue that merits discussion.
At the time, however, with the public record of
the Canadian inflation-targeting framework’s goals, actions,
and results available for all to see, discussion was limited to
debate over the costs and benefits of low inflation and did
not address topics of ideology or of competence. This focus
forced participants to take an explicit stand (as Fortin did)
on defining the goal of monetary policy. The Bank of
Canada’s response was to articulate further its rationale for
the existing 1 to 3 percent inflation target. In a speech to
the Ecole des Hautes Etudes Commerciales in Montreal on
October 9, 1996, Governor Thiessen put the debate in
exactly these terms while addressing Fortin’s argument
(without mentioning him by name):
A distinction should be made here between reducing
inflation and maintaining it at a low level. Reducing
inflation requires a downward adjustment in inflation expectations and may entail transition costs,
which is not the case with simply maintaining low
inflation. It is generally agreed that the gains
achieved by reducing inflation exceed transition
costs when inflation is high. Where opinions are
more divided is on the question of how far inflation
should be reduced. Some fear that if inflation falls
below a certain threshold, the economy will be
deprived of a lubricant. . . . I must say that this
argument assumes a degree of money illusion
that I find difficult to reconcile with the observed

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behavior of wages in inflationary periods. . . .
Recent experience will provide us with more useful
information in [the wage behavior during periods of
slow wage growth]. We have therefore undertaken
new research on this question. . . . Since this
research is just getting under way, I will confine
myself here to reporting that our preliminary
examination of the major wage agreements concluded between 1992 and 1994 does not lend
evident support to the thesis of inflation as lubricant. (Thiessen 1996d, p. 3)
There are three key points to make about Governor
Thiessen’s remarks: first, the costs of disinflation are once
again forthrightly acknowledged; second, the argument is
made on the basis of empirical claims, with the Bank
assuming the burden of having to provide supporting (or
opposing) research; and third, the discussion is centered on
the appropriate level of inflation to target and the pace at
which that level should be reached, not on what the goals
of monetary policy should be. Later in his remarks, Thiessen
attributed the stalling of the expansion in 1994 and 1995
to increased interest rate risk premia due to international
market fluctuations and to political uncertainties about
Canada. “In such a context [of high interest rates], the
benefits of low inflation were slow to be felt” (Thiessen
1996d, p. 7). Referring to the easing of monetary conditions since that time and the decline in the Canadian–U.S.
interest rate differential, he stated, “It shows that keeping
inflation down is a low-interest-rate policy and not, as
some critics have often claimed, a high-interest-rate
policy” (Thiessen 1996d, p. 7).
A month later, Thiessen gave another speech
responding even more directly to the Fortin argument,
titled “Does Canada Need More Inflation to Grease the
Wheels of the Economy?” 39 He opened by characterizing
some ideas you have probably heard about
recently. . . . The suggestion is that the Bank, with
its focus on bringing inflation down, is largely
responsible for Canada’s sluggish pace of economic
expansion and stubbornly high unemployment in
the 1990s. . . . Moreover, in this view, a monetary
policy that emphasizes price stability will somehow
always be too tight to allow the economy to
achieve its full potential in the future. (Thiessen
1996a, p. 63)

After making an extended argument that most of
what slowed the Canadian economy in the early 1990s was
the combination of externally induced high interest rates
and widespread structural change in response to globalization and technical changes, and that the economy was now
poised to pick up over the long term, Thiessen made
explicit his vision of the relationship between maintaining
low inflation and economic growth:
In fact, when the Bank takes actions to hold
inflation inside the target range of 1 to 3 per cent,
monetary policy operates as an important stabilizer
that helps to maintain sustainable growth in the
economy. When economic activity is expanding at
an unsustainable pace . . . the Bank will tighten
monetary conditions to cool things off. But the
Bank will respond with equal concern, by relaxing
monetary conditions when the economy is sluggish
and there is a risk that the trend of inflation will fall
below the target range. (Thiessen 1996a, p. 67)
Having drawn the policy implication of the distinction between disinflating and maintaining low
inflation given an announced inflation target, Thiessen
then reiterated his belief that the process of wage setting in
a low-inflation environment would be flexible enough to
allow for occasional wage reductions in industries that
required it, thus countering the view that zero inflation
would be costly to the economy because of downward
nominal wage rigidity. 40
The purpose of our extended treatment of this
third critical juncture in Canadian monetary policy since
the adoption of inflation targets is not to give credence to
one side of the argument, or even to the existence of the
argument itself, but rather to emphasize the form the
argument took. The existence of the inflation-targeting
framework channeled debate into a substantive discussion
about appropriate target levels, with all sides having to
make explicit their assumptions and their estimates of
costs and benefits while working from a common record
of what the goal had been and how well it had been met.
Interestingly, although this argument gave a
potentially far better-grounded means of attacking the
Bank’s stance than that utilized in the 1993 elections, the
run-up to the 1997 elections has, in contrast, not

included criticism of the Bank of Canada as a major issue.
What this difference indicates most of all is that the failure of political accountability claimed by Fortin in “The
Great Canadian Slump” address did not exist—rather,
this difference indicates that the Bank’s form of response,
as with previous challenges, had to be through its
acknowledged communications efforts. Indeed, the Bank
won support through its response, its responsiveness, and
its record.

KEY LESSONS FROM THE CANADIAN
EXPERIENCE
The Canadian experience suggests that an inflationtargeting framework that shares the ultimate goals of the
New Zealand framework but relies on a different operational
structure can be highly successful. The key lessons are as
follows: First, although some have argued that tight constraints upon or contracts for central banks are necessary to
establish counterinflationary credibility, as in New
Zealand, inflation has been low under the Canadian
inflation-targeting regime, which is characterized by close
informal links between the Bank of Canada and the Ministry
of Finance and a greater emphasis on accountability to
the general public than on meeting specified contracts.
Canada’s good inflation performance occurred even in the
face of negative supply shocks, such as VAT increases and
depreciations of the exchange rate induced by fiscal and
political developments. Indeed, the Bank’s concerted
efforts at transparency may have helped the public to distinguish between onetime shocks and movements in
trend inflation.
Second, inflation targeting has worked to keep
inflation low and stable in Canada even though the
inflation-targeting regime is more flexible, similar to
Germany’s, with misses of the target range less explicitly
tied to punishment. This flexibility has allowed the Bank
of Canada more room to deviate from the targets when
unforeseen shocks occur. As in the German case, a key component of Canada’s success with inflation targeting is the
Bank of Canada’s strong and increasing commitment to
transparency and the communication of monetary policy
strategy to the general public.

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67

Third, Canadian inflation targeting has been seen
by the central bank as helping to dampen business cycle
fluctuations, because the floor of the target range is taken
as seriously as the ceiling. Indeed, at times, the Bank
of Canada has been able to justify easing of monetary
conditions in the face of a weak economy by appealing to

the inflation targets, with the confidence that this easing
would not lead to expectations of higher inflation in the
future. Thus, inflation targeting did not force the Bank to
forswear all responsibility for stabilization of the real
economy.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

ECONOMIC TIME LINE: CANADA
Chart 1

Core Inflation and Targets
Percent
14
Start of inflation
targeting
(February 1991)

12

10
8
6
Target range
4
2
0
-2
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Sources: Bank of Canada; Bank for International Settlements.
Note: The I-shaped bars indicate the target range for inflation in effect before adoption of an ongoing target range of 1 to 3 percent in January 1996; a dashed line marks
the midpoint of the ongoing target range.

Chart 2

Overnight and Long-Term Interest Rates
Percent
25
Start of inflation
targeting
(February 1991)
20

15
Long-term rate
10
Overnight rate
5

0
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Sources: Bank for International Settlements; International Monetary Fund, International Financial Statistics.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

69

ECONOMIC TIME LINE: CANADA (CONTINUED)
Chart 3

Nominal Effective Exchange Rate
Index: 1990 = 100
110

105

100

95

90

85
Start of inflation
targeting
(February 1991)

80

75
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

94

95

96

97

Source: Bank for International Settlements.

Chart 4

GDP Growth and Unemployment
Percent
15

Start of inflation
targeting
(February 1991)

Unemployment
10

5
GDP growth

0

-5
1980

81

82

83

84

85

86

87

88

89

Source: Organization for Economic Cooperation and Development, Main Economic Indicators.

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FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

90

91

92

93

Part VI.

United Kingdom

T

he United Kingdom followed Canada in adopting
inflation targeting, but under quite different circumstances. In discussing its experience, we focus

providing the principal forecast of inflation and
assessing past inflation performance. As a result, the
Bank functioned as the Chancellor of the Exchequer’s
counterinflationary conscience.

on the following themes:
• Like the other countries examined, the United Kingdom
adopted inflation targets after a successful disinflation. Unlike these countries, however, the United
Kingdom took this step in the aftermath of a foreign
exchange rate crisis in order to restore a nominal
anchor and to lock in past disinflationary gains.
• In the United Kingdom, there is less attempt to treat
inflation targeting as a strict rule than in New
Zealand, making the targeting regime more akin to
the German and Canadian approach.
• As in the other inflation-targeting countries, monetary policy in the United Kingdom also responds
flexibly to other factors, such as real output growth.
• Like Canada, but unlike New Zealand, the United
Kingdom separates the entity that measures the
inflation target variable (Office for National Statistics)
from the entity that assesses whether the target has
been met (the Bank of England).
• In the United Kingdom, the headline consumer price
index (CPI) is not used in constructing the inflation
target variable; the target variable excludes mortgage
interest payments, but does not exclude energy and
food prices or other adjustments.
• Initially, the Bank of England targeted an inflation
range, but then shifted to a point target.
• Because the British central bank lacked independence
until the May 1997 election, it was accountable for
meeting the inflation targets but did not fully control
decisions about the stance of monetary policy.1
Indeed, up until May 1997, the Bank was limited to

• In part because of its weaker position before May
1997, the Bank of England focused its inflationtargeting efforts on communicating its monetary
policy strategy and its commitment to price stability,
relying heavily on such vehicles as the Inflation Report,
an innovation that has since been emulated by other
inflation-targeting countries.
Although the relationship between the Bank of
England and the Chancellor of the Exchequer has now
changed, the United Kingdom’s targeting framework prior to
the granting of independence in May 1997 is an important
example to consider in the design of inflation-targeting
frameworks in general. (We briefly discuss the post–May
1997 regime at the end of this case study.) In particular,
our analysis indicates that the split between the monetary
policy decision maker and the primary public inflation
forecaster had significant implications for the performance
of U.K. monetary policy between October 1992 and May
1997; future actions of the newly independent Bank of
England will support or disprove our belief about the
importance of this relationship to target performance.

ADOPTION OF THE INFLATION TARGET
The Chancellor of the Exchequer, Norman Lamont, announced
an inflation target for the United Kingdom at a Conservative
Party conference on October 8, 1992.2 Three weeks later,
at his annual Mansion House Speech to the City (Lamont
1992), he “invited” the Governor of the Bank of England
to publish a quarterly Inflation Report detailing the progress

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

71

being made in achieving the target, an invitation that the
Governor accepted.
The adoption of a target was an explicit reaction
to sterling’s exit from the European Exchange Rate
Mechanism (ERM) three weeks before. The Chancellor
wished to reestablish the credibility of the government’s
commitment to price stability, which had seemed to gain
from the pound’s two years in the ERM (as primarily measured by interest rate differentials with Germany and
spreads in the U.K. yield curve). Given the United
Kingdom’s history of trying and abandoning a series of
monetary regimes in the post–Bretton Woods period, there
was considerable potential for damage to credibility, both
at home and abroad, from the aftermath of the Black
Wednesday foreign exchange crisis in September 1992 and
a currency devaluation of more than 10 percent.
There had been no prior public discussion on the
part of either the Treasury or the Bank about setting inflation targets. While the pound was maintaining parity in
the ERM, of course, such talk would have been irrelevant
because the United Kingdom was committed to attempting
to match the Bundesbank’s inflation performance. As the
exchange rate crisis approached, revealing the existence of a
fallback plan could have been dangerous. Accordingly, the
announcement of an inflation target of 1 to 4 percent per
year in October 1992, unaccompanied by an explanation
of the methods for monitoring and achieving this performance, had a certain amount of shock value. Perhaps this
approach was seen as underlining the commitment by
plunging ahead in a decisive manner. It is important to
emphasize that the Chancellor announced the policy adoption at a partisan, though public, forum, and he committed
the nation to the targets only “through the end of the
present parliament,” that is, May 1997. In other words,
this was a policy of the ruling Conservative majority, and
could not be given a life independent from their own
commitment—except to the extent that the framework’s
success could earn support from the public and opposition
parties.
When, in September 1992, the government was
faced with the choice between attempting to defend the
exchange rate at length (with at least a major downward

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realignment inevitable) and leaving the ERM, it opted for
the latter despite the damage to credibility. The unwillingness of the U.K. monetary policymakers to raise interest
rates to defend the currency beyond Black Wednesday—in
contrast to, say, Italy or Sweden—suggests that their commitment to the ERM was not very strong.
It thus seems fair to say that the United Kingdom’s
adoption of an inflation target presented two elements of
continuity and one of change with respect to the monetary
regime of ERM membership. First and foremost, there was
no change in the objective of monetary policy—price
stability. The explicitness of this goal and its primacy,
however, had increased over the 1990s. By the time the
pound exited the ERM, the government had made clear
that it did not wish to be let free from discipline, merely
from the conflict between German and British business
cycles. Second, the strategy followed to achieve this objective had to have credibility with the public through a
transparent means of communicating the stance and
success of policy.
The main change for the United Kingdom, having
abandoned both monetary and exchange rate targets, was
the strategic decision not to employ any intermediate target variable in the setting of policy. In fact, in Chancellor
Lamont’s speech announcing the inflation-targeting policy,
he took pains to make clear that money growth and
exchange rate measures would be monitored but would not
determine policy. 3 A speech delivered by the Bank of
England Governor, Robin Leigh-Pemberton, on November 11,
1992, made the point abundantly clear:
Experience leads us to believe that monetary policy
cannot be conducted with reference to a single target variable. The overriding objective of monetary
policy is price stability. Therefore policy must be
conducted with reference to our expectations of
future inflation. . . . Consequently, policymakers
should make use of every possible variable, with the
importance attached to any given variable at any
point in time dependent on its value as a guide to
prospective inflation. (Leigh-Pemberton 1992, p. 447)
Thus, targeting the inflation goal directly was
seen as the only practical way to achieve the goal. This conclusion, however, still left open the question of how to

make this new policy credible, especially after the exit from
the visible restraint of the ERM. In his speech, the Governor
continued: “But in such an eclectic framework it is possible
for the underlying rationale of policy to be lost in a welter
of statistical confusion. That is why we have opted for a
policy of openness.”
This last point, reflecting a belief that efforts at
effective ongoing communication with the public—not
the announcement of a simple goal alone—are required for
credibility, is the operational core of the United Kingdom’s
inflation-targeting framework. Nevertheless, while the
framework emphasizes accountability, the idea that rules
have replaced discretion (as in the Reserve Bank of New
Zealand’s “contract,” for example) is not prominent. This
may have been more a matter of the reality of ultimate
monetary policymaking resting with the elected government rather than of a consciously held conviction. As noted
in the discussion of New Zealand, the extent to which
inflation targeting is treated as a rule is best seen as a
design choice. 4

THE OPERATIONAL FRAMEWORK
The intermediate target variable for policy set by the
Chancellor and the Bank of England is the annual change
in the retail price index excluding mortgage interest
payments (RPIX). RPIX was to remain in a range of 1 to
4 percent until at least the next election, with the intent
that it would settle itself in the lower half of that range by
then (2.5 percent or less).5 The long-term intended average
for RPIX is 2.5 percent or less. RPIX is meant to capture
underlying inflation and is usually reported along with
RPIY, which is RPIX altered to exclude the first-round
effect of indirect taxes. The British have chosen to include
the effects of commodity price shocks, including oil
shocks, in their target. In all inflation targets other than
headline inflation, there is some trade-off between transparency (because headline CPI is what people are accustomed to following) and flexibility (because then onetime
or supply shocks are defined out of the target requirement).
RPIX has proved to be an effective measure for the
Bank, however, with the financial press and the public

adapting to it over time. There was some consideration of a
change to RPIY in 1995, but that was seen as switching
too often and opening the possibility of being perceived as
constantly expanding the list of shocks for which monetary
policy would not be responsible. Indeed, to discourage this
perception, the Office for National Statistics, an agency
separate from the Bank (the forecaster), was asked to calculate the various inflation series (and thus the actual results
to be compared with the forecasts).
The target band width, set by the Chancellor, was
intended to limit the scope for both slippage and countercyclical monetary policy. Later interpretations by the Bank
and the U.K. Treasury, however, indicate that it was never
intended as a range strictly speaking, but as an admission
of imperfect control.6 Once set, however, the band width
takes on a life of its own, so that widening the band would
likely be seen as a loosening of policy or a failure to keep
the commitment.
The official position agreed to by the Treasury and
the Bank in recent years is that there is no longer an actual
range for the target, but a point target of 2.5 percent to be
met on an ongoing basis. This change was made explicit in
Chancellor Kenneth Clarke’s (1995) Mansion House
Speech to the City on June 14, 1995.7 In reality, the endpoint of such a time horizon is likely to correspond to the
lifetime of any parliamentary majority, as it did in New
Zealand when the country changed its target range after
the October 1996 election. Unlike New Zealand, however,
the United Kingdom makes no explicit commitment to
remain within a range. Therefore, the U.K.’s inflation
point target allows flexibility by permitting short-run
unavoidable deviations while shifting the focus away from
the values of the bands themselves.
Another issue inherent in the United Kingdom’s
targeting framework was the tying of the endpoint of the
target period to a specific event—the end of the then-sitting
Parliament. Unless the commitment to inflation targeting
is open-ended, there is uncertainty about whether the
targeting regime will continue past the close of the designated period. As a result, there may be increasing doubts
about the country’s will to undertake necessary actions to
meet the targets as the end of the period approaches and

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pressures increase to let bygones be bygones. As noted in
the discussion of German monetary targets in the run-up
to European Monetary Union (EMU), these doubts and
pressures will arise for any targeting framework that is not
renewed far ahead of its announced (or politically determined) endpoint. Just as the Liberal majority in Canada,
shortly after taking office in 1993, extended the 1995 targets to 1998, the British Labour Party made clear that it
would extend the inflation target of 2.5 percent or less for
the duration of its tenure in office should it win in May
1997, thereby removing a potential source of uncertainty
and lowering credibility.8 In contrast, in the New Zealand
elections of October 1996, there was no way to shield the
time horizon of the targets from the political process. This
difference may, in part, have been related to the formal
agreements tightly tying the Reserve Bank of New
Zealand’s goals to the majority in government.
In reality, the actual target of Bank of England
policy is the expectation of RPIX inflation in the domestic
economy. The success in meeting the target is judged by
whether the Bank’s own inflation forecast over the next two
years falls within the intended range. This approach to
assessing success is consistent both with a forward-looking
orientation and a belief that it takes about two years for
monetary policy to affect inflation. At the time of the
Chancellor’s initial announcement of the adoption of targets, he was criticized by market observers for focusing on
a lagging indicator by targeting RPIX inflation per se.
From the first Inflation Report onward, the Bank
has increasingly considered private sector inflation forecasts
and their spread in addition to the distribution of the Bank’s
own inflation forecasts. In recent issues of the Inflation Report,
this focus has shown itself in discussions emphasizing the
skew of forecast distributions as opposed to a point estimate or even confidence intervals. 9 Most important, the
Bank does appear to have successfully communicated to the
press and the public that a forward-looking monetary policy must be designed to achieve a balance of risks rather
than tight control (even with lags considered). Since many
central banks have this intellectual framework behind their
policymaking, there is much to be appreciated in the
Bank’s efforts in this direction.

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The Bank of England does appear to be working
from a standard policy feedback framework in line with the
Chancellor’s and Governor’s initial speeches—that is, one
in which all pieces of information are gathered and
weighed. M0 and M4 (narrow and broad money) figures
must be reported, with “monitoring ranges” announced for
them, but with an explicit escape clause indicating that
when their information conflicts with RPIX forecasts, the
RPIX forecasts are to be believed. Exchange rates and
housing prices have been repeatedly cited as other indicator
variables in the policy decisions by the chancellors and
governors over the period, but with the pointed absence of
any explicit ranking of the usefulness of different indicator
variables. The Bank acknowledges that its failed experiences with money and exchange rate targeting have made
it hesitant to rely on the stability of any one indicator or
relationship.
The stated ultimate goal of the United Kingdom’s
inflation targets is price stability, “namely that the rate of
inflation anticipated by economic agents is unimportant to
savings, investment, and other economic decisions”
(Leigh-Pemberton 1992). As in most other countries, a target of zero inflation was dismissed as unduly restrictive
given the failure to capture all quality adjustments in price
indexes (although the Bank of England points out that
RPIX is rebased far more frequently than in many other
countries, so there would be less substitution bias for the
United Kingdom’s price index). Consequently, price stability
is operationally defined as growth in RPIX of 2.5 percent
or less. The choice of this figure was primarily a pragmatic
decision, with the likelihood that if the 2.5 percent goal
were achieved and maintained, a lower goal, say of 2 percent, would then be set. No consideration of any other
goals, such as exchange rate stability or business cycle
smoothing, is explicitly acknowledged within the target
framework.
Like every other central bank, however, the Bank
of England remains de facto committed to trading off disinflation when necessary against its real-side costs and its
effects on the financial system. This is best illustrated by
excerpts from Governor Leigh-Pemberton’s November
1992 speech about the policy shift, “The Case for Price Sta-

bility.” The speech, reprinted in the Bank of England’s
Quarterly Bulletin, states, “The overriding objective of monetary policy is price stability.” In the preceding paragraph
of the speech, however, the Governor explains why other
factors overrode that objective and prompted the pound’s
exit from the ERM:
It [the ERM] certainly offered a very visible sign of
our commitment to price stability . . . [but] there
was a real risk of these disinflationary forces doing
quite unnecessary damage to the real economy.
Although we would have achieved price stability
very quickly—indeed there is reason to believe we
might have reached that position during 1993—
there was a real danger that the deflation which was
already apparent in certain sectors of the economy
(notably asset markets) would have become much
more widespread. It was not necessary to compress
the transition phase to price stability into such a
short time span and could well have been counterproductive in the longer term.10 (p. 446)
This trade-off is recognized even in contexts
where the choice between achieving an inflation goal
quickly at a high cost in real output or more slowly at
lower cost is less stark than that presented by the divergence of German and British domestic needs within the
European Monetary System (EMS) in 1992. Why else
would the achievement of price stability be pursued gradually, as outlined by the Bank and the Chancellor for the
path from the September 1992 RPIX rate of 3.6 percent?
Clearly, a gap exists between the claims and reality of inflation as a sole goal even under inflation targeting.11 Various
speeches by Governor Eddie George in recent years have
been at pains to stress that the Bank aims to stabilize the
business cycle (and thereby at least partially engender
exchange rate stability) within the target constraint.
Only three weeks after the decision to adopt inflation targeting, Chancellor Lamont coordinated with the
Bank of England an institutional implementation of the
policy. The Bank would produce its own inflation outlook
on a quarterly basis, beginning with February 1993; the
Bank’s medium-term forecast for inflation would be the
main yardstick of success or failure. As mentioned above,
the role of this forecast in accountability for policy becomes
quite complicated. One complication arises when interest

rate decisions are inconsistent with the implications of the
published forecasts, but a full explanation for the rationale
behind the decision is not made public. Nevertheless, the
rapidity with which the commitment to publish forecasts
was undertaken underlines just how central communication efforts are to the operation of the United Kingdom’s
inflation targets—and how the announcement of the targets was never thought to be enough on its own.
As part of its role in tracking progress toward the
inflation target, the Bank of England’s Inflation Report
details past performance of the U.K. economy, compares
actual inflation outcomes (both RPIX and its components)
with prior forecasts of the Bank, identifies factors presenting the most danger to price stability, and forecasts the
likelihood that inflation will in two years’ time be in the
target range. In the words of Governor Leigh-Pemberton
(1992), “Our aim will be to produce a wholly objective and
comprehensive analysis of inflationary trends and pressures,
which will put the Bank’s professional competence on the
line.” From the third issue (August 1993) onward, the
Inflation Report has consistently followed a six-part format
covering developments in inflation, money and interest
rates, demand and supply, the labor market, pricing behavior,
and prospects for inflation. In addition, the Inflation Report
does not supplant the ongoing publication of policy speeches
and relevant research in the Quarterly Bulletin, in which the
authors of the research articles are always identified.
The transparency of the Bank’s views and the
Chancellor’s reaction to them is meant to be the check on
the government’s monetary stance between elections. Following the third Inflation Report in August 1993, it was
decided that the Bank would only send the report to the
Treasury after it had been finalized. Thus, the Treasury
would have no chance to edit or even suggest changes. This
agreement on timing indicates the government’s conscious
acceptance of the Bank’s distinct voice.
The Inflation Report is best seen in the context of
the Bank’s traditional role as adviser to the Chancellor on
monetary policy. Even after the adoption of inflation targeting, the Bank’s contribution remains that of advice and
information, just as it had presumably been consulted on
Chancellor Lamont’s initial decision to implement inflation

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75

targeting and the choice of target range and midpoint.
What is innovative is the fact that the Bank would be
called upon to report to the public independently of its
regular consultations with the Treasury staff and with the
Chancellor directly. Often overlooked, however, is the fact
that the Treasury, which reports directly to the Chancellor,
was commissioned to produce its own monthly monetary
report from December 1992 onward. This publication,
which predates the Inflation Report and is issued more frequently, had a mandate to track the growth of broad (M4)
and narrow (M0) money in the monitoring ranges set by
the Chancellor and to keep readers apprised of moves in the
foreign exchange and asset markets, particularly U.K.
housing. In other words, the Chancellor committed U.K.
monetary policy to the monitoring of a particular set of
indicators compiled by his own staff, even if the Bank of
England chose to emphasize other variables or compute
numbers differently. The Bank, despite the Inflation Report,
has not been given a monopoly on monetary policy advice.
The emphasis on public explanations of policy,
and especially on delineating differences between the
Chancellor’s and the Bank’s points of view, was buttressed
by three additional institutional changes. First, in February
1993, the monthly meeting between the Chancellor and
the Governor to set monetary policy was formalized. Second, starting in November 1993, the timing of any interest
rate changes decided upon by the Chancellor at the
monthly meeting would be left to the Bank’s discretion as
long as the changes were implemented before the next
meeting. Combined with the Bank’s commitment to issue
a press release explaining the reason for any interest rate
change once made, this discretion gave the markets a great
deal of information about the Bank’s view of the Chancellor’s
decision. Third, and most significant, since April 1994,
the minutes of the monthly Chancellor-Governor meetings
have been publicly released two weeks after the next meeting
(replacing the prior lag of thirty years with one of six weeks).
In essence, the Bank has operated as the government’s institutional counterinflationary conscience. There
was an underlying tension in this role because the Bank
remained under the control of the Chancellor while the
instruments of monetary policy remained out of its control.

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The Bank’s use of public and formalized forums to communicate its forecasts, its analyses, and even its explicit monetary policy recommendations does increase the cost for the
government of going against the Bank’s assessment and
thus, presumably, of not serving price stability. Unfortunately, since the Chancellor did not have a requirement to
report his reasoning beyond what he chose to reveal at
these monthly meetings, disputes over preference or competence can become shrouded as competitions over forecast
accuracy (see next section).
The standing given the Bank by the monthly
minutes did not, however, provide monetary policy with
democratic accountability beyond that given already by
elections; it was the Bank, not the market or the people,
that was passing judgment, but any punishment or reward
for that judgment (beyond market reactions) had to wait
until the next election. Even under the new Monetary Policy Committee of the Bank, which sets U.K. monetary policy, ultimate responsibility for the goals and outcome of
policy rests with the parliamentary majority at the next
elections.12 Nor did these forums provide clarity about the
intent of ultimate policy, since, for all the Bank’s statements, the Chancellor could override them with only
limited public explanation.

BRITISH MONETARY POLICY
UNDER INFLATION TARGETING
This section summarizes briefly the macroeconomic outcomes and the interaction between the Treasury and the
Bank at critical junctures in the policy-setting process
since target adoption. The section draws on various issues
of the Bank’s quarterly Inflation Report and on the Minutes
of the Monthly Monetary Meetings between the Chancellor
and the Governor. To support this review of monetary policy,
Charts 1-4 (pp. 84-5) track the path of inflation, interest
rates, the nominal effective exchange rate (henceforth the
exchange rate), GDP growth, and unemployment in the
United Kingdom both before and after inflation targeting
was introduced.
The period from October 1992 until the end of
1993 was marked by the beginning recovery of the U.K.
economy. Sterling’s exit from the ERM coincided with the

end of recession. GDP growth turned positive in the first
quarter of 1993, and the unemployment rate peaked at
10.6 percent in December 1992 (Chart 4, p. 85). Throughout 1993, output growth was accelerating, and the unemployment rate declined. With some brief interruptions,
RPIX inflation continued its downward trend, reaching
the midpoint of the designated target range of 2.5 percent
for the first time in November 1993 (Chart 1, p. 84). The
exchange rate bottomed out in February 1993, then strengthened through the remainder of the year (Chart 3, p. 85).
Two major themes in the medium-term inflation
forecasts of the first two issues of the Inflation Report (February and May 1993) are the inflationary impulses from
sterling depreciation and the growing government budget
deficit. The official interest rate (the base rate) had been
reduced from 10 percent in August 1992 to 6 percent in
January 1993 (Chart 2, p. 84), reflecting the desire to
escape from German monetary tightness. Unsurprisingly,
between the United Kingdom’s exit from the ERM and
early February 1993, sterling had depreciated by 14.5 percent.13 In explaining why inflation expectations might
still be above the target range, the Bank mentioned fears of
eventual monetization of the unsustainable debt. The Bank
did not make any call for immediate fiscal action or
actively criticize the government’s stance. The Bank’s inflation projections in the first two reports continued to fall at
all horizons discussed.
In the May 1993 Inflation Report, the Bank stated
that it believed that the government would manage to hold
inflation below 4 percent for the following eighteen
months. This statement did not represent an endorsement
of the government’s monetary stance: not only had the
Chancellor committed to being within the inflation range
(that is, below 4 percent) in two years, but he had also
stated that he would have inflation in the lower half of that
range (below 2.5 percent) by 1997. It is interesting that
the Bank felt comfortable tracing the source of inflation
risk to the government’s decisions (suggesting that it was a
matter of the government’s choice), rather than to economic risks. The Bank expressed concern about the
exchange rate’s potential effects, noting that the 5 percent
appreciation of sterling (trade-weighted) since February

permitted only a small measure of optimism, but surveys
and financial market interest rates continued to indicate a
lack of medium-to-long-run credibility. The Bank also
emphasized that the principal uncertainty about the inflation forecast, most of it on the upside, had to do with
domestic wages and profits. The meaning of these concerns
became clear three weeks later when Governor George
gave a speech explicitly warning against a rate cut. The
Bank apparently feared that with the imminent change in
chancellors (from Norman Lamont to Kenneth Clarke)
and submission of the budget, a decision to ease would be
made in compensation for various fiscal measures. At the
time, rates were not cut.
Six months later, in the November Inflation Report,
the Bank touched on the same themes but even more
sharply. There was a slight probability now, according to
the Bank, that inflation would exceed the target in the near
term. Moreover, the Bank said it foresaw real potential for a
wage push if headline inflation were to be allowed to rise
up to the 4 percent target band. Again, the Bank was
responding to a political situation in which many Conservative Party backbenchers and commentators were expecting
an interest rate cut. The government had agreed to certain
spending cuts and an extension of the value-added tax
(VAT) to domestic fuel and power starting in April 1994,
while economic real-side news was generally not good.
This time Chancellor Clarke did lower rates 3/4 percent
without further fiscal tightening to compensate.
What made this conflict between Bank and Chancellor particularly interesting was that the Bank had
already offered an out for the Chancellor in the May and
November issues of the Inflation Report. The Bank attributed 0.4 percent of the projected rise in inflation in 1994
to the VAT change, which it was sympathetic to in general
terms as a deficit reduction, and reminded people that if
RPIY (which excludes the first-round effect of taxes) rather
than RPIX were considered, the inflation would be on target (albeit near the top of the range and with upside risks).
For whatever reason, the Chancellor did not take advantage
of the proffered defense.
Though unexercised, this sort of definitional tactic
raises a real dilemma for accountability. If indirect taxes are

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77

legitimately to be excluded, why did the Chancellor and
the Bank choose to target RPIX and not RPIY in the first
place? If the government had in fact switched to RPIY
after the Bank had “allowed” (that is, explained without
criticizing) the move, how could the markets and electorate
have been sure this was not just a onetime escape clause?
And if the wage spiral the Bank worried about sparking
tends to run on headline inflation, would this switch have
been beside the point, or would it have allowed a shift of
blame to the unions’ lack of sophistication? On the basis of
this case, it would appear that the people who set the definitions of the inflation measures should be kept separate
from the people who assess success in achieving them. The
United Kingdom’s framework might be compared with
New Zealand’s on this score: New Zealand’s central bank—
partly because of the country’s small size—retains some
amount of discretion over the short-run definition of the
target inflation series and, on a few occasions, has exercised it.
Around the beginning of 1994, against the background of the better than expected inflation performance,
the Chancellor eased monetary policy further. Inflationary
pressures remained subdued as the lagged effect on prices
of the earlier depreciation was offset by a reduction in unit
labor costs related to continued weak employment. It was
apparent at the time that pass-through of the onetime drop
in the exchange rate upon ERM exit had been effectively
averted—a major success for the new monetary regime. 14
This triumph was even more impressive than the Bank of
Canada’s successful avoidance of passing through a onetime
rise in taxes in 1991, given that it followed a presumptive
blow to U.K. credibility upon the country’s exit from the
ERM. The base rate, which had been reduced from 6 percent to 5.5 percent in November 1993, was cut to 5.25 percent
in February 1994. These rate reductions occurred despite
projections in every Inflation Report from August 1993 on
that inflation would rise until the end of 1995. Indeed,
actual inflation did not start to rise until the end of 1994.
When assessing its past predictions, the Bank
repeatedly mentioned slow earnings growth and a squeeze
in retail margins as reasons for the unexpectedly low
inflation outcome. Although cast as a difference over the
implications of incoming economic data, the divergence

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between the Bank’s opinion and the Chancellor’s policies
could, in our view, reflect differing assessments of the
importance of achieving the inflation target in the short
run. Indeed, as long as the elected official can appeal
to differences between his or her own private forecast and
the central bank’s published forecast, the official can hide
what is actually a weaker commitment to the stated
inflation goal. We find this pattern again in the next
situation we consider.
Throughout 1994, GDP grew vigorously, with
fourth-quarter GDP exceeding the previous year’s by 4 percent. For the first ten months, RPIX inflation was trending
downward, reaching a twenty-seven-year low of 2 percent
in September and October before it started to rise to 2.5 percent
in December. The unemployment rate fell further during
the year, to around 9 percent. Sterling (according to the
Bank’s index) had peaked at the end of 1993 and trended
slightly downward during the year.
During the summer of 1994, it became clear to
the Bank that the economy was rebounding more strongly
than expected, and the Inflation Report began to cite evidence of inflationary pressures (for example, growth in
wholesale prices). Despite the still-improving inflation
performance—both RPIY and RPIX inflation at the time
were below 2.5 percent and falling—the Chancellor, on the
advice of the Governor, raised the base rate on September 12,
and again on December 7, by 0.5 percent each time.
Unlike the previous tightening in 1988, these base rate
increases were preemptive—a fact that was widely noted in
the press. 15 The ability to tie current policies to a future
priority, and to justify those policies as acting with a lag,
appears to be one advantage of having a specified mediumterm goal consistent across targeting regimes.
The discussions between Chancellor Clarke and
Governor George during the time leading up to the September 1994 tightening offer some insight into the role
that the Bank’s medium-term inflation forecasts play in the
policy-setting process. During their meeting on July 28,
the Governor pointed out that, on the basis of the Bank’s
latest forecast,
he did see a risk to the inflation objective in 1996,

implying a need to tighten policy in some degree
before very long. . . . He was not, on the current
best guess, forecasting a strong upturn in inflation,
and there was, as always, a significant margin of
error around that best guess. But the best guess for
mid-1996 was already slightly above the mid-point
of the target range, and there was an uncomfortable
sense that the upside risks to the medium-term
forecast might, this time, be somewhat greater than
the downside risks.16
The Chancellor, however, remarked that “there
was a danger of trying to set a game plan too far in advance
and not looking at the actual evidence as it unfolded. . . .
The forecasts suggested inflation might be even lower in
the next few months.”17 Although agreement was
reached not to raise interest rates at that time, this decision made ambiguous the extent to which monetary policy
decisions were indeed based on the Bank’s medium-term
forecast. While the existence of target commitments, and
the Bank’s open statements of opinion, moved the U.K.
government toward a more forward-looking monetary
policy, the government could not be forced into the policy
that the Bank considered optimal. Again, the government’s private forecast—even if driven as a politically
motivated markdown from the Bank’s formal analysis—
became the actual target. Moreover, because both the
estimate itself and the reasoning behind it were not
shared with the public, the government forecast could not
fully serve as a transparent target. 18
During 1995, GDP growth decelerated, from
4 percent between the fourth quarter of 1993 and the
fourth quarter of 1994, to 2 percent by the last quarter of
1995. The unemployment rate continued its gradual
downward trend, reaching 8 percent at year’s end. RPIX
inflation rose to 2.8 percent in January, and for the rest of
the year fluctuated between 2.6 percent and 3.1 percent
without exhibiting any trend. Early in 1995 it became
apparent that output growth, although slightly slower
than in early 1994, was still running high relative to
potential, and that observation contributed to the Bank
and the Chancellor’s belief in a worsening inflation outlook. Consequently, on February 2, the base rate was
raised 0.5 percent, to 6.75 percent. Despite this preemp-

tive interest rate increase, the exchange rate fell steeply
over the three months following the February increase. By
May 4, the Bank of England’s sterling index was down
4.7 percent from February 2. The depreciation was seen
to aggravate the discrepancy between the recovery in the
tradables sector and that in the nontradables sector, a discrepancy that became increasingly evident at this time.
This “dual economy” was highlighted by the contrast
between 10 percent growth in export volumes during 1994
and flat retail sales and falling earnings growth in services
during early 1995.
As a consequence of the depreciation and the
resulting increase in import prices, the Bank’s RPIX inflation projection in May 1995 was revised upward nearly
1 percent throughout 1996 from the February forecast,
with RPIX inflation reaching almost 4 percent in the first
half of 1996 before falling to around 2.5 percent in early
1997. 19 The potential consequences of the exchange rate
development for the inflation outlook completely dominated the discussion during the monthly meetings on
April 5 and May 5. At least indirectly, this discussion
informed the public that the pass-through to inflation
from exchange rate movements was faster than that from
either output or interest rates.
It was against the background of this upward
revision of the Bank’s inflation forecast and the dual
economy mentioned above that in their meeting on May 5,
1995, the Chancellor overruled the Governor’s advice to
raise interest rates. This refusal of Chancellor Clarke to
raise rates provides an even starker example of the conflict
(and the difficulties in assigning accountability) arising
from the Bank of England’s dependent status than the
November 1993 episode discussed earlier. At the end of
that day’s monthly meeting with Governor George,
Chancellor Clarke immediately summoned the press and
announced that he was leaving rates unchanged; since, contrary to custom, the Governor was not present to echo the
Chancellor’s post-meeting statement, and Clarke gave
some details of the discussion (including some of George’s
reasons for concluding that inflation was a real threat)
rather than waiting for release of the minutes six weeks
later, it was clear that Clarke was overruling the Bank. 20

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Clarke cited his personal skepticism about the incoming
and forecasted U.K. growth numbers but seemed to be as
intent on making the conflict apparent as on explaining it
(Chote, Coggan, and Peston 1995).
Perhaps this candor from Chancellor Clarke was a
response to the new strength granted the Bank through the
inflation-target-reporting framework: facing this reality,
Clarke may have felt that the best defense was a good
offense. The conflict would have been confirmed with the
release of the Bank’s May Inflation Report a week later. The
Bank’s central estimate was for 3 percent inflation in two
years’ time, indicating that, contrary to the government’s
pledge, inflation would be in the upper half of the target
range at the end of the sitting Parliament. Furthermore,
the Bank added that the risks to its forecast were almost
uniformly on the upside and that these risks were “large.”
The Bank explicitly noted that sterling was depreciating as
it had in the fall of 1992, but that, unlike then, wage and
capacity pressures were high.
Upon taking office, Chancellor Clarke had made a
commitment to Governor George that he would not censor
the Inflation Report at any time, but in return he reserved
the right to say he disagreed. What seems to have emerged
as accountability for policy decisions in this framework is a
system in which the Chancellor has to make explicit his or
her independence from the Bank of England’s position
when a disagreement exists, and to make some modest
effort to justify the rejection of the Bank’s inflation forecast. As suggested above, however, while this system may
have a salutary effect on the overall counterinflationary
stance of policy, it may undermine public trust in the competency and objectivity of forecasting and of policymaking,
and may even obscure what the actual forecast is.
Over the following months, it became apparent
that the Chancellor had guessed right as a forecaster. GDP
first-quarter growth was revised downward, new numbers
on housing and manufacturing came in below expectations,
and the global bond market rally (surrounding the
expected drop in U.S. interest rates) supported the pound.
In a September 1995 account of the Chancellor-Governor
discussions since May, Governor George reiterated that “we
still think that the chances are against achieving the infla-

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tion target over the next 18 months or so without some
further [base rate] rise,” but he conceded that “we are not
in fact pressing for one—and have not been doing so since
before the summer break” (George 1995a).
So should the Bank be taken to task for being less
accurate in forecasting than the Chancellor ex post in this
one instance? Since the Chancellor’s private forecast of May
1995 remained private in number and reasoning, at least in
comparison with the Inflation Report, it again proved
impossible to determine whether Clarke disagreed with the
Bank because he was skeptical of the growth forecasts, or
simply because he was willing to take a risk of greater
inflation to achieve higher growth. Would a point-bypoint rebuttal of the Inflation Report, however, have been
worth the additional information given the damage it
might have done to perceptions of the Bank’s forecasting
role? A record of forecast performance clearly matters for
accountability; equally clearly, however, reducing the
monetary policy debate to a Chancellor-Bank forecasting
competition is undesirable. This tension appears to be
inevitable as long as the transparent (and intended-to-bepersuasive) forecast and the interest rate decisions come
from different sources.
The minutes of the meetings do not provide any
clear answers to these questions but accentuate the issues.
Specifically, the minutes give the impression that the
subject of discussion between the Governor and the
Chancellor is never the stated reasoning behind the
Bank’s medium-term forecast itself, but rather whether
the most recent data that feed into the forecast represent
an underlying trend or are distorted by some contemporaneous event. The minutes of the discussion during the
June 7, 1995, meeting state that “while one strength of
the policy process was that all the new evidence was
examined each month for its implications for inflation, it
was important not to read too much into one month’s
data which could prove to be erratic.” 21 This sort of discussion might be construed as undermining the importance
of the Bank’s medium-term forecast.
On June 14, 1995, in his Mansion House Speech
to the City, Chancellor Clarke (1995) extended the
announced inflation target beyond the latest possible date

of the next general election. The Chancellor did admit,
however, that inflation could well temporarily rise above
4 percent, the top of the target range, in the following two
years; he also left some confusion about whether meeting
the target entailed being below the 4 percent ceiling or
below the 2.5 percent target set by him and his predecessor
for the end of this Parliament. Governor George (1995b),
in his speech to the same audience, referred only to the
2.5 percent target, calling it achievable. Inflation expectations at a ten-year horizon, as derived from government
bond yields, then rose upon these remarks, from 4.36 percent in early May to 4.94 percent in late July, a move that
only in late 1996 began to be reversed.
The Bank’s inflation outlook during the second
half of 1995 was shaped by weighing the upside risks to
inflation resulting from the lagged effects of the earlier
sterling depreciation against the downside risks from
increasing signs of slowing output growth and a buildup in
inventories, particularly during the second quarter of
1995. Domestically generated inflation pressures remained
weak, with tradables inflation continuing to outpace that
of nontradables. In addition, the Bank noted in its November Inflation Report that during the current cycle, real wages
had been much more subdued than expected. Still, RPIX
inflation, at 3.1 percent in the year to September, was forecast to peak at about 3.5 percent during the first half of
1996. Substantial downward revisions of GDP figures for
the first three quarters of 1995 and an unexpectedly low
RPIX inflation rate of 2.9 percent in the year to November
set the stage on December 13 for the first of four successive
quarter-point cuts in the base rate.
The hoped-for “soft landing” of the U.K. economy
materialized in 1996. GDP growth picked up toward the
end of 1996; in the third quarter, GDP was up 2.4 percent
over its level for the third quarter of 1995. The unemployment rate continued its gradual decline, dropping to
6.7 percent by December 1996. From October 1995 to
September 1996, RPIX inflation fluctuated only between
2.8 percent and 3 percent, then rose to 3.3 percent in
October and November. From January to the end of September, sterling strengthened gradually from 83.4 to 86.1
according to the Bank’s exchange rate index, then finished

the year in a rally at 96.1, an appreciation of 11.6 percent
over three months.
Receding cost pressures and weak manufacturing
output data, as well as a GDP figure of 0.5 percent, for the
last quarter of 1995 prompted the next two quarter-point
base rate cuts on January 18 and March 8. At their March 8
meeting, the Chancellor and the Governor agreed that
demand and output were likely to pick up later in the year
and through 1997, and that there was a possibility that the
latest rate cut would have to be reversed at some point.
Again, given the credibility of the Bank of England’s role
as the Chancellor’s counterinflationary conscience, the
Bank granted the Chancellor a de facto escape clause—or at
least justification of future reversals as necessary and not
reflective of a shift in preferences—when the Bank supported the Chancellor’s interpretation of the economy. In
May 1995, a similar defense had been offered, but not used;
this time the option was exercised by mutual agreement.
The Bank’s assessment did not change during the
spring, and its medium-term projection published in the
May Inflation Report was essentially unchanged from the
previous one. The central projection of RPIX inflation in
two years remained at 2.5 percent, with the risks biased
downward over the short term but upward over the
medium term because of uncertainties concerning the
strength of the expected pickup in activity. Following the
June 5 meeting, the Chancellor announced another
quarter-point cut in the base rate despite the opposition of
the Governor, arguing that the cut “was sufficiently small
not to cause any significant inflationary risk, while reducing the downside risks to the recovery. If consumer demand
started growing too strongly, and put the inflation target at
risk, the rates could be raised when this became evident.” 22
In this instance as in those discussed earlier, there appears
to be some tension between the Bank’s forward-looking
approach based on its projections and the Chancellor’s tendency to emphasize the current economic situation and the
latest data. With the election approaching (and the time
dwindling for monetary policy to take effect before the
election), the elected Chancellor may have been willing to
take greater inflation risks on behalf of economic growth
than before.

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The August Inflation Report was unusually frank
about the consequences of the June base rate cut the Bank
had opposed. Citing as evidence “lower interest rates since
May, the new Treasury forecasts for taxes and public spending, and the slightly better-than-expected gross export
performance in the first half of the year” (p. 45), the Bank
projected that inflation would rise above 2.5 percent. Consistent with this assessment, from their August meeting
on, the Governor was pressing for a rate increase, but it was
only on October 30, 1996, that the Chancellor agreed to
raise the base rate by a quarter point, to 6 percent. Some in
the financial press speculated that the decision to raise the
base rate then might be intended to avert further rate
increases as the general elections, which had to be held by
May 1997 at the latest, approached.23
This ongoing split between the agency that makes
the inflation forecast and the agency that makes the policy
decisions, and the bias it imparts to inflation expectations,
could be characterized as the basic limitation of the largely
successful inflation-targeting regime in the United Kingdom.
The problem may have contributed to the decision on
May 6, 1997, by the new Labour Government to grant
operational independence to the Bank of England. The new
Chancellor of the Exchequer, Gordon Brown, called a news
conference moving up his scheduled monthly meeting
with the Governor of the Bank of England; it was expected
that he would announce an interest rate hike—long sought
by the Bank—to deal with mounting inflation pressures
(RPIX inflation was forecast to be 2.9 percent by the end
of 1997). Chancellor Brown did announce a quarter-point
hike in the base rate, the main monetary policy instrument, but then also made the surprise announcement that
control of the base rate in pursuit of the inflation targets (as
well as short-term exchange rate intervention) would now
be given to the Bank of England.
One important factor in the decision to grant the
Bank of England operational independence was its successful performance over time as measured against an
announced clear baseline. Another factor cited by Chancellor
Brown in granting independence was the increased
accountability achieved through the emphasis on transparency in the inflation-targeting framework—a change that

82

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

made monetary policy from an independent central bank
more responsive to political oversight. When monetary
policy goals and performance in meeting them are publicly
stated, as they are in the U.K.’s inflation-targeting regime,
the policies pursued cannot diverge from the interests of
society at large for extended periods of time, yet can be
insulated from short-run political considerations.
Decision-making power was vested in a newly
created Monetary Policy Committee, and beginning in
June, meetings of that Committee replaced the ChancellorGovernor meetings. The Committee consisted of nine
members: the Governor and two Deputy Governors (one
for monetary policy, one for financial matters), two other
Bank Executive Directors, and four members appointed by
the government (all well-known academic or financial
economists). Members serve (eventually staggered) threeyear renewable terms.
The elected government retained a “national interest” control over monetary policy, in essence an escape
clause allowing it to overrule the Bank’s interest rate decisions or pursuit of the inflation target when it deemed such
action necessary. The government did not specify ahead of
time any formal process for implementing the escape clause
or any set of conditions under which the clause would hold.
On June 12, just prior to the first meeting of the
Monetary Policy Committee, Chancellor Brown told the
Committee to pursue a target of 2.5 percent for underlying
inflation. The range was officially replaced with a 1 percent
“threshold” on either side of the target. “Their function is
to define the points at which I shall expect an explanatory
letter from you [the Committee],” stated Brown. The open
letter would require the Bank’s explanation of why inflation has moved so far from the target, what policy actions
will be taken to deal with it, when inflation is expected
to be back on target, and how this meets its monetary
policy objectives. The Chancellor retains the ability to tell
the Bank how quickly he wishes the miss to be rectified
(see Chote [1997]).
It is important to point out that the mandated
response to a target miss in this framework is to provide
more public explanation. The government is not precommitted to punishing the Bank for misses, say by dismiss-

ing the Governor, nor to a specified course of action. Thus,
the government’s control over the Bank of England is more
like that exerted by the Canadian Parliament over the Bank
of Canada than that imposed by the New Zealand government on its central bank through a very explicit and
rule-like escape clause. As in all the cases we consider
except the Bundesbank, however, the level and time horizon of the inflation target remained under the Cabinet’s
control—the Bank was not granted goal independence.24
As we noted at the start of this section, we would
expect this change in framework to increase transparency
of monetary policy by tying decisions to the published
Inflation Report forecasts (and reasoning), thereby increasing accountability and decreasing interest rate uncertainty.
In addition, such a move may be expected to increase the
credibility of the United Kingdom’s commitment to its
inflation targets, because deviations from target now
require the government to overrule the Bank publicly or to
reset the target. Under the old regime, the government
could potentially attribute deviations from the announced
target to disagreements over short-run forecasts.

KEY LESSONS FROM THE
UNITED KINGDOM’S EXPERIENCE
The United Kingdom’s experience has particularly interesting lessons for inflation targeting. Until May 1997,

inflation targeting was conducted under severe political
constraints—that is, under a system in which the government, not the central bank, set the monetary policy instruments. As a result, it was not at all clear what motivated
decisions to move (or keep steady) interest rates: was it
differences in forecasts between the Chancellor and the
Governor or differences in commitment to the announced
inflation goals? Also unclear was the party accountable for
achieving the inflation targets: was it the agency that made
public forecasts (the Bank of England) or the agency that
set the monetary policy instruments (the Chancellor of the
Exchequer)? In addition, as we noted above, this lack of
clarity led to much confusion about the degree of commitment to inflation targets and gave a strong impression that
short-run political considerations were influencing monetary policy.
Despite this handicap, however, British inflation
targeting has helped produce lower and more stable inflation rates. The success of inflation targeting in the United
Kingdom can be attributed to the Bank of England’s focus
on transparency and the effective explanation of monetary
policy strategy. Perhaps because for many years its position
was weaker than that of the other central banks discussed
here, the Bank of England led the way in producing innovative ways of communicating with the public, especially
through its Inflation Report. Indeed, the Bank of England’s
achievements in communication have been emulated by
many other central banks pursuing inflation targeting.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

83

ECONOMIC TIME LINE: UNITED KINGDOM
Chart 1

RPIX Inflation and Targets
Percent
14
Start of inflation
targeting
(October 1992)

12
10
8
6
4
2
0
-2
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Sources: Bank of England; Bank for International Settlements.
Note: The chart shows the shift from an inflation target range of 1 to 4 percent, in effect from October 1992 to June 1995, to a point target of 2.5 percent (the midpoint
of the range, marked by a dashed line).

Chart 2

Overnight and Long-Term Interest Rates
Percent
20
Start of inflation
targeting
(October 1992)
15

10
Long-term rate
Overnight rate
5

0
1980

81

82

83

84

85

86

87

Source: Bank for International Settlements.

84

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

88

89

90

91

92

93

94

95

96

97

ECONOMIC TIME LINE: UNITED KINGDOM (CONTINUED)
Chart 3

Nominal Effective Exchange Rate
Index: 1990 = 100
140
Start of inflation
targeting
(October 1992)

130

120

110

100

90

80
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

95

96

97

Source: Bank for International Settlements.

Chart 4

GDP Growth and Unemployment
Percent
15

Start of inflation
targeting
(October 1992)
Unemployment

10

5

GDP growth
0

-5
1980

81

82

83

84

85

86

87

88

89

90

91

92

93

94

Source: Organization for Economic Cooperation and Development, Main Economic Indicators.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

85

Part VII. How Successful Has Inflation
Targeting Been?

A

n initial look suggests that inflation targeting
has been a success: inflation was within or below
the target range for all targeting countries, and

noticeably below the countries’ average inflation levels of
the 1970s and 1980s. The macroeconomic baselines
shown in the chart series in Parts III-VI of this study indicate
that the reduced inflation levels in these countries were
sustained without benefit or harm from unusual macroeconomic conditions.
In New Zealand, the disinflation during the four
years prior to target adoption was accompanied by a period of
sluggish GDP growth and, since 1988, rising unemployment.
The continuation of the disinflation during 1990-91, amid
recession in many other Organization for Economic
Cooperation and Development (OECD) economies, led to
recession and sharply rising unemployment. In Canada, the
disinflation was achieved along with continued progress in
lowering unemployment, only a brief spike in nominal
interest rates, and continued positive, though slowing,
growth. Similarly, in the United Kingdom, the disinflation begun two years prior to target adoption (during
membership in the Exchange Rate Mechanism) continued
against a background of improving growth, falling
unemployment, and much lower nominal interest rates
in the wake of the United Kingdom’s exit from the
European Monetary System.
Yet, while the reduction of inflation in these three
countries represents a genuine achievement, it is not clear
whether the reduction was the result of forces that had
already been put in place before inflation targeting was
adopted. Did the adoption of an inflation target in the
countries considered here have an effect on inflation and on

its interaction with real economic variables? In this section,
we provide some tentative evidence on this question by
undertaking a very simple forecasting exercise. (Additional
evidence from a wider range of statistical investigations on
a larger set of countries is found in Laubach and Posen
[1997b].) We estimate a three-variable unrestricted vector
autoregression (VAR) model of core inflation, GDP
growth, and the central bank’s overnight instrument interest
rate from the second quarter of 1971 to the date of target
adoption; we then allow the system to run forward five
years from the time of target adoption, plugging in the
model’s forecast values as lagged values.1
This exercise is meant to give a quantitative
impression of whether the interaction between inflation
and short-term interest rates exhibits a pattern of behavior
after the adoption of the inflation target that differs
markedly from the pattern before.2 The unconditional forecast of each variable represents the way we would expect the
system to behave in the absence of shocks from the situation
at the time of target adoption. The comparison between
what actually happened to these variables and their
unconditional forecast is reasonable for the early 1990s,
given the absence of major supply and demand shocks since
adoption for the three inflation targeters we examine.3
In the three countries adopting inflation targets,
disinflation through tighter monetary policy had largely
been completed by the time the target was adopted,
allowing interest rates to come down. (The year or so of
further disinflation appears to be attributable to prior
monetary policy moves, given policy lags.) This sequence
of events is consistent with our finding in the case studies
that countries adopted targets when they wished to lock

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

87

in inflation expectations at a low level after a disinflation.
The key question is whether upward blips in inflation
do or do not lead to persistent rises—holding output
and inflation constant—as they would have in a system
estimated under the prior regime.
Charts 1-4 (pp. 89-92) plot the results of these
simulations against the actual path of the variables over
the period for each of the three inflation-targeting countries plus Germany. As might be expected, the simulations over time flatten out toward their sample means or a
slight trend (given the absence of shocks imposed by the
unconditionality of the simulation). For all three inflation
targeters, the actual inflation rate comes in consistently
below what would have been expected and exhibits
something of a downward trend as opposed to the simulation’s slight upward tendency. Complementarily, for
all three targeters, the actual interest rate used as the
monetary policy instrument remains well below the
simulation’s forecast throughout the period. Output
appears to be largely undisturbed by the adoption of targeting, averaging around the projected path in all three countries. In general, inflation and nominal short-term interest
rates seem to have declined since target adoption without any
major effect on output.
These results can be interpreted as consistent with
a greater direct response of inflation to monetary policy
with fewer output effects along the way, given the movement
of interest rates at or below those forecast on average in the
three targeters. Alternatively, these results can be an indication that in the targeting countries, disinflation through
tighter monetary policy had begun and been largely completed by the time that targeting began, but that inflation
did not bounce back up afterward as expected. 4

By contrast, the simulations for Germany clearly
reflect the effects of monetary unification, with both
inflation and the monetary policy instrument exceeding
their projections and returning to them only in early
1994. GDP growth initially exceeded the projection as a
result of the expansion in aggregate demand, until in
1992 and 1993 the effects of the increasingly restrictive
monetary policy—as seen in interest rates well above
those forecast into the second half of 1994—forced output growth below its projected trend. We interpret the
return over time of inflation and the monetary policy
instrument to their projected levels after a surprise
demand shock of great magnitude as a characteristic of a
successful targeting regime.
Our assessment of the effectiveness of inflation
targeting in New Zealand, Canada, and the United Kingdom
is on the whole positive. In all three countries, the adoption
of targets was followed by the movement of inflation into,
and the maintenance of inflation within, the announced
target range. In the time since the adoption of inflation
targets, our unconditional forecasts indicate that inflation
and nominal interest rates have remained low in all
three countries relative to the amount of output growth
seen (which itself approximates the level forecast). This set
of results is consistent with the interpretation that inflation does not appear to rise with business cycle expansions
as it had in the past. Laubach and Posen (1997b) provide
further support for this interpretation, presenting evidence
from private sector forecasts and interest rate differentials
that medium- and long-run inflation expectations in New
Zealand, Canada, and the United Kingdom lie within these
countries’ target ranges.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

88

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

Chart 1

Dynamic Simulations: Germany
Percent
8
Actual

Panel A: Inflation
6

4

2
Simulated
0
German monetary
unification
(July 1990)

-2

-4
10

Panel B: GDP Growth
8
Actual
6
Simulated

4
2
0
-2

German monetary
unification
(July 1990)

-4
-6
10

Panel C: Nominal Interest Rate

Actual

German monetary
unification
(July 1990)

9
8
7
6

Simulated
5
4
3
1986

87

88

89

90

91

92

93

94

95

96

Sources: Authors’ calculations; Bank for International Settlements; Organization for Economic Cooperation and Development, Main Economic Indicators.
Notes: The chart depicts the results of a dynamic simulation of inflation, GDP growth, and the nominal interest rate based on an unrestricted vector autoregression
(VAR) of quarterly observations of these three variables from the second quarter of 1971 up to the time of German monetary unification. The solid line represents the
actual values of the variables, and the dashed line represents the unconstrained forecast of the variables made from unification forward using the VAR coefficients. The
forecasts show the path the variables would have taken in the absence of German monetary unification and other unforeseen shocks. In Panel C, the nominal interest rate
used is the central bank’s instrument interest rate.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

89

Chart 2

Dynamic Simulations: New Zealand
Percent
14

Panel A: Inflation

12
Start of inflation
targeting
(March 1990)

10

Simulated

8
6
4
Actual
2
0
-2
-4
20

Panel B: GDP Growth

Start of inflation
targeting
(March 1990)

15
10

Simulated
5
0
-5

Actual

-10
-15
35

Panel C: Nominal Interest Rate
30
Start of inflation
targeting
(March 1990)

25

20
Simulated
15
Actual
10
5
1986

87

88

89

90

91

92

93

94

95

Sources: Authors’ calculations; Reserve Bank of New Zealand; International Monetary Fund, International Financial Statistics.
Notes: The chart depicts the results of a dynamic simulation of inflation, GDP growth, and the nominal interest rate based on an unrestricted vector autoregression
(VAR) of quarterly observations of these three variables from the second quarter of 1971 up to the time of inflation target adoption. The solid line represents the
actual values of the variables, and the dashed line represents the unconstrained forecast of the variables made from adoption forward using the VAR coefficients. The
forecasts show the path the variables would have taken in the absence of inflation targeting and other unforeseen shocks. In Panel C, the nominal interest rate used is
the New Zealand ninety-day bank bill rate.

90

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

Chart 3

Dynamic Simulations: Canada
Percent
8

Panel A: Inflation
6
Simulated
4
2
0
Actual

Start of inflation
targeting
(February 1991)

-2
-4
-6
10

Panel B: GDP Growth

Start of inflation
targeting
(February 1991)

8
6

Simulated
4
2
Actual
0
-2
-4
-6
14

Panel C: Nominal Interest Rate
12
Simulated
10

8
Actual
Start of inflation
targeting
(February 1991)

6

4
2
1986

87

88

89

90

91

92

93

94

95

96

Sources: Authors’ calculations; Bank for International Settlements; Organization for Economic Cooperation and Development, Main Economic Indicators.
Notes: The chart depicts the results of a dynamic simulation of inflation, GDP growth, and the nominal interest rate based on an unrestricted vector autoregression
(VAR) of quarterly observations of these three variables from the second quarter of 1971 up to the time of inflation target adoption. The solid line represents the
actual values of the variables, and the dashed line represents the unconstrained forecast of the variables made from adoption forward using the VAR coefficients. The
forecasts show the path the variables would have taken in the absence of inflation targeting and other unforeseen shocks. In Panel C, the nominal interest rate used is
the central bank’s instrument interest rate.

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

91

Chart 4

Dynamic Simulations: United Kingdom
Percent
14

Panel A: Inflation

Start of inflation
targeting
(October 1992)

12
10
8

Simulated

6

Actual

4
2
0
-2
10

Panel B: GDP Growth

Start of inflation
targeting
(October 1992)

8
6

Simulated
4
2
Actual
0
-2
-4
16

Panel C: Nominal Interest Rate

Start of inflation
targeting
(October 1992)

14

12
Simulated
10

8
Actual
6
4
1986

87

88

89

90

91

92

93

94

95

96

97

Sources: Authors’ calculations; Bank for International Settlements; Organization for Economic Cooperation and Development, Main Economic Indicators.
Notes: The chart depicts the results of a dynamic simulation of inflation, GDP growth, and the nominal interest rate based on an unrestricted vector autoregression
(VAR) of quarterly observations of these three variables from the second quarter of 1971 up to the time of inflation target adoption. The solid line represents the
actual values of the variables, and the dashed line represents the unconstrained forecast of the variables made from adoption forward using the VAR coefficients. The
forecasts show the path the variables would have taken in the absence of inflation targeting and other unforeseen shocks. In Panel C, the nominal interest rate used is
the central bank’s instrument interest rate.

92

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

Part VIII. Conclusions: What Have We Learned?

O

ur case studies indicate that both the adoption of
inflation targets and the design choices for that
framework have made a difference in the opera-

tion of monetary policy. The design choices of the targeting countries have tended to converge over time with
regard to the operational design questions posed in Part II,
suggesting that a consensus is emerging on best practice in
the operation of an inflation-targeting regime. Where the
design choices have differed, however, the experiences in
the countries examined provide some insight about what
has resulted from the different choices. In general, the public
announcement of numerical targets for inflation has been
very effective in balancing the needs for transparency and
flexibility in monetary policy.
The areas of operational design that show a
convergence of practice include the use of inflation as
the target variable. Despite all the rhetoric associated with
the pursuit of price stability, all the targeting countries
examined here have chosen an inflation target—ranging
from 0 to 4 percent annual inflation—rather than a pricelevel target. This choice reflects concerns that a price-level
target may require deflation when prices overshoot the target,
an outcome that could entail far higher costs in output
losses than are acceptable. Reversals of past target misses,
which would be required by a price-level target, do not
appear to be necessary for the maintenance of low inflation.
Relatedly, targeting countries that have chosen target values
for inflation greater than zero make the possibility of
deflations less likely. It is important to emphasize that
maintaining an inflation target at a level even somewhat
greater than zero for an extended period, as the Bundesbank has done, does not appear to lead to instability in

inflation expectations or diminished central bank credibility.
Even with a positive inflation target, admission of
occasional errors does not appear to be damaging.
These design choices are also consistent with
building a high degree of flexibility into the inflationtargeting regimes in all the countries studied here, in
which central bankers do demonstrate concern about real
output growth and fluctuations. This is seen particularly in
the gradualism all targeting countries have exercised when
disinflating, as well as in the treatment by some countries
of the inflation target’s (implicit or explicit) floor on price
movements as a stabilizing factor. While the targeting
countries differ in the degree to which they emphasize
particular indicators of inflation in their decision making,
all rely on an inclusive information framework untied to
specific intermediate target variables. All of these design
choices support the contention in Bernanke and Mishkin
(1997) that inflation targeting should be seen as a framework rather than a rule.
In addition, all of the targeting countries allow for
deviations from their targets in response to supply shocks.
Usually, the central bank will take action at its own discretion,
when such a response is not already built into the target
definition, and then explain its actions. Only in New
Zealand has an explicit escape clause been invoked to justify
such actions, although the Reserve Bank of New Zealand
has also engaged in the more discretionary forms of
response. Actual inflation targets have been moved over
time by all targeting countries, whether up—as in the case
of Germany after the 1979 oil shock or New Zealand after
the 1996 election—or down—as in all countries considered
as disinflations proceeded. As long as target movements are

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

93

announced sufficiently far in advance, there is no sense that
the target is being moved to meet the short-run outcome;
target movements are perceived as adaptations to economic
conditions. The key to the exercise of discretion in a disciplined
manner has been the central banks’ ability to convey to the
public the distinction between movements in trend
inflation and onetime events.
The second main area in which targeting regimes
have converged relates to their stress on transparency and
communication. The central banks in targeting countries
communicate by responding to elected officials’ mandated
as well as informal inquiries. Even more important, the
central banks keep the public informed about their policies
and performance by making frequent speeches on the strategy of monetary policy, as in the Bank of Canada Governing Council’s concerted public outreach campaign, and by
periodically issuing lay-oriented publications, such as the
Bank of England’s Inflation Report. Both of these efforts are
designed to explain clearly to the public the goals of monetary policy, the long-run implications of current policy, and
the strategies for achieving inflation targets. Even the fully
independent Bundesbank, which enjoys strong public support, has always made great efforts along these lines.
Indeed, the intensive efforts by the central banks we
study here to improve communication have been crucial to the
success of the targeting regimes. Increased transparency and
communication make explicit the central bank’s policy
intentions in a way that improves private sector planning,
enhances the possibility of sensible public debate about what a
central bank can and cannot achieve, and clarifies the responsibility of both the central bank and the politicians for the
performance of monetary policy with respect to inflation goals.
Another feature of all the targeting regimes
discussed here is the increased accountability of the central
bank. This feature is most evident in the case of New
Zealand, where the Reserve Bank is accountable not only to
the general public, but also (and even more directly) to the
elected government, which can insist on the dismissal of
the Governor if the inflation targets are breached. In the
other targeting countries, the accountability of the central
bank to the government is less formalized, but because of
the increased transparency of the targeting regime, the central

94

FRBNY ECONOMIC POLICY REVIEW / AUGUST 1997

bank is still highly accountable to the general public and
the political process.
As seen in the cases of Canada and the United
Kingdom, as well as in the Bundesbank’s long experience,
even where a rigid format of performance evaluation and
punishment is not present, successful performance over
time against an announced clear baseline can build public
support for a central bank’s independence and its policies.
Inflation targeting may thus be seen as consistent with an
appropriate role for a central bank in a democratic society:
though inflation performance may improve by insulating
a central bank from short-term political pressures on
interest rate decisions, a central bank can only sustain
such performance by remaining highly accountable to the
political process over the medium term for achieving
appropriate, stated goals. When monetary policy goals
and performance in meeting them are publicly stated,
they cannot diverge from the interests of society at large
for extended periods of time.
Another design choice common to the inflationtargeting countries is the decision to formally adopt the
new regime only after achieving some success in lowering
inflation from high levels. This reflects a tactical decision
that it is important to have a high likelihood of success in
meeting the initial inflation targets in order to gain credibility
for the inflation-targeting regime. It also reflects the reality
that credibility gains in the form of changes in the outputinflation trade-off or other economic structures will not
occur immediately. Inflation targeting has been successfully
used to lock in the benefits of previous disinflations in the
face of imminent onetime shocks, as we saw in the United
Kingdom’s exit from the European Exchange Rate
Mechanism and Canada’s 1991 fiscal developments.
Although there are many similarities among the
design choices of the targeting countries studied here,
there are also some important differences. For example, the
targeting countries differ on the precise measure of inflation that
should be used for the target. Some countries use the headline consumer price index (CPI) as the price index in the
inflation target because it is readily understood by the public, while others exclude items from the CPI index to allow
for monetary policy accommodation of first-round effects of

temporary supply shocks. In the cases of Germany, Canada,
and the United Kingdom, the emphasis has been on simple
target definitions, accompanied by potentially complicated explanations of deviations from target, while in
New Zealand the reverse course has been pursued
(although the long-run goal remains underlying inflation).
The primary danger for any target series, however defined,
is to sacrifice transparency for policy flexibility. So long as a
target series is neither adjusted too frequently nor set too
far from headline inflation, so that the definition remains
clear in the mind of the public, the exact choice of series is
not that critical.
Indeed, this balancing of transparency and flexibility
relates to the manner of producing the measured inflation
series as well as to the definition per se. To permit flexibility in its inflation-targeting regime, New Zealand has
allowed the agency that is accountable for meeting the targets
(the Reserve Bank) to measure and make adjustments to
the target variable as well. In contrast, the other countries
studied separate the agency responsible for meeting the
targets from the agency that measures the target variable.
Although allowing the central bank to measure and adjust
the target variable has distinct advantages in terms of
increased flexibility, it has the undesirable effect of decreasing transparency, which can weaken the effectiveness of the
inflation-targeting regime.
Another major difference in the design of inflation-targeting regimes is that some countries have a target
range for inflation while others, such as the United Kingdom,
now have a point target. The apparent advantage of a range
is that it gives the targeting regime more explicit flexibility
and conveys to the public the message that control of
inflation is imperfect. Nevertheless, as we have seen in
countries targeting an inflation range, and as we know
from the similar experience of exchange rate targeting, the
bands tend to take on a life of their own, encouraging central
banks, politicians, and the public to focus too much on the
exact edges of the range rather than on deviations from the
midpoint of the range. Furthermore, because a high degree
of uncertainty is associated with inflation forecasts, it is
very likely that even with entirely appropriate monetary
policy, the inflation rate may fall outside the target

range. This control problem can then lead to a loss of
credibility for the inflation-targeting regime.
In addition, firm bands can also lead to an instrument-instability problem, particularly if the time horizon
for assessing whether the target has been met is short—say
on the order of a year. This problem occurs when efforts to
keep the targeted variable within a specified range cause policy
instruments, such as short-term interest rates or the
exchange rate, to undergo undesirably large movements.
The control and instrument-instability problems have been
comparatively more difficult in the case of New Zealand.
One solution to these problems is to widen the
target range, as New Zealand did in October 1996. However, if the range is made wide enough to reduce the
instrument-instability and control problems significantly, the targeting regime may lose credibility. This
would be particularly true if the public focuses on the
edges of the range rather than the midpoint, with an
upper limit that might then be intolerably high. The act
of widening the range (as distinct from moving the target
level in accord with events) might be seen as a weakening
of resolve in and of itself.
Another solution is to use a point target rather
than a range, as the United Kingdom decided to do in
1995 and as the Bundesbank has done for inflation since
1975. To avoid control and instrument-instability problems
with a point target, however, it is imperative that the
central bank communicate clearly to the public that a
great deal of uncertainty exists around the point target.
This communication imposes a greater burden on the
power and persuasiveness of the central bank’s explanations
for deviations from target than exists with a range. At the
same time, the central bank’s actual flexibility to cope with
target misses without damage to credibility is greater as
long as the explanations are believed. With a point target,
success is not measured by hitting the target exactly, but
rather by how consistently the central bank gets close to
the target over a medium term.
The analysis in this paper suggests that targeting
inflation—whether directly, as in New Zealand, Canada,
and the United Kingdom, or as the basis for a monetary
targeting regime, as in Germany—can be a useful strategy

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for the conduct of monetary policy. Since the defining
feature of the monetary frameworks in all four countries
is the publicly announced numerical target for mediumterm inflation, we do not draw as great a distinction
between these two types of targeting regimes in operation
as many do in theory. Transparency and flexibility, properly
balanced in operational design, appear to create a sound
foundation for a monetary strategy in pursuit of price
stability, without requiring the imposition of unnecessary
rule-like constraints on policy.
That said, as our case studies suggest, inflation
targeting is no panacea: it does not enable countries to
eliminate inflation from their systems without cost, and
anti-inflation credibility is not achieved immediately upon
the adoption of an inflation target. Indeed, the evidence
suggests that the only way for central banks to gain
credibility is the hard way: they have to earn it.

Still, we have seen that inflation targeting has been
highly successful in helping countries such as New
Zealand, Canada, and the United Kingdom to maintain
low inflation rates, something that they have not always
been able to do in the past. Furthermore, inflation targeting
has not required the central banks to abandon their concerns about other economic outcomes, such as the level of
the exchange rate or the rate of economic growth, in order
to achieve low inflation rates. Indeed, there is no evidence
that inflation targeting has produced undesirable effects on
the real economy in the long run; instead, it has likely had
the effect of improving the climate for economic growth.
Given inflation targeting’s other benefits for the operation of
monetary policy—it increases transparency and communication, accountability, and the institutional commitment
to low inflation—it is a monetary policy strategy that
deserves further study and consideration.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

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ENDNOTES

INTRODUCTION
1. See a companion piece to this study, Bernanke and Mishkin (1997),
for a more theoretical discussion of the rationale for inflation targeting.
In particular, the authors stress that inflation targeting should be seen
not as a rule, but as a framework that has substantial flexibility.

PART I. THE RATIONALE FOR INFLATION TARGETING
1. “I believe that the potentiality of monetary policy in offsetting other
forces making for instability is far more limited than is commonly
believed. We simply do not know enough to be able to recognize minor
disturbances when they occur or to be able to predict either what their
effects will be with any precision or what monetary policy is required to
offset their effects. We do not know enough to be able to achieve state
objectives by delicate, or even fairly coarse, changes in the mix of
monetary and fiscal policy” (Friedman 1968, p. 14).
2. This argument is made in the leading macroeconomics and money
and banking textbooks. For examples, see the discussion in Dornbusch
and Fischer (1994, p. 437), Hall and Taylor (1993, pp. 440-1), Mankiw
(1994, p. 323), and Mishkin (1994, pp. 701-4).
3. This view is accepted in the leading macroeconomics and
monetary economics textbooks. For examples, see Abel and Bernanke
(1995, pp. 458-9), Barro (1993, p. 497), Hall and Taylor (1993, p. 222),
Mankiw (1994, p. 479), and Mishkin (1994, pp. 651-4).
4. This argument was developed in papers by Kydland and Prescott
(1977), Calvo (1978), and Barro and Gordon (1983).
5. Briault (1995) gives a good summary of these effects.
6. Sarel (1996), for example, presents a strong argument that the
growth costs of inflation are nonlinear and rise significantly when
inflation exceeds 8 percent annually.
7. See Judson and Orphanides (1996). Hess and Morris (1996) also
disentangle the relationship between inflation variability and the
inflation level for low-inflation countries.
8. For central bankers’ views, see Crow (1988), Leigh-Pemberton
(1992), and McDonough (1996a); for academics’ views, see Fischer
(1994) and Goodhart and Viñals (1995).
There is also a literature suggesting that lower inflation will not only
produce a higher level of output but also cause higher rates of economic
growth, thereby providing a further reason for pursuing the goal of price
stability. For example, see Fisher (1981, 1991, 1993), Bruno and Easterly
(1995), and Barro (1995).

NOTES

9. However, as pointed out in Bernanke and Mishkin (1997), the
provisions for short-run stabilization objectives in inflation-targeting
regimes suggest that, in practice, inflation targeting may not be very
different from nominal GDP targeting.

PART III. GERMAN MONETARY TARGETING: A PRECURSOR
TO INFLATION TARGETING
1. Laubach and Posen (1997a) provides a more detailed analysis of the
German case as well as a comparison with the Swiss monetary targeting
regime and address many of the same themes.
2. While this belief may indeed be consistent with later academic
arguments that there is an inflationary bias to monetary policy (for
example, because of time inconsistency) requiring a central bank to tie its
hands, it is important to note that Germany’s adoption of monetary
targeting precedes these arguments by several years. Some later observers
have argued that the Germans were broadly distrustful of monetary
discretion, but this interpretation should not be exaggerated through
contemporary mindset. To most observers, that issue had already been
addressed by the granting of independence to the Bundesbank in 1957,
the distrust being the politicization of monetary policy.
3. The announcement was reprinted in Deutsche Bundesbank (1974b,
December, p. 8).
4. The central bank money stock is defined as currency in circulation
plus sight deposits, time deposits with maturity under four years, and
savings deposits and savings bonds with maturity under four years, the
latter three weighted at their required reserve ratios as of January 1974.
The Bundesbank’s rationale for this choice of intermediate target
variable will be discussed in the next section.
5. Neumann (1996) and Clarida and Gertler (1997) argue both points,
that the Bundesbank has multiple goals and that it does not strictly
target money. Von Hagen (1995) and Bernanke and Mihov (1997) focus
on the latter point, while Friedman (1995) discusses why the
Bundesbank might not want to look at M3.
6. The weights are 16.6 percent, 12.4 percent, and 8.2 percent,
respectively.
7. See, for example, Deutsche Bundesbank (1981a, “Recalculation of
the Production Potential of the Federal Republic of Germany”).
8. The vast variety and depth of information provided by the
Bundesbank in its Monthly Report and Annual Report would appear to be
evidence that a wide range of information variables, far beyond M3,

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ENDNOTES (Continued)

Note 8 (continued)
velocity, and potential GDP, play a role in Bundesbank decision making
(the work involved in producing the data and analysis makes it unlikely
that it is merely a smokescreen or a public service). Nevertheless,
monetary policy moves are always justified with reference to M3 and/or
inflation developments, rather than with these other types of data.
9. The Bundesbank describes the Annual Report as “a detailed
presentation of economic trends, including the most recent
developments, together with comments on current monetary and general
economic problems.”
10. Actually, it was the third year of four in a row where the 8.0 percent
CBM monetary growth point target was exceeded by at least a percentage
point (see Bernanke and Mishkin [1992, p. 201, Table 4]).
11. Two more technical developments also suggested the switch from
CBM to M3 targets. The first was that minimum reserve requirements
had changed substantially since 1974, so that CBM, computed on the
basis of 1974 ratios, corresponded less and less to the monetary base and
thus to “the extent to which the central bank has provided funds for the
banks’ money creation.” The second development was the increasing
need to include new components, such as Euro-deposits held by domestic
nonbanks, in some broadly defined money stock for control purposes.
Since these components had never been subject to minimum reserve
requirements, the weight at which they should enter CBM was not clear,
a problem that does not exist for some extended definition of M3.
12. “While officially the question of the correct exchange rate was still
under discussion, the German Chancellor announced his decision on the
exchange rate without informing Bundesbank President Karl-Otto Pöhl,
although they had met only a few hours before” (Hefeker 1994, p. 383).
See Marsh (1992) for a longer historical description. For most east
German citizens, personal assets were converted at the rate of 1 to 1.
However, for larger holdings, a declining rate of exchange was employed.
13. Since the achievement in the mid-1980s of effective price stability
in Germany, the Bundesbank has spoken of “normative price increases”
rather than “unavoidable inflation” in response to the high inflation of
the 1970s and early 1980s (we are grateful to Otmar Issing for
emphasizing this shift to us). This change in language could be
interpreted as a sign that the Bundesbank expresses greater confidence in
its ability to achieve its ultimately desired inflation goal.
14. For two recent examples of this repeated argument, see Issing
(1995b) and Schmid (1996).

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PART IV. NEW ZEALAND
1. Before the passage of the Reserve Bank of New Zealand Act of 1989,
the Reserve Bank was ranked as low in independence. See Alesina and
Summers (1993).
2. “The role of monetary policy under [the new government’s] approach
is aimed in the medium term at achieving suitably moderate and steady
rates of growth in the major monetary aggregates. This is directed
ultimately at the inflation rate, as control over the monetary aggregates
is seen as a prerequisite for a lower, more stable rate of inflation” (Reserve
Bank of New Zealand 1985b, p. 513).
3. The problem of the treatment of housing costs was addressed at the
beginning of 1994, when the weight of existing dwellings in the CPI was
largely replaced by including the cost of construction of new houses.
Similar problems in the treatment of housing costs were a feature of the
CPI in the United States before 1983.
4. This is not simply a matter of who guards the guardian, serious
though that may be. “Because the Reserve Bank’s estimate of underlying
inflation relies on judgment in its construction, its validity cannot be
directly verified [by outside observers]. In addition, there is room for
disagreement concerning the proper model to be used in estimating the
impact of one-time shocks” (Walsh 1995). The Reserve Bank itself has
made note of this potential conflict of interest and its possible effect on
credibility in articles in the Reserve Bank of New Zealand Bulletin.
5. Strictly speaking, the first PTA only allowed for, or required
renegotiation of, the Agreement, while the second and third PTAs
required such a response to shocks.
6. We are grateful to Governor Brash for clarifying this point. The
exclusion of the effects of taxes imposed by local authorities proved
impractical given the difficulties of identifying policy changes at that
level. The effect, however, remained potentially quite large, with the
movement toward “user-pays pricing” of services provided by the public
sector as part of the broader reforms.
7. Some bank documents, however, have made the contradictory claim
that the move to targeting and central bank independence would be
expected to have an effect on the potential costs of disinflation. For
example, “in order to improve the prospects of monetary policy to
remain—and be seen to remain—on the track to low inflation, and
thereby help reduce the costs of disinflation, attention turned to possible
institutional arrangements which would improve monetary policy
credibility” (Lloyd 1992, p. 208). See Posen (1995), Hutchison and
Walsh (1996), and Laubach and Posen (1997b) for econometric
assessments of this effect.

NOTES

ENDNOTES (Continued)

8. Again, this may be contrasted to the Bundesbank’s framework,
which does not address the short-run real effects of monetary policy in
public statements but keeps all responsibility for the timing and
duration of disinflation with the Bundesbank.

18. See, for example, Louisson (1994).

9. The article cited here, while signed by Lloyd, not only appeared in
the Reserve Bank of New Zealand Bulletin under the authoritative title “The
New Zealand Approach to Central Bank Autonomy,” but parts of it also
appeared verbatim in other statements by Reserve Bank of New Zealand
officials given in 1992 and 1993, so it is reasonable to treat this statement
as representative of the Bank’s view.

20. Proportional representation was approved in a nationwide
referendum. It was largely interpreted as a means for the public to put a
brake on activist programs by the government—be they of the right or
left reform persuasion—for under majoritarian parliaments, New
Zealand had seen major shifts (such as Labour’s “Rogernomics” reforms
after 1984), whereas coalition governments would be less likely to
accomplish this. The effects of multiple parties on inflation rates and
fiscal policy (usually held to increase the former and loosen the latter in
the economics literature) do not seem to have entered the discussions.

10. With regard to financial stability, inflation targeting has an important
advantage over an exchange rate peg because under an inflation target, the
central bank has the ability to act as a lender of last resort. This option is not
as available with a fixed exchange rate regime, as the Argentinean
experience in 1995 demonstrates (see, for example, Mishkin [1997]).
11. A similar point about the gap between the perception and the
operational reality of monetary targeting in Germany was made in the
case study in Part III.
12. For brevity, references in this section are given by the month and
year of the Monetary Policy Statement.
13. See, for example, New Zealand Herald (1990a).
14. See New Zealand Herald (1990b). Interestingly, after losing power,
the Labour Party, which instituted the inflation targets (and the
economic reforms, more generally) after taking office in 1984, announced
its opposition to the inflation target remaining at a narrow 2 percent
band, although it continued to be adamant that the center of the target
range should remain at 1 percent.
15. In March 1997, the Bank discussed moving to a more directly
controlled instrument rate, but in June the Bank announced that a
directly controlled interest rate would in fact not be adopted.
16. See, for example, Reuters Financial Service (1991).
17. Until December 1993, the Bank’s inflation forecasts assumed that
the exchange rate would remain constant at the level present at the time
of the forecast. The vindication of the statement above over the preceding
two years led the Bank in June 1994 to assume from that point on an
annual appreciation equal to the difference between the trade-weighted
inflation forecasts for New Zealand’s main trading partners and the
midpoint of the 0 to 2 percent target range from June 1994.

NOTES

19. We are grateful to Governor Brash for his discussion of these
developments.

PART V. CANADA
1. To cite two examples of expectational sluggishness: “There is no
doubt that Canadian markets are not at all supportive of inflationary
actions nowadays. But it does take time for such reality to have an impact
on market behavior, and on the costs and prices that flow from this
behavior” (Crow 1991b, p. 13); “the lags in the response of the Canadian
rate of inflation to changes in monetary policy have traditionally been
long, both as a result of institutional characteristics . . . and expectational
sluggishness” (Freedman 1994a, p. 21). Moreover, Longworth and
Freedman (1995) explain how backward-looking expectations play a
significant role in the current Bank of Canada forecasting model.
2. See similar statements in Jenkins (1990), Bank of Canada (1991c),
and Freedman (1994a).
3. The example of New Zealand was probably not yet well established,
and it is not acknowledged in public statements by senior Bank officials
until Freedman (1994a).
4. Thiessen (1994a, p. 86) makes an almost identical statement of these
two points.
5. “Over longer periods of time, the measures of inflation based on the
total CPI and the core CPI tend to follow similar paths. In the event of
persistent differences between the trends of the two measures, the Bank
would adjust its desired path for core CPI inflation so that total CPI
inflation would come within the target range” (Bank of Canada 1996,
November, p. 4).
6. “Accommodating the initial effect on the price level of a tax change
but not any ongoing inflation effects was the approach set out with the
February 1991 inflation-reduction targets, and restated in the December

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ENDNOTES (Continued)

Note 6 (continued)
1993 agreement [extending the target framework]” (Thiessen 1994a,
p. 82). Of course, unlike the assessment of differences between core and
headline CPI, the assessment of the size of a tax increase’s initial as
opposed to pass-through effect on prices depends on an analyst’s
assumptions. The Bank does publish its own calculations of the price
effects of tax changes.
7. “It is important to stress that the objective continues to be the
control of inflation as defined by the total consumer price index”
(Thiessen 1996d, p. 4).
8. “The targets continue to be expressed as a range or a band rather than
a specific inflation rate because it is impossible to control inflation
precisely” (Thiessen 1994a, p. 86).
9. “Other sources of unexpected price increases, which are typically less
significant than the three singled out for special attention, will be
handled within the one percent band around the targets for reducing
inflation” (Bank of Canada 1991c, p. 4).
10. This may be due to the fact that more than any other
inflation-targeting country, Canada has had to cope with headline
inflation falling below the target or reaching the target ahead of schedule
and, perhaps as a result, with greater public criticism of the targets as
harmful to the real economy. These challenges are discussed in the next
section.
11. See Thiessen (1994a, p. 89) and Freedman (1994a, p. 20) for examples.
12. This statement is representative of the Bank’s position. See also, for
example, Bank of Canada (1995, May), which states: “The ultimate
objective of Canadian monetary policy is to promote good overall
economic performance. Monetary policy can contribute to this goal by
preserving confidence in the value of money through price stability. In
other words, price stability is a means to an end, not an end in itself.”
13. This interpretation of short-run flexibility was raised in a different
context in Bernanke and Mishkin (1992). In a more recent example, in
the Bank of Canada’s Annual Report, 1994, the Bank states that “in late
1994 and early 1995, the persistent weakness of the dollar began to
undermine confidence in the currency, and the Bank of Canada took
actions to calm and stabilize financial markets” (p. 7), while the Annual
Report, 1996 lists “promoting the safety and soundness of Canada’s
financial system” (p. 4) as the second part of its section “Our
Commitment to Canadians.” In short, the Bank found no inherent
conflict between seeking within limits either the goal of financial
stability or the goal of limiting real economic swings (as seen in the

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gradual convergence discussed above) and the pursuit of price stability
over the long run. In this characteristic, it is similar to all central banks
we studied, though perhaps more open about it.
14. Real—that is, inflation-indexed return—bonds have been issued in
Canada since 1991 following the example of the United Kingdom. One
motive cited for the creation of these real bonds was precisely to obtain a
measure of inflation expectations. As the Bank of Canada itself has
pointed out, however, the market for real bonds to date has been
relatively small and illiquid. In addition, it has only a short history,
which makes direct measurement of the implicit inflation expectations
difficult.
15. This idea has been picked up since by a number of other countries
and several private sector forecasting groups as a compact means of
expressing the relative tightness of monetary policy in open economies.
16. For a more complete discussion of the MCI, see Freedman (1994b).
17. Freedman (1995, p. 30) offers the opinion that “it may well be that
their [Monetary Policy Report’s] most important contribution will be to
signal prospective inflationary pressure and the need for timely policy
action, at a time when actual rates of inflation (which are of course a
lagging indicator) are still relatively subdued.” This scenario is premised
on Canada starting from a situation of “relatively subdued” inflation
pressures, which was the case by 1995.
18. Citing New Zealand, the United Kingdom, and Sweden, Freedman
(1995, pp. 29-30) notes, “These reports, which have both
backward-looking and forward-looking perspectives, have received
considerable attention and careful scrutiny by the press, the financial
markets, and parliamentary committees.” See also Thiessen (1995d,
p. 56), who states: “This report will provide an account of our
stewardship of monetary policy and will be useful for those who want to
know more about monetary policy for their own decision-making.”
19. This move may have seemed necessary after the October 1993
election was fought in part over the Bank’s monetary policy, and Crow
eventually decided not to be considered for a second term. The newly
elected Liberal Government chose to extend rather than to replace the
inflation targets. This event demonstrates how inflation-targeting
frameworks can differ or change along the axis of accountability
independently of their stated inflation goals and monetary policy
procedures (which may remain the same).
20. According to Cukierman’s (1992) legal index of central bank
independence, the Bank of Canada ranks, with the Danish central bank,
just below the Federal Reserve in independence.

NOTES

ENDNOTES (Continued)

21. Laidler and Robson (1993, Chap. 9) provide an extensive discussion
of the Bank of Canada’s practical independence and its limits up through
1992.
22. In this regard, Canada’s framework is even more similar to that of
Switzerland—a country that, like Canada, has a small, open economy. See
Laubach and Posen (1997a).
23. Creating Opportunity: The Liberal Plan for Canada, cited in Crane
(1993).
24. The targets were intended to define the path implied by the various
actual inflation targets at eighteen-month intervals of 3 percent by yearend 1992, 2.5 percent by mid-1994, and 2 percent by year-end 1995.
25. For example, “‘the government is betting on its own inflation
targets,’ said Toronto-Dominion Bank chief economist Doug Peters,
referring to Canada’s target of 2 percent inflation in 1995” (Szep 1991).
26. See, for example, Ip (1991).
27. The committee’s formal title was the Standing Committee on
Finance, Subcommittee on the Bank of Canada, of the House of
Commons, but it was called the Manley Committee after its chairman,
John Manley. See its report, The Mandate and Governance of the Bank of
Canada, February 1992.
28. It should be noted that, for all the attention central banks’ written
charters and legal mandates attract, there are only a few central banks
that have dedicated price stability mandates. Not only have many
inflation targeters—such as Canada, Sweden, Australia, and the United
Kingdom—adopted largely successful inflation-targeting regimes
without revision of their legal mission, but the Bundesbank is the only
one of the three independent central banks with a long-standing
successful inflation record (the Swiss National Bank and the U.S. Federal
Reserve are the others) that has had such a clearly limited legal mandate.
29. The Liberal Party’s campaign platform, Creating Opportunity: The
Liberal Plan for Canada, included the statements: “Liberals believe that
economic policies must not merely attack an individual problem in
isolation from its costs in other areas. . . . The Conservatives’
single-minded fight against inflation resulted in deep recession, three
years without growth, declining incomes, skyrocketing unemployment,
a crisis in international payments, and the highest combined set of
government deficits in our history.” See Crane (1993).
30. For a sample of private sector reactions, see Marotte (1993).

NOTES

31. For press coverage of Freedman’s speech, see, among others, Ip
(1993).
32. During the period of an announced downward path for inflation,
the emphasis in the Bank of Canada’s discussion was on the midpoint,
whereas once the range of 1 to 3 percent was reached, the emphasis
shifted to the bands. We are grateful to Charles Freedman for discussion
of this point.
33. Some press observers characterized the contemporaneous
developments in transparency undertaken by the Bank as reflecting a
desire to make the Bank seem more generally accountable rather than
identified with a particular individual. See, for example, Vardy (1993)
and McGillivray (1994).
34. The Bank had explained beforehand that it expected only a
temporary blip in inflation in 1995 from the depreciation of the
Canadian dollar. The fact that the depreciation did not lead to a
persistent rise in inflation, even without a further tightening of monetary
conditions, helped build the Bank’s credibility.
35. The body of the Monetary Policy Report states, “Since the last Report,
the Canadian economy has been weaker than expected and the degree
of slack in labor and product markets has been correspondingly greater”
(p. 3). And later, “Although a slowdown had been anticipated, the Bank
was surprised (along with most others) by how abruptly the situation
changed” (p. 6).
36. For example, “for the medium-term, a key issue is whether the trend
of inflation might move below the 1 to 3 percent target range. . . . This
in turn would imply an easing in the desired path of medium-term
monetary conditions” (Bank of Canada 1996, May, p. 3). Governor
Thiessen and other officers made similar statements to the press.
37. In addition to citing Akerlof, Dickens, and Perry (1996), Fortin also
gives prominence to James Tobin’s discussion of the macroeconomic
significance of the nominal wage floor in his 1971 Presidential Address
to the American Economic Association (p. 779).
38. See, for example, Crane (1996) and Fortin (1996b).
39. The speech, reprinted in Thiessen (1996a), was delivered before the
Board of Trade of Metropolitan Toronto on November 6, 1996.
40. “However, inflation will work as a lubricant only if it fools people
into believing that they are better off than they really are. There is, in
fact, every reason to expect that people’s behavior adapts to
circumstances. In a low-inflation environment, employees are likely to

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ENDNOTES (Continued)

Note 40 (continued)
come to understand the need for occasional downward adjustments in
wages or benefits” (Thiessen 1996a, pp. 68-9). Note that Thiessen does
not assert that such wage flexibility has already occurred or is likely to
arise quickly.

PART VI. UNITED KINGDOM
1. On May 6, 1997, the new Labour Chancellor of the Exchequer,
Gordon Brown, announced that he was granting the Bank of England
“operational independence,” that is, the Bank could now set interest rates
in the pursuit of the specified inflation goal at its own discretion. We
return to this development at the end of this section.
2. This announcement was made official by the simultaneous delivery
of a letter from the Chancellor to the Chairman of Parliament’s Treasury
and Civil Service Committee.
3. Speeches by officials of the Bank of Canada in the late 1980s leading
up to that country’s adoption of inflation targets made the same point
with some of the same rhetorical spirit.
4. Of course, the Bank of England and the Chancellor were aware of the
innovations in inflation targets in New Zealand and Canada, but, as
typical and reasonable for national officials, explicit references in public
to other countries’ behavior were avoided. Still, the U.K adoption of
inflation targeting may be legitimately thought of as part of a larger
movement.
5. In a speech on June 14, 1995, Chancellor Kenneth Clarke (1995)
announced that this objective would be extended indefinitely beyond the
next general election. Without a change in the status of the Bank of
England, however, the ruling party had no power with which to bind
future governments, so the force of Clarke’s statement was unclear. In late
1996, prior to the spring 1997 election campaign, Labour Party leaders
indicated that they would continue the inflation-targeting framework
(and the current targets) should they, as expected, win the election.

actions and intervening developments. We are grateful to Mervyn King
for clarifying this point.
8. The Labour Party’s commitment to the inflation target and to
greater operational independence for the Bank of England was made
explicit in the party’s official election platform. The rapid granting of
independence—the day after Labour took office—nonetheless was a
surprise to all observers.
9. The conveying of this information in an appropriate way to a
nontechnical audience has challenged the staff of the Inflation Report.
Initial efforts to depict the trend path of inflation with probability
“cones” moving out from it were not widely understood. The recent
pictures of a probability density for future inflation with shading from
red (most likely) to pink (tail of distribution) appear to have been well
received.
10. The statements quoted represent the Bank’s official stance. In the
same issue of the Quarterly Bulletin, the Bank’s “General Assessment”
echoes both statements—that “the achievement of price stability
remained the ultimate objective of monetary policy” (p. 355), and that
“had the United Kingdom remained in the ERM, it is quite possible that
price stability would have been achieved during the next year. Although
clearly desirable in itself, price stability attained too quickly might have
intensified the problems of domestic debt deflation. Some easing of
policy was, therefore, desirable” (p. 356).
11. At least, so long as an “optimal” contract for central bankers
penalizing inflation performance alone is not in force.
12. There is some requirement for the Bank and its senior staff to give
testimony to the House of Commons Treasury Committee, now on a
regular basis as opposed to the by-request (though frequent) appearances
in the past. Nonetheless, the record of these past testimonies—as well as
the lack of incentives facing backbenchers on the committee to deviate
from respective party leaderships’ lines on monetary policy—suggests
that these hearings are unlikely to influence Bank policy significantly.

6. This is akin to the Swiss National Bank’s rationale for its point target
for monetary growth. As the Bank of England’s own research suggests,
however, if a target range were designed to truly capture some reasonable
confidence interval of outcomes, given control problems, the range would
be too wide for credibility with the general public. See Haldane and
Salmon (1995).

13. The depreciation is measured by the Bank of England’s exchange
rate index.

7. Note that the point target does not imply performance assessment on
the basis of a backward-looking average. Instead, the inflation
performance relative to the point target is explained as the result of past

15. See, for example, Economist (1994).

102

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14. The point should not be exaggerated, however, since Italy also
managed to limit the pass-through effect of its ERM exit without
adoption of inflation targets (see Laubach and Posen [1997b]).

16. Minutes of the Monthly Monetary Meeting, July 28, 1994, p. 5.

NOTES

ENDNOTES (Continued)

17. Minutes of the Monthly Monetary Meeting, July 28, 1994, p. 6.
18. Svensson (1996) makes clear the benefits of having the transparent
target be the monetary policymaker’s inflation forecast.
19. The Bank assumes in its projections unchanged official interest rates
and movements in the exchange rate reflecting the differential between
U.K. and trade-weighted overseas short-term interest rates.
20. Several British press commentators observed that the timing of the
May meeting was postponed until after some local elections, and took
this as an indication that a rate hike was coming, since Clarke would not
want to implement his policy the day before the polls. While the BankChancellor meetings are monthly, the exact timing is not systematic,
with occasional reschedulings occurring. In this instance, there was a
widespread expectation before the meeting that the Chancellor would
agree with the Bank’s assessment; his later public overruling of the Bank,
leaving rates unchanged, might be seen as an accommodation to broader
Tory political reality, but one that emphasized the economic realities as
well. As noted below, the U.K. press tends to look for politicization of
monetary policy.
21. Minutes of the Monthly Monetary Meeting, June 7, 1995, p. 8.
22. Minutes of the Monthly Monetary Meeting, June 5, 1996, p. 9.
23. See, for example, Financial Times (1996). It should be noted that the
British press tends to focus on the possibility that business and monetary
cycles are governed by political and electoral developments, despite little
econometric or other evidence to believe that such cycles are operative in
the United Kingdom, an open economy with brief election campaigns on
short notice.
24. Debelle and Fisher (1994) make the useful distinction between
“goal” independence and “instrument” independence for central banks.
For example, the Bundesbank has goal as well as instrument
independence because it chooses inflation targets and sets interest rates.
In the other three countries considered here, central banks have only
instrument independence because the government, acting alone or
jointly with the central bank, sets the goals of policy.

PART VII. HOW SUCCESSFUL HAS INFLATION TARGETING BEEN?
1. Ammer and Freeman (1995) perform a similar exercise. They
interpret their results as showing below-predicted GDP growth after
targeting, as well as lower inflation and interest rates. Their simulations,
however, were based on data series ending two years before the series
presented here. As can be seen in the GDP growth results for New
Zealand and Canada (Panel B of Charts 2 and 3), GDP growth was
initially below predicted values, perhaps due to the pre-adoption
disinflationary policies. Over the whole post-targeting-adoption period,
however, GDP growth rebounds and averages the predicted level.
For New Zealand, we use the discount rate because it is the only
continuously available series that can be seen as reflecting the stance of
monetary policy. Since the late 1980s, the Reserve Bank has been
keeping the discount rate 0.9 percent above the interbank overnight rate.
2. A formal test for structural breaks in monetary policy reaction
functions has three limitations that prevent its use in this assessment of
inflation targeting’s effectiveness: first, the test would be of extremely
low power given the limited time since adoption even in New Zealand;
second, the test would require us to impose a structural model of
monetary policymaking for each country, which appears excessive; third,
the test would provide a yes/no answer where more qualitative results are
of interest.
3. Country-specific shocks are not the only potential source of problems
for this comparison. Another possible reason why inflation and interest
rates could be lower than forecast would be the existence of a widespread
disinflationary trend across many countries over this time period, which
drove these variables down in targeters and nontargeters alike. Laubach
and Posen (1997b), however, explicitly compare the simulations for
targeters and nontargeters over the same period and find that significant
inflation and interest rate undershooting of forecast occurs only in the
targeting countries.
4. Additional evidence suggests that the latter interpretation should be
given more weight than the former. The effect of the adoption of inflation
targeting on sacrifice ratios, or on the predictive power of previously
estimated Phillips curves to continue forecasting inflation in the 1990s,
appears to have been minimal, as mentioned at several points in the case
studies.

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
any information contained in documents produced and provided by the Federal R eserve Bank of New York in any form or
manner whatsoever.

NOTES

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The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal
Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of
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NOTES