Inflation targeting is probably the most widely-known policy adopted by central banks around the world. Under an inflation-targeting regime, the government (usually the central bank or treasury) announces an inflation target (usually with lower and upper limits). It is then up to the central bank to decide how to achieve the target. Seen in this light, inflation targeting is more of a constrained discretionary policy than a strict monetary rule.
Inflation targeting is often recommended as a mechanism for reducing inflation rates in the least costly way. In theory, the credible announcement of an inflation target anchors inflation expectations. Since economic actors expect inflation rates to fall, they will not contract output as severely as they would if the change were unexpected. In practice, the effectiveness of such strategies is not so clear.
Ben Bernanke, Thomas Laubach, and Frederic Mishkin study a number of inflation-targeting regimes and reach two important conclusions. First, inflation targeting is usually adopted after the inflation rate has been reduced. Since we do not have much experience with countries credibly announcing their target in advance, it is difficult to say the extent to which such a policy would reduce the costs of transition. Second, those countries that have successfully reduced their inflation rates have incurred considerable economic and social costs to do so. Again, that is not to say that a credible announcement would not reduce these costs. Pre-commitments are rare—and it is hard to say the extent to which they were considered credible at the time.
The available evidence suggests that it is painful to lower inflation rates—and that pre-commitments do little to mitigate those costs. Low-inflation countries should keep this in mind. The only sure way to avoid the costs of reducing inflation is to never find yourself in a situation where you need to reduce inflation. At the same time, the evidence suggests that high-inflation countries should not wait around until they are able to pre-commit. Instead, they should muster the political will to reduce inflation rates now and do their best to communicate that such costs—unlike those of persistently-high inflation rates—will be short-lived.
Written by Nicolás Cachanosky
Published in AIER