RDP 9503: Monetary Policy Goals for Inflation in Australia 1. Introduction

An increasing number of countries have adopted targets for inflation over the past five years or so. New Zealand and Canada were the first countries to outline an explicit target path for prices, but a number of others – including the United Kingdom, Finland, Israel, Spain and Sweden – have followed suit.

The gain in popularity of inflation targets can perhaps best be seen as a step in the evolution of monetary policy regimes in countries which have battled to achieve or maintain monetary and price stability in the past couple of decades. A number of the countries concerned have in the past pursued monetary aggregate targets, or exchange rate targets (in a number of instances both) as an intermediate goal along the path to medium-term inflation control. In most cases, experience with such intermediate targets had its disappointments. The announcement of a specific goal for inflation is an attempt to anchor inflationary expectations and develop a measure of confidence in the conduct of monetary policy in much the same way that monetary or exchange rate objectives were designed to do, while avoiding the problems of unstable velocity or being a sitting target for speculative players in currency markets.

It is striking that this trend, unlike the adoption of monetary targets in the mid 1970s, has not been much influenced by academic discussion of the appropriate operational features of monetary policy. Indeed, while the idea of inflation targets is obviously a manifestation of the principle of long-run monetary neutrality, compared to discussion on monetary targets, nominal GDP targets and exchange rate targets, there is a relative paucity of academic literature on operating monetary policy with explicit inflation targets. Instead, the discussion has been driven by central banks grappling with current problems.

While these problems have many common aspects across countries, national differences mean that the exact nature of inflation targets varies as to the rate of price change, width of bands, time period and so on. Implementation of policy under the targets may well vary even more. Since in many instances the announcement of inflation targets is a relatively recent phenomenon, and no country has yet operated with an inflation target through an entire business cycle, these differences are, almost certainly, not yet as apparent as they will become over the next few years.

In Australia, there is also an announced inflation objective. It is in some ways somewhat less ambitious and hard-edged, less precisely calibrated, than in some other countries. This does not represent, in our view, a lesser degree of commitment to “price stability” as a long-term objective for monetary policy. It reflects, instead, a measure of caution about what Australian monetary policy can claim to be capable of achieving over short periods.

This paper describes the present monetary policy approach, and outlines a rationale for the nature of the stated policy objective. In so doing, it makes few references to other countries, although it ranges over several issues with which other countries almost certainly have had to grapple. The paper is organised as follows. Section 2 outlines the stated price goals for monetary policy in Australia, and gives some background as to their interpretation. Section 3 discusses issues to do with the appropriate specification of the objectives for the mean and variance of inflation over the policy horizon – which we take to be a period of around two but perhaps as long as four or five years – and the response to shocks. Section 4 gives some results of our attempts to put some empirical content to the discussion by developing a simple macroeconomic model of the economy, and using simulation techniques to address the relationship between short-term price and output variance under alternative policy reactions to shocks.