RDP 2015-09: Inflation Targeting: A Victim of Its Own Success? 4. Conclusion

The practice of inflation targeting over the past 25 years has fundamentally changed the character of target inflation measures. Unlike in the early years of inflation targeting, before credibility had been established, long-term inflation expectations are firmly anchored at target, moving little in response to inflation surprises. Variability of the domestic component of inflation has declined substantially, and much of the variation in CPI inflation is now caused by imported shocks, such as commodity price and exchange rate changes. Stabilisation of the domestic component of inflation has weakened the relationship between inflation and domestic economic conditions – the Phillips curve has become flatter.

These changes in the inflation process have resulted in a breakdown in the correspondence between output and inflation stabilisation. Changes in CPI inflation are now more likely to reflect idiosyncratic shocks than signal deviations in output from potential. Some critics argue that this calls for inflation-targeting frameworks to be fundamentally reengineered, placing more weight on output than inflation stabilisation. It is argued by some that weighting output more heavily in central banks' objective function would avoid the stability of inflation blinding central banks to spare capacity, and reduce the likelihood of inappropriate monetary policy tightening in response to imported price shocks.

We argue that while the character of target inflation measures has changed, the fundamental structure of the economy and the nature of the shocks have not. Sound monetary policy still requires the stabilisation of output about potential, and the accommodation of idiosyncratic inflation shocks. Inflation targeting should not be abandoned or fundamentally reengineered, but its practice must reflect the changing nature of target inflation measures. With inflation credibility now firmly established, central banks can afford to accommodate persistent commodity price and exchange rate swings. Similarly, policymakers can choose to exert gradual pressure to offset cost-push shocks rather than needing to induce large upfront contractions in activity to avoid any unanchoring of inflation expectations. But stabilisation of output about potential is now a more complicated task as the relationship between domestic output and inflation is weaker than in the past and domestic inflationary pressures are likely to be hidden in noise. Identifying deviations in output from potential is as important as ever, but the task has become much harder.

This creates a problem for central bank communications and analysis. First, because the analysis required to differentiate domestically generated demand shocks from imported shocks is tricky, the communication challenge for the central bank is likely to be similarly difficult. While some inflation shocks will be accommodated, others will merit a response. This is compounded if the appropriate response is much more gradual than in the past – the central bank may appear to be being too passive. Second, because the potential for shocks to be hidden in noise is magnified now that the effect of any given shock is smaller, there is an increased possibility that mistakes might be made.

Notwithstanding this, the solution is not to declare victory over inflation and switch the primary focus to output. While widespread vaccination has dulled the memory of how dangerous measles and other infectious diseases can be, that does not mean they have become any less dangerous. Both inflation targeting and vaccination programs are victims of their own success. The inflation process has changed over the past 25 years, and the practice of inflation targeting must evolve accordingly. But the same issues that led to the choice of inflation targeting over the alternatives in the past continue to apply with the same force.