Strategies for Controlling Inflation | Conference – 1997 (2024)

1. Introduction

In the past fifteen years, an extraordinary development has occurred in economiesthroughout the world: inflation has fallen dramatically in many industrialisedas well as emerging-market countries, to the point where many of them havereached what might arguably be called price stability. Why did this happenand how did policy-makers achieve this feat?

This paper examines these questions by first outlining why a consensus has emergedthat inflation needs to be controlled. Then it examines different strategiesfor controlling inflation and highlights the advantages and disadvantages ofthese different strategies. The discussion should shed light not only on howdisinflation might best be achieved, but also on how the hard-won gains inlowering inflation can be locked in, so that inflation is less likely to rearits ugly head in the future.

2. The Growing Consensus for Inflation Reduction

An important reason why so many countries have reduced their inflation rates in recentyears is that there has been a growing consensus, particularly among centralbankers and even in the public at large, that inflation reduction and pricestability should be the primary or overriding long-term goal of monetary policy.This consensus has emerged from economic research and actual economic eventsover the past thirty years, as is discussed in this section.

The rationale for pursuing price stability as the primary long-term goal for monetarypolicy rests on two basic propositions. First is that activist monetary policyto reduce unemployment in the short run might be undesirable because it canlead to higher inflation but not lower unemployment. Second is that price stabilityin the long run promotes a higher level of economic output and more rapid economicgrowth. The corollary of these two propositions is that price stability isthe appropriate overriding, long-run goal of monetary policy because it willproduce better economic outcomes.

2.1 The case against monetary-policy activism

Thirty years ago, both the public and the majority of the economics profession supporteda so-called activist monetary policy: i.e., the taking of active steps to reduceunemployment with expansionary monetary policy whenever unemployment rose abovea ‘full-employment level’. In the 1960s this level was definedto be around4 per cent in the United States. Support for activism was based on twoprinciples. First was that macroeconometric models, particularly large oneswith many equations, had become sufficiently advanced to accurately predictthe impact of changes in both monetary and fiscal policy on the aggregate economy.Thus, manipulation of monetary and fiscal policy levers could be used to dampenfluctuations in the business cycle.

The second principle supporting an activist monetary policy was popularised by PaulSamuelson and Robert Solow in their famous paper in 1960. They suggested thatthere was a long-run Phillips-curve trade-off which could be exploited. A simplelinear version of this Phillips curve can be written as follows:

where: π_t = inflation at time t;

k = constant;

α = the slope of the Phillips curve, i.e. how much inflationchanges for a given change in

U_t = the unemployment rate at time t; and

= the natural rate of unemploymentat time t, i.e. the rate of unemployment consistent with full employmentat which the demand for labour equals the supply of labour.

Figure 1 shows what the Phillips-curve relationship looked like for the United Statesbefore 1970. As we can see from Figure 1, the relationship worked well before1970 and seems to suggest that there was a trade-off between unemployment andinflation: if policy-makers wanted to have lower unemployment, they could ‘buy’it by accepting a higher rate of inflation. Combining this view with confidencein the ability of large-scale macroeconometric models to evaluate the effectsof policy, naturally led many economists in the 1960s to advocate activistpolicy measures to keep the economy at a target unemployment level.

However, there are three powerful arguments against monetary activism: there arelong and variable lags in the effects of monetary policy on the economy; thereis no long-run trade-off between output (unemployment) and inflation; and thetime-inconsistency problem. These three arguments have so strongly undercutthe case for monetary-policy activism that support for it is now held by onlya minority of economists. We look at each of these arguments in turn.

Long and variable lags. The first salvos that had a majorimpact against activism came from the monetarists led by Milton Friedman. Monetaristspointed out some serious flaws in Keynesian macroeconometric models. They alsonoted that the effects of macro policy were highly uncertain. Indeed, MiltonFriedman staked out his famous position that activist policy would be counterproductivebecause policy, and particularly monetary policy, affects the economy onlywith ‘long and variable lags’.

Although long lags, in and of themselves, do not rule out successful activism, thereis a political-economy argument why they make activist policy counterproductive.The public, and particularly politicians, often have a very myopic view ofpolicy: that is, they only focus on the short run and cannot understand thatpolicy lags may be very long and indeed may be longer than the time it takesfor the problem to correct itself. Therefore, politicians have a tendency towant immediate results and often fall into the trap of overmanipulating policylevers. In the case of monetary policy, this may lead policy-makers to tryto solve a problem such as too high unemployment using expansionary monetarypolicy, but by the time the expansionary policy is effective because of longlags, self-correcting mechanisms may have already returned the economy to fullemployment. The result is that activist monetary policy may lead to an overheatedeconomy, which in turn leads either to inflation or to an attempt by policy-makersto reign in the economy by reversing course, which can generate further economicinstability. Monetarists therefore saw activist policy as having only a negativeimpact on the economy and instead advocated nonactivist policy such as a rulein which the money supply grows at a constant rate.

The view that the effects of monetary policy are variable and that this variabilitymakes activist policy less attractive has been accepted not only by monetarists,but also by the large majority of the economics profession, who do not necessarilyaccept the monetarist position that macroeconomic policy should focus on themoney supply and a monetary-policy rule involving the growth rate of the moneysupply. Economists are no longer confident that macroeconometric models canaccurately predict the impact of changes in both monetary and fiscal policyon the aggregate economy and, therefore, accept the view that the design ofsuccessful activist monetary policy is very difficult.

There are two primary reasons why the majority of the economics profession has cometo doubt the usefulness of macroeconometric models to evaluate the impact ofpolicy. One reason is that the performance of large macroeconometric modelsin both forecasting the economy and predicting the effect of policy has notbeen as good as the model builders once hoped. The second and more importantreason is the so-called ‘Lucas critique’ developed in Lucas'famous paper, ‘Econometric Policy Evaluation: A Critique’, whichalready had become very influential by the time I left graduate school in 1973,but was not published until 1976 (Lucas 1976). Lucas's challenge to policyevaluation using econometric models was based on a simple principle of rational-expectationstheory:

The way in which expectations are formed (the relationship of expectations to pastinformation) changes when the behaviour of forecasted variables changes.

So when policy changes, the relationship between expectations and past informationwill change, and because expectations affect economic behaviour, the relationshipsin the econometric model will change. The econometric model which has beenestimated with past data will then no longer be the correct model for evaluatingthe response to this policy change and may consequently prove highly misleading.

Along with the earlier monetarist criticisms of Keynesian macroeconometric models,the theoretical argument in the Lucas critique, when combined with a mixedperformance of macroeconometric models in their ability to forecast and predictthe effects of policy, dealt a body blow to the earlier optimism of the professionand the public that macroeconometric models could be used to design effective,activist stabilisation policy.

No long-run trade-off between unemployment and inflation. Thesecond blow to policy activism was delivered by Milton Friedman in his famouspresidential address to the American Economic Association in 1967(Friedman 1968). There, Milton Friedman pointed out that the secondprinciple supporting activist policy, the Phillips-curve trade-off betweenunemployment and inflation, was incorrect. He pointed out a severe flaw inthe Phillips-curve analysis: it left out an important factor that affects wagesand price inflation – expectations of inflation.

Friedman noted that firms and workers are concerned with real variables, such asreal wages, and are thus concerned with wages and costs of production thatare adjusted for any expected increase in the price level. Workers and firms,therefore, take inflation into account when setting wages and prices, withthe result that inflation will respond not only to tightness in the labourmarkets but also to expected inflation as well. This reasoning leads to anexpectations-augmented Phillips curve in which the constant term in Equation(1) is replaced by expected inflation, expressed as:

The expectations-augmented Phillips curve implies that as expected inflation rises,the Phillips curve will shift upward. Friedman's modification of the Phillips-curveanalysis was remarkably clairvoyant: as inflation increased in the late 1960s,the Phillips curve did indeed begin to shift upward, as we can see from Figure2. An important feature of Figure 2 is that a long-run trade-off between unemploymentand inflation no longer exists: as the points in the scatter diagram indicate,a high rate of inflation is no longer associated with a low rate of unemployment,or vice versa. This is exactly what the expectations-augmentedPhillips curve predicts: a rate of unemployment below the natural rate of unemploymentcannot be ‘bought’ permanently by accepting a higher rate of inflation.

This prediction can be derived straightforwardly from the expectations-augmentedPhillips curve as follows. When inflation is kept at a higher level for a substantialperiod of time, expected inflation would adjust upwards to a long-run valuethat would equal actual inflation. Substituting π_t for in the expectations-augmentedPhillips curve in Equation (2) then yields:

which implies that . This implies that in the long run, for anylevel of inflation, the unemployment rate will settle to its natural-rate level:hence, the long-run Phillips curve is vertical, and there is no long-run trade-offbetween unemployment and inflation.

Indeed, if anything, the scatter plot in Figure 2 seems to suggest a slight tendencyfor unemployment and inflation to be positively correlated over the long run.In his Nobel prize address, Milton Friedman provided a rationale for why higherinflation might actually lead to higher, rather than lower, unemployment inthe longrun.^[1]His position that the long-run Phillips curve may even be positively slopedtherefore provides additional ammunition against the pursuit of output goalsand supports the desirability of a price-stability goal.

The time-inconsistency problem. The third intellectual developmentthat argues against activist policy was developed in papers by Kydland andPrescott (1977), Calvo (1978) and Barro and Gordon (1983), and is commonlyreferred to as the time-inconsistency problem of monetary policy.The time-inconsistency problem stems from the view that economic behaviouris influenced by expectations of future policy. A common way for making policydecisions is to assume that, at the time that policy is made, expectationsare given. In the case of monetary policy, this means that with expectationsfixed, policy-makers know that they can boost economic output (or lower unemployment)by pursuing monetary policy that is more expansionary than expected. Thus,as a result, policy-makers who have a high output objective will try to producemonetary policy that is more expansionary than expected. However, because theirdecisions about wages and prices reflect expectations about policy, workersand firms will not be fooled by the policy-makers' expansionary monetarypolicy and so will raise not only their expectations of inflation but alsowages and prices. The outcome is that policy-makers are actually unable tofool workers and firms, so that, on average, output will not be higher undersuch a strategy, but unfortunately inflation will be. The time-inconsistencyproblem shows that a central bank may end up with a suboptimal result of abias to high inflation with no gains on the output front, even though the centralbank believes that it is operating in an optimal manner.

Although the analysis of the time-inconsistency problem sounds somewhat complicated,it is actually a straightforward problem that we encounter in our every daylife. Anyone who has children has had to deal with this problem continually.It is always easy to give in to children in order to keep them from actingup. However, the more the parent gives in, the more demanding a child becomes.The reason, of course, is that a child's expectations about the parent'spolicy changes depending on the parent's willingness to stand up to thechild. Thus, giving in, although seemingly optimal based on the assumptionthat a child's expectations remain unchanged, leads to suboptimal policybecause the child's expectations are affected by what the parent does.Similar reasoning applies to the conduct of foreign policy or any type of negotiation:it is very important not to give in to an opponent even if it makes sense atthe time, because otherwise the opponent is more likely to take advantage ofyou in the future.

McCallum (1995) points out that the time-inconsistency problem by itself does notimply that a central bank will pursue expansionary monetary policy which leadsto inflation. Simply by recognising the problem that forward-looking expectationsin the wage-and price-setting process create for a strategy of pursuing unexpectedlyexpansionary monetary policy, central banks can decide not to play that game.Although McCallum's analysis is correct as far as it goes, it suggeststhat the time-inconsistency problem is just shifted back one step: even ifthe central bank recognises the problem, there still will be pressures on thecentral bank to pursue overly expansionary monetary policy, with the resultthat expectations of overly expansionary monetary policy are still likely.

2.2 The gains from price stability

The analysis above indicates that attempts to use monetary policy to pursue realoutput objectives are likely to be counterproductive. But it still leaves openthe question of why price stability is the appropriate long-term goal for monetarypolicy. The answer is that price stability promotes an economic system thatfunctions more efficiently.

If price stability does not persist, that is, inflation occurs, there are severaleconomic costs to the society. While these costs tend to be much larger ineconomies with high rates of inflation (usually defined to be inflation inexcess of 30 per cent a year), recent work shows that substantial costs ofinflation arise at low rates of inflation as well.

The cost that first received the attention of economists is the so-called ‘shoeleather’ cost of inflation, namely, the cost of economising on the useof non-interest-bearing money (Bailey 1956). The history of pre-war centralEurope makes us all too familiar with the difficulties of requiring vast andever-rising quantities of cash to conduct daily transactions. Unfortunately,hyperinflations have occurred in emerging-market countries within the pastdecade as well. Given conventional estimates of the interest elasticity ofmoney and the real interest rate when inflation is zero, this cost is quitelow for inflation rates less than 10 per cent, remaining below 0.10 per centof GDP. Only when inflation rises to above 100 per cent do these costs becomeappreciable, climbing above1 per cent of GDP.

Another cost of inflation related to the additional need for transactions is theoverinvestment in the financial sector that inflation produces. At the margin,opportunities to make profits by acting as a middleman on normal transactions,rather than investing in productive activities, increase with instability inprices. A number of estimates put the rise in the financial sector's shareof GDP on the order of 1 percentage point for every10 percentage points of inflation up to an inflation rate of100 per cent(English 1996). The transfer of resources out of productive uses elsewherein the economy can be as large as a few percentage points of GDP, and can evenbe seen at relatively low or moderate rates of inflation.

The difficulties caused by inflation can extend to decisions about future expendituresas well. Higher inflation increases uncertainty both about relative pricesand the future price level which makes it harder to make the appropriate productiondecisions. For example, in labour markets, Groshen and Schweitzer (1996) calculatethat the loss of output due to inflation of10 per cent(compared to a level of 2 per cent) is2 per cent of GDP. More broadly, the uncertainty about relative pricesinduced by inflation can distort not only the attractiveness of real versusnominal assets for investment, but also short-term versus long-term contracting,risk premia demanded on savings, and the frequency with which prices are changed(as in menu-coststories).^[2]

The most obvious costs of inflation at low to moderate levels seem to come from theinteraction of the tax system with inflation. Because tax systems are rarelyindexed for inflation, a rise in inflation substantially raises the cost ofcapital, which lowers investment below its optimal level. In addition, highertaxation which results from inflation causes misallocation of capital to differentsectors that both distorts the labour supply and leads to inappropriate corporatefinancing decisions. Fischer (1994) calculates that the social costs from thetax-related distortions of inflation amount to 2 to 3 per cent of GDP at aninflation rate of 10 per cent. In a recent paper, Feldstein (1997) views thiscost to be even higher: he calculates the cost of an inflation rate of 2 percent rather than zero to be 1 per cent of GDP per year.

The costs of inflation outlined here decrease the level of resources productivelyemployed in an economy, and thereby the base from which the economy can grow.There is mounting evidence from econometric studies that at high levels, inflationalso decreases the rate of growth of economies as well. While long time-seriesstudies of individual countries and cross-national comparisons of growth ratesare not in total agreement, there is a consensus that inflation is detrimentalto economicgrowth.^[3]The size of this effect varies greatly with the level of inflation, with theeffects usually thought to be much higher at higherlevels.^[4]However, a recent study has presented evidence that inflation variability associatedwith higher inflation has a significant negative effect on growth even at lowlevels of inflation, in addition to and distinct from the direct effect ofinflationitself.^[5]

2.3 Bottom line

In view of the long and variable lags in the effects of monetary policy on the economy,the weakened confidence in the ability of macro models to evaluate the effectsof active policy, the recognition that no long-run trade-off exists betweenunemployment and inflation, and the development of the theoretical literatureon the time-inconsistency problem, both the economics profession and the publicnow doubt the efficacy of activist policies to eliminate unemployment. Thiscase against monetary-policy activism, along with the recognition of the benefitsof price stability in producing less uncertainty in the economy and a healthiereconomic environment and thereby leading to greater real activity and economicgrowth, have led to an emerging consensus that price stability should be theoverriding long-run goal for monetary policy.

3. Strategies for Controlling Inflation

With the growing consensus that price stability should be the overriding long-rungoal of monetary policy, many countries have taken active steps to reduce andcontrol inflation. What strategies have they used to do this?

There are four basic strategies that central banks have used to control and reduceinflation:

• exchange-rate pegging;
• monetary targeting;
• inflation targeting; and
• inflation reduction without an explicit nominal anchor, which, for want of a bettername, might best be referred to as ‘just do it’.

Here, we will look at each of these strategies in turn and discuss the advantagesand disadvantages of each in order to provide a critical evaluation.

3.1 Exchange-rate pegging

One commonly used method to reduce inflation and keep it low is for a country topeg the value of its currency to that of a large, low-inflation country. Insome cases, this strategy involves pegging the exchange rate at a fixed valueto that of the other country so that its inflation rate will eventually gravitateto that of the other country, while in other cases it involves a crawling pegor target in which its currency is allowed to depreciate at a steady rate sothat its inflation rate can be higher than that of the other country.

3.1.1 Advantages

A key advantage of an exchange-rate peg is that it provides a nominal anchor whichcan prevent the time-inconsistency problem. As discussed above, the time-inconsistencyproblem arises because a policy-maker (or the politicians who have influenceover the policy-maker) have an incentive to pursue expansionary policy in orderto raise economic output and create jobs in the short run. If policy can bebound by a rule that prevents policy-makers from playing this game, then thetime-inconsistency problem can be avoided. Indeed, this is what an exchange-ratepeg can do if the commitment to it is strong enough. With a strong commitment,the exchange-rate peg implies an automatic monetary-policy rule that forcesa tightening of monetary policy when there is a tendency for the domestic currencyto depreciate, or a loosening of policy when there is a tendency for the domesticcurrency to appreciate. The central bank no longer has the discretion thatcan result in the pursuit of expansionary policy to obtain output gains whichleads to time inconsistency.

Another important advantage of an exchange-rate peg is its simplicity and clarity,which makes it easily understood by the public: a ‘sound currency’is an easy-to-understand rallying cry for monetary policy. For example, theBanque de France has frequently appealed to the ‘franc fort’ inorder to justify tight monetary policy. In addition, an exchange-rate peg cananchor price inflation for internationally traded goods and, if the exchange-ratepeg is credible, help the pegging country inherit the credibility of the low-inflationcountry's monetary policy. As a result, an exchange-rate peg can help lowerinflation expectations quickly to those of the targeted country(Bruno 1991).This should help bring inflation in line with that of the low-inflation country reasonablyquickly.

An exchange-rate peg to control inflation has been used quite successfully in industrialisedcountries. For example, in Figure 3, we see that, by tying the value of thefranc closely to the German mark, France has kept inflation low. In 1987, whenFrance first started tying the value of the franc closely to the German mark,its inflation rate was3 per cent, two percentage points above the German inflation rate (Figure4).By 1992, its inflation rate had fallen to 2 per cent and was below that inGermany. By 1996, the French and German inflation rates were nearly identical,slightly below 2 per cent. Similarly, by pegging to the German mark in 1990,the United Kingdom was able to lower its inflation rate from10 per cent to 3 per cent when it was forced to abandon the ExchangeRate Mechanism (ERM) peg in 1992 (Figure5).

Exchange-rate pegging can be an especially effective means of reducing inflationquickly if there is a very strong commitment to the exchange-rate peg. A particularlystrong form of commitment mechanism to a pegged exchange rate is a currencyboard. A currency board requires that the note-issuing authority, whether thecentral bank or the government, announces a fixed exchange rate againsta particular foreign currency and then stands ready to exchange domestic currencyfor foreign currency at that rate whenever the public requests it. In orderto credibly meet these requests, a currency board typically has more than 100per cent foreign reserves backing the domestic currency and allows the monetaryauthorities absolutely no discretion. In contrast, the typical fixed or peggedexchange-rate regime does allow the monetary authorities some discretion intheir conduct of monetary policy because they can still adjust interest ratesor conduct open-market operations which affect domestic credit. The currencyboard thus involves a stronger commitment by the central bank to the fixedexchange rate and may therefore be even more effective in bringing down inflationquickly.

An important recent example in which a currency board was implemented to reduce inflationis Argentina. Because of continuing bouts of hyperinflation and previous pastfailures of stabilisation programs, the Argentine government felt that theonly way it could break the back of inflation was to adopt a currency board,which it did in 1990 by passing the Convertibility Law. This law required thecentral bank to exchange US dollars for new pesos at a fixed exchange rateof 1 to 1. The early years of Argentina's currency board looked stunninglysuccessful. Inflation which had been running at over a 1,000 per cent annualrate in 1989 and 1990 fell to well under5 per cent by the end of 1994 and economic growth was rapid, averagingalmost an 8 per cent annual rate from 1991 to 1994(Figure6).

3.1.2 Disadvantages

However, there are some quite serious difficulties that arise from an exchange-ratepeg. One of the key disadvantages stems from the loss of an independent monetarypolicy for the pegging country. As long as a country has open capital markets,interest rates in a country pegging its exchange rate are closely linked tothose of the anchor country it is tied to, and its money creation is constrainedby money growth in the anchor country. A country that has pegged its currencyto that of the anchor country therefore loses the ability to use monetary policyto respond to domestic shocks that are independent of those hitting the anchorcountry. For example, if there is a decline in domestic demand specific tothe pegging country, say because of a decline in the domestic government'sspending or a decline in the demand for exports specific to that country, monetarypolicy cannot respond by lowering interest rates because these rates are tiedto those of the anchor country. The result is that both output and even inflationmay fall below desirable levels, with the monetary authorities powerless tostop these movements.

Furthermore, with a pegged exchange rate, shocks specific to the anchor country willbe more easily transmitted to the targeting country. A clear-cut example ofthis occurred with German reunification in 1990. Concerns about inflationarypressures arising from reunification and the massive fiscal expansion requiredto rebuild East Germany, led to rises in German long-term interest rates untilFebruary 1991 and to rises in short-term rates untilDecember 1991.Although German reunification was clearly a shock specific to Germany – theanchor country in the ERM – it was transmitted directly to the othercountries in the ERM whose currencies were pegged to the mark because theirinterest rates now rose in tandem with those in Germany. The result was a significantslowing of economic growth in countries such as France, as illustrated in Figure3.

Another important disadvantage of a pegged exchange-rate regime is that, as emphasisedin Obstfeld andRogoff (1995), it leaves countries open to speculative attacks on theircurrencies. Indeed, the aftermath of German reunification was a European exchange-ratecrisis in September 1992. As we have seen, the tight monetary policy in Germanyresulting from German reunification meant that the countries in the ERM weresubjected to a negative demand shock that led to a decline in economic growthand a rise in unemployment. It was certainly feasible for the governments ofthese countries to keep their exchange rates fixed relative to the mark inthese circ*mstances, but speculators began to question whether these countries'commitment to the exchange-rate peg would weaken because the countries wouldnot tolerate the rise in unemployment and thus would not keep interest ratessufficiently high to fend off speculative attacks on their currencies.

At this stage, speculators were in effect presented with a one-way bet: the exchangerates for currencies such as the French franc, the Spanish peseta, the Swedishkrona, the Italian lira and the British pound could only go in one direction,depreciate against the mark. Selling these currencies thus presented speculatorswith an attractive profit opportunity with potentially high expected returnsand yet little risk. The result was that inSeptember 1992, a speculative attack on the French franc, the Spanishpeseta, the Swedish krona, the Italian lira and the British pound began inearnest. Only in France was the commitment to the fixed exchange rate strongenough, with France remaining in the ERM. The governments in Britain, Spain,Italy and Sweden were unwilling to defend their currencies at all costs andso devalued their currencies.

The attempted defence of these currencies did not come cheaply. By the time the crisiswas over, the British, French, Italian, Spanish and Swedish central banks hadintervened to the tune of an estimated $100 billion, and the Bundesbank alonehad laid out an estimated $50 billion for foreign-exchange intervention. Itis further estimated that these central banks lost $4 to $6 billion as a resultof their exchange-rate intervention in the crisis, an amount that was in effectpaid by taxpayers in these countries.

The different response of France and the United Kingdom after the September 1992exchange-rate crisis (shown inFigures 3 and 5) also illustrates the potential cost of using an exchange-ratepeg to control inflation. France, which continued to peg to the mark and therebywas unable to use monetary policy to respond to domestic conditions, foundthat economic growth remained slow after 1992 and unemployment increased. TheUnited Kingdom, on the other hand, which dropped out of the ERM exchange-ratepeg, had much better economic performance: economic growth was higher, theunemployment rate fell, and yet inflation performance was not much worse thanFrance's.

The aftermath of German reunification and the September 1992 exchange-rate crisisdramatically illustrate two points: a fixed or pegged exchange rate does notguarantee that the commitment to the exchange-rate-based monetary-policy ruleis strong; and the cost to economic growth from an exchange-rate peg that resultsin a loss of independent monetary policy can be high.

The September 1992 episode and its aftermath suggest that using exchange-rate pegsto control inflation may be problematic in industrialised countries. However,exchange-rate pegs may be an even more dangerous strategy for controlling inflationin emerging-market countries.

As pointed out in Mishkin (1996), in emerging-market countries, a foreign-exchangecrisis can precipitate a full-scale financial crisis in which financial marketsare no longer able to move funds to those with productive investment opportunities,thereby causing a severe economic contraction. Because of uncertainty aboutthe future value of the domestic currency, many nonfinancial firms, banks andgovernments in emerging-market countries find it much easier to issue debtif the debt is denominated in foreign currencies. This was a prominent featureof the institutional structure in the Chilean financial markets before thefinancial crisis in 1982 and inMexico in 1994. This institutional feature implies that, when thereis an unanticipated depreciation or devaluation of the domestic currency, thedebt burden of domestic firms increases. On the other hand, since assets aretypically denominated in domestic currency, there is no simultaneous increasein the value of firms' assets. The result is that a depreciation leadsto a substantial deterioration in firms' balance sheets and a decline innet worth, which, in turn, means that their effective collateral has shrunk,thereby providing less protection to lenders. Furthermore, the decline in networth increases moral hazard incentives for firms to take on greater risk becausethey have less to lose if the loans go sour. Because lenders are now subjectto much higher risks of losses, there is now a decline in lending and hencea decline in investment and economic activity.

Mexico's recent experience illustrates how dangerous using an exchange-rate pegto control inflation can be in emerging-market countries. After experiencingvery high inflation rates, Mexico decided to peg the peso to the dollar inDecember 1987 and moved to a crawling peg in January 1989. Up until December1994, this strategy appeared to be highly successful. Inflation fell from over100 per cent in 1987 to below 10 per cent in 1993and 1994, while economic growth averaged over 3.5 per cent from 1988to 1994(Figure7).

However, with the Colosio assassination and other political developments such asthe uprising in Chiapas, the Mexican peso began to come under attack. Giventhe commitment to a pegged exchange rate, theBanco de Mexico intervened in the foreign-exchange market to purchasepesos, with the result that there was a substantial loss of international reserves,but because of the weakness of the banking sector, speculators began to suspectthat the Mexican authorities were unwilling to raise interest rates sufficientlyto defend the currency. By December, the speculative attack had begun in earnest,and even though the Mexican central bank raised interest rates sharply, thehaemorrhaging of international reserves forced the Mexican authorities to devaluethe peso on 20 December 1994.

By March 1995, the peso had halved in value. The depreciation of the peso startingin December 1994 led to an especially sharp negative shock to the net worthof private firms, which decreased the willingness of lenders to lend to thesefirms. In addition, the depreciation of the peso led to a deterioration inthe balance sheets of Mexican banks; the banks had many short-term liabilitiesdenominated in foreign currency which then increased sharply in value, whilethe problems of firms and households meant that they were unable to pay offtheir debts, resulting in loan losses on the assets side of the banks'balance sheets. The result of the deterioration in the balance sheets of bothnonbanking and banking firms was a financial and banking crisis that led toa collapse of lending and economic activity(Figure7).^[6]

An additional danger from using an exchange-rate peg to control inflation in emerging-marketcountries is that a successful speculative attack can actually lead to higherinflation. Because many emerging-market countries have previously experiencedboth high and variable inflation, their central banks are unlikely to havedeep-rooted credibility as inflation fighters. Thus, a sharp depreciation ofthe currency after a speculative attack that leads to immediate upward pressureon prices, is likely to lead to a dramatic rise in both actual and expectedinflation. Indeed, as we see in Figure 7, Mexican inflation surged to 50 percent in 1995 after the foreign-exchange crisisin 1994.

A rise in expected inflation after a successful speculative attack against the currencyof an emerging-market country can also exacerbate the financial crisis becauseit leads to a sharp rise in interest rates. The interaction of the short durationof debt contracts and the interest-rate rise leads to huge increases in interestpayments by firms, thereby weakening firms' cash-flow position and furtherweakening their balance sheets. Then, as we have seen, both lending and economicactivity are likely to undergo a sharp decline.

A further disadvantage of an exchange-rate peg is that it can make policy-makersless accountable for pursuing anti-inflationary policies because it eliminatesan important signal both to the public and policy-makers that too expansionarypolicies may be in place. The daily fluctuations in the exchange rate provideinformation on the stance of monetary policy, and this cannot happen with anexchange-rate peg. A depreciation of the exchange rate may provide an earlywarning signal to the public and policy-makers that policies may have to beadjusted in order to limit the potential for a financial crisis. Thus, likethe long-term bond market, the foreign-exchange market can constrain policyfrom being too expansionary. Just as the fear of a visible inflation scarein the bond market that causes bond prices to decline sharply constrains politiciansfrom encouraging overly expansionary monetary policy, fear of immediate exchange-ratedepreciations can constrain politicians in countries without long-term bondmarkets from supporting overly expansionary policies.

Although the stronger commitment to a fixed exchange rate may mean that a currencyboard is better able to stave off a speculative attack against the domesticcurrency than an exchange-rate peg, it is not without its problems. In theaftermath of the Mexican peso crisis, concern about the health in the Argentineeconomy resulted in the public pulling their money out of the banks (depositsfell by 18 per cent) and exchanging their pesos for dollars, thus causing acontraction in the Argentine money supply. The result was a sharp contractionin Argentine economic activity with real GDP dropping by over 5 per cent in1995 and the unemployment rate jumping to above 15 per cent (Figure6).Only in 1996, with financial assistance from international agencies such asthe IMF, the World Bank and the Inter-American Development Bank, which lentArgentina over $5 billion to help shore up its banking system, did the economybegin to recover. Because the central bank of Argentina had no control overmonetary policy under the currency-board system, it was relatively helplessto counteract the contractionary monetary policy stemming from the public'sbehaviour. Furthermore, because the currency board does not allow the centralbank to create money and lend to the banks, it limits the capability of thecentral bank to act as a lender of last resort, and other means must be usedto cope with potential banking crises.

Although a currency board is highly problematic, it may be the only way to breaka country's inflationary psychology and alter the political process sothat the political process no longer leads to continuing bouts of high inflation.This indeed was the rationale for putting a currency board into place in Argentina,where past experience had suggested that stabilisation programs with weakercommitment mechanisms would not work. Thus, implementing a currency board maybe a necessary step to control inflation in countries that require a very strongdisciplinary device. However, as discussed here, this form of discipline isnot without its dangers.

It is also important to recognise that emerging-market countries are far more vulnerableto disastrous consequences from a successful speculative attack on their currenciesthan industrialised countries. Industrialised countries have a history of lowinflation and have much less debt denominated in foreign currencies. Thus,a depreciation of the currency does not lead to a deterioration of firms'balance sheets or a sharp rise in expected inflation. Indeed, as the performanceof the United Kingdom after the September 1992 foreign-exchange crisis illustrates,an industrialised country that has its currency depreciate after a successfulspeculative attack may do quite well. The United Kingdom's economic performanceafter September 1992 was extremely good: inflation remained low and real growthwas high. The different response to speculative attacks in industrialised versusemerging-market countries suggests that, although using an exchange-rate pegto control inflation in industrialised countries is not without severe problems,it may be even more dangerous to use such a peg to control inflation in emerging-marketcountries.

3.2 Monetary targeting

We have seen that using an exchange-rate peg to control inflation is not withoutit* problems. However, in many countries, an exchange-rate peg is not evenan option because the country (or block of countries) is too large or has nonatural country to which to anchor its currency. Another strategy for controllinginflation is monetary-aggregate targeting. For example, the collapse of thefixed-exchange-rate Bretton Woods regime encouraged monetary targeting by manycountries, especially Germany and Switzerland starting in the mid 1970s.

One way of pursuing monetary targeting is to follow Milton Friedman's suggestionfor a constant-money-growth-rate rule in which the chosen monetary aggregate,say M2, is targeted to grow at a constant rate. In practice, even among themost avid monetary targeters, a quite different approach has been used. Aspointed out in Bernanke and Mishkin (1992), no monetary-targeting central bankhas ever adhered to strict, ironclad rules for monetary growth. Instead, monetarytargeting is quite flexible: all monetary targeters deviate significantly fromtheir monetary-growth targets in order to be responsive to short-term objectivessuch as real output growth and exchange-rate considerations, and are very explicitabout their willingness to be flexible andpragmatic.^[7]

3.2.1 Advantages

A major advantage of monetary targeting over exchange-rate pegging is that it enablesa central bank to adjust its monetary policy to cope with domestic considerations.It enables the central bank to choose goals for inflation that may differ fromthose of other countries and allows some response to output fluctuations.

Monetary targeting also has several advantages in common with exchange-rate pegging.First is that a target for the growth rate of a monetary aggregate providesa nominal anchor that is fairly easily understood by thepublic. (However, the target may not be quite as easily comprehended as anexchange-rate target.) Also like an exchange-rate peg, informationon whether the central bank is achieving its target is known almost immediately– announced figures for monetary aggregates are typically reported periodicallywith very short time-lags, within a couple of weeks. Thus, monetary targetscan send almost immediate signals to both the public and markets about thestance of monetary policy and the intentions of the policy-makers to keep inflationin check. These signals then can help fix inflation expectations and produceless inflation. Second, monetary targets also have the advantage of being ableto promote almost immediate accountability for monetary policy to keep inflationlow and so constrain the monetary policy-maker from falling into the time-inconsistencytrap.

The prime example of a monetary-targeting regime is that of Germany which has engagedin monetary targeting for over twenty years. A key feature of the German monetary-targetingframework is the strong commitment to transparency and communication of thestrategy of monetary policy to the public. As is emphasised in Bernanke andMishkin (1992) and Mishkin and Posen (1997), the calculation of targetranges is a very public exercise. First and foremost, a numerical inflationgoal is prominently featured in the setting of the target ranges. Then withestimates of potential output growth and velocity trends, a quantity-equationframework is used to generate the desired monetary growth rate. The Bundesbankalso spends tremendous effort, both in its publications (the Monthly Reportand Annual Report) and in frequent speeches by members of its governingcouncil, to communicate to the public what the central bank is trying to achieve.Indeed, given that the Bundesbank frequently has missed its monetary targetswith both significant overshoots and undershoots, its monetary-targeting frameworkmight be best viewed as a mechanism for transparently communicating how monetarypolicy is being conducted to achieve the Bundesbank's inflation goals andas a means for increasing the accountability of the central bank.

As Figure 3 suggests, Germany's monetary-targeting regime has been quite successfulin producing low inflation. Indeed, an important success story occurred inthe aftermath of German reunification in 1990. (This episode is discussed extensivelyin Mishkin and Posen (1997).) Despite a temporary surge in inflation stemmingfrom the terms of reunification, the high wage demands and the fiscal expansion,the Bundesbank was able to keep these one-off effects from becoming embeddedin the inflation process, and by 1995, inflation fell below the Bundesbank'sinflation goal of 2 per cent.

3.2.2 Disadvantages

All of the above advantages of monetary-aggregate targeting depend on two big ifs. The biggest if is that there must be a strong and reliablerelationship between the goal variable (inflation and nominal income) and thetargeted aggregate. If there is velocity instability, so that the relationshipbetween the monetary aggregate and the goal variable (such as inflation) isweak, then monetary-aggregate targeting will not work. The weak relationshipimplies that hitting the target will not produce the desired outcome on thegoal variable and thus the monetary aggregate will no longer provide an adequatesignal about the stance of monetary policy. Thus, monetary targeting will nothelp fix inflation expectations and be a good guide for assessing the accountabilityof the central bank. The breakdown of the relationship between monetary aggregatesand goal variables such as inflation and nominal income certainly seems tohave occurred in the United States (Stock and Watson 1989; Friedman and Kuttner1993, 1996; Estrella and Mishkin 1997) and may also be a problem even for countriesthat have continued to pursue monetary targeting.

The second if is that the targeted monetary aggregate must be well-controlledby the central bank. If not, the monetary aggregate may not provide as clearsignals about the intentions of the policy-makers and thereby make it harderto hold them accountable. Although narrow monetary aggregates are easily controlledby the central bank, it is far from clear that this is the case for broadermonetary aggregates like M2 or M3(Friedman 1996).

These two problems with monetary targeting suggest one reason why even the most avidmonetary targeters do not rigidly hold to their target ranges, but rather allowundershoots and overshoots for extended periods of time. Moreover, an unreliablerelationship between monetary aggregates and goal variables calls into questionthe ability of monetary targeting to serve as a communications device thatboth increases the transparency of monetary policy and makes the central bankaccountable to the public.

3.3 Inflation targeting

Because of the breakdown in the relationship between monetary aggregates and goalvariables such as inflation, many countries have abandoned monetary targeting– or as attributed to Gerald Bouey, the former governor of the Bank ofCanada, ‘We didn't abandon monetary aggregates, they abandoned us’.Another choice for a monetary-policy strategy that has become increasinglypopular in recent years is inflation targeting, which involves the public announcementof medium-term numerical targets for inflation with an institutional commitmentby the monetary authorities to achieve thesetargets.^[8]Additional key features of inflation-targeting regimes include increased communicationwith the public and the markets about the plans and objectives of monetarypolicy-makers and increased accountability of the central bank for obtainingits inflation objectives.

3.3.1 Advantages

The primary advantage of inflation targeting is its transparency to the public. Likemonetary-aggregate and exchange-rate targets, it is readily understood by thepublic, but, even more directly than the others, it makes clear the commitmentto price stability. Inflation targeting keeps the goal of price stability inthe public's eye, thus making the central bank more accountable for keepinginflation low which helps counter the time-inconsistency problem.

In contrast to the exchange-rate target, but like the monetary-aggregate target,inflation targets enable monetary policy to focus on domestic considerationsand to respond to shocks to the economy. Finally, inflation targets have theadvantage that velocity shocks are largely irrelevant because the monetary-policystrategy no longer requires a stable money-inflation relationship. Indeed,an inflation target allows the monetary authorities to use all available information,and not just one variable, to determine the best settings for monetary policy.

The increased accountability of the central bank under inflation targeting can alsohelp reduce political pressures on the central bank to pursue inflationarymonetary policy and thereby avoid the time-inconsistency problem. Moreover,inflation targeting helps focus the political debate on what a central bankcan do – that is control inflation – rather than what it cannotdo – raise economic growth permanently by pursuing expansionary policy.An interesting example of this occurred in Canada in 1996, discussed extensivelyin Mishkin and Posen (1997), when the president of the Canadian Economic Associationcriticised the Bank of Canada for pursuing monetary policy that was too contractionary.The existence of the inflation target helped channel a debate on whether theBank of Canada was pursuing too contractionary a policy into a substantivediscussion over what should be the appropriate target level for inflation,with both the Bank and its critics having to make explicit their assumptionsand estimates of the costs and benefits of different levels of inflation. Indeed,as a result of the debate, theBank of Canada won support through its response, its responsiveness,and its record, with the result that criticism of the Bank was not a majorissue in the run-up to the 1997 elections as it had been before the 1993 elections.

The first three countries to adopt formal inflation targets were the United Kingdom,Canada and New Zealand. All three have found this monetary-policy strategyto be very effective in keeping inflation under control, as can be seen inFigures 5, 8 and 9. After implementing inflation targeting in 1990, New Zealandcontinued a disinflation that had started in the mid 1980s, and since 1992core inflation has remained within the inflation target range of 0 to 2 percent most of thetime.^[9]

Shortly after adopting inflation targets in February 1991, the Bank of Canada wasfaced with a hike in the value-added tax, a negative supply shock that in thepast might have led to a ratcheting up in inflation. Instead, this supply shockled to only a one-time increase in the price level and was not passed throughto a persistent rise in the inflation rate. Indeed, after the initial effectof the tax rise, inflation resumed its downward trend, causing the inflationtargets to even be undershot. By 1992, inflation had fallen to below 2 percent and has remained close to this level ever since, which can arguably beviewed as achieving price stability.

After the September 1992 foreign-exchange crisis, when the British were forced outof the ERM and therefore lost their exchange-rate nominal anchor, the Britishgovernment resorted to an inflation-targeting regime to keep inflation in check.Inflation continued its downward trend and, by November 1993, it had fallento the midpoint of the target range of 2.5 per cent. The inflation-targetingregime in the United Kingdom was not without its problems, however, becauseit was conducted under severe political constraints: that is, under a systemin which the government, not the central bank set the monetary-policy instruments.As a result, accountability for achieving the inflation targets was unclear:whether it was the agency that made the public forecasts(the Bank of England) or the agency that set the monetary-policy instruments(the Chancellor of the Exchequer). This lack of accountability led to muchconfusion as to the degree of commitment to the inflation targets, an issuethat was finally resolved with the May 1997 announcement by the Labour governmentthat it would grant operational independence to the Bank of England and makeit fully accountable for achieving the inflation targets. Yet, even given thishandicap, British inflation targeting, which had been accompanied by intensiveefforts by the Bank of England to communicate clearly and actively with thepublic, has been associated with lower and more stable inflation rates, somethingthat might not necessarily have been expected given past British experience.

Given the success of inflation targeting in controlling inflation in New Zealand,Canada and the United Kingdom, other countries such as Australia, Finland,Israel, Spain and Sweden have followed in their footsteps and adopted inflationtargets.

3.3.2 Disadvantages

Although inflation targeting has been successful in controlling inflation in countriesthat have adopted it, it is not without criticisms. In contrast to exchangerates and monetary aggregates, inflation is not easily controlled by the monetaryauthorities. Furthermore, because of the long lags in the effects of monetarypolicy, inflation outcomes are revealed only after a substantial lag. Thus,an inflation target is unable to send immediate signals to both the publicand markets about the stance of monetary policy. However, we have seen thatthe signals provided by monetary aggregates may not be very strong, while anexchange-rate peg may obscure the ability of the foreign-exchange market tosignal that overly expansionary policies are in place. Thus, inflation targetingmay nevertheless dominate these other strategies for the conduct of monetarypolicy.

Some economists, such as Friedman and Kuttner (1996), have criticised inflation targetingbecause they believe that it imposes a rigid rule on monetary policy-makersthat does not allow them enough discretion to respond to unforeseen circ*mstances.This criticism is one that has featured prominently in the rules-versus-discretiondebate. For example, policy-makers in countries that adopted monetary targetingdid not foresee the breakdown of the relationship between these aggregatesand goal variables such as nominal spending or inflation. With rigid adherenceto a monetary rule, the breakdown in their relationship could have been disastrous.However, the interpretation of inflation targeting as a rule is incorrect andstems from a confusion that has been created by the rules-versus-discretiondebate. In my view, the traditional dichotomy between rules and discretioncan be highly misleading. Useful policy strategies exist that are ‘rule-like’in that they involve forward-looking behaviour which constrains policy-makersfrom systematically engaging in policies with undesirable long-run consequences,thereby avoiding the time-inconsistency problem. These policies would bestbe described as ‘constrained discretion’.

Indeed, inflation targeting can be described exactly in this way. As emphasised inBernanke and Mishkin (1997) and Mishkin and Posen (1997), inflation targetingas actually practised is very far from a rigid rule. First, inflation targetingdoes not provide simple and mechanical instructions as to how the central bankshould conduct monetary policy. Rather, inflation targeting requires that thecentral bank use all available information to determine what are the appropriatepolicy actions to achieve the inflation target. Unlike simple policy rules,inflation targeting never requires the central bank to ignore information andfocus solely on one key variable.

Second, inflation targeting as practised contains a substantial degree of policydiscretion. Inflation targets have been modified depending on economic circ*mstances.Furthermore, central banks under inflation-targeting regimes have left themselvesconsiderable scope to respond to output growth and fluctuations through severaldevices. First, the price index on which the official inflation targets arebased is often defined to exclude or moderate the effects of ‘supplyshocks’; for example, the officially targeted price index may excludesome combination of food and energy prices, indirect-tax changes, terms-of-tradeshocks, and the direct effects of interest-rate changes on the index (for example,through imputed rental costs). Second, as already noted, inflation targetsare typically specified as a range. While the use of ranges generally reflectsuncertainty about the link between policy levers and inflation outcomes, itis also intended to allow the central bank some flexibility in the short run.Third, short-term inflation targets can and have been adjusted to accommodatesupply shocks or other considerations, such as the value of the exchange rate.This accommodation is done either by modifications to the inflation targetor by having an explicit escape clause in which the inflation target can besuspended or modified in the face of certain adverse economic developments.

However, despite its flexibility, inflation targeting is not an exercise in policydiscretion subject to the time-inconsistency problem. Because an inflationtarget by its nature must be forward-looking and because inflation targetingmakes a central bank highly accountable by transparently making clear how itis to be evaluated, inflation targeting constrains discretion so that the time-inconsistencyproblem is ameliorated.

An important criticism of inflation targeting is that a sole focus on inflation maylead to larger output fluctuations. However, a counter to this argument isthat inflation targeting provides not only a ceiling for the inflation rate,but also a floor. Inflation targeting thus can act to attenuate the effectsof negative, as well as positive, shocks to aggregate demand. An interestinghistorical example is that of Sweden in the 1930s, which adopted a ‘normof price stabilisation’ after leaving the gold standard in 1931. As aresult, Sweden did not undergo the devastating deflation experienced by othercountries during the Great Depression (Jonung 1979). It is almost always truethat the process of disinflation itself has costs in lost output and unemployment,and these costs may well increase the closer one comes to pricestability.^[10]

Nevertheless, disappointingly, there is little evidence that inflation targetinglowers sacrifice ratios even when central banks have adopted inflation targetsand have credibly maintained price stability for a length of time(Debelle and Fischer 1994; Posen 1995). Indeed, as we have seen in inflation-targetingcountries such as Canada and New Zealand (Figure 8 and 9), the decline in inflationthat occurred even with inflation targets was accompanied by slow growth anda rise in unemployment. Only after the disinflation had taken place did theseeconomies begin to experience high growth rates.

The experience with costly disinflations suggests that a single-minded focus on inflationmay be undesirable. For this reason, several economists have proposed thatcentral banks should target the growth rate of nominal GDP rather than inflation(Taylor 1985; Hall and Mankiw 1994). Nominal GDP growth has the advantage thatit does put some weight on output as well as prices. Under a nominal-GDP target,a decline in projected real output growth would automatically imply an increasein the central bank's inflation target, which would tend to bestabilising.^[11]Cecchetti (1995) has presented simulations suggesting that policies directedto stabilising nominal GDP growth may be more likely than inflation targetingto produce good economic outcomes, given the difficulty of predicting and controllinginflation.

Nominal-GDP targeting is a strategy that is quite similar to inflation targetingand has many of the same advantages and so is a reasonable alternative. However,there are two reasons why inflation targets are preferable to nominal-GDP targets.First, a nominal-GDP target forces the central bank or the government to announcea number for potential GDP growth. Such an announcement is highly problematicbecause estimates of potential GDP growth are far from precise and change overtime. Announcing a specific number for potential GDP growth may thus indicatea certainty that policy-makers may not have, and may also cause the publicto mistakenly believe that this estimate is actually a fixed target for potentialGDP growth. Announcing a potential GDP growth number is likely to be politicaldynamite because it opens policy-makers to the criticism that they are willingto settle for growth rates that the public many consider to be too low. Indeed,a nominal-GDP target may lead to an accusation that the central bank or thetargeting regime is anti-growth, when the opposite is true because a low inflationrate 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 becomesembedded in the public mind as a target, it leads to the classic time-inconsistencyproblem demonstrated in the model of Barro and Gordon (1983) in which thereis a positive inflation bias.

A second reason why inflation targets are preferable to nominal-GDP targets relatesto the likelihood that the concept of inflation is much better understood bythe public than the concept of nominal GDP, which is often easily confusedwith real GDP. If this is so, the objectives of communication and transparencywould be better served by the use of an inflation target. Furthermore, becausenominal and real GDP can easily be confused, a nominal-GDP target may leadthe public to believe that a central bank is targeting real GDP growth, somethingthat is highly problematic as explained above.

It is important to recognise that, given the various escape clauses and provisionsfor short-run flexibility built into the inflation-targeting approach, thereis little practical difference in the degree to which inflation targeting andnominal-GDP targeting would allow for accommodation of short-run stabilisationobjectives. Thus, inflation targeting has almost all the benefits of nominal-GDPtargeting, but does not suffer from the disadvantages discussed.

3.4 ‘Just do it’: pre-emptive monetary policy without an explicit nominal anchor

Several countries in recent years, most notably the United States, have been ableto successfully reduce and control inflation without an explicit nominal anchorsuch as an exchange rate, a monetary-aggregate target, or an inflation target.Although in these cases, there is no explicit strategy that is clearly articulated,there is a coherent strategy for the conduct of monetary policy nonetheless.This strategy involves forward-looking behaviour in which pre-emptive monetary-policystrikes against inflation are conducted periodically.

As emphasised earlier, monetary-policy effects have long lags. In industrialisedcountries with a history of low inflation, the inflation process seems to havetremendous inertia: estimates from large macroeconometric models of the USeconomy, for example, suggest that monetary policy takes as long as two yearsto affect output and three years to have a significant impact on inflation.For other countries whose economies respond more quickly to exchange-rate changesor that have experienced highly variable inflation, and therefore have moreflexible prices, the lags may be shorter.

The presence of long lags means that monetary policy must not wait until inflationhas already reared its ugly head before responding. By waiting until inflationhas already appeared, the monetary authorities will be too late; inflationexpectations will already be embedded in the wage-and price-setting process,creating an inflation momentum that will be hard to halt. Once the inflationprocess has started rolling, the process of stopping it will be slower andcostlier.

In order to prevent inflation from getting started, monetary authorities must thereforebehave in a forward-looking fashion and act pre-emptively: that is, dependingon the lags from monetary policy to inflation, policy-makers must act wellbefore inflationary pressures appear in the economy. For example, if it takesroughly three years for monetary policy to have its full impact on inflation,then, even if inflation is quiescent currently but, with an unchanged stanceof monetary policy, policy-makers see inflation rising over the next threeyears, they must act today to tighten monetary policy to prevent the inflationarysurge.

This pre-emptive monetary-policy strategy is clearly also a feature of inflation-targetingregimes because monetary-policy instruments must be adjusted to take accountof the long lags in their effects in order to hit future inflation targets.However, the ‘just do it’ strategy differs from inflation targetingin that it does not officially have a nominal anchor and is much less transparentin its monetary-policy strategy.

3.4.1 Advantages

The main advantage of the ‘just do it’ policy is that it has worked wellin the past. As we can see in Figure 10, the Federal Reserve has been ableto bring down inflation in the United States from double-digit levels in 1980to around the 3 per cent level by the end of 1991 and has kept it in a narrowrange around this level since then. Indeed, the performance of the US economyhas been the envy of the industrialised world in the 1990s: inflation has remainedlow, real GDP growth has been high, while unemployment has been well belowthat of the majority of the other OECD countries. The ‘just do it’strategy has the advantage of central banks solving the time-inconsistencyproblem by engaging in forward-looking behaviour, along the lines McCallum(1995) has suggested, but still has left the central bank with discretion todeal with unforeseen events in the economy.

3.4.2 Disadvantages

Given the success of the ‘just do it’ strategy, a natural question toask is why countries such as the United States should consider other monetary-policystrategies which would change something that has already worked well, especiallygiven the inability to know what types of challenges will confront monetarypolicy in the future: In other words, ‘If it ain't broke, why fixit?’ The answer is that the ‘just do it’ strategy has somedisadvantages that may cause it to work less well in the future.

An important disadvantage of the ‘just do it’ strategy is that it maynot be very transparent. This may create financial and economic uncertaintythat makes the economy function less efficiently. Furthermore, because of thelack of transparency, a ‘just do it’ strategy may leave the centralbank relatively unaccountable. As a result, the central bank is more susceptibleto the time-inconsistency problem, whereby it may pursue short-term objectivesat the expense of long-term ones. Furthermore, because of the lack of transparencyand accountability, it may be harder for the central bank to lock in low inflation:the absence of a nominal anchor makes inflation expectations more susceptibleto rise when there are negative supply or other shocks to the economy, thusmaking higher inflation likely.

The most important disadvantage of the ‘just do it’ strategy is thatit depends on individuals: that is, the chairman or governor of the centralbank and the composition of the monetary board that participates in monetary-policydecisions. Having forward-looking individuals who sufficiently value pricestability can produce excellent policies. For example, Chairman Greenspan andother Federal Reserve officials continually have expressed a strong preferencefor low, steady inflation, and their comments about stabilisation policieshave prominently featured consideration of the long-term inflation implicationsof their policies.

The problem with a strategy that is based on individuals is that the individualscan change. If the chairman or other members of the FOMC were replaced by peoplewho were less committed to price stability as an important goal for the Fed,the Fed could conceivably return to policies that created the high inflationof the 1970s. Moreover, our earlier discussion suggested that the time-inconsistencyproblem and a bias towards high inflation may not arise in the central bank,but may instead come from pressures exerted by politicians. Thus, for example,even if similar individuals to those currently on the FOMC were in charge ofmonetary policy, a different political environment might push them to pursuemore expansionary policies. Indeed, in recent years the executive branch ofthe US government has rarely criticised the Federal Reserve for its policies,and this may have contributed to the success the Federal Reserve has had incontrolling inflation.

One way to encourage monetary policy to focus on long-run objectives such as pricestability is to grant central banks greater independence. In the view of manyobservers, politicians in a democratic society are shortsighted because theyare driven by the need to win their next election. With their focus on theupcoming election, they are unlikely to focus on long-run objectives, suchas promoting a stable price level. Instead, they will tend to seek short-runobjectives, like low unemployment and low interest rates, even if the short-runobjectives may have undesirable long-run consequences. With a grant of independence,central banks are able to communicate to the public that they will more likelybe concerned with long-run objectives and thus be a defender of price stability,particularly if there is a legislated mandate for the pursuit of price stability.

Recent evidence seems to support the conjecture that macroeconomic performance isimproved when central banks are more independent. When central banks in industrialisedcountries are ranked from least legally independent to most legally independent,the inflation performance is found to be the best for countries with the mostindependent centralbanks.^[12]However, there is some question as to whether causality runs from central bankindependence to low inflation, or rather, whether a third factor is involvedsuch as the general public's preferences for low inflation that createboth central bank independence and low inflation (Posen 1995).

Central bank independence may have much to recommend it and, while there is a currenttrend to greater independence of central banks, this independence may stillnot be enough to produce sufficient commitment to the goal of price stability.This is why, despite the success of a ‘just do it’ strategy formonetary policy, it may be very worthwhile to institutionalise the commitmentto price stability and formalise the strategy by making explicit a commitmentto a nominal anchor as with inflation targeting.

4. Conclusions

What we have seen over the past thirty years is a growing consensus that price stabilityshould be the overriding, long-term goal of monetary policy. With this mandate,the key question for central bankers is what strategies for the conduct ofmonetary policy will best help to achieve this goal. This paper discusses fourbasic strategies: exchange-rate pegging, monetary targeting, inflation targeting,and the ‘just do it’ strategy of pre-emptive monetary policy withno explicit nominal anchor. Although none of these strategies dominates theothers for every country in the world, we do see that some strategies may makemore sense under certain circ*mstances than others. For example, the breakdownof the relationship between monetary aggregates and goal variables, such asnominal spending or inflation, implies that monetary targeting is unlikelyto be a viable option in the United States for the foreseeable future. On theother hand, exchange-rate pegging is not even an alternative for theUnited States because it is too large a country to anchor to its currencyto any other. Thus, a lively debate is worth pursuing over whether the UnitedStates would be better served by the Federal Reserve continuing to operateas it has, or whether it would be better for it to switch to an inflation-targetingregime with its increased transparency and accountability.

For some other countries that are both small and where government institutions haverelatively low credibility, a stronger commitment mechanism may be requiredto keep inflation under control. In these circ*mstances, a strategy of exchange-ratepegging, particularly with a strict commitment mechanism such as a currencyboard, might be more attractive. However, as this paper makes clear, such astrategy is not without its dangers and may require measures to protect thefinancial sector from adverse shocks.

The study of strategies to control inflation is one of the most important that monetaryeconomists encounter. Indeed, this paper is just part of a larger project onthis topic that has been under way under my direction at the Federal ReserveBank of New York.