An explicit inflation target has been praised as a simple, visible, verifiable, easily understood and rarely changing goal that permits central bankers’ to enhance their reputation for being tough on inflation. Unfortunately, however, if inflation is too high, the public may not be able to tell whether the central bank has an inflation bias arising from the time-inconsistency problem or is just incompetent or unlucky.
Central banks have various instruments at their disposal with which to try to attain their desired level of inflation. These include open-market operations, discount rates and reserve requirements. A motivated member of the public might attempt to infer from open-market operations, reserve requirements and discount window rates whether or not the central bank is being too expansionary, but the relationship between these instruments and inflation is highly complex.
8 Countries such as the Baltics and Iceland would benefit in the short run from unilaterally adopting the euro and
Even the central bank might find it difficult to infer undue expansion from the values it sets for these instruments. Since it is difficult to know what level of a particular instrument will be most apt to produce a given inflation rate, central banks often use intermediate targets; that is, the central banks target variables that are both more directly related to inflation than their instruments and easier to target precisely using their instruments than inflation itself. As many economists believe that there is a stable long-run relationship between money and inflation, monetary aggregates were a popular intermediate target in the 1970s and 1980s and were used by the German Bundesbank and the Swiss National Bank.
A problem with this regime is that its merits depend upon the short-term and medium-term relationships between the monetary aggregates chosen as targets and inflation. Currently, these relationships are not stable or predictable enough for monetary aggregates targeting to be a good way of ensuring that inflation is low and not too variable. In addition, the targeting of monetary aggregates is relatively hard for the public to understand, making it more difficult to acquire and maintain a reputation for inflationary toughness. The success of the Bundesbank in maintaining low inflation may have been due to its legendary inflation aversion, rather than properties inherent in this framework. Bernanke and Mihov (1997) use data from 1969–1995 to argue that the Bundesbank would have been better described as an inflation-targeter than as a money-targeter.
The ECB originally assigned a prominent role to the broad monetary aggregate M3, stating that it would announce a reference value for M3 that would be consistent with price stability. While the Governing Council of the ECB did not commit to always meeting this target in the short run, it stated that deviations would signal a threat to its low-inflation objective. This policy was probably intended as a mechanism for the ECB to communicate its monetary policy to the public. However, as M3 regularly exceeded its reference value the policy served only to undermine the ECB’s credibility. On 8 May 2003, to the near universal approval of academic economists, the Council announced that M3 no longer had a special role.9
While it is neither surprising nor regrettable that the targeting of monetary aggregates has been abandoned, it may seem somewhat curious that money is of so little importance in modern monetary policy-making. There is a well-established connection between monetary base creation by central banks and the rate of inflation in the long run. Mervyn King (2002) calculates that over the 30-year horizon 1968–1998 the correlation coefficient between both narrow and broad measures of money and inflation was .99. Yet, money plays no role in the canonical New Keynesian macroeconomic model that is en vogue today and, as Mervyn King (2002) comments, econometric forecasting models in most central banks do not include money.
The problem is that, as previously mentioned, the short-run correlation between money and output is small and unstable so that reduced-form models are of little use. Estrella and Mishkin (1997) and Stock and Watson (1999) find that money growth has little or no useful information for inflation forecasting. Nevertheless, some prominent economists, such as Charles Goodhart (2007), believe that matters have gone too far; that paying attention to money, especially in times of turbulence, is important. Not all economists have despaired of developing structural models that would enable the extraction of information from monetary aggregates – see Chadha et al (2008) – but, this research is in its infancy.
9 See Svensson (2003) and Wyplosz (2003). Gerlach and Svensson (2003) find that the growth of M3 appears to
have no predictive power in forecasting future inflation. Woodford (2007) argues strongly against a special importance for money in policymaking.
Because of the problems with monetary aggregates, most inflation-targeting central banks have adopted short-term interest rates as intermediate targets. Monetary policy-makers make monetary policy by announcing a policy interest rate and then having the central bank staff conduct liquidity management operations to attempt to ensure that the announced policy rate coincides with some reference interest rate10. Thus, central bank short-term interest rates often play a double role in central bank policy: they serve as intermediate targets and they are used to signal the central bank’s monetary policy stance to the public.