CIAO DATE: 07/02

Does Talk Matter After All? Inflation Targeting And Central Bank Behavior

Abstract

Since 1990, a number of countries have adopted inflation targeting as their declared monetary strategy. Interpretations of the significance of this movement, however, have differed widely. To some, inflation targeting mandates the single-minded, rule-like pursuit of price stability without regard for other policy objectives; to others, inflation targeting represents nothing more than the latest version of cheap talk by central banks unable to sustain monetary commitments. Advocates of inflation targeting, including the adopting central banks themselves, have expressed the view that the transparency and communication of the inflation targeting framework grant the central bank greater short-run flexibility in pursuit of its long-run inflation goal.

This paper assesses whether the talk that inflation targeting central banks engage in matters to central bank behavior, and which interpretation of the strategy is consistent with that assessment. We distinguish five distinct interpretations of inflation targeting, consistent with various strands of the current literature, and characterize those interpretations as movements between various strategies in a conventional model of time-inconsistency in monetary policy. The empirical implications of these interpretations are then compared to the response of central banks to movements in inflation of three countries that adopted inflation targets in the early 1990s.

For all three, the evidence shows a break in inflation's time series properties consistent with a strengthened commitment to price stability. In no case, however, is there evidence that the adoption of an inflation targeting strategy entails a single-minded pursuit of the inflation target. For the U. K. and Canada, the results are generally consistent with adopting banks' own interpretation of inflation targeting, i. e., successful approximation of the optimal state-contingent rule. For these central banks, lower inflation levels and persistence are combined with greater accommodation of real shocks and more stable private-sector inflation expectations than seen prior to adoption. The results for New Zealand are more a mix of increased conservatism and trust, perhaps reflecting the more rule-like strictures of that nation's targeting framework.

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