P248 inflation targeting(2)

A broader mandate: Why inflation targeting is inadequateThe foundations of inflation targetingInflation-targeting regimes were built upon two key intellectual foundations.• The first was Friedman’s (1968) insight that there is no long-run trade-off betweeninflation and output.While a short-run trade-off may exist in which higher output can be obtained at theexpense of higher inflation, in the long run the level of output that will prevail should beindependent of inflation. Since inflation is unpopular and output is beyond their controlover the long run, this insight implied that central banks should focus on what they cancontrol – a low rate of inflation.• The second is the literature on dynamic inconsistency pioneered by Kydland andPrescott (1977), and further explored in relation to monetary policy by Barro andGordon (1983) and Rogoff (1985).This research pointed out that, because a short-term trade-off exists between output andinflation, the public may expect a central bank to occasionally ‘cheat’ an inflation targetto produce higher output. It argued for institutional structures that encouraged centralbanks to commit to a low inflation outcome in a way that will be accepted by the public.If this outcome is obtained, a central bank will not only achieve its long-run inflationtarget, but will also face a friendlier short-run trade-off as inflationary expectations tendto stay ‘anchored’ in response to shocks.Combined with the unsatisfactory stagflation experience of advanced economies in the1970s, this academic literature had a profound influence on central-banking practice.From the late 1980s onwards, there was a significant trend towards making centralbanks more independent, giving them explicit inflation targets and setting price stabilityas their primary legal goal. Central bankers themselves increasingly conformed toRogoff’s recommendation, taking turns to see who could come across as more hawkishon inflation and inflicting long, boring speeches about the endless benefits of pricestability on many a captive audience.105