Simple rules for monetary policy 257

These problems of the implicit rule of monetary targeting are discussed

theoretically in the Poole model (see Appendix 4.1 above), which analyses
the effects of an unstable demand for money.

8.4. INFLATION TARGETING

For a consideration of inflation targeting this section will discuss the
approach of the Bank of England (BoE), which has played a similarly pio-
neering role for this approach as the Bundesbank did for monetary targeting.

• The explicit rule of the BoE's inflation targeting can be formulated as fol-
lows: Keep the conditional inflation forecast of the retail price index
(excluding mortgage interest payments) for a target horizon of two years
close to the target value of 2.5°/o.
• The implicit rule is less specific but can be formulated as follows: If
the conditional forecast exceeds (falls short of) the inflation target, an
increase (reduction) in interest rates is required. The example of the
Reserve Bank of New Zealand shows that an inflation forecast can be
also conditional upon an interest rate path.

Inflation targeting looks similar to monetary targeting, since it too

reduces monetary policy decisions to a single cue: the central bank's infla-
tion forecast. But, while this rule looks simple at first sight, we will see that
it is very different from a 'fast and frugal heuristic'.

8.4.1. Introduction
Since 1988, a number of countries have explicitly adopted a monetary pol-
icy approach which is generally described as 'inflation targeting'. New
Zealand was the first to do so in 1989, followed by Canada (1991), Israel
(1991), the United Kingdom (1992), Sweden (1993), Finland (1993),
Australia (1993), and Spain (1994). While monetary targeting had been
drawn up after an intensive academic discussion, inflation targeting was
developed mainly as an ad hoc solution. In Canada and New Zealand,
it was, above all, the unsatisfactory experience with monetary targeting
that prompted the change of approach. In the European countries the deci-
sion to try a new strategy was triggered by the fact that their exchange
rate target vis-a-vis the Deutschmark or the Ecu had become obsolete
following the unexpected collapse of the Exchange Rate Mechanism (ERM)
in the 1992-3 crisis. In these cases a new strategy had to be found
almost overnight. This explains the quite pragmatic approach of inflation
258 Policy
targeting, for which a theoretical framework was developed only many years
after its first application (Leidermann and Svensson 1995; Svensson 1997).
We shall begin with an attempt to identify the specific elements of infla-
tion targeting, above all in comparison with monetary targeting. We will
then consider the concrete application of inflation targeting by the Bank of
England. Finally, we will discuss the 'simple rule' that can be deduced from
inflation targeting and will compare it above all with monetary targeting.

8.4.2. Genuine elements of inflation targeting

In their comprehensive study, Bernanke et al. give the following definition
of'inflation targeting':
Inflation targeting is a framework for monetary policy characterised by the public
announcement of official quantitative targets (or target ranges) for the inflation
rate over one or more time horizons, and by explicit acknowledgement that low,
stable inflation is monetary policy's primary long-run goal. Among other import-
ant features of inflation targeting are vigorous efforts to communicate with the
public about plans and objectives of monetary authorities, and in many cases,
mechanisms that strengthen the central bank's accountability for attaining those
objectives. (Bernanke et al. 1999: 4)

This definition more or less circumscribes what in Germany, above all,

has long since been understood as a 'stability-oriented monetary policy'. It
is much less demanding than a definition that can be found in Svensson:
Inflation targeting is characterised by, first, an explicit numerical inflation target.
The inflation target is pursued in the medium run, with due concern for avoiding
real instability, for instance, in the output-gap; that is, inflation targeting is
'flexible' rather than 'strict'. Second, due to the unavoidable lags in the effects of
instruments on inflation, the decision framework is in practice 'inflation-forecast
targeting' — Third, communication is very explicit and to the point; policy deci-
sions are consistently motivated with reference to published inflation and output
(-gap) forecasts. (Svensson 2000&: 95)

An additional element of'inflation targeting' as it is presented in the study

by Bernanke et al. is a preference for an inflation target that is set by
'elected officials':
Because ultimately policy objectives in a democracy must reflect the popular will,
they should be set by elected officials. (Bernanke et al. 1999: 312)

As far as the execution of the inflation target is concerned, Bernanke

et al. favour 'instrument independence', which means that the central bank
 Simple rules for monetary policy 259
should have the sole responsibility for the setting of interest rates. This
topic and the problems of a lack of goal independence have already been
discussed in Chapter 6.
The different elements of inflation targeting according to the definitions
by Bernanke et al and Svensson are summarized in Table 8.2. If we start
with the definition by Bernanke et a/., it would be very difficult to identify
the specific features of inflation targeting. As we will see in Section 9.3, the
ECB's approach matches almost all parts of the definition by Bernanke
et al The same applies to the Bundesbank, which, although it did not
explicitly publish an inflation target, announced a numerical normative
inflation target on an annual basis when setting its monetary target
(Section 8.3). In spite of this accordance, however, Bernanke etal. classify
these two central banks not as inflation targeters but as' "hybrid" inflation
targeters and monetary targeters' (Bernanke etal 1999:41). The main rea-
son for this seems to be that both central banks attach an importance to
monetary targeting. Thus, the definition by Bernanke et al. implicitly
includes as a negative criterion that a central bank can only be regarded as
an inflation targeter if it does not follow traditional intermediate targets
like the money stock or the exchange rate. This criterion becomes more
explicit in the definition by Svensson, who defines inflation targeting as
'inflation forecast targeting', which he regards as a rule that is completely
different from monetary targeting (Svensson 1999b). Thus, we shall follow
this definition in the following and interpret inflation targeting as an

Table 8.2. Alternative definitions of inflation targeting

Criterion Bernanke etal. (1999) Svensson (20006)

(1) Price stability as the main Yes Yes

target of monetary policy
(2) Announcement of a Yes Yes
numerical target
(3) Medium-term target Unclear ('one or more Yes
time horizons')
(4) Intensive communication Yes Yes
with the public
(5) Specific monetary policy rule Unclear Inflation forecast
targeting
(6) Published inflation and Not required Yes
output forecasts
(7) Target set by government Yes Not required
('goal dependence1)
(8) Instrument independence Yes Yes, but not explicitly
addressed
260 Policy
approach to monetary policy in which a central bank pursues the ultimate
target of price stability without taking recourse to traditional intermediate
target aggregates such as the exchange rate or the money supply.
A somewhat unclear issue in the classification of inflation targeting is
the importance of publishing a central bank's internal inflation forecast.
While Bernanke ct al are not very specific about this question, Svensson
regards the publication of internal forecasts as essential. However, the
Bank of Canada and the Bank of Australia are widely regarded, and regard
themselves, as inflation targeters, although they provide only rather non-
technical forecasts that are hardly different from statements that can be
found in the ECB publications.12
In the context of this chapter, the elements (l)-(4) of Table 8.2 will not
be discussed in detail. As they are not a specific feature of inflation tar-
geting, they have already been described and analysed in the preceding
chapters. In this chapter we will focus on the interesting issue of whether
inflation targeting can be regarded as a 'simple rule' for the setting of a
central bank's short-term interest rates.

8.4.3. The explicit rule of inflation targeting

The explicit rule of inflation targeting requires that a central bank keeps its
inflation forecast close to its inflation target. Thus, the determination of the
target value and the forecast value of inflation play a crucial role in the
whole concept
We have already seen that inflation targets can be formulated quite dif-
ferently. In the United Kingdom, the inflation target is set by the chancel-
lor of the Exchequer. The present target, which was determined on 12 June
1997, is a rate of 2.5°/o for the RPIX, i.e. the index for retail price inflation
excluding mortgage interest payments. The target is surrounded by a
threshold of ± l°/o. When the threshold is reached, the chancellor expects
an explanatory letter from the Bank.
While the definition of the target \s relatively simple, the determination
of the forecast is quite complicated. The Bank of England publishes this
forecast, which it calls its 'inflation projection', in a quarterly Inflation
Report together with a projection for real GDP. As already mentioned, the
forecast is presented as a conditional forecast; i.e., it is based on the

12
See e.g. European Central Bank (1999c: 6): 'Available forecasts suggest that, despite the expected
rise in the rate of increase in the H1CP in the coming months, price increases will nevertheless remain
below 2% in 2000 and 2001.' In December 2000 the ECB published an inflation projection that was pre-
pared by its staff, but it maintained that this does not entail a switch to inflation targeting (ECB 2000d).
 Simple rules for monetary policy 261

Figure 8.4. The Bank of England's 'fan-chart'for inflation (RPIX)

Source: Bank of England: www.bankofengland.co.uk.

assumption of a constant short-term interest rate. A different approach is

followed by the Reserve Bank of New Zealand, which makes its forecast
conditional upon an interest rate path (i.e. it forecasts the annual average
for the three-month money market rate). The Bank of England forecast is
made for a time horizon of two years in advance. As Figure 8.4 shows, the
inflation projected is presented in the form of the so-called 'fan chart'. It
can be read rather like a contour map. The Bank of England states:
At any given point during the forecast period, the depth of the shading represents
the height of the probability density function over a range of outcomes for inflation.
The darkest band includes the central (single most likely) projection and covers
10% of the probability. Each successive pair of bands is drawn to cover a further
10% of the probability until 90% of the probability is covered. The bands widen as
the time horizon is extended, indicating increasing uncertainty about outcomes.
(Bank of England 20006: iv)

Haldane describes how the Bank's inflation projection is produced:

The general point here is that the Bank's published inflation projection is not a
mechanical extrapolation from a single macro model. Rather, it draws upon a much
wider and richer set of information variables—quantitative and qualitative, real and
monetary. Indeed, increasingly, the Bank's published projection is also drawing on
262 Policy
a wider set of models, as well as information variables — The eclectic approach to
the use of models mirrors the approach when using indicators Using a 'portfolio'
of models offers insurance against model uncertainties. Diversification applies as
much to policy-makers when choosing among uncertain indicators and macro
models as it does to investors when choosing among uncertain securities and asset-
pricing models. (Haldane 1997: 21)
If we compare this with the concept of monetary targeting (which is
different now from how it used to be practised—see Section 9.2), we can
see that inflation targeting entails a completely different approach. While
monetary targeting (and other 'simple rules') intends to reduce the com-
plexity of the economic process to a 'fast and frugal heuristic' that can be
easily implemented by the central bank and easily monitored by the
public, the 'eclectic approach' favoured by inflation targeting leaves it
completely open how such a reduction should be achieved. While mone-
tary targeting uses only the money stock to predict inflation, inflation
targeting implies that almost all available information is used. In other
words, inflation targeting can certainly not be regarded as a 'simple rule'.
Bernanke et al. put this as follows:
First, at a technical level, inflation targeting does not provide simple, mechanical
operating instructions to the central bank. Rather inflation targeting requires
the central bank to use structural and judgmental models of the economy, in con-
junction of whatever information it deems relevant, to pursue its price-stability
objective. In other words, inflation targeting is very much a 'look at everything'
strategy, albeit one with a focused goal. (Bernanke et al. 1999: 22)

As a result, the targeting process is also difficult for the public to monitor.
Monetary targeting requires a comparison of two relatively objective data:
the monetary target derived by the 'potential formula', and the actual mon-
etary growth. Inflation targeting requires a comparison of a target value,
which is also easy to derive, with an inflation forecast, which is very diffic-
ult to verify, at least by the public.
Because of these completely different approaches, it is also problematic
to regard the central bank's inflation forecast as an intermediate target of
monetary policy (Haldane 1995; Svensson 1999b). Of course, this analogy
can be derived from a comparison with monetary targeting, where the
money stock serves as the main forecast for inflation and at the same time
as the intermediate target of monetary policy. But our discussion of inter-
mediate targets has shown that they were designed for an indirect tar-
geting process, i.e. as alternative to a direct targeting of ultimate goals.
As inflation targeting implies such a direct targeting, it must lead to con-
fusion if the inflation forecast is treated as an intermediate target.
 Simple rules for monetary policy 263

8.4.4. The implicit rule of inflation targeting

The implicit rule of inflation targeting, as it is understood in the policy
debate, is relatively simple: if the conditional forecast leads to a value that
is higher (lower) than the target, an increase (decrease) in the short-term
interest rate is required. Thus,

The interest rate in thas to be higher than the interest rate in t - 1, if the
conditional forecast in t for T quarters ahead on the basis of the interest rate
in t - 1 exceeds the target value. This rule looks compatible with the prac-
tice of the Bank of England, which Haldane (1997: 22) describes as follows:
the constant interest rate assumption is useful in helping the Bank decide on the
appropriate direction for future interest rate moves — (Haldane 1997: 22)
However, this 'simple rule' leaves open
1. by how much the interest rate has to be adjusted if the forecast deviates
from the target, which depends on the value of y, and
2. whether any deviation from target is already a cause for an interest rate
adjustment which depends on the nature of macroeconomic shocks.
Alternatively, the implicit rule could also be formulated as:
with
This variant which comes relatively close to a Taylor rule can be found
in Svensson (1999b: 615), but so far the Bank of England has not made any
statement on an average short-term interest rate i, which would be neces-
sary for the implementation of such a rule.

8.4.5. Inflation targeting and macroeconomic shocks

While monetary targeting has been designed as a medium-term or even
long-term strategy defining a passive role of monetary policy, inflation
targeting leads to a more activist approach based on a short- to medium-
term orientation of interest rate policy. We will describe this using the
IS/LM-AS/AD apparatus.
The main difference between monetary targeting and inflation targeting
can be shown in the situation of a (e.g. negative) demand shock. If the shock
is persistent enough to affect the two-year time horizon of the inflation fore-
cast, the central bank has to react by adjusting its interest rates with the aim
of completely offsetting the shock. In the AS/AD model this implies that the
264 Policy
aggregate demand curve that was shifted to the left by the shock is shifted
back to its original position by an expansionary monetary policy (back to
AD0 in Figure 8.2). With monetary targeting, the aggregate demand curve
would not have been readjusted. Thus, inflation targeting with a two-year
horizon requires a fine-tuning of economic activity which is absent in mon-
etary targeting.13 If the time horizon were extended to, say, four years, infla-
tion targeting would also lead to a more passive attitude of monetary policy.
In the situation of a supply shock that affects the forecast, inflation tar-
geting seems to prescribe a completely non-accommodating policy stance.
If interest rates are set so that the forecast of inflation rate remains always
identical with the target, a supply shock would require a much stronger
interest-rate increase than under monetary targeting or a nominal income
rule. In practice, however, inflation targeting is much more flexible. As
mentioned in Section 5.4, the targets are often defined for core inflation,
which means that they exclude energy and food prices. In the case of the
Bank of England, the threshold of ± l°/o offers some additional flexibility.

8.4.6. Inflation targeting: a framework, but not a 'simple rule'

So far, we have seen that inflation targeting as it is recommended by aca-
demics and applied by central banks is very different from a 'simple rule'
for policy-makers and the public at large.
With its 'eclectic approach', it does not prescribe a specific set of variables
and a specific model with which an inflation forecast can be produced.
Thus, the explicit rule leaves ample room for discretion in producing an
inflation forecast.
The implicit rule that can be derived from inflation targeting is not spe-
cific enough either, as it leaves it open by how much the interest rate has to
be adjusted if a deviation from the inflation target is expected. Nor does it
give any clear advice in the case of supply shocks.
Thus, if a stability-oriented central banker were to seek guidance from
such a policy rule, she would soon realize that there is little to learn from
inflation targeting except that she should
1. pursue a forward-looking approach (but she might know this already);
2. not rely solely on traditional intermediate targets like the money stock
or the exchange rate (but, at least in the case of monetary targets,
nobody did that anyway-see Section 9.2);
13
AsSvensson (1999&) shows, monetary targeting could be also designed for an inflation targeting
approach. In this case, the money stock would have to be permanently readjusted in order to generate
an interest rate level that is compatible with the attainment of the inflation target. But this implies a
completely different framework from the Bundesbank approach presented in Section 8.2.
 Simple rules for monetary policy 265
3. use different macroeconomic models; but also
4. rely on her judgement (which is another term for an 'eclectic approach').
In other words, although inflation targeting is often understood a 'rule'
facilitating a stability-oriented monetary policy, it comes relatively close
to pure discretion. Also, an approach that is 'indescribable in detail'
(Vickers 1998) is not very helpful for communicating with the public. For
those observers who are unable to produce their own forecasts, there is
no other 'rule' by which they could at least check the plausibility of the
central bank's forecast. This is especially problematic if the central bank
forecast is conditional on a given interest rate level and external forecasts
are made under the assumption of a certain interest rate path, which means
that a comparison of internal and external forecasts is impossible.
Thus, in spite of its seeming transparency, inflation targeting is a rather
intransparent approach, as far as the realization of the ultimate targets of
monetary policy is concerned. It can be compared to a cookery book that,
instead of providing concrete recipes, only contains pictures of the pre-
pared dishes and the advice to buy the best ingredients and prepare them
as skilfully as possible. This does not mean that inflation targeting is use-
less as a policy framework for a stability-oriented monetary policy. It
clearly has its merits, by providing numerical targets for the inflation rate
which serve as the main benchmark for the evaluation of central bankers.
The limited contribution of inflation targeting to the transparency of
monetary policy is confirmed by the evidence of its concrete effects. In the
view of Svensson (2000a: 155), inflation targeting can be regarded as an
'apparent success'. Bernanke era/. (1999: 6) come to the result that inflation
targeting 'has had important benefits for the countries that have used it'.
Upon closer scrutiny, however, the benefits of inflation targeting are much
less clear-cut. Even Bernanke et a/., contains a rather sceptical assessment:
Overall, though, we must admit that the economic performance of the non-
targeters over the period considered is not appreciably different from that of infla-
tion targeters. (Bernanke et al 1999: 283)
Lane and van den Heuvel (1998), Siklos (1999), and Jonsson (1999) come
to rather similar results. Jonsson shows that inflation has become less
volatile after the introduction of inflation targeting, but the same effect
can be observed in many other industrial countries.

8.4.7. Inflation expectations as an intermediate target aggregate

In the discussion of inflation targeting, relatively little attention has been
paid to the role of private-sector inflation expectations. This is somewhat
266 Policy
astonishing, as several central banks now provide intensive information
on different indicators of such expectations. Four different groups of indi-
cators can be distinguished.
1. Surveys of the results of inflation forecasts made by professional
researchers. For instance, the ECB has conducted a quarterly survey of
inflation expectations in the euro area: the Survey of Professional
Forecasters (SPF).14 In its Monthly Bulletin the ECB publishes the SPF
together with other survey-based indicators of future price develop-
ments (e.g. from Consensus Economics).
2. Surveys of inflation expectations of households, managers, trade union
officials. Such data are published by, e.g., the Reserve Bank of Australia
or the Bank of England.
3. Indicators of inflation expectations derived from financial market data,
above all long-term bond yields and the difference between such yields
and the yields of index-linked gilts. Such data are regularly published
by the ECB and other central banks.
4. In addition, the results of wage settlements can be used as very import-
ant indicators of inflation expectations and of future cost pressure.
The theoretical basis for the specific role of private inflation expectations
is provided by the 'expectations channel' (see Section 4.5). As already men-
tioned, its main feature is that market participants' inflation expectations
provide a link between the instruments available to the central bank and
the ultimate objective of monetary policy:
Instruments => Operating target => Inflation expectations
=> Inflation target.
Compared with the highly complicated process of producing an internal
inflation forecast, the four sets of data on inflation expectations provide a
relatively simple rule for monetary policy. As long as inflation expect-
ations are identical with the inflation target, the risk of missing the inflation
target is relatively low, especially if the currency area is relatively large so
that it is not very much exposed to the disturbances of exchange rates.
This does not necessarily imply that interest rates will be held constant.
If private inflation expectations are made under the assumption of an inter-
est rate path, e.g. with increasing rates, this rule implies that the central

14
For details, see ECB (2000o: 28): The inflation expectations obtained from the SPF are based on
the responses to a questionnaire submitted to a sample of 83 forecasters throughout the EU.
Respondents are asked to provide estimates of the expected rate of change in the euro area HICP, look-
ing one and two years ahead. Once a year, in February, the SPF also requests expectations for five years
ahead.'
 Simple rules for monetary policy 267
bank will also follow this path. In its quarterly Inflation Report, the Bank of
England presents a survey of twenty-eight forecasters who, in addition to
their inflation forecasts, provide a survey of their forecasts for the repo
rate. In case of inflation expectations that diverge from the inflation target,
the rule calls for a change in interest rates or for an interest rate path that
differs from the forecasts for interest rates.
This use of inflation expectations in a 'simple rule' does not imply that
the central bank is reacting mechanistically to inflation expectations. In
the same way as the proponents of monetary targeting always envisage the
possibility of a deviation as long as the central bank can justify it, a mon-
etary rule based on private inflation expectations can be suspended as long
as the central bank has convincing arguments for such a procedure
(Bernanke and Woodford 1997: 682).
Important reasons for not reacting to private inflation forecasts that
differ from the inflation target could be
• a supply shock;
• a demand shock of a very short-term nature;
• a wrong assumption of outside forecasters about the future interest rate
path.
In order to serve as an intermediate target, inflation expectations must be
controllable by the central bank, and they must also have a close correlation
with the ultimate goal of price stability. The second of these conditions seems
relatively unproblematic (see Deutsche Bundesbank 2001). As is discussed in
detail in Section 4.5.2, because of price rigidities, the inflation rate is in the
short run essentially determined by inflation expectations in the previous
period. This correlation is especially strong in a large economy or in a smaller
economy that is able to maintain a fixed exchange rate vis-a-vis an anchor
currency (e.g. Austria and the Netherlands in the 1980s and 1990s).
When considering the suitability of inflation expectations as an intermedi-
ate target, it is also important that they can be controlled by the central bank's
instruments. This question is discussed in more detail in Section 4.5.7, where
it is shown that, when a central bank's reputation is high, low inflation expect-
ations tend to stabilize themselves and there is very little need for active man-
agement on the part of the central bank. In the event of a massive inflationary
shock which drives inflation expectations up, the central bank will have to
raise its real money market rates substantially in order to trigger restrictive
impulses in the real economy via the aggregate demand channel. If the cen-
tral bank uses its instruments in this way, private individuals can deduce from
this that the central bank is giving high priority in its target function to the
objective of price stability (relative to the employment objective). They will
268 Policy
therefore adjust their inflation expectations downwards. Such management
of inflation expectations thus takes place as follows:
Nominal money market rates T => (assuming short-term price
rigidities) Real money market rates t => Macroeconomic demand 1
=> Unemployment T => Inflation expectations 1
In the case of the Federal Reserve Board's monetary policy, Goodfriend
describes this mechanism in the context of disinflation as follows:
Inflation scares appear to be central to understanding the Fed's management of
short-term rates— Sharply rising long rates in the first 9 months of 1981 indi-
cated that the Fed had yet to win credibility for its disinflationary policy, and prob-
ably contributed to the Fed maintaining very high real short rates for as long as it
did. (Goodfriend 1995: 137)
As well as exerting influence on inflation expectations 'by deeds'
(Briault et al. 1996: 67), central banks can also seek to produce a similar
effect 'by words'. The main instruments of a central bank's communication
policy have already been discussed in Section 7.3.

8.5. THE TAYLOR RULE:

A RULE FOR AN OPERATING TARGET
After considering rules for the setting of an intermediate target and an
ultimate target of monetary policy, we now come to rules prescribing a
concrete value for the short-term interest rate that serves as the operating
target for all central banks in the world. We have already discussed two
implicit rules for the setting of operating targets that serve as implicit rules
for the control of the monetary growth and the central bank's inflation
forecast. In this section we will focus on a rule that has been formulated
explicitly for the short-term interest rate, the so-called Taylor rule. This
was developed by John Taylor (Taylor 1993) and states: keep the real-
short-term interest rate constant as a neutral policy stance, and make a
surcharge (discount) when the output gap is positive (negative) and/or
inflation is above (below) a target rate.
This rule comes very close to the ideal of a 'fast and frugal heuristic', as
it reduces the monetary policy decision process to a limited set of relatively
easily accessible variables.

8.5.1. Introduction
Like inflation targeting, the Taylor rule was not developed from a compre-
hensive theoretical model or an intensive academic debate. It was the result