Whither inflation targeting as a global monetary standard?

Summary

Focus

From its tentative beginnings, inflation targeting has spread to become the de facto global monetary standard. Historically, only the Gold Standard has had a longer lifespan. What have been the framework's successes and failures? What adjustments could make it fit for purpose in the longer term?

Contribution

This paper examines the challenges inflation targeting has faced since its inception. It distinguishes those challenges that are independent of the framework from those that are at least in part the result of its operation. This forms the basis for suggested improvements.

Findings

Inflation targeting has helped hardwire price stability – its primary objective. At the same time, it has faced a number of challenges that are in part the result of its operation: the rise of financial instability, difficulties in pushing inflation back up to point targets, and a historical erosion in the room for policy manoeuvre. The proposed adjustments include more systematic consideration of the longer-term economic damage that financial forces can cause and of the importance of safety margins in the conduct of policy. And all this would need to be grounded on a clear recognition of what monetary policy can and cannot deliver. The adjustments are all the more important given that in all probability the toughest challenges for monetary policy are still to come.

Abstract

From its tentative beginnings, inflation targeting has spread to become the de facto global monetary standard. Historically, only the Gold Standard has had a longer lifespan. Inflation targeting has done its job: helping to hardwire a low-inflation regime, even in the face of the post-Covid inflation surge. But the journey has been far from easy. Inflation targeting had to contend with the rise of financial instability, most spectacularly in the form of the Great Financial Crisis. In the wake of that crisis, it struggled to push inflation back up to point targets, and it saw a historical erosion in the room for policy manoeuvre. This paper assesses these challenges and considers possible adjustments to the framework. These include more systematic consideration of the longer-term damage that financial factors can cause to the economy and of the importance of safety margins in the conduct of policy. And all this should be grounded on a clear recognition of what monetary policy can and cannot deliver.

JEL classification: E43, E51, E52, E58, E31

Keywords: monetary policy, business cycle, financial cycle, inflation targeting, deflation, natural interest rate