Inflation Targeting
Why It Works And How To Make It Work Better
William T. Gavin
Inflation targeting has worked well because it leads policymakers to debate, decide on, and communicate the inflation objective. In practice, this process has led the public to believe that the central bank has a long-term inflation objective. Inflation targeting has been successful, then, because the central bank decides on an objective and announces it, not because of a change in its day-to-day behavior in money markets or the way it reacts to news about unemployment or real gross domestic product. By deciding on an inflation rate and announcing it, the central bank is providing information the public needs in order to concentrate expectations on a common trend. The central bank gains control indirectly by creating information that makes it more likely that people will price things in a way that is consistent with the central bank’s goal.
The way to improve inflation targeting is to be more explicit about the average inflation rate expected over all relevant horizons. Building a target path for the price level, growing at the desired inflation rate, is the best way to institutionalize a low-inflation environment. In a wide variety of economic models, a price-path target mitigates the problem of a zero lower bound, eliminates worries about deflation, and improves the central bank’s ability to stabilize the real economy.
This paper was presented at the 45th annual meeting of the National Association for Business Economics, September 2003.