Advancing the Frontiers of Monetary Policy: The Book by the Architects of Inflation Targeting

In 2018, IMF experts published a book entitled Advancing the Frontiers of Monetary Policy, edited by Tobias Adrian, Douglas Laxton, and Maurice Obstfeld, which provided a rare insight into the perspective of a group of people who could be considered the architects of inflation targeting. The book deals with practical issues surrounding this monetary policy regime, which has rapidly gained broad acceptance and is currently applied by the majority of central banks worldwide. Certain of the issues brought up in the book regarding the continued evolution of the inflation targeting policy are also relevant to Russia.

The general theme of the book is the evolution of what is officially known as the ‘inflation targeting regime’, potential ways of applying it, and possible approaches to further improving it. The regime was first implemented in New Zealand about thirty years ago; Canada almost immediately followed suit. In the 1990s and early 2000s, this monetary policy regime became widespread in both advanced and emerging economies. Now, only a handful of highly or moderately developed economies favour other monetary policy regimes, usually as a result of the special conditions under which they operate.

The evolution of inflation targeting

Over its almost thirty-year history, the inflation targeting regime has undergone an evolution. The essence of this evolution has been to alter the very concept of reaching and deviating from policy goals. Thirty years ago, the key problem faced by both developed and emerging economies was high inflation, which the inflation targeting regime helped bring down to a constant, low level. At first, in order to achieve this, central banks followed the rules for meeting the inflation target quite strictly.

However, as economies adapted to the inflation targeting regime and to anchoring inflation expectations around the target, central banks came to adopt a more flexible approach to the inflation target. The authors call this ‘inflation forecast targeting’. In adopting this approach, when implementing their policies, central banks take into account the nature of the gap between actual inflation and the inflation target, and the balance of risks to inflation and economic growth. On this basis, they decide how to achieve the inflation target, create relevant forecasts, and implement the policy they deem suitable.

This approach required substantial changes to central banks’ internal procedures, as well as to their systems of communication with the market and the public in general. To create a forecast that the expert community would consider trustworthy, a central bank has to devote considerable effort to developing its own research and analysis capacity.

All central banks that carry out inflation targeting policy have research departments handling model construction, data analysis, and forecasting. These units constantly communicate with research and expert communities, take part in conferences, and have their research papers published in scientific journals. When central banks favoured fixed exchange rate policies, this economic analysis and modelling capacity was irrelevant.

New communication policy

In the era of fixed exchange rates, and also during the following period of floating exchange rates with no clear targets, having a special communication policy was equally futile. On the contrary, central banks often adhered to the principle of secrecy. They did not disclose even their operating targets for money market interest rates, let alone their forecasts.

However, the switch to inflation forecast targeting brought about a major change. Today, communication is considered a key element of central bank’s policy. At a minimum, the necessary communications would include an announcement of decisions about the interest rate taken by the Board of Directors (or Monetary Policy Committee) straight after their meetings and an almost immediate explanation of the rationale behind them. This could be in the form of either a press release or a press conference given by the Chairman of the Board of Directors or the head of the Monetary Policy Committee. In addition, most countries publish a more detailed monetary policy report (or the ‘inflation report’, as it is called in some countries), and many countries issue a more detailed description of the Board of Directors’ meetings (the so-called ‘minutes’). As the inflation targeting regime has been used in different economies where markets have reached various stages and depths of development, operating procedures are diverse.

Issues relevant to Russia

In the 1990s–2000s, inflation targeting helped many countries reduce inflation and keep it low, thereby creating new opportunities to develop their economies and financial markets. However, the 2008 crisis gave rise to new issues. What’s more, the inflation targeting regime itself continues to improve in a variety of countries, allowing practices to be enhanced. Advancing the Frontiers of Monetary Policy covers the main controversies and provides recommendations for the continued improvement of inflation targeting. We will, therefore, dwell on issues that are also relevant to Russia: above all, issues of communication.

The issue of what central banks’ policy forecasts should look like is currently a focus of widespread debate. The authors believe that best practice would consist in publishing interest rate forecasts along with the overall economic forecast in a report by employees. Only a few central banks (for instance, those of Norway and the Czech Republic) have adopted this approach; most merely issue rather general statements.

A case against interest rate forecasts

The central banks’ main concern is that the status of this forecast is unclear and that it could be perceived as a policy commitment. This concern is all the more understandable as, in the period of close-to-zero interest rates, unconventional communications regarding future policies were indeed commitments. According to the authors, such an interpretation can be avoided if the forecast is published in a report prepared by central bank employees who do not take part in interest rate decision-making, and if this report explains how the forecast is related to other elements of economic development scenarios. Moreover, forecast publishing helps align the central bank’s expectations with those of the market. In particular, the authors hypothesize that the market response to the Fed’s announcement of its plans to abandon quantitative easing in 2013 (the so-called ‘tapering’) could have been less volatile if, instead of general statements, the Fed had published its forecast of interest rate changes. However, this recommendation, in our view, is not universally applicable.

In most cases, the Bank of Russia follows a more usual approach, making general policy comments. This enables us to align our expectations with those of the market while allowing for policy flexibility in the face of multiple structural shocks. In our view, publishing interest rate paths, even with reservations, could indeed be perceived as a commitment. This would not only reduce policy flexibility, but also shift the focus of the discussion away from its ultimate goal, inflation, towards interim goals. Nevertheless, when our internal interest rate forecasts differ significantly from those of the market, we can turn to clearer communications. In late 2016, the Bank of Russia in effect made a commitment not to revise its interest rate for several months if the economy developed as forecasted. In 2017–2018, the regulator started forecasting the pace of switching to neutral rates while announcing the interest rate path.

Political issues surrounding inflation targeting

We note that a sizeable proportion of the book in question is devoted to discussion of the application of the inflation targeting regime in emerging markets and less developed countries. The experience of India, which chose to adopt inflation targeting despite massive structural inflation shocks, might well be of interest to Russia.

All in all, the analysis of global experience provided in the book shows that structural features of economies and financial markets do not impede the successful implementation of inflation targeting regimes. The main problem is of a political nature: the problem of fiscal domination. The crux of this issue might lie in the fact that a central bank is directly exposed to political pressure and is forced to make decisions driven by goals other than inflation control. Another manifestation of this problem is an unbalanced fiscal policy that constrains the effectiveness of monetary policy. This is precisely why a Russian budget rule was introduced in 2017, enhancing the Bank of Russia’s effectiveness in achieving inflation targets, and helping cut long-term interest rates.

• The full article is available at the Russian Journal of Money and Finance, №2/2018