Unit 5 Macroeconomic policy: Inflation and unemployment
5.9 Monetary policy and inflation targeting
- monetary policy
- Central bank or government actions aimed at influencing economic activity through changes in interest rates or the prices of financial assets. See also: quantitative easing.
We now examine in more detail the role of the second of the two policymakers we introduced in Section 5.2. The central bank implements monetary policy, via changes in the (nominal) policy interest rate, which in turn affects the real interest rate, and hence the aggregate demand and output in the economy.
The distinction between the two tools of policy does not necessarily imply that there must be two distinct policymakers. Indeed, until roughly the late 1980s, in the majority of countries in the world, central banks had very little operational independence. National monetary policy, like fiscal policy, was more or less directly controlled by national governments. In some countries including China, this remains the case even today.
- inflation target, inflation targeting
- Inflation targeting is a form of monetary policy, where the central bank changes interest rates in order to influence aggregate demand and keep the economy close to an inflation target rate, which is normally specified by the government.
- central bank independence
- A central bank is described as independent if it controls the operation of monetary policy (subject to the objectives of monetary policy set by the government).
In the 1990s, the policy known as inflation targeting by central banks was increasingly widely adopted. This was usually accompanied by a shift towards central bank independence, meaning that governments delegated the operation of monetary policy to central banks. But this was coupled with the requirement for the central bank to have a clear remit to control inflation at a target rate. Governments set the target, but central banks were given the task of achieving it. Extension 5.9 discusses the path towards central bank independence.
Before we turn to the details of inflation targeting, we pause briefly to ask: why did this shift happen? Following the experience of high and volatile inflation across the world in the 1970s, there was a rethinking of how macroeconomic policy should be designed during the late 1980s. Figure 5.12 provides some background. This chart provides data on outcomes for unemployment and inflation for selected years in the UK from 1950 to 2022.
Unemployment and inflation were both low in the 1950s and 1960s at the bottom right of the chart. Unemployment is falling from left to right, just as in the Phillips curve diagram. The first oil shock in 1973 led to the ‘high inflation 1970s’ (top right) and the 1980s resulted in the combination of high inflation and high unemployment called ‘stagflation’. It is a story that in our model reflects a combination of upward shifts in the Phillips curve (1970s) and movements along a Phillips curve to the bottom left (1980s). You can move your finger along the chart to track the reduction in inflation from 15% in 1980 to below 5% in 1984 and verify that this came at a very high cost to the British economy: the unemployment rate increased from just over 6% to almost 12%.
Having so painfully reduced inflation to below 5%, the government adopted inflation targeting in 1992. Inflation and unemployment were both lower thereafter than in the turbulent 1970s and 1980s. As we discussed in Section 5.4, the energy shock of 2022 presented a challenge to the inflation targeting policy.
Figure 5.12 UK unemployment rate (falling from left to right) and inflation rate—selected years (1950–2022).
Note: the dots indicate the combinations of unemployment and inflation observed in a sample of years between 1950 and 2022. The period 1980–1984 is highlighted to show the rise in unemployment to its peak level associated with the fall in inflation from 15% to below 5%.
Which target inflation rate to pick?
Section 4.3 discussed why people dislike rising or volatile inflation, but also that most people have no reason to object to relatively low and relatively predictable inflation, as long as it does not affect their real spending power. In many respects therefore, the choice of target inflation rate is somewhat arbitrary; and not all the countries picked exactly the same target. But the great majority of target inflation rates currently lie in the relatively narrow range of 2% to 3%.
An argument that economists make when proposing an inflation target that is higher than 2% relates to the zero lower bound on the nominal interest rate.
The zero lower bound and fear of deflation
- zero lower bound
- This refers to the fact that the nominal interest rate cannot be negative, thereby setting a floor on the nominal interest rate that can be set by the central bank at zero. See also: quantitative easing.
If the policy interest rate were negative, people would simply hold cash rather than put it in the bank, because they would have to pay the bank for holding their money (that’s what a negative interest rate means). This is the zero lower bound on the nominal interest rate. This matters because when the economy is in a deep recession, a policy rate of zero may not be low enough to achieve a sufficiently low real interest rate to drive up interest-sensitive spending and get the economy going again. It is quite possible that a negative real interest rate is needed to generate sufficient aggregate demand to restore the supply-side equilibrium.
For example, if a real interest rate of −2% is required to increase aggregate demand by the required amount, it will not be possible to achieve this using monetary policy (setting the policy rate at its zero lower bound) unless expected inflation is above 2%. If expected inflation is negative (that is, deflation is expected) then changing the policy rate cannot provide enough stimulus.
Remember that the real interest rate is equal to the nominal interest rate minus expected inflation (the Fisher equation). So the zero lower bound on the nominal interest rate means that the lower bound on the real interest rate is equal to minus one times the expected inflation rate. And if inflation is expected to be negative (deflation) then the real interest rate is positive:
\[\begin{align*} r &= i - \pi^E \\ i_{\text{ZLB}} &= 0\% \\ r_{\text{ZLB}} &= i_{\text{ZLB}} - \pi^E = -\pi^E \end{align*}\]So, for an expected inflation rate of −1%, for example, the real interest rate cannot be reduced below 1%, which is not low enough in our example. And the more rapidly prices are expected to fall, the higher is r.
- quantitative easing (QE)
- Central bank purchases of financial assets aimed at reducing interest rates on those assets when conventional monetary policy is ineffective because the policy interest rate is at the zero lower bound. See also: zero lower bound.
After the global financial crisis of 2007–2009, policy interest rates were reduced to close to zero in many economies, but this was not enough to restore aggregate demand to the supply-side equilibrium. Governments had to step in with fiscal stimulus and central banks used unconventional monetary policy called quantitative easing (QE), which aimed at reducing interest rates on long-term borrowing. Effectively, long-term interest rates became the policy instrument of monetary policy during this period.
In order to reduce the chance of the economy hitting the zero lower bound and running the risk of prolonged deflation, some economists argue that countries with inflation targets of 2% should raise them to 4% in order to provide more scope for reductions in the policy rate in a slump.1
Question 5.7 Choose the correct answer(s)
Using the fictional data on inflation and the interest rate in the table below, choose the correct statement(s).
| 2019 | 2020 | 2021 | 2022 | |
|---|---|---|---|---|
| Expected inflation rate | 0% | 1.5% | 1% | 2% |
| Nominal interest rate set by the central bank | 0% | 0% | 2% | 1% |
- The real interest rate falls from 0% to −1.5%.
- The outcome of the central bank’s monetary policy stance depends on the real interest rate, which has decreased. This means that monetary policy became more expansionary, although the central bank did not change the nominal interest rate.
- The lower bound on the real interest is the answer to the question: if the nominal interest rate is at the ZLB, what is the lowest value the real interest rate can take? This is the negative of the expected inflation rate—in this case, −1%.
- A rise in expected inflation will cause the real interest rate to fall faster than the nominal rate.
What determines the long-run inflation rate?
As we stressed at the end of Section 5.2, policymakers in general are very far from being able to exert a perfect and precise control over the economy. This caveat applies to fluctuations in both output and inflation. However, if we take a longer-term perspective, there is a distinct contrast between output growth and inflation.
In Units 9 and 10, we shall learn that there is a very strong case that neither fiscal nor monetary policy can affect the long-run growth rate of the economy, which must ultimately be determined by supply-side factors.
But when central banks target an inflation rate of x%, the best answer to the question ‘why does inflation systematically revert back to x% per annum?’ is: ‘because the central bank makes it happen’.
When, for example, a central bank reports a decision to raise the policy rate, it normally justifies the rise by saying either that current inflation is too high or that it expects inflation would rise in the future if interest rates were left unchanged. The rise is expected to dampen aggregate demand, raise cyclical unemployment and, as a result, bring inflation back down towards the target.
In Section 5.14, we show that in an open economy the impact of monetary policy will also to a significant extent work via the exchange rate. Nevertheless, the long-run rate of inflation is still determined by the central bank’s behaviour in guiding the economy to its inflation target.
Conversely, if the central bank announces a lower interest rate, they usually explain that this is because there is a danger of inflation falling too low (possibly into deflation). Just as a reduction in aggregate demand and employment will bring inflation down, a rise in aggregate demand and employment will increase inflation back towards the target.
Of course, as we have stressed, central banks are not infallible. Faced with an inflation shock, they may not initially increase the interest rate by enough to bring it back down to target. Or they may overreact to a shock, and be forced to reverse the change. If this happens, central banks may be obliged to explain what they have got wrong. Exercise E5.1 in Extension 5.9 examines some examples of central banks getting it wrong.
But the key feature of inflation targeting is that it is a continuous process. If central banks get it wrong, and inflation gets too far from target, the central bank has to take further action. Indeed it is in their job description that they must keep on taking action until inflation comes back close enough to target.
Therefore, as long as the target rate of inflation is not itself changed, and as long as the responsibility to keep near to the target is truly delegated to the central bank, then inflation itself will, at least over the long term, always be pulled back to within a relatively narrow range of the target. The central bank will make this happen.
In policy discussions this is sometimes referred to as the central bank providing the ‘nominal anchor’ for the economy. The inflation rate that some central banks use is the Consumer Price Index (CPI). This index is calculated using consumer goods prices, which are affected by government policies such as changes in sales tax or value added tax, or changes in subsidies for certain goods or services (health care, public transport). To ensure that central bank does not react to fiscal policy, the European Central Bank does not use CPI as the target rate but instead uses the HICP (harmonized index of consumer prices), which is constructed in a way to exclude the effects of the government’s actions.
As we show in the next section, there is potentially an additional bonus from consistent inflation targeting. If households and firms in the economy know that the central bank can be relied upon to get the job done, this may lead to inflationary expectations being ‘anchored’ at the central bank’s target rate. The extent to which inflation expectations are anchored can have a significant impact on the costs, in terms of lost output, of bringing inflation under control.
Extension 5.9 Why make central banks independent?
In this extension, we explain why governments chose to grant operational independence to central banks in setting the policy interest rate, giving them the objective of achieving an inflation target. We compare inflation targets with outcomes across a large number of economies.
The lessons of the modelling in Unit 4 and Section 5.3 about the upward shifts of Phillips curves, and the high costs of unemployment incurred by countries in the 1980s as they brought inflation down (illustrated in Figure 5.12), created the impetus for making central banks independent. The arguments for doing so relied on both economic theory and some quite strong evidence.
Unit 4 showed that the Phillips curve offers a short-term trade-off between inflation and unemployment. But if unemployment is kept too low on a sustained basis, and inflation expectations become embedded, the Phillips curve shifts upward. As a result the model implies that there is no long-run trade-off between inflation and unemployment.
Politicians may nonetheless feel tempted to exploit the short-run trade-off, and promise higher growth now, in order to be re-elected—even if this leads to higher inflation later on. But if central banks have more independence, and therefore are not affected by these short-term considerations, they will be able to counteract this tendency.
This argument was quite strongly supported by the data. Figure E5.1 illustrates the relationship between the average inflation between 1962 and 1990 and a measure of central bank independence across OECD countries. There is a strong negative correlation between the two variables. Countries with little central bank independence in the mid-1980s were those where inflation was, on average, higher over the 30-year period.
Figure E5.1 Inflation and central bank independence: OECD countries.
CPI inflation: OECD. 2015. OECD Statistics. Independence of central bank; Vittorio Grilli, Donato Masciandaro, Guido Tabellini, Edmond Malinvaud, and Marco Pagano. 1991. ‘Political and Monetary Institutions and Public Financial Policies in the Industrial Countries’. Economic Policy 6 (13): pp. 341–392.
In light of both theoretical arguments and this evidence, countries increasingly granted greater independence to their central bank, with a low inflation target embedded in official statutes.
New Zealand, which had previously had high inflation, was one of the first countries to make the shift. In 1990, it made its central bank independent and introduced an inflation target in the range 1%–3%. Inflation fell and remained low. Others soon followed.
Figure E5.2 shows that for 38 countries that adopted inflation targets between 1991 and 2015 (mostly, but not invariably, coupled with significant increases in central bank independence) there was a similar pattern to New Zealand’s experience. The horizontal axis shows the gap between actual inflation and the target rate at the time the target was adopted, and the vertical axis shows the gap in 2019 (therefore anything from 14 to 24 years after the target was introduced).
Figure E5.2 Inflation vs target inflation in 38 countries.
In contrast to most scatter diagrams, which are usually designed to show a significant positive or negative correlation, the striking thing about this scatter diagram is the lack of correlation. There was a wide range of variation between the initial gaps: some countries had inflation initially as much as 12 percentage points above target. But by 2019, in most countries, inflation lies within a range of two percentage points above or below target. In a significant number of countries inflation was very much closer to target.
A common feature of many scatter diagrams is that there are ‘outliers’: points on the diagram that do not fit the general pattern. Such outliers are often revealing. In the case of Figure E5.2, one of the outliers is Serbia. In 2019, inflation in Serbia was still around 12%, therefore roughly 8% above the target of 4%. Why is the case of Serbia so different? We noted above that for inflation targets to be effective, the central bank must be given sufficient autonomy to be able to pursue the target. While the National Bank of Serbia is officially independent, both the EU and the IMF have expressed concern that in practice the government continues to exert effective control over monetary policy, and that as a result the National Bank has not been allowed to focus on keeping inflation close to target.
For example, read the coverage in the Financial Times, 4 August 2012: ‘Serbia Tightens Grip on Central Bank’. The article notes that ‘Parliament adopted amendments to the law on the National Bank of Serbia, as the government aims to harness the bank to a promise of more expansive fiscal policies to halt a slide into recession and rein in unemployment of 25 per cent.’
Figure E5.2 only uses inflation data up to 2019. The return of high inflation to many countries in 2022, which we discuss further in Section 5.10, provided a major test for the robustness of the inflation targeting model. But so far at least, the evidence still seems supportive of the original evidence shown in Figure E5.1, which was used to justify the transition to inflation targeting.
Exercise E5.1 Central bank mandates
When the inflation target is persistently missed, the head of the central bank has to account for the failure. Use the models you have learned so far to illustrate and discuss the explanations given by the following central banks for deviations from the target.
- Bank of Japan (BoJ), December 2019: In December 2019, the CPI inflation rate in Japan was at 0.5% and the BoJ’s inflation target was 2%. Deputy Governor Masayoshi Amamiya gave a speech in which he explains the reasons for the low inflation rate. In particular:
- entrenched low inflation expectations due to a prolonged recent history of low growth and deflation that kept inflation low despite an economic expansion
- a decline in crude oil prices.
- European Central Bank (ECB), April 2022: In April 2022, inflation in the euro area had reached 7.5%—well above the ECB’s 2% target. Christine Lagarde, president of the ECB, addressed the situation in a speech. Some of the main reasons she highlighted were:
- increased energy and food prices due to the war in Ukraine
- supply chain bottlenecks as the economy reopened post-pandemic
- increased demand following the removal of pandemic restrictions.
Lagarde also warned that even if these factors were temporary, there was still a risk inflation could increase further if these price increases caused wage growth or led to higher inflation expectations.
- Bank of England (the UK’s central bank), January 2020: In January 2020, inflation in the UK had fallen below the 2% target to around 1.5%. The Bank of England’s monetary policy report lists some reasons why:
- uncertainty about the outcome of Brexit negotiations reducing business investment
- lower growth in other countries reducing the demand for UK exports.
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‘Controlling Interest’. The Economist. Updated 21 September 2013. ↩
