RDP 1999-08: Inflation Targeting and Output Stabilisation 7. Conclusion

Inflation targeting has sometimes been criticised for being ‘inflation only’ targeting and ignoring output considerations. This paper has argued that such criticism is misplaced. From a theoretical perspective, even if a ‘strict’ inflation target is adopted, output considerations are still important because of the critical role that output plays in determining future inflation. The central bank will still have output in its reaction function. Rather, the argument would be better conducted in terms of the weight that should be placed on output stabilisation in the central bank's objective function; that is, how flexible the inflation-targeting regime should be.

The countries that have pursued inflation targets have adopted flexible regimes. This has been illustrated in the Australian case in the response of monetary policy in three episodes over its history of inflation targeting. Similar episodes have occurred in the other inflation-targeting countries.

The decision to pursue a more flexible approach reflects the shape of the inflation/output variability trade-off in most countries. Generally it is the case that, starting from a position of strict inflation targeting, one can adopt a more flexible approach without dramatically increasing inflation variability while simultaneously benefiting from large reductions in output variability.

The design of the inflation-targeting framework also affects the degree of output stabilisation that can be achieved. The use of an underlying or core measure of the inflation rate, the adoption of measures to enhance credibility including transparent and frequent communication with the public, and the choice of the policy horizon all affect the trade-off available to the policy-maker. Such issues however, introduce a trade-off between flexibility and credibility. Too flexible a regime may undermine the public's confidence in the regime as a whole. Too rigid a regime may result in an unnecessarily large amount of output variability. However, in deciding on the appropriate degree of flexibility to adopt, consideration must be given to establishing credibility early to allow greater flexibility in the longer run.