Krzysztof Rybiński: Inflation targeting and the challenges ahead
Opening remarks by Mr Krzysztof Rybiński, Deputy President of the National Bank of Poland, at the
"Inflation Targeting - Third Joint NBP & SNB Seminar on Monetary Policy", Warsaw, 18-20 May 2006.
* * *
Ladies and Gentlemen,
I am pleased to welcome you at the third seminar on monetary policy organized jointly by the Swiss
National Bank and the National Bank of Poland. Let me start by thanking staff members from the host
central banks, who have not spared their efforts on preparing this seminar.
For the first time in our seminar, apart from economists from the host central banks we have invited
representatives of other central banks to share with us their knowledge and experience with inflation
targeting. Thus I would like to warmly welcome our guests from the Czech National Bank - the first
inflation targeter in Central and Eastern Europe, and from the Central Bank of Turkey - a brand new
inflation targeter, which has adopted the framework only this year.
The topic of this year's seminar is inflation targeting (henceforth called IT). As the distinguished former
Fed chairman Paul Volcker recently remarked1, inflation targeting may sound like an oxymoron since
usually central banks strive to fight inflation rather than to breed it. So should we gather here to
discuss ways of breeding inflation?
Needless to say, Paul Volcker perfectly knows that it is low and stable inflation and not any inflation
that inflation targeters are trying to achieve. Yet, if we know that low inflation is our objective then what
is the most suitable monetary policy? How low should the inflation target be, which price index to
target, what about stabilizing output or preventing asset bubbles, should we be strict or flexible
inflation targeters, how to communicate our policies? All central bankers, both those beginning the IT
adventure and those more advanced with it, have to address these questions. I hope this meeting will
provide an opportunity to do it.
* * *
Since 1990, when the pioneering Reserve Bank of New Zealand first introduced IT, over twenty
countries have followed its example. The National Bank of Poland along with the Czech National Bank
were among the first emerging market countries' to adopt IT.
From the very beginning IT has been practiced in very diverse economies, from the UK and Peru to
Korea and Ghana. Many other and more diverse countries consider following the fashion, just to
mention Botswana or China. IT attracts growing interest both in developing countries, some of which
are still struggling with high inflation, and countries with relatively long history of macroeconomic
stability such as the United States or Japan. It is widely known that Alan Greenspan's successor Ben
Bernanke is a strong advocate of IT2 and this makes Fed's adoption of IT quite probable. Some
economists urge the Bank of Japan to soon join the IT club3. So, what is so special about IT and what
makes it so attractive for so many central bankers and economists?
Undoubtedly, the source of the growing IT popularity is its effectiveness in ensuring macroeconomic
stability. Firstly, IT has proved effective in delivering price stability. Though the contribution of IT to
lowering inflation is still a matter of debate4, empirical research suggests that it has significantly
contributed to lowering inflation and its volatility, especially in emerging markets5. Secondly, empirical
evidence suggests that IT has also improved other macroeconomic variables (lower output sacrifice
ratio, decreased influence of price shocks and output shocks on inflation, smaller inflation
persistence6). Thirdly, it has facilitated stabilisation of long-term inflation expectations7, thus reducing
the cost of maintaining low inflation. Certainly, IT was not the only factor behind reduced inflation and
good macroeconomic performance. There were other fundamental things at play, such as spreading
central bank independence. But for sure, as the Governor of the Bank of England Mervyn King puts it,
"inflation targeting made our job easier by reducing the cost of making the right decisions"8.
If IT has proved so successful then is there anything left do improve or shall monetary economists and
central bankers go on holidays? Surely, a good rest is always an attractive option, yet some questions
about IT remain unresolved, so the holiday should not be too long.
First, there is the question of flexible versus strict inflation targeting9, i.e. a way of incorporating output
and employment fluctuations into monetary policy decisions. IT-guru Lars Svensson claims that in
practice "all real-world inflation targeting is flexible inflation targeting"10. By that he means that
considerations on output (and employment) are always present in the decision-making process.
However, though most central bankers agree that limiting output and employment fluctuations should
enter the policy equation, there's no consensus about how to do it in practice. No wonder some central
banks find it difficult to clearly express their approach regarding output stabilisation. A promising
example in this respect is the Norgesbank, which is explicit about its flexible approach. Norwegians
state openly that they "operate a flexible inflation targeting regime, so that weight is given to both
variability in inflation and variability in output and employment"11. Also the monetary policy objectives
of the Fed are formulated in this vein12. It is worth stressing however that the degree of appropriate
flexibility in a particular country may depend on the duration of low inflation13. Thus the Norwegian
case may not be applicable to countries during disinflation or shortly thereafter.
Another important question regards the choice of the targeted price index. Should it be headline
inflation which is more familiar to the public or core inflation which is less vulnerable to short-term
deviations? And what about asset prices? Should they be included in the index? The question of
including asset prices into the targeted price index is related to a wider policy debate, namely on the
5
"Although macroeconomic performance improved in most non-industrial countries over the past decade, countries adopting
inflation targeting have, on average, outperformed countries with other monetary policy frameworks." - IMF,
"Inflation
Targeting and the IMF", March 2006. Empirical evidence show also that inflation targeters achieve better sustainability
records in terms of disinflation, though the findings are statistically not robust - Hofstetter M. "Why have so many
Documento Cede 2005-65, November 2005.
disinflations succeded?",
6
See: Corbo V., Landerretche O., Schmidt-Hebbel K. "Does Inflation Targeting Make a Difference" in: Loayza N., Soto R.
(ed.) "Inflation Targeting: Design, Performance, Challenges", Central Bank of Chile, 2002.
7
Gürkaynak R.S., Levin A.T., Marder A.N., Swanson E.T. "Inflation Targeting and the Anchoring of Inflation Expectations in
the Western Hemisphere", forthcoming in Mishkin F., Schmidt-Hebbel K. (ed.), Series on Central Banking, Analysis and
Economic Policies X: Monetary Policy under Inflation Targeting (Santiago, Chile: Banco Central de Chile), 2006 and
Gürkaynak R.S., Levin A.T. Swanson E.T.
"Does Inflation Targeting Anchor Long-Run Inflation Expectations? Evidence
Federal Reserve Bank of San Francisco Working Paper
from Long-Term Bond Yields in the U.S., U.K., and Sweden",
200609, March 2006.
8
King M. "What Has Inflation Targeting Achieved?" in Bernanke B.S., Woodford M. (ed.): The Inflation-Targeting Debate,
NBER, 2005.
9
Strict inflation targeting implies monetary policy focused only on price stability. In contrast, "flexible inflation targeting implies
that the central bank is not exclusively concerned about stabilizing inflation around the inflation target but is also concerned
with the stability of the real economy, as represented by the output gap, the employment gap, or the unemployment gap." -
Svensson L. "Optimal Inflation Targeting: Further Developments of Inflation Targeting", October 2005.
10
"Although inflation-targeting central banks normally acknowledge that they are flexible inflation targeters, they are normally
not very explicit and transparent and probably not very consistent about the relative weight they attach to stability of other
variables than inflation." - Svensson L., op. cit.
11
"Norges Bank operates a flexible inflation targeting regime and seeks to achieve an interest rate path that provides a
reasonable balance between the objective of bringing inflation up towards 2.5% over time and stabilising developments in
output and employment." - Norgesbank, Inflation Report, March 2006.
12
According to the Federal Reserve Act, the Board of Governors and the Federal Open Market Committee should seek "to
promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
13
Cukierman A. "Central Bank Independence and Policy Results: Theory and Evidence", Lecture prepared for the
International Conference on: "Stability and Economic Growth: The Role of the Central Bank", Mexico City, 14-15 November
2005.
way central banks should respond to asset prices. Fed Chairman Bernanke claims that central
bankers should respond to asset prices only insofar as they affect output gap and thus inflation14.
Another FOMC15 member Donald Kohn has described this approach as "conventional strategy" and
proposed, what he called, an "extraaction" policy16. Monetary "extra action" - according to Kohn -
would be required if there were clear signals of an asset bubble building up - especially a one fuelled
by excessively loose monetary policy - and if costs of "extra action" policy were smaller than the costs
of further build-up and subsequent collapse of a bubble. This question basically relates to the Year-old
discussion of "should the central bank prick bubbles or not?"
Today asset price considerations are present in central banking practice in many countries - Norway,
eurozone or Japan, to name just a few. Norgesbank speaks openly that when setting interest rates it
does not ignore developments in asset and credit markets17 and its inflation report contains an asset
price forecast. The ECB's president Trichet has in turn acknowledged that the monetary pillar of the
ECB "contributes to assessing the extent to which excess creation of liquidity and over-extension of
credit can be a driving force behind excessively valued assets [...] and might reflect the inflating of an
asset price bubble"18. Bank of Japan said in its "New Framework for Monetary Policy" that "risk factors
include [...] generating an asset price bubble" and that "in conducting monetary policy, the Bank needs
to do its utmost to prevent the materialisation of such potential risks."19
A hot issue in today's discussion about IT is transparency and communication. More and more
economists realise that communication is the primary channel of central bank's impact on the
economy and monetary policy is increasingly becoming an art of managing expectations. Lars
Svensson argues that current level of central bank interest rates matters very little for future inflation
and economic activity, while Michael Woodford claims even that apart from expectations, little else
matters20. For this reason inflation targeters put an ever larger weight to effective communication.
Useful tools for it are decision statements, inflation reports, published inflation forecasts and central
bankers' public speeches. These tools are now standard in communication among the best
ITperformers. For central banks from emerging markets applying these standards is very desirable, as in
this way they can gain some 'confidence premium' from the market, who perceive such central banks
as 'goodpractice' followers. This is very important especially amid growing internationalisation of
financial markets, when interpreting central bank's policy is much easier under standard
communication.
Surely, it is not the amount of communication that matters but rather its quality. This refers especially
to central bankers' talk. It is more important, what you say than how you say it as unclear signals may
actually misguide the market. A recent example of communication problems was the puzzle over the
first congressional testimony of Governor Bernanke and his later comments.
Transparency and communication earned attention of most central bankers, yet some are keener than
others. In 1997 Reserve Bank of New Zealand started publishing its three-year interest rate forecast.
Since 2005 the bank has been presenting a central interest rate scenario. The RBNZ innovation has
14
McCulley P. Global Central Bank Focus, PIMCO, May 2006.
"The Root of All Evil",
15
FOMC: Federal Open Market Committee.
16
"The extra-action strategy responds to a perceived speculative boom with tighter monetary policy - and thus lower output
and inflation in the near term - with the expectation of significantly mitigating the potential fallout from a possible future
bursting of the bubble. Thus, the strategy seeks to trade off the near-certainty of worse macroeconomic performance today
for the chance of disproportionally better performance in the future, on the theory that the repercussions of a major market
correction could be highly nonlinear. But the extra-action proposal is by no means a bold call for central banks to prick
market bubbles." - Kohn D. "Monetary Policy and Asset Prices" at "Monetary Policy: A Journey from Theory to Practice - An
ECB Colloquium held in honor of Otmar Issing", 16 March 2006.
17
"Interest rate setting must also be assessed in the light of developments in property prices and credit. Wide fluctuations in
these variables may in turn constitute a source of instability in demand and output in the somewhat longer run." -
Norgesbank, Inflation Report, March 2006.
18
Trichet J.C. "Asset price bubbles and monetary policy" Speech of the President of the ECB, Mas lecture, Singapore, 8 June
2005.
19
Fukui T.
"New Framework for the Conduct of Monetary Policy: Toward Achieving Sustainable Economic Growth with Price
Summary of a Speech Given by Toshihiko Fukui, Governor of the Bank of Japan, to the Japan Chamber of
Stability",
Commerce and Industry in Tokyo on 16 March 2006.
20
Woodford M. "For not only do expectations about policy matter, but (...) very little else matters." - Interest and Prices:
Foundations of a Theory of Monetary Policy, Princeton University Press, 2003.
BIS Review 42/2006 3
been followed recently by the Norgesbank21. At first (since 2003) the Norwegian MPC published its
monetary policy intentions only for the next four months in the form of an interest rate forecast interval.
Last November it went further and started publishing a forecast for interest rates three years ahead in
the form of a central forecast (with two alternative scenarios) along with a fanchart). These bold steps
made New Zealanders and Norwegians push the frontier of central banking ahead and set a new
benchmark for inflation targeters22. Are we ready to follow?
In 2000 Mahadeva and Sterne measured central banks transparency23. Back then the Polish central
bank was below the average among inflation targeters. However since then the NBP has made
considerable progress. Major changes to communication have been introduced such as publication of
inflation forecasts, modification of inflation reports and decision statements in order to make them
more forward-looking. Łyziak et al. have applied the Mahadeva-Sterne and Eijffinger-Geraats indices
to assess current transparency of the NBP and showed that it has markedly improved24. Nevertheless,
we are not resting complacently. There are still ways to go and things to learn. Later today Marek
Rozkrut will present results of an empirical study conducted at the NBP25 showing that central bank
communication strategies in the Czech Republic, Hungary and Poland exhibit large differences. The
Czech National Bank seems to do a much better job than the other two banks in matching words with
deeds. There is also some evidence that pursuance of too many targets under IT framework leads to
inconsistencies also in central bank communication, as in the case of the Hungarian National Bank.
Finally, to those of you, who intend to adopt IT in the future let me say one last thing. A standard view
is that IT should not be introduced unless a number of criteria are fulfilled. As Piotr Szpunar will tell
you in the first presentation, at the time Poland adopted IT one could claim we were not ready as we
did not comply with all of these criteria (e.g. a robust and well examined transmission mechanism)26.
Yet Poland succeeded. Today we have low inflation with fairly low interest rates. What was the source
of this success? We could probably think of a bunch of factors, but one thing cannot be overlooked.
"The evidence suggests that successful adoption of inflation targeting depends more on establishing a
credible commitment to the strategy than on fulfilling a lengthy list of technical prerequisites27". To put
it bluntly, credible commitment to price stability is the very key and there's no substitute for it. Those
who ignore it are bound to fail.
* * *
I am sure the seminar will spark inspiring discus sions and give us a deeper insight into the problems
of inflation targeting. I hope that it will also address some open questions about the future of IT and
monetary policy at large. Let us not forget that the ideas of today shape the world of tomorrow. And
the monetary policy of tomorrow is still to be discovered.
I wish you a pleasant and interesting seminar.
21
"When our MPC decided to move forward and publish a forecast of the central bank interest rate path, the decision was
based on several arguments. One was the well established theoretical argument that monetary policy mainly works through
expectations. Monetary policy is only effective if the central bank is able to influence interest rate expectations." - Qvigstad
J.F., Speech at the conference "The ECB and Its Watchers VIII" in Frankfurt on 5 May 2006.
22
The Norgesbank is keen to recall that this innovation is not necessarily suitable for all central banks: "[...] one should bear in
mind what Alan Blinder and Charles Wyplosz said at the American Economic Association conference last year:
"The
appropriate volume and methods of central bank communication depend crucially on the nature of the monetary policy
committee." So what is useful and correct to do in Oslo may not be the best solution in Frankfurt. The MPCs are set up in
different ways. There is not necessarily "one fit for all."" - Qvigstad J.F., op. cit.
23
Mahadeva L., Sterne G. (ed.) Monetary Policy Frameworks in a Global Context, Routledge, 2000.
24
The improvement of monetary policy transparency in Poland is documented in Łyziak et al. "Central bank credibility and
transparency - the case of Poland", mimeo, 2005.
25
Rozkrut M., Rybinski K., Sztaba L., Szwaja R. „Quest for Central Bank Communication. Does It Pay To Be "Talkative?"",
mimeo, April 2006.
26
"According to Debelle (1997) and Mason et al. (1997), one of the key prerequisites for the successful adoption of inflation
targeting is that the central bank must have an adequate ability to produce inflation forecasts and to assess the impact of
changes in monetary instruments on inflation (the magnitude of the effects, their lags etc.)." In Poland until 1998 (IT was
introduced in 1999) there was no clear statistical linkage between changes in the short-term policy interest rates and
changes in inflation - Christoffersen P., Wescott R. "Is Poland ready for inflation targeting?", IMF Working Paper, 1999.
27
IMF, op. cit.
4 BIS Review 42/2006
Thank you.
BIS Review 42/2006 5