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The effectiveness of monetary policy.

This analysis addresses changing views of the role and effectiveness of monetary policy, inflation targeting as an "effective monetary policy," monetary policy and short-run (output) stabilization, and problems in implementing a short-run stabilization policy. (JEL E520)

Federal Reserve Bank of St. Louis Review, September/October 2007, 89(5), pp. 447-89.

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The effectiveness of monetary policy has been a long-standing question in the monetary economics and central banking literature. Perspectives on the question have been influenced in part by developments in monetary theory and in part by interpretations of monetary history. Progress in the discussion has also been influenced--indeed, some might say hindered--by changing definitions of both "monetary policy" and "effectiveness." Our discussion will address (i) changing views of the role and effectiveness of monetary policy, (ii) inflation targeting as an "effective monetary policy," (iii) monetary policy and short-run (output) stabilization, and (iv) problems in implementing a short-run stabilization policy.

CHANGING VIEWS ON THE ROLE AND EFFECTIVENESS OF MONETARY POLICY

What do analysts mean by "monetary policy" and the "effectiveness" thereof?. Each term is something of a moving target. At times "monetary policy" has referred to central bank actions to influence and/or target some measure of the money stock. Frequently, though certainly not always, the definition of monetary policy has focused on a measure of "high powered money"--liabilities of the central bank. For a long time, this was the definition incorporated in theoretical models; in the policy arena this definition was the foundation of the "monetarist revolution" in the 1960s and 1970s. A counter definition that was likely the dominant perspective of policymakers was that monetary policy referred to central bank actions to influence and/or target short-term interest rates or nominal exchange rates. Sargent and Wallace (1975) advanced the proposition that, in a model with "rational expectations," the price level (and all other nominal variables) could be indeterminate if central banks set targets for nominal interest rates, because the economy would lack a "nominal anchor." McCallum (1981) showed that an appropriately defined interest rate rule would avoid such indeterminacy. The interest rate rule had to include a "nominal anchor." In recent years, in particular since Taylor's (1993) proposed characterization of Federal Open Market Committee (FOMC) behavior in the early Greenspan years, interest rate rules that include a "nominal anchor" in the form of a desired or target inflation rate have become the basic specification of "monetary policy" in theoretical analyses. (See, for example, Clarida, Gall, and Gertler, 1999.)

The legacy of the Great Depression in the United States and other industrialized economies was that monetary policy was "ineffective." This perspective is most prominent in Keynes's General Theory and in the writings of the "Keynesian economists" in the 1940s through the 1960s. For example, the Radcliffe Committee in the United Kingdom reported that
 [t]he immediate object of monetary policy
 action is to affect the level of total demand ...
 In theory, monetary action may work upon
 total demand by changing the interest incentive;
 we believe that only very limited reliance
 can be placed on this. More certainly, monetary
 action works upon total demand by altering
 the liquidity position of financial institutions
 and of firms and people desiring to spend on
 real resources; the supply of money itself is not
 the critical factor. (Radcliffe, 1959, p. 135)


In the United States the minimalist perspective on the role and effectiveness of monetary policy can be seen in the first two reports of the Kennedy Council of Economic Advisers:
 Unless the Government acts to make compensating
 changes in the monetary base, expansion
 of general economic activity, accompanied by
 increased demands for liquid balances and for
 investment funds will tend to tighten interest
 rates and restrict the availability of credit ...
 Discretionary policy is essential, sometimes to
 reinforce, sometimes to mitigate or overcome,
 the monetary consequences of short-run fluctuations
 of economic activity. In addition, discretionary
 policy must provide the base for
 expanding liquidity and credit in line with
 the growing potential of the economy.
 (Council of Economic Advisers, 1962, p. 85)

 Monetary policy as well as debt management
 policy must be coordinated with fiscal policy
 to secure the objectives of high employment
 and growth without inflation. We are, and for
 some time still will be, in a situation of substantial
 slack in labor force and capital resources,
 a situation in which expansionary policies are
 required ... What matters most at this time is
 that financial policy should be designed to
 facilitate rather than retard the expansionary
 process which the tax program is designed to
 launch. (Council of Economic Advisers, 1963,
 p. 55)


A decade later, perspectives on the effectiveness of monetary policy had changed; and, in some circles, monetary policy was viewed as equally important as fiscal policy for affecting both inflation and output fluctuations:
 The past 10 years have been characterized by
 an average growth rate of aggregate expenditures
 that is very high by historical standards
 and that has substantially outstripped the sustainable
 growth of supply of real goods and
 services. Contributing significantly to the
 growth of aggregate demand were rapidly
 increasing Government expenditures along
 with monetary policies that were appreciably
 more expansionary than those in earlier post-World
 War II periods ... When the inflationary
 phase has lasted so long that expectations of
 further inflation are firmly embedded in the
 cost trend, a shift to policies of restraint first
 exerts an adverse influence on output and the
 desired price deceleration effect materializes
 only with a lag. Any convincing interpretation
 of the events during 1970 and 1973-4 must
 stress this difficulty. (Council of Economic
 Advisers, 1975, pp. 128-29)


This was not the only view of monetary and fiscal policy at that time. The 1960s saw the rise of "monetarism" subsequent to the work of Friedman and Schwartz (1963), Friedman and Meiselman (1963), and Andersen and Jordan (1968). There were several planks in the monetarism platform. First and foremost was that sustained inflation was a monetary phenomenon and that central banks should be held accountable for maintaining price stability. Monetarists contended that central banks should control the stock of money in the economy, and not focus on targeting short-term nominal interest rates, as the mechanism to achieve this long-run inflation objective. The rationale for the focus on the growth of the money stock was that, in a fiat money economy, the money stock provided the nominal anchor for the system.

In the eyes of monetarists, inflation control was not the only concern of the monetary authorities. They saw monetary policy as having significant effects on short-run fluctuations in real output (Andersen and Jordan, 1968; and Andersen and Carlson, 1970), though not affecting long-run

output growth. Indeed, many monetarists (see Brunner and Meltzer, 1968; Meltzer, 1976, 2003; and Friedman and Schwartz, 1963) believed monetary policy was responsible for aggravating, not attenuating, historical cyclical fluctuations in real output.

With the "rational expectations revolution" in macroeconomics came the "policy ineffectiveness proposition" of the New Classical Macroeconomics (Sargent and Wallace, 1975). The initial interpretations of this paradigm were that, in any macroeconomic model, the assumption of rational expectations would render monetary policy ineffective in influencing real output, both in the short run and long run. Hence, there was no role for monetary policy in output stabilization. Subsequent research (Fischer, 1977; Taylor, 1980; and Calvo, 1983) demonstrated that it was the interaction of the rational expectations hypothesis and an assumption of perfectly flexible wages and/or prices that generated the "policy ineffectiveness proposition." The outgrowth of this insight was the New Keynesian perspective.

With the widespread use of New Keynesian models, the monetarist tenets about how "monetary policy" affects economic activity have become widely held throughout academia and central banking circles today, though most academics and almost all central bankers would disown a monetarist label. Money has largely disappeared from discussions on monetary policy. Fry et al. (2000, Chart 7.2, p. 123), using data from a Bank of England survey, report that in the 1970s 11 (of 22) central banks in industrial countries reported using a money and credit framework to formulate monetary policy; but, by the 1990s, only 2 of these banks maintained this framework. Von Hagen (2004, Table 4) found a negative trend from 1970 to 2002 in the fraction of titles of articles in major economics journals that included the word "money," though the frequency of titles including "inflation" was relatively constant. He also found that the frequency of "money" in the annual reports of major central banks declined over the period 1996-2002 (Von Hagen, 2004, Table 5). King (2002) notes that
 there is a paradox in the role of money in economic
 policy. It is this: that as price stability
 has become recognized as the central objective
 of central banks, the attention actually paid by
 central banks to money has declined. (p. 162)

 The decline and fall of money in policy formation
 is confirmed by a fall in the number of
 references to money in speeches of central
 bank governors. So much so that over the past
 two years, Governor Eddie George has made
 one reference to money in 29 speeches,
 Chairman Greenspan one in 17, Governor
 Hayami one in 11 and Wim Duisenberg three
 in 30. (pp. 162-63)


In contemporary literature, models, and policy discussions, attention is given to the role of an inflation objective in a central bank "policy rule" as the nominal anchor in a fiat money economy. "Taylor rules" (Taylor, 1993) that specify a systematic relation between the target for a short-term interest rate and deviations of inflation from an inflation target and of real output from a measure of "potential output" have become the norm for the analysis of the impact of monetary policy. (1) In this "rule like" environment, the setting of the interest rate value is the policy action; the policy itself is represented by the parameters of the "rule," including the inflation objective ([pi.sup.*]) and the respective weights that are assigned to deviations of observed inflation from that objective and deviations of real output from "potential output."

LONG-RUN STABILIZATION OBJECTIVES FOR MONETARY POLICY

Over the past 15 years, a number of countries, starting with New Zealand, have announced explicit numeric inflation objectives (the [pi.sup.*] term in the Taylor rule framework). The relevant question is, How effective are central banks at hitting explicit numeric inflation targets?

Clearly, one straightforward way to address this question is to look at the performance of those countries that have announced explicit numeric inflation targets. Our list of the countries in this group (23 in all) is shown in Table 1. For each country, Figure I graphs the year a target was adopted and the inflation rate at that time. (2,3) As far as we have been able to determine, no country has joined the group since 2002. In many, but certainly not all of these countries, inflation was below 5 percent at the time of the announcement of the inflation-targeting regime. The appendix provides the details on the target index(es), the target ranges, dates of target adoption, target setting responsibility, and public reporting on the performance of the inflation policy.

Figures 2 through 22 show the history of inflation for each of the inflation-targeting countries. (4) For those countries that have changed the index in which they define their inflation target, there is a separate graph for each index. The graphs show the inflation target range (the shaded area) or the point inflation target as appropriate. It is immediately apparent from these graphs that the period-to-period (month-to-month or quarter-to-quarter) annualized rate of inflation is highly volatile in all of the countries that pursue an explicit numeric inflation target. These short-run inflation rates are as likely as not to be outside the target range. If effective monetary policy were to be defined in terms of stability of high-frequency rates of inflation, then all of these central banks would have to be judged as failing to achieve the objective. However, it is neither reasonable nor desirable to define the objective in such short-run terms. Shocks to the price level--that is, transitory shocks to inflation--originate from numerous sources, both monetary and nonmonetary. No central bank can foresee such shocks and probably cannot accurately predict the dynamics by which such shocks ultimately impact the price level. Economic theory suggests that central banks can be held accountable for "sustained inflation." Correspondingly, inflation-targeting central banks, and even central banks without explicit numeric targets, such as the Fed, typically focus on "medium term" inflation. The duration of the medium term is frequently, and probably intentionally, left ambiguous. (5) Absent a precise definition of the medium term, some measures must be specified to judge the effectiveness of the inflation-targeting policies.

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We examine two measures of the effectiveness of explicit numeric inflation targeting. Both measures are based on moving averages of the observed rates of inflation. These measures are indicated in Figures 2 to 23 by the heavy lines. Relative to the dates indicated on the horizontal axis, this line shows the leading moving average of the rate of inflation to the end of 2004. The shortest moving average shown is one year. The question is, What is the maximum period, ending with 2004, that the moving average of the inflation rate remained within the bounds determined by the current (end of 2004) inflation target? These periods are shown for each of the inflation-targeting countries in Table 2.

Judged by this metric, there are a number of inflation-targeting countries in which monetary policy has been very effective. For five countries, New Zealand, Norway, Switzerland, Thailand, and the United Kingdom, the moving average of the rate of inflation has been within the current announced target range since before the adoption of the inflation-targeting procedure. (6) Canada and Australia also have maintained, for considerable periods, an average rate of inflation within the range currently in effect. (Note that for Australia and New Zealand, data are quarterly and not monthly.) None of these countries has a particularly wide target range. The Czech Republic and South Africa have shorter records of success by this metric, but nevertheless have moderately effective performances. The Czech Republic is notable because the inflation rate there was fairly high when the target was adopted and the moving average of the rate of inflation has fallen outside of the target range only on the low side. Nevertheless, the moving average of Czech headline inflation has been positive for the entire period since it fell below the lower bound of the current target range (in February 2002).

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Israel, Peru, and Poland have experienced long-term average inflation below their current target ranges. The short-horizon moving averages for Hungary, Peru, and Poland have exceeded the current target ranges. In Israel, the moving average of the rate of inflation actually went negative in 2002 and 2003. Three countries--Chile, Colombia, and Hungary--have adjusted their targets downward over time, and generally the average inflation rate has fallen below the ranges, consistent with success in moving to the lower inflation targets. Deviations from the target ranges have been symmetric. Other countries, notably Brazil, Mexico, and the Philippines, have consistently missed their target ranges on the high side.

Although averages provide interesting insights into the sustainability of inflation performance, they obscure the marginal performance. A moving average could remain within the target range for a long period of time if, over time, the inflation rate converges toward the midpoint of the range. Alternatively, the same moving average could result if, early in the period, the inflation rate was close to one end point of the target range and, as time progressed, inflation moved close to the opposite edge of the target range. The latter situation could be characterized as "skating on thin ice."

To examine this issue, Table 2 shows the value of the moving average over the two-year period 2003-04 and a standardized deviation of this two-year moving average from the midpoint of the target range that prevailed at the end of 2004. The standardization is constructed by dividing the deviation of the moving average from the midpoint by one-half the difference between the upper and lower endpoints of the target range.

By this metric, the bulk of the inflation-targeting countries have been doing quite well over the past two years. The exceptions are Brazil, Colombia, Hungary, Mexico, and the Philippines (whose average inflation rate over the past two years fell above their target ranges) and Israel and Sweden (whose average inflation rate over the past two years fell below the target ranges). Our conclusion from these data is that central banks that have announced explicit numeric inflation objectives have been quite effective in achieving the stated inflation stabilization objective.

The FOMC has not adopted this framework, though it is known that on at least three occasions the pros and cons of adopting this approach have been debated around the FOMC table. (7) Several current participants in the FOMC have stated on the record their preference for an explicit numeric target and given their preferred measures. Included are then-Governor Ben Bernanke, President Jeffrey Lacker of the Federal Reserve Bank of Richmond, President Janet Yellen of the Federal Reserve Bank of San Francisco, and former-President Anthony Santomero of the Federal Reserve Bank of Philadelphia. (8)

Then-Governor Bernanke indicated his preferred inflation target is 1 to 2 percent as measured by the core personal consumption price index. (9) President Lacker has indicated his preference for a target of 2 percent as measured by the core CPI or 1.5 as measured by the core personal consumption price index; he has also indicated a preference that inflation be kept above 1 percent (Lacker, 2005). President Yellen has indicated a preference for a target of 1.5 percent as measured by the core personal consumption price index, with a range of about [+ or -] 1 percent (Reuters News, 2005). Former-President Santomero indicated his preference for a target range of 1 to 3 percent as measured by a 12-month moving-average rate of change in the core personal consumption price index (AFX Asia, 2004). Other current participants at FOMC meetings, including Vice Chairman Donald Kohn (2005), have indicated that they do not prefer an explicit numeric inflation objective. President William Poole has stated that he believes "ambiguity with respect to the Fed's inflation and employment objectives is not large and is not the main problem the Fed faces with its communication policies" (Poole, 2005b).

Differences of opinion among FOMC participants notwithstanding, in May 2003 the press release following the FOMC meeting indicated that "the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. (10) The minutes of that FOMC meeting (FOMC Minutes, May 6, 2003) indicate the rationale for this statement:
 Members commented that substantial additional
 disinflation would be unwelcome
 because of the likely negative effects on economic
 activity and the functioning of financial
 institutions and markets, and the increased
 difficulty of conducting an effective monetary
 policy, at least potentially in the event the
 economy was subjected to adverse shocks.
 Members also agreed that there was only a
 remote possibility that the process of disinflation
 would cumulate to the point of a decline
 for an extended period in the general price
 level. (11)


At that time, core personal consumption inflation was measured in the neighborhood of 1 percent. Although the FOMC has never stated a numeric inflation objective, individual FOMC participants have expressed preferences for both the core CPI and core personal consumption price index; they have typically indicated values for core CPI inflation one-half percent above those for the core personal consumption inflation rate. It seems reasonable to conclude that the FOMC has a lower bound of an acceptable medium-term rate of inflation in the neighborhood of I percent for the core personal consumption inflation rate and perhaps 1.5 percent for the core CPI inflation rate.

Former-Governor Larry Meyer (2004) is also on record in favor of an explicit numeric inflation objective. However, his position is that the "dual mandate" inherent in the Federal Reserve Act differentiates the U.S. environment from that of other inflation-targeting central banks that operate under a "hierarchical mandate." Meyer defines a hierarchical mandate as an environment "in which price stability is identified as the principal objective, and central banks are restricted from pursuing other objectives unless price stability has been achieved" (p. 151). He contrasts this with the "dual mandate," where "monetary policy is directed at promoting both full employment and price stability with no priority expressed, and with the central bank responsible for balancing these objectives in the short run" (p. 151). It is our opinion that Meyer's view does not allow for the effectiveness of monetary policy to vary in the long and short runs. In terms of long-run objectives, central banks must necessarily operate under a hierarchical mandate, given the consensus view of monetary policy that policymakers are not presented a long-run tradeoff between inflation and real output. Indeed, in specifying a policy rule, whether an instrument or target rule, the exercise of determining how much weight to place on short-run movements in inflation versus short-run movements in real output is conditioned on the prespecification of the long-run inflation target ([pi.sup.*]). In this sense, any central bank seeking to operate in such a monetary policy framework has to be hierarchical: First it must specify its long-run inflation objective and then, and only then, can it set its preferred (or optimal) weights for short-run fluctuations. (12) The choice of weights could be such that the central bank follows a hierarchical mandate in both the long and short runs; however, there is nothing to preclude pursuing a dual goal, with a short-run mandate nested within a hierarchical long-run mandate. It is likely that most, if not all, central banks that have adopted an explicit inflation target pursue that objective within a nested hierarchical/dual structure.

Panels A and B of Figure 23 show the core CPI inflation and core personal consumption price inflation for the United States; the leading moving average from each of the dates since January 1990 until the end of 2004 are also shown. (13) The shaded area, from 1 to 3 percent in core CPI inflation, appears to encompass the preferences of the FOMC participants who have spoken out in favor of an explicit numeric inflation objective. The leading moving-average rate of core CPI inflation in the United States bottomed out in August 2002 at a value of 1.64 percent (annual rate). The corresponding date and value for core personal consumption price inflation are December 2002 and 1.28 percent, which appear to be close to the bottom of the FOMC's implicit acceptable range of inflation. On the other end of the scale, the leading moving-average rate of core CPI inflation has been below the 3 percent level since March 1991, whereas that for personal consumption price inflation has been below the 3 percent level since March 1987. These are comparable to the best performance of the inflation-targeting central banks against their announced targets. Accordingly, it cannot be claimed that an explicit numeric inflation target is a necessary condition to produce low and stable rates of inflation for an extended period. The question, which will not be answered unless inflation pressures build in the future, is whether in the absence of a public numeric inflation objective the institutional commitment exists to take potentially unpopular policy actions to resist upward creep in inflation.

HOW EFFECTIVE ARE CENTRAL BANKS AT SHORT-RUN (OUTPUT) STABILIZATION?

The evidence on the effectiveness of monetary policy as a short-run stabilization device is problematic. As Poole (2005b) has noted,
 [t]he only certainty is that the effect of policy
 actions on real variables eventually dissipates.
 "Eventually" may cover a period of several
 years, and may be longer in some circumstances
 than others. It is worth noting that these
 hedges on my part reflect ignorance--mine and
 the profession's--and not obfuscations. We just
 don't have precise estimates of the magnitudes
 and durations of effects of monetary policy on
 real variables.


Our objective here is to examine why a definitive answer to this question remains so illusive. On one hand there is "case study" evidence supporting the idea that monetary policy does affect output fluctuations in the short run. The most prominent evidence from such studies highlights the contractionary effects of monetary policy. On the other hand, there are volumes of VAR analyses that fail to determine a major role for monetary policy in short-run stabilization.

The best known, though not uncontested, case-study analysis of the short-run response of real activity to monetary policy is Friedman and Schwartz's (1963) monetary history. They argue that the Federal Reserve put the "great" in the Great Contraction:
 The monetary character of the contraction
 changed drastically in late 1930, when several
 large bank failures led to the first of what were
 to prove a series of liquidity crises involving
 runs on banks and bank failures on a scale
 unprecedented in our history ...

 The drastic decline in the stock of money and
 the occurrence of a banking panic of unprecedented
 severity did not reflect the absence of
 power on the part of the Reserve System to prevent
 them. Throughout the contraction, the
 System had ample powers to cut short the
 tragic process of monetary deflation and banking
 collapse. Had it used those powers effectively
 in late 1930 or even in early or mid-1931,
 the successive liquidity crises that in retrospect
 are the distinctive feature of the contraction
 could almost certainly have been prevented
 and the stock of money kept from declining,
 or indeed, increased to any desired extent.
 Such action would have eased the severity of
 the contraction and very likely would have
 brought it to an end at a much earlier date.
 (pp. 10-11)


Romer and Romer (1989) construct case studies of six episodes from World War II through 1979 in which they believe that the Fed deliberately took action to induce a recession to reduce inflation. They conclude that the evidence supports the hypothesis that the monetary policy actions had a significant negative effect on real output in all of these instances. Case studies such as these address the qualitative question of whether monetary policy has an effect on real output; they do not address the question of the magnitude of the output response to a change in policy.

The final experience that is widely cited as evidence of a contractionary effect of monetary policy is the U.S. experience in 1979-83: the so-called "Volcker disinflation." This period is marked by two separate recessions: January-July 1980 and July 1981-November 1982. The first recession followed closely the introduction of the "new operating procedures" in October 1979 and an increase of 6 percent in the federal funds rate. (14) Note that the increase in the funds rate was not directly targeted by the Fed under the "new operating procedures." Furthermore, the impact of the monetary policy action in 1980 is confounded with the introduction of credit controls by the Carter administration in March 1980. (15)

Goodfriend (2005) maintains that the recession of 1981-82 was the direct consequence of monetary policy directed at disinflation:
 The lesson of 1980 was that the Fed could not
 restore credibility for low inflation if it continued
 to utilize interest rate policy to stabilize
 the output gap ... As measured by personal
 consumption expenditures (PCE) inflation,
 which was about 10 percent in Q1 1981, real
 short-term interest rates were then a very high
 9 percent. Not surprisingly, the aggressive
 policy tightening began to take hold by mid-year.
 (pp. 316-17)


Certainly, the home building industry in the United States regarded the collapse of housing construction during both recessions as the direct responsibility of the Volcker Fed, as evidenced by the numerous complaints delivered to the Board of Governors written on 2 x 4s. The housing construction industry in the United States showed highly cyclical fluctuations through the recession of 1990-91 (see Figure 24), and concerns about the sensitivity of this industry to monetary policy actions had been the focus of discussion at least since the early 1960s. (16)

Housing starts and housing construction behaved very differently in the 2001 recession than in prior postwar recessions: No slowdown is obvious. Admittedly, this cyclical slowdown was very mild, at least as measured in terms of real output growth. Yet this raises the question of whether cyclical fluctuations in housing should be cited as universal evidence of an impact of monetary policy on short-run fluctuations. (17)

One legacy of the Great Depression in the United States has been the use of price controls on bank deposits--so-called Reg Q ceilings. In 1966 these controls were extended to liabilities of thrift institutions that, at the time, were the principal source of mortgage financing. Cyclical fluctuations in interest rates had a major impact on the availability of mortgage financing during this period. By the mid-1980s these price controls had been removed, but by that time (economic) insolvency was widespread among thrift institutions. The resolution of the crisis in the housing finance industry continued through the recession of 1990-91. Hence, it may be more appropriate to argue that the interaction of monetary policy with the system of deposit price controls produced a unique environment that supported a cyclical response of the economy to monetary policy actions. In the current U.S. environment, where mortgage securitization has become the rule and specialized deposit intermediaries have ceased to be significant players in mortgage finance, a traditional argument for the transmission of monetary policy may be more tenuous.

[FIGURE 24 OMITTED]

Econometric models provide alternative evidence on the effectiveness of monetary policy in influencing the short-run behavior of real output. Over the past 25 years, since the publication of Sims's (1980) classic article, literally hundreds, perhaps thousands, of econometric studies in vector autocorrelation (VAR) frameworks have sought to address this question. We believe that few people would argue that research in this framework has provided conclusive evidence to support the hypothesis that monetary policy has strong short-run effects on real output fluctuations. Christiano, Eichenbaum, and Evans (1999) summarize their extensive overview of this literature:

"[V]iewed across both sets of identification strategies that we have discussed, there is a great deal of uncertainty about the importance of monetary policy shocks in aggregate fluctuations" (p. 127) and "there is agreement that monetary policy shocks account for only a very modest percentage of the volatility of aggregate output; they account for even less of the movements in the aggregate price level" (p. 71). But if a consensus from case studies of historical episodes is that there are substantial effects, the question is how to reconcile the apparently conflicting evidence. An early assessment of the VAR type of study is provided by Cagan (1989):
 If we accept the bulk of historical evidence as
 confirming the important monetary effects on
 the real economy, contrary findings cannot be
 fully valid. And, if such contrary evidence is
 not valid, what kind of evidence in monetary
 research is acceptable and convincing? (p. 119)

 The VAR seems to me to be hopelessly unreliable
 and low in power to detect monetary
 effects of the kind we are looking for and
 believe, from other kinds of evidence, to exist.
 (p. 127)


In the approximately 15 years since Cagan posed this question, analysts have become much more aware of the limitations of VAR analyses. It is now well understood that the VAR approach does not solve the fundamental econometric problem of identification. The VARs that are readily estimated using standard econometric software are no more than reduced-form models. (18) Indeed, there is substantial risk of misspecification as a result of omitted variables, given the limits on the dimensionality of the typical VAR that is imposed by the available time span of macroeconomic data series.

In the formative years of VAR analysis (say 1980-86) the typical approach was to "rotate and orthogonalize shocks" by computing a Cholesky decomposition of the covariance matrix of the estimated VAR residuals and to assume that one of the resulting "shocks," frequently that associated with a short-term interest rate, represented the monetary policy innovation--the unpredictable component of monetary policy. Analyses of the effectiveness of monetary policy were constructed from impulse response functions and variance decompositions with respect to this "monetary shock."

Gradually, it became recognized that "recursiveness and orthogonalization" is the imposition of a particular set of identifying restrictions--a triangular Wold causal chain structure. (19) This approach to identification was widely reiected by the econometrics establishment when initially proposed in the 1960s. Starting in the mid-1980s, alternative restrictions for identification of "structural VARs" (SVARs) appeared in the literature. (20) Generally the SVAR framework has maintained the identifying restrictions that the shocks in the "economic model" are independent and has found the additional required restrictions among the only available alternatives: constraints on impact or steady-state multipliers of the SVAR or exclusion restrictions on the slope coefficients among contemporaneous variables or steady-state relationships in the SVAR.

Steady-state identifying restrictions are those for which accepted theory provides the most insight. Such restrictions may provide information on the dynamics of a real output response to a monetary policy shock that produces a permanent change in the inflation rate (assuming that inflation is approximately a nonstationary variable during the sample period). This is facilitated by received macroeconomic theories that suggest only monetary shocks can produce sustained changes in inflation. In an economy where the central bank focuses on a rule for an interest rate target that responds to deviations from a desired rate of inflation and other variables such as output gaps, such monetary shocks occur only when there is a change in the inflation target. (21) This does not get to the question of the effectiveness of monetary policy for short-run output stabilization. Here, the issue is how real output responds to monetary shocks that cause transitory fluctuations in the inflation rate (i.e., changes in the price level).

Unfortunately, received macroeconomic theories suggest that shocks from many nonmonetary sources can have a permanent effect on the price level. Examples include fiscal policy shocks, energy price shocks, productivity shocks, and terms-of-trade shocks. In such economic structures, restrictions on impact multipliers are hard to justify and sufficient restrictions on slope coefficients among the contemporaneous variables in the VAR to identify the desired monetary shock are problematic. This concern is echoed in Romer and Romer (1989, p. 121):
 The reason that purely statistical tests, such
 as regressions of output on money, studies of
 the effects of "anticipated" and "unanticipated"
 money, and vector autoregressions, probably
 have not played a crucial role in forming most
 economists' views about the real effects of
 monetary disturbances is that such procedures
 cannot persuasively identify the direction of
 causation.


Identification of the effectiveness of monetary policy to stabilize output fluctuation is further complicated by a lack of transparency and likely a lack of stationarity in the rule-like behavior of central banks. There is an ongoing debate about whether FOMC behavior over a long period can be characterized by a common rule-like specification. Romer and Romer (2002a,b) argue that the actions of the FOMC in the 1950s and in the 1980-90s were similar in their rule-like characteristics, but that during the 1960s and 70s a different "regime" was in place. Orphanides (2001 and 2002) and Orphanides and van Norden (2002) argue that, when judged in terms of real-time data, the rule-like behavior of the FOMC in the 1960s and 1970s is consistent with behavior in the 1980s and 1990s. They conclude that the Great Inflation did not result from bad policy, but from applying reasonable policy without recognition of and adjustment for biased measurements of "potential output." Either view of the 1960 and 1970s poses a challenge to the standard approach of identifying monetary shocks in SVAR structures.

Beyond the arguments about the specification of monetary policy during the Great Inflation, there are other concerns that at least occasionally dominate central bankers' discussions of policy objectives. Such concerns at a minimum contaminate efforts to identify policy rules with measurement error and likely also contaminate the assumed identifying restrictions.

For the FOMC, there are at least four incidents in the past 20 years (documented in the published record of FOMC minutes and transcripts) in which concerns about financial stability dominated policy decisions and policy actions were driven by issues in addition to inflation or output stabilization. These incidents include the stock market collapse in October 1987, the Asian crisis/Russian default in August-October 1998, Y2K in late 1999, and the 9/11 tragedy in September 2001. Some analysts add the credit crunch/financial headwinds concern in 1990-93 to this list. (22)

According to the unofficial staff interpretations of FOMC policy changes compiled by Thornton and Wheelock (2000), the expected funds rate was decreased by 37.5 basis points on October 23, 1987, and by an additional 12.5 to 25 basis points on October 28, 1987, in response to the stock market crash. This interrupted the succession of increases in the expected funds rate that had started on January 15, 1987. Increases in the expected funds rate were not resumed until March 29, 1988, roughly six months after the crash. During a conference call on October 20, 1987, Chairman Greenspan noted,
 I think we're playing it on a day-to-day basis.
 And in a crisis environment. I suspect we
 shouldn't really focus on longer-term policy
 questions until we get beyond this immediate
 period of chaos. (FOMC Transcripts, conference
 call, October 20, 1987, p. 1)


On September 29, 1998, the FOMC reduced the funds rate target by 25 basis points. This was followed by a two additional reductions of 25 basis points on October 15 and November 17. Chairman Greenspan noted the following at the February 1999 FOMC meeting:
 I have not heard it argued specifically, but our
 75 basis point action last fall was directed at
 countering a freezing-up of financial markets,
 which constituted a demonstrable threat to the
 stability of our economy, and arguably we have
 largely succeeded. It is true that one can still
 observe some residual impact of the liquidity
 problems that we have experienced, with yields
 on junk bonds remaining significantly above
 Treasuries and even obligations rated A and AA
 still running spreads against Treasuries that
 we haven't seen for a very long time. If it is
 correct that we have succeeded, then one could
 argue that we ought to reverse at least part of
 our easing moves. (FOMC Transcripts,
 February 2-3, 1999, p. 104)


The funds rate target established in November was maintained until the FOMC meeting in June 1999, though no argument was made that financial markets remained unsettled after November.

On December 21, 1999, the FOMC press release noted that the funds rate target was kept unchanged, in spite of
 the possibility that over time increases in
 demand will continue to exceed the growth
 in potential supply, even after taking account
 of the remarkable rise in productivity growth.
 (FOMC Press Release, December 21, 1999)


The maintenance of the existing target funds rate was explained by concerns about the century date change:
 Nonetheless, in light of market uncertainties
 associated with the century date change, the
 Committee decided to adopt a symmetric directive
 in order to indicate that the focus of policy
 in the intermeeting period must be ensuring a
 smooth transition into the Year 2000. (FOMC
 Press Release, December 21, 1999)


On September 17, 2001, the FOMC press release noted that the funds rate target was reduced 50 basis points in response to the uncertainty about financial market conditions in light of the terrorist attack on the World Trade Center:
 The Federal Reserve will continue to supply
 unusually large volumes of liquidity to the
 financial markets, as needed, until more normal
 market functioning is restored. (FOMC Press
 Release, September 17, 2001)


On the same date, Chairman Greenspan noted:
 It's clear that the events of last week, at a minimum,
 have created a heightened degree of fear
 and uncertainty that is placing considerable
 downward pressure on asset prices, increasing
 the probability of an asset price deflation, with
 its obvious impact on the economy. (FOMC
 Transcripts, conference call, September 17,
 2001)


It is worth noting that, while in real time FOMC participants were concerned about significant weakness in economic activity in the fourth quarter of 2001, the current estimate is that gross domestic product (GDP) grew at a positive 1.6 percent annual rate in that quarter.

Our conclusion from these questions is that considerable care and additional research is required to ensure that a valid identified model of the economy is constructed to enable us to draw inferences about the effectiveness of monetary policy as a tool for short-run stabilization of an economy. The number of issues that remain to be addressed suggests that we are a long way from a definitive answer.

If the objective of a well-identified model is achieved, then how should it be used to address the question of the effectiveness of monetary policy? Impulse response functions and variance decompositions that investigate the response to a monetary shock may not be the most informative analyses. These address only how the economy responds to the unpredictable component of monetary policy--the deviations from rule-like behavior. Cagan (1989, p. 135) complained that in the VAR analysis available at the time, the impact of such residuals was so small as to be implausible:
 By removing all serial and cross correlations
 from economic series, VAR reduces them to
 exogenous movements and looks for correlation
 between these movements in each pair of
 series. But these exogenous movements are
 little more that isolated blips in the series,
 which in monetary growth have little effect
 on GNP. The financial system filters out the
 effect on monetary blips. Only changes in
 monetary growth that are maintained for an
 extended period of time affect business activity
 These extended changes in monetary growth,
 however, exhibit serial correlation and, despite
 their variable lags in affecting output and
 prices, tend to be correlated with cyclical
 movements in other economic variables. The
 VAR accordingly eliminates the correlated
 movements in money as endogenous to the
 economic system. Thus does this technique
 give new meaning to the old cliche of "throwing
 the baby out with the bathwater."


An alternative investigation is to vary the parameters in the equation of the identified economic model that characterize the rule-like behavior of the monetary authorities. The question then becomes not how effective monetary policy has been in stabilizing the economy under the historical characterization of policy, but how effective it could be with alternative rule-like behaviors. Christiano, Eichenbaum, and Evans (1999, pp. 134-46) argue that with VAR models this type of analysis may be difficult, because identification of monetary policy shocks is not sufficient to identify the historical policy rule pursued by the central bank. The answer to the question of how effective monetary policy could be in short-run stabilization likely depends on the nature of the shocks that are assumed to hit the economy and, at least for some shocks, the relative tolerance for short-run inflation volatility versus output volatility.

Finally, has increased transparency and accountability of monetary authorities led to increased economic stability? This question has been raised in several contexts. First, some analysts have argued that the "Great Moderation" since approximately 1983 is substantially due to better monetary policy and improved transparency. Stock and Watson (2003, p. 29) use three different econometric models of the U.S. economy and replace their estimate of a post-1984 monetary policy rule with their estimate of a pre-1979 monetary policy rule. They conclude from these experiments that the models "all suggest that improved monetary control brought inflation under control, but accounts for only a small fraction--among the models fit to the United States data, less than 10 percent--of the reduction in output volatility."

Other analysts argue that improved transparency and accountability of central banks anchor long-term inflation expectations more firmly, thus giving central banks more latitude to pursue short-run stabilization objectives. Support for this argument requires two kinds of research: (i) What evidence would support the hypothesis that long-term inflation expectations are less variable and (ii) has the rule-like behavior of any central bank become more aggressive in reacting to short-term fluctuations of output? Levin, Natalucci, and Piger (2004) provide some evidence on both of these issues by comparing inflation-targeting industrial countries with industrial countries that do not announce inflation targets; they conclude (p. 75) that inflation targeting in these countries has "played a role in anchoring inflation expectations and in reducing inflation persistence."

Chairman Greenspan early on argued that a low and stable inflation environment contributed to the higher rate of productivity growth in the United States after 1995:
 Given these real-world uncertainties, it is
 important for policymakers to be as explicit
 as possible about not only the central bank's
 long-run inflation objective but also about its
 short-run policy objectives. The more ambiguous
 policymakers are about these objectives,
 the more difficult it will be for the public to
 differentiate policy actions that may reflect a
 change in the central bank's long-run inflation
 objective from actions intended only to offset
 the effects of real shocks on economic activity
 ... Implicit in that argument, if we are to move
 toward price stability, is that the process in and
 of itself induces an acceleration of productivity.
 (FOMC Transcripts, July 2-3, 1996, p. 47)

 It is not that low or stable prices are an environment
 that is conducive to capital investment
 to reduce costs, but rather that it is an environment
 that forces productivity enhancements.
 It forces people who want to stay in business
 to take those actions--such as cutting down the
 size of the cafeteria, reducing overtime, and
 taking away managers' drivers--that they did
 not want to take before in the ordinary course
 of business in a modest inflationary environment
 because it was easier then just to raise
 prices to maintain margins. If you force the
 price level down, you induce real reallocations
 of resources because to stay in business firms
 have to achieve real as distinct from nominal
 efficiencies. (FOMC Transcripts, July 2-3, 1996,
 p. 67)


This is an intriguing hypothesis that is difficult to investigate, given the limited understanding and theory of the determinants of productivity growth. Unfortunately, it is difficult to reconcile this hypothesis with the apparent uniqueness of the U.S. experience with the "productivity boom" in the face of almost worldwide low and stable inflation over the past decade.

PROBLEMS IN THE IMPLEMENTATION OF SHORTRUN STABILIZATION POLICY

One important issue for the implementation of short-run stabilization policy that did not receive much attention for a considerable period of time is the inherent uncertainty of the environment in which central bankers make decisions.

There are several dimensions to this uncertainty: (i) lack of accurate information about the contemporary state of the economy, (ii) inability to forecast accurately the future path of the economy, and (iii) lack of accurate information about how policy actions affect the economy.

Two problems face central bankers (and policymakers in general) in assessing the need for a short-run stabilization action: lags in the availability of data and measurement error in preliminary data.

In the United States, major economic statistics are available at either monthly or quarterly frequency, usually with an initial publication lag of a month or two. In other countries, comparable data may be measured at lower frequency and with longer publication lags. Consequently, most formal statistical data that are available for policy deliberations are "stale." In the FOMC process, such data are supplemented by anecdotal data from the various Federal Reserve Districts. (23) The latter data are not collected from scientific surveys, and the number of respondents surveyed is small. Hence, there is a danger of inappropriately extrapolating from the small environment to the macroeconomy. Nevertheless, such reports can give insights into and reduce, though not eliminate, uncertainty about emerging trends.

The second problem, measurement error, is well known; but until recently, it did not receive much attention, probably because it has been regarded as a mundane problem and research into it is unlikely to receive much attention. In appears that, recently, attitudes have been changing. Research using real-time data has become more fashionable. Some of this research (Orphanides, 2001 and 2002) alleges that the principal culprit in the Great Inflation in the United States was systematic bias in the real-time assessment of "potential output" and the "output gap" in FOMC deliberations. Nevertheless, formal consideration of measurement error in forecasting models, whether constructed by private sector entities or by the staff of policy agencies, remains underdeveloped, even though the econometric methodology is well understood. The paucity of readily accessible vintage data may contribute to this problem. (24)

An additional issue is the limited accuracy in the forecasts or projections that are available to monetary policymakers. Absent instantaneous reaction of the economy to policy actions, effective stabilization actions require an assessment of the future state of the economy. Gavin and Mandal (2001) found the accuracy of the forecasts by FOMC participants as recorded in monetary policy reports from 1983 through 1994 for real output growth are comparable to those of private forecasters (e.g., Blue Chip forecasters). (25) However, the root-mean-squared forecast error at 12- and 18-month horizons was roughly I percent (at annualized rates.) At a 6-month horizon the forecast error was 0.75 percent. In a subsequent analysis, Gavin and Mandal (2003) extended the sample of forecasts to 1979-2001. For this longer sample, they found that the root-mean-squared forecast errors at the 12- and 18-month horizons were 1.32 and 1.59 percent, respectively. The same statistic at a 6-month forecast horizon was only slightly less than I percent. (26) This forecast (in)accuracy suggests that variations in real output growth, from recessions to rapid expansions, cannot be reliably distinguished on a horizon as short as a year.

The projection accuracy for real output of the Reserve Bank of New Zealand (RBNZ) appears to be comparable to that of the participants in the FOMC. (27) Root-mean-squared projection errors of the RBNZ are reported as I percent at a 1-quarter horizon and 1.5 percent at a 1-year horizon.

The Bank of England publishes estimates of the "uncertainty associated with its numeric projections of inflation and GDP growth" with each of its Inflation Reports. (28) At the 1-year projection horizon conditioned on market interest rate expectations, the reported uncertainty measure is 0.76 percent; at the 2-year horizon it is 1.0 percent; and at the 3-year horizon it is 1.10 percent. These values are on the order of 50 percent of the root-mean-squared error of the RBNZ and FOMC projections at comparable horizons, but still suggest substantial uncertainty relative to business cycle fluctuations in real GDP. Other inflation targeting central banks also make public projections of real output growth, though this information does not appear to have a long history and we have not found any other analyses of the performance of these projections. (29)

The final problem is the paucity of accurate information about the dynamic effects of policy actions. Specifically, received macroeconomic theories generally provide little insight into dynamic structures. This is reflected in the VAR paradigm that eschews any restrictions on dynamics.

One perspective, associated with Milton Friedman, is that lags in the impact of monetary policy are "long and variable." Another perspective is derived from impulse response functions of econometric models, including VAR specifications. In many such models, the effect of a shock to the monetary policy variable is constrained to be zero as part of the identifying restrictions imposed on the data. In such models, a typical response pattern is that several quarters elapse before a significant response of real output builds up, and then this response dissipates over 12 to 18 months. (30) In general, estimated confidence intervals around the impulse response functions are quite wide. This leaves a policymaker interested in short-run stabilization with a difficult and unfortunate dilemma: The impact of a policy action at any horizon is highly uncertain, and the horizon over which any policy action is most likely to have a major impact is one where the future is not predicted with any precision.

CONCLUSION

Several conclusions seem warranted. First, inflation-targeting central banks appear to have an admirable record of consistently hitting targets on a medium-run horizon. However, it is not clear what the marginal contribution of inflation targeting beyond a credible commitment to price stability is, because the Federal Reserve, which eschews an inflation-targeting framework, has accumulated a comparable record of low and stable inflation.

Second, it is not clear what will happen to low and stable inflation if "bad shocks" are realized and the going gets tough. "Good luck" in the form of a decade or two of relatively mild shocks cannot be ruled out as a significant environmental factor during the inflation-targeting period (see Stock and Watson, 2003, pp. 46-47.) Finally, the case for consistently effective short-run monetary stabilization policies is problematic-there are just too many dimensions to uncertainty in the environment in which central banks operate.
APPENDIX
Characteristics of Inflation Targeting Regimes of Countries

 Current target
Country Inflation measure value (%)

Australia Headline CPI 2-3

Brazil Headline CPI 4.5 [+ or -] 2.5

Canada CPI and core 2 [+ or -] 1
 CPI (3)

Chile Headline CPI 2-4

Colombia CPI 6

Czech Republic Net inflation 1-3
 through 2001 (4);
 headline CPI
 thereafter

Finland (6) Core CPI NA

Hungary CPI 4 [+ or -] 1

Iceland CPI 2.5 [+ or -] 1.5

Israel Headline CPI 1-3

Korea CPI (1998) 2.5-3.5
 core inflation
 (after 1999)

Mexico Headline CPI 3 [+ or -] 1

New Zealand Headline CPI (7) 1-3

Norway CPI-ATE (8) 2.5

Peru Headline CPI 2.5 [+ or -] 1

Philippines CPI (they monitor 4.5-5.5
 core CPI
 measures also)

Poland Headline CPI 2.5 [+ or -] 1

South Africa CPIX (9) 3-6

Spain (10) Headline CPI NA

Sweden Headline CPI 2 [+ or -] 1

Switzerland Headline CPI <2

Thailand Core CPI 0-3.5
 (excludes raw
 food and energy
 prices)

United Kingdom Headline CPI (11) 2

 Inflation
Country targets (%) Adoption date

Australia 2-3 June 1993 (1)

 Treasury
 underlying CPI
 until 1998 and
 CPI thereafter

Brazil 1999: 8 [+ or -] 2 June 1999

 2000: 6 [+ or -] 2

 2001:4 [+ or -] 2

 2002: 3.5 [+ or -] 2.

 2003: 4 [+ or -] 2.5 (2)

 2004: 4.5 [+ or -] 2.5

Canada 1991: 3-5 (for 22 months) February 1991

 1992: 2-4 (multiyear)

 June 1994: 1.5-3.5

 1995-2004:1-3

Chile 1991:15-20 September 1990

 1992:13-16

 1993:10-12

 1994:9-11

 1995:8

 1996: 6.5

 1997: 5.5

 1998: 4.5

 1999: 4.3

 2000: [+ or -] 3.5

 2001 onward: 2-4

Colombia 1999: 15 September 1999

 2000: 10

 2001: 8

 2002: 6

 2003: 4-6

 2004: 5-6

 2005: 4.5-5.5

 2006: 3.5-5.5

Czech Republic Net inflation January 1998

 1998: 5.5-6.5

 1999: 4-5

 2000: 3.5-5.5

 2001: 2-4

 Headline CPI

 band starts Jan.
 2002: 3-5;

 band ends Dec.
 2005: 2-4;
 from 2006 (5): 3

Finland (6) Since 1993: 2 February 1993 to
 June 1998
Hungary 2001: 7.5 [+ or -] 1
 July 2001
 2002: 4.5 [+ or -] 1

 2003: 3.5 [+ or -] 1

 2004: 3.5 [+ or -] 1

 2005: 4 [+ or -] 1

 2006: 3.5 [+ or -] 1

Iceland Since 2001: March 2001
 2.5 [+ or -] 1.5

Israel 1992:14-15 December 1991

 1993: 10

 1994: 8

 1995: 8-11

 1996: 8-10

 1997: 7-10

 1998: 7-10

 1999: 4

 2000: 3-4

 2001: 3-4

 2002: 3-4

 2003: 1-3

 2004: 1-3

Korea 1998:9 [+ or -] 1 April 1998

 1999:3 [+ or -] 1

 2000: 2.5 [+ or -] 1

 2001: 2.5 [+ or -] 1

 2002: 3 [+ or -] 1

 2003: 3 [+ or -] 1

 Jan. 2004: change
 to medium-term
 (instead of annual)
 targeting system;
 target for 2004-06:
 2.5-3.5

Mexico 1999: 13 January 1999

 2000: <10

 2001: 6.5

 2002: 4.5

 2003: 3 [+ or -] 1

 (in line with
 trading partners)

New Zealand 1990: 3-5 March 1990

 1991: 2.5-4.5

 1992: 1.5-3.5

 1993-1996: 0-2

 1997-2001: 0-3

 2002-present: 1-3

Norway 2001-present: 2.5

Peru 1994: 15-20 March 2001

 1995: 9-11

 1996: 9.5-11.5

 1997: 8-10

 1998: 7.5-9

 1999: 5-6

 2000: 3.5-4

 2001: 2.5-3.5

 2002: 2.5 [+ or -] 1

 2003: 2.5 [+ or -] 1

 2004: 2.5 [+ or -] 1

Philippines 2002: 5-6 January 1994

 2003: 4.5-5.5

 2004: 4-5

 2005: 4-5

Poland 1998: <9.5 October 1998

 1999: 6.6-7.8

 2000: 5.4-6.8

 2001: <6-8, 3 by 2003

 2002: 5 [+ or -]
 1, <4 by 2003

 2003: 3 [+ or -] 1

 2004: 2.5 [+ or -] 1

South Africa 2003: 3-6 February 2000

Spain (10) 1996: 3.5-4 November 1994
 to June 1998
 1997: 2.5

 1998: 2

Sweden Since 1995: 2 [+ or -] 1 January 1993

Switzerland Since 2000: <2 January 2000

Thailand Since 2000: 0-3.5 May 2000

United Kingdom 1992: RPIX inflation 1-4 October 1992

 1995: "2.5 or less"

 1997:2.5

 Dec. 2003: CPI inflation
 2 [+ or -] 1

 Published
 Who sets Separate infla- inflation
Country the target? tion report forecast

Australia Government and No: statements Yes:
 central bank on monetary monetary
 jointly policy contain policy
 prospects for report
 inflation growth

Brazil Government Yes Yes
 in consultation
 with central
 bank

Canada Government and No Yes:
 central bank monetary
 jointly policy
 report

Chile Central bank Yes Yes
 in consultation
 with government

Colombia Jointly by Yes Yes
 government and
 central bank

Czech Republic Central bank Yes Yes

Finland (6) Central bank No No

Hungary Central bank Yes Yes

Iceland Central bank No: monetary Yes
 and bulletin
 government contains
 jointly prospects for
 inflation
 growth

Israel Central bank Yes Yes

Korea Government in Yes Yes
 consultation
 with central
 bank

Mexico Central bank Yes Yes

New Zealand Government and Yes Yes
 central bank
 jointly

Norway Government Yes Yes

Peru Central bank Yes Yes
 in consultation
 with government

Philippines Jointly by Yes Yes
 central bank
 and government

Poland Central bank Yes Yes

South Africa Government after Yes No
 consultation
 with the reserve
 bank and
 the national
 treasury

Spain (10) Central bank Yes Yes

Sweden Central bank Yes Yes

Switzerland Central bank No: monetary Yes
 policy report,
 monetary policy
 assessment,
 and inflation
 forecast pub-
 lished quarterly

Thailand Government in Yes Yes
 consultation
 with central bank

United Kingdom Government Yes Yes

NOTE: (1) Reserve Bank of Australia (RBA). Although the first formal
agreement on the conduct of monetary policy between the RBA and the
government was made in 1996, the RBA effectively adopted inflation
targeting in 1993. (2) Bank of Brazil Open Letter 2002, 2003, 2004;
www.bcb.gov.br/ingles/relinf/OpenLetter2003.pdf. (3) Canada's core
CPI excludes food, energy, and the effect of indirect taxes.
(4) Net inflation is calculated by the Czech Statistical Office
as the growth of prices in the unregulated part of the consumer
basket adjusted for changes in indirect taxes and for abolition of
subsidies. (5) The 3 percent inflation target had been announced for
the period from January 2006 until the Czech Republic's accession
to the euro area. (6) Since 1998, Finland has been a member of the
European System of Central Banks and Eurosystem.
(7) Officially CPI, but the Reserve Bank of New Zealand targets
"underlying" or "core" inflation. (CPI: Since December 1997, the
CPI excluding credit services was used; before then, overall CPI was
used. In late 1999, mortgage interest rates were removed from the
index.) (8) CPI inflation adjusted for tax changes and excluding
energy products.
(9) The CPI for metropolitan and other urban areas excluding
the interest cost of mortgage bonds. (10) Since 1998, Spain is a
member of the European System of Central Banks and the Eurosystem.
(11) Since December 2003, CPI inflation became the target, formerly
known as the harmonized index of consumer prices. Prior to that,
RPIX inflation was targeted.

SOURCE: Authors' compilations based on each central banks' web site
discussions on monetary policy, individual monetary policy and
inflation reports of each country, Mishkin and Schmidt-Hebbel
(2002), and Morande (2002).


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(1) There is an active discussion in the contemporary literature over the design of monetary policy rules. Some economists (for example, Svensson, 2005) argue for instrument rules that are optimized from an objective function of the central bank and models of the macroeconomy. Others (for example, McCallum and Nelson, 2004) argue for independently constructed target rules in the spirit of Taylor (1993). Both sides in this debate appear to accept the proposition that monetary policy can affect both inflation and real output in the short run, but only inflation in the long run. Hence, this theoretical debate is about how to best implement monetary policy rules, not about the effectiveness of policy.

(2) We consider two countries that at one time had explicit numeric targets--Finland and Spain--that have dropped from the group upon accession to the European Monetary Union.

(3) This figure updates similar figures that can be found in Loayza and Soto (2002) and Mishkin and Schmidt-Hebbel (2002).

(4) For early discussions of the implementation of and experience with inflation targeting for several of these countries, see Leiderman and Svensson (1995).

(5) President Santomero of the Federal Reserve Bank of Philadelphia stated that he preferred measuring inflation against an explicit target range on a 12-month moving-average (year-over-year) basis. Few central bankers have been this explicit about their definitions of a "medium term."

(6) Norway has a stated target of 2.5 percent, not an inflation range. The moving average of the inflation rate has been below this value since 2000 and only dipped slightly below zero in early 2003.

(7) Transcripts of two of these debates, on January 31, 1995, and July 2, 1996, can be found on the web site of the Board of Governors of the Federal Reserve System: www.federalreserve.gov/fomc/ transcripts/transcripts_1995.htm and www.federalreserve.gov/ fomc/transcripts/transcripts_1996.htm, respectively. A summary of the most recent debate at the February 1, 2005, FOMC meeting is also available on the Board's web site: www.federalreserve.gov/ fomc/minutes/20050202.htm.

(8) During the July 1996 FOMC debate on inflation targets, President Gary Stern of the Federal Reserve Bank of Minneapolis indicated that a 2 percent target (in terms of the CPI) would be acceptable to him (FOMC Transcripts, July 2-3, 1996, p. 56). The discussion at that time was not framed in terms of a target point or a target range.

(9) See, for instance, Derby (2005).

(10) See www.federalreserve.gov/boarddocs/press/monetary/2003/ 20030506/default.htm.

(11) See www.federalreserve.gov/fomc/minutes/20030506/htm.

(12) See also Svensson (2004).

(13) Relative to the end of 2004, the line indicates a trailing moving average of inflation back to the date indicated.

(14) For an analysis of the environment that led to the introduction of the "new operating procedures" and the objectives that the Volcker Fed sought to achieve with this innovation, see Lindsey, Orphanides, and Rasche (2005).

(15) See Schreft (1990).

(16) See, for example, Federal Reserve Bank of Boston (1970) and Grebler and Maisel (1963).

(17) Stock and Watson (2003) note the large decline in the volatility of residential construction (though not nonresidential construction) in the United States since the mid-1980s (p. 39).

(18) For an extensive discussion of the identification problem in VAR models, see Christiano, Eichenbaum, and Evans (1999, Section 2).

(19) See Wold (1954 and 1960).

(20) See, for example, Sims (1986) and Bernanke (1986).

(21) This conclusion should hold regardless of whether the central bank pursues an instrument rule or a target rule.

(22) See, for example, Romer and Romer (2002b, p. 68).

(23) See, for example, Poole (2002).

(24) For the United States, a limited amount of vintage data has been reconstructed by the research staff of the Federal Reserve Bank of Philadelphia. Complete archives of the FRED[R] data base have been preserved since the web version of this service was introduced in 1996 at least at monthly intervals and since 1999 at weekly intervals. A new data service (ArchivaL FRED, i.e., ALFRED[R]) has been implemented by the Research Division of the Federal Reserve Bank of St. Louis. ALFRED allows the user to retrieve a data list that is indexed with an "as of" vintage date. Over time, vintage data that was preserved on hard copy of National Economic Trends and Monetary Trends will be added to this archive.

(25) Gavin and Mandal (2001, Table 2): Forecasts are fourth-quarter over fourth-quarter growth rates.

(26) Gavin and Mandal (2003, Table 1): Forecasts are fourth-quarter over fourth-quarter growth rates.

(27) See Reserve Bank of New Zealand's "The Projection Process and Accuracy of the RBNZ Proiections"; www.rbnz.govt.nz/monpol/ review/0096577.html.

(28) The recent estimates are in the "Numerical Parameters of Inflation Report Probability Distributions, February 2005"; www.bankofengland.co.uk/publications/inflationreport/index.htm. This report indicates that the uncertainty measure is the standard deviation of the forecast error in those cases where the distribution of forecast errors is symmetric.

(29) We have found quantitative projections/forecasts of real output in published inflation/monetary reports of the central banks of Chile, Hungary, Iceland, Israel, Korea, Mexico, Norway, Peru, Sweden, and the United Kingdom. Undoubtedly, we have missed some reports and we have not completed a tabulation of all published estimates.

(30) Impulse response functions that are typical of those derived from VAR analysis can be found in Christiano, Eichenbaum, and Evans (1999, Figures 2 and 4).

Robert H. Rasche is a senior vice president and director of research and Marcela M. Williams is a senior research associate at the Federal Reserve Bank of St. Louis. This article was originally presented at the Bank of Korea's conference, "The Effectiveness of Stabilization Policies," May 27, 2005, Seoul, Korea, and was published in their conference proceedings in 2006. The article is reprinted here with permission from the Bank of Korea.
Table 1
Inflation Targeting Countries by
Year of Adoption

Year Country Total

1990 New Zealand 2
 Chile
1991 Canada 2
 Israel
1992 United Kingdom 1
1993 Sweden 3
 Australia
 Finland *
1994 Peru 2
 Spain *
1995 -- 0
1996 -- 0
1997 -- 0
1998 Czech Republic 3
 Korea
 Poland
1999 Mexico 3
 Brazil
 Colombia
2000 South Africa 3
 Switzerland
 Thailand
2001 Norway 3
 Iceland
 Hungary
2002 Philippines 1

NOTE: * Finland and Spain are considered to have become
non-inflation-targeting countries on joining the third stage of
the European Monetary Union in 1999.

SOURCE: Authors' compilation based on monetary policy and inflation
reports of each country's central bank and Mishkin and Schmidt-Hebbel
(2002) and Morande (2002).

Table 2
Effectiveness of Explicit Numeric Inflation Targeting

 Target First date for
 range as of which target
 Country Dec. 2004 (%) range is not met

Australia 2-3 June 2000
Brazil 4.5 [+ or -] 2.5 Dec. 2003
Canada 2 [+ or -] 1 Nov. 1992
Chile 2-4 Nov. 2003
Colombia 5-6 Dec. 2002
Czech Republic 1-3 Feb. 2002
Hungary 3.5 [+ or -] 1 Dec. 2003
Iceland 2.5 [+ or -] 1.5 Aug. 2003
 (next date is April 2001)
Israel 1-3 Nov. 2003
Korea 2.5-3.5 Nov. 2003
 (next date is Nov. 2001)
Mexico 2-4 Dec. 2003
New Zealand 1-3 Never (1)
Norway (2) 2.50 Never
Peru 2.5 [+ or -] 1 Nov. 2003
Philippines 4-5 Dec. 2003
Poland 2.5 [+ or -] 1.5 Dec. 2003
South Africa 3-6 Feb. 2002
Sweden 2 [+ or -] 1 Dec. 2003
Switzerland -2 Never (3)
Thailand 0-3.5 Never (4)
United Kingdom 2 [+ or -] 1 Never (5)

 Number of rate of inflation Standardized
 periods from Dec. 2002 deviation from
 Country within range to Dec. 2004 (%) moving average

Australia 17 2.51 0.02
Brazil 12 8.80 1.72
Canada 109 2.24 0.24
Chile 13 1.76 -1.24
Colombia 24 6.17 1.34
Czech Republic 34 1.93 -0.07
Hungary 12 5.75 2.25
Iceland 16 3.37 0.58

Israel 13 -0.35 -2.35
Korea 13 2.87 -0.26

Mexico 12 4.69 1.69
New Zealand 59 2.15 0.15
Norway (2) 45 0.85 --
Peru 13 3.03 0.53
Philippines 12 6.38 3.76
Poland 12 3.09 0.39
South Africa 34 4.25 -0.17
Sweden 12 0.78 -1.22
Switzerland 59 0.97 -0.03
Thailand 55 0.30 -0.83
United Kingdom 146 1.460 (6) -0.54

NOTE: (1) Average rate of inflation for New Zealand has never gone
outside the range since inflation targeting was adopted (1990).
(2) No index numbers for CPI-ATE (CPI, adjusted for tax changes and
excluding energy products) are available. Average rate of headline
CPI inflation was used instead. Value for average rate of headline
CPI inflation has never exceeded 2.5% since inflation targeting was
adopted (2001). (3) Average rate of inflation for Switzerland has never
gone outside the range since inflation targeting was adopted (2000).
First date for which the average rate of inflation was outside the
range was October 1989 at 2.09%. (4) Average rate of inflation for
Thailand has never gone outside the range since inflation targeting
was adopted (2000). The first date for which the average rate of
inflation was outside the range was August 1992 at 3.52%. (5) First
date for which the average rate of inflation was outside the range
was March 1992 at 3.03% for average rate of RPIX inflation. (6) Note
that in December 2002, the United Kingdom targeted RPIX and not
headline CPI. The value for the average rate of inflation of RPIX
at that time was 2.6%, still within the target range as of December
2004.
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