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News Release

United States, Euroland, and Japan Should Adopt Inflation Targeting

October 30, 2003

Contact:    Edwin M. Truman    (202) 328-9000

Washington, DC-The central banks of the G3 (United States, Euroland, and Japan) should adopt inflation targeting for the conduct and evaluation of monetary policy to improve the performance of their own economies and the world economy. There is essentially no downside risk in doing so. Twenty-two central banks of countries representing more than 20 percent of global GDP have adopted inflation targeting, and it has generally been effective there in reducing inflation (or maintaining low inflation) without adverse impacts on growth or its variability.

Inflation Targeting in the World Economy, by senior fellow Edwin M. Truman, who directed the Division of International Finance at the Federal Reserve for over 20 years, concludes that by adopting inflation targeting, the Fed could improve the transparency and accountability of its policy, contributing positively to US economic performance. The case for adoption of inflation targeting by the European Central Bank (ECB) is even stronger because the shortfall in ECB policy transparency is larger; moreover, if the ECB were to choose 2½ percent as the midpoint for its target, close to its recent performance, the bank would be better positioned to promote European growth. Japan would benefit substantially from the adoption of inflation targeting, even as the Bank of Japan (BOJ) has been edging in that direction, as it would provide the BOJ with the scope to act more flexibly and imaginatively in implementing its policy of quantitative easing while reducing the risk of being too easy too long.

The world economy would benefit from collective G3 adoption of inflation targeting through the increased clarity about the policy intentions of its key countries. This should improve the policy dialogue among the G3 and help other countries to make better policy choices. Inflation targeting would also provide an insurance policy for the world economy in the form of antideflation targeting by the major central banks, guarding against the severe and asymmetric risks associated with sustained deflation.

Inflation targeting is broadly and successfully applicable to a wide range of countries. This study finds no evidence to support the view that smaller, open, more vulnerable, or less institutionally developed economies should avoid its adoption. On balance, inflation targeting has had a beneficial effect in reducing inflation without significant negative effects on growth; it has not adversely affected trade-offs between inflation and growth or the variability of inflation and growth.

This study of the experience of the countries that have adopted inflation targeting:

  • describes the principal elements of inflation targeting;
  • explains the origins of the framework and examines empirically the factors associated with countries choosing it;
  • provides evidence on the conditions associated with successful inflation targeting and empirical results on countries' experience to date with the framework;
  • critically evaluates the case for the adoption of inflation targeting by the G3 central banks and outlines a procedure through which each of them could do so;
  • discusses the compatibility of inflation targeting with various exchange rate regimes; and
  • reviews the implications of inflation targeting for the international financial architecture and the design of IMF programs of financial support.

The study concludes that inflation targeting is compatible with a variety of exchange rate regimes, ranging from free floating to regimes envisaging more active concern about exchange rate movements. Inflation targeters should be serious about achieving low inflation. To the extent that exchange rate movements are also important in their policy calculus, inflation targeters should specify in advance that the principal objective is controlling inflation and clearly justify any departures from this hierarchy.

Inflation targeting poses an important challenge for the International Monetary Fund (IMF). It requires the IMF to modify its traditional approach to programs, which places heavy emphasis on monitoring the economy's performance and protecting the IMF's resources through restrictions on the member's central bank balance sheet. The IMF should adopt a more benign and constructive attitude toward those of its members that choose to adopt inflation targeting, whether they are receiving IMF financial support or not, and it should continue to encourage high inflation countries like Turkey to embrace the framework. The IMF has adapted its policy conditionality in programs supporting members practicing inflation targeting, such as Brazil, Colombia, and Peru, but it should further modify and experiment in this area by applying the criteria laid out in this study.

About the Author

Edwin M. Truman, senior fellow, was assistant secretary of the US Treasury for international affairs (1998-2000). He directed the Division of International Finance of the Board of Governors of the Federal Reserve System from 1977 to 1998. From 1983 to 1998, he was one of three economists on the staff of the Federal Open Market Committee. He has been a member of numerous international groups working on international economic and financial issues, including the Financial Stability Forum's Working Group on Highly Leveraged Institutions (1999-2000), the G22 Working Party on Transparency and Accountability (1998) created in the wake of the Asian financial crisis, the G10-sponsored Working Party on Financial Stability in Emerging Market Economies (1996-97), the G10 Working Group on the Resolution of Sovereign Liquidity Crises (1995-96), and the G7 Working Group on Exchange Market Intervention (1982-83). He has published on international monetary economics, international debt problems, economic development, and European economic integration.

About the Institute

The Institute for International Economics, whose director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. Its staff of about 50 focus on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and cover all key regions—especially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site.

Inflation Targeting in the World Economy
by Edwin M. Truman
October 2003 • 288 pp. • $25.00
ISBN paper 0-88132-345-4