The academic merits of using intermediate targets as monetary policy tools have filled the pages of numerous economic journals over the past few decades. But, as successive intermediate targets have run into difficulties, policy-makers in a number of countries have shifted instead to targeting the inflation rate itself.

New Zealand was the first country to shift to an inflation target in 1989, followed closely by Canada in 1991. In both cases, the shift followed an unsatisfactory period trying to target unstable money targets as apparently stable relationships between monetary aggregates and the price level broke down.

But it was the 1992-3 crisis in the European exchange rate mechanism (ERM) that hastened the shift away from monetary and exchange rate targets and towards inflation targets. The UK, Sweden and Finland have all introduced inflation targets after they were forced to leave (or break fixed exchange rate links with) the ERM.

Yet, despite these inauspicious beginnings, the shift to inflation targeting has so far been successful. This is the cautious conclusion of a recently published CEPR Report, which provides the first comprehensive evaluation of the impact of these inflation targets on monetary policy and inflation performance.

The Report examines the experiences of five countries which have explicit inflation target regimes - Canada, Finland, New Zealand, Sweden and the UK - and compares them with those of four other, less explicit regimes - Germany, Israel, Italy and the US.

The Report defines an inflation target regime by two characteristics: the country must have an explicit quantitative inflation target; and there is usually no explicit intermediate target for monetary aggregates or the exchange rate. All five inflation target regime countries pass both tests, while the US Federal Reserve fails both of them.

But there are considerable variations among the five inflation target regimes. In each country, the inflation target will typically specify an appropriate inflation indicator, target level, tolerance interval and time frame, both medium- and long-term. It may also define the situations under which the target may be modified or disregarded. Finland has a point inflation target of 2 per cent, New Zealand has an inflation target range of 0-2 per cent and the UK has a target range of 1-4 per cent and a point objective of 2.5 per cent or less.

The legal and institutional supports for inflation targets also vary widely. At one extreme, as in New Zealand, the targets are one element of a three part strategy for improving monetary performance: a legislated price stability goal, independence of the central bank in choosing the means to fulfil the goal, and clear accountability for the central bank. In the UK, by contrast, the government both decides its own target, which is not statutorily defined, and sets interest rates to meet that target after consulting the Bank of England.

The case for inflation targets is twofold. First, they are a better way of anchoring and coordinating expectations among wage bargainers and in financial markets than a more abstract intermediate target such as the rate of broad money growth. Second, they reinforce the authorities' commitment, discipline and accountability for the achievement of price stability by providing a clear yardstick against which to judge policy.

In practice, however, inflation targets run into many of the same difficulties facing monetary and exchange rate targets. The fact that the price level reacts with ‘long and variable lags’ - and with varying effects - to changes in interest rates means that there is considerable uncertainty about how to pull the policy levers to meet the inflation target eighteen months or two years ahead. Intermediate indicators, such as changes in monetary aggregates and exchange rates, inevitably continue to have operational significance.

Indeed, the fact that there are as yet no simple rules for how monetary policy should be conducted in the varying circumstances that may arise under an inflation target regime helps explain why policy-makers in inflation target regime countries have stressed the importance of transparency and openness in order to build credibility.

So how have inflation targets performed? Impressively to date, the Report concludes, with targets generally fulfilled or even undershot. But the hard part may be yet to come. In most countries, the targets were adopted in a period of considerable slack in the economy, and countries without explicit targets have also recently had relatively low inflation. Greater inflationary pressures will show more clearly whether inflation targets regimes are more effective than other monetary regimes, and the relative importance of the target as opposed to the institutional set-up. Particularly important will be a comparison of New Zealand with other target regimes, such as the UK, which has declined to adopt central bank independence.

In any case, the debate over the relative merits of money and inflation rate targets will intensify over the next few years as the blueprints for European economic and monetary union (EMU) are refined and the question of the relationship between ‘ins’ and ‘outs’ is defined.

The inevitable time lag in tracking the link between money and inflation at the European aggregate level during Stage III of EMU may make targeting EMU-wide inflation a more sensible objective. And inflation targets have also been proposed as a way of stabilizing and codifying the economic relationships between the monetary union and those European countries which cannot, and choose not, to join at the beginning.

Yet Bundesbank officials show no sign of losing their long-standing enthusiasm for broad money targeting. And if they have their way, that will be the model that the independent European Central Bank also adopts when, and if, Stage III begins in January 1999.

Inflation Targets is edited by Leonardo Leiderman (Tel Aviv University and CEPR) and Lars E O Svensson (Institute for International Economic Studies, Stockholm University, and CEPR). The following economists contributed: Charles Freedman (Bank of Canada), Andreas Fischer (Schweizerische National Bank), Alex Bowen (Bank of England), Johnny Åkerholm and Anne Brunila (Bank of Finland), Jurgen von Hagen (Universität Mannheim, Indiana University, and CEPR), Marvin Goodfriend (Federal Reserve Bank of Richmond), Ignazio Visco (Banca d’Italia), Gil Bufman and Meir Sokoler (Bank of Israel) and Alex Cukierman (Tel Aviv University and Tilburg University). Support for the publication was provided by the Commission of the European Communities under its Human Capital and Mobility programme.