Reddell

In addition to this paper, we need to consider Ellen Brown on Volker's Long Shadow - this also makes a contribution to Inflation Targeting - Volker ruthlessly crushed inflation using high interest rates, while ignoring the enormous cost paid in terms of unemployment. In reality, inflation came down due to oil price changes, but Volker and the world got the impression that high interest was the route to crush inflation. This needs to be combined with the info given below

Reddell, Michael. "Origins and early development of the inflation target." Reserve Bank of New Zealand Bulletin 62.3 (1999): 63-71.

1:Intro: Goals of Monetary Policy have been changing (over the past decade) - How did we get to inflation targeting, and how did we set ourselves current goal of re-establishing enduring price stability?

2:Intermediate Targets - till 1971, primary goal was management of FX rate. After Nixon shock, CBs search for a way to guide monetary policy - (Interest Rate Parity) - Credibility of announcements is of the essence. Early 1980s Monetarist influence, CBs were announcing monetary growth targets BECAUSE (i) to control inflation (part of FX bundle), (ii) Medium term benchmark for day-to-day policy, (iii) communications device, signal to public, (iv) performance evaluation against benchmark, (v) Dominant: convince public of serious efforts to fight inflation. Focus on "intermediate targets" (like money growth) rather then final outcomes (goals) because easier to evaluate, and also long and variable lags between int targets impacts on goals. NZ followed trends but did not publish policies because of tensions between getting inflation under control and implications for interest and output gap.

3.1 1984: Focus on Inflation - elections in 1984 led to rapid change. No interest rate control, no reserve ratios, floating FX rate. NAIRU led to belief that long term only inflation can be controlled - short term money illusion leads to fake possibility of affecting output gap, is a distraction. Sharp rise in FX, dropping price controls, implied high inflationary projections. Goals was to control, but horizon was not clear. By mid-1985 inflation was at 16%, targeting for 5% inflation or price stability seemed like remote and abstract goals. Key Question: how would policy makers, and public, know that policies would credibly reduce inflation? Wage-setters needed to know this, to set wages appropriately. CB needs credibility to influence setting of wages and prices throughout the economy. For credibility, CB needs to show that it can achieve what it announces. Evaluated targets of money growth, credit growth, concluded that it could not be done - too much structural change and variability! Contrary to Friedman's rule. Determinants of money and credit aggregates hard to identify, relationships appeared unstable.

3.2 Closer in Causal Chain: Target Primary Liquidity (PL) - Money banks keep in reserve at Central Bank -- seems like more amenable to direct control. Hope was that stable relationships would emerge between PL and major economic aggregates. Hope faded as PL remained highly variable, and was accompanied by high erratic variations in interest and exchange rates. Next attempt was nominal GDP growth target - projection was 10-13%, but actual growth was around 16%. Roger Douglas MoF attempted to use these projection to influence wage negotiations, but without much effect. 1987 Post-Election Briefing by CB indicates no real progress - "no explicit targets on disinflation ... because of complex nature of linkage between monetary policy and inflation". Late 1987 first indication of goal to bring down inflation to single digits.

4. Reserve Bank Autonomy. Mid-86 Douglas approached Treasury and CB to explore ways of freeing them from political influences on policy. T & CB came up with different approaches. CB wanted "autonomy" - built in price stability objectives, and six monthly policy published statements, to create accountability, and possibility of dismissal for non-performance. Treasury emphasized accountability to politicians. Managerial approach - give managers authority to manage, but hold them accountable for outputs. T had 3-point critique of CB approach: (i) Publishing 6-monthly MPS was not specific & measurable. (ii) It was not an output - something produced by CB, (iii) Group creates shared responsibility, with risk of no one being held accountable. Compromise: Governor personally accountable. Long debate on "output". Monetary aggregates examined and rejected. Many intermediate targets, with varying levels of control, examined. But no long run stable relationship between directly controllable outputs and long run GOALS of monetary policy could be identified. Eventual agreement on: no prior specifications about intermediate goals, focus on final goals. Accountability in terms of JUDGMENT of Governor in terms of responding to emerging situations. This would be assessed via 6 monthly MPS statements, which would explain past judgment and outline policy dimensions for future. Governor's 5 year contract would include inflation targets (but this was not a big deal at the time).

5.1 Genesis of Inflation Target: In 1987, Governor's contract evolved into "Policy Targets Agreement" - started out with more clarification about disinflation goals - numbers and time frames. This clarity and focus paid off as inflation fell to about 9% in March 1988. Roger Douglass was concerned that public (financial markets, employers, unions) would assume that government was targeting to maintain inflation at around 5% and would make plans accordingly. To prevent this, RD MoF announce the goal of bringing inflation down to under 1%, by the next election in 1990, and campaigned vigorously to create public expectations aligned with these ambitious targets (to the surprise of CB). They announced (to test government resolve) that rapid reductions in inflation would impose heavy economic costs, and would require vigorous campaign for expectations management. Government backed off, announcing zero inflation as a longterm goal without timelines. This was not references in ongoing negotiations about CB independence.Policy alignment occured when CB and government publicly agreed to a 0-2% inflation as suitable definition of price stability, like Switzerland, Germany, and Japan.

5.2 Lengthy report from CB to MoF documents evolving thinking at the CB. Reports states that benefits of zero inflation may be low, and costs high. BUT, now that goal has been announced, credibility of monetary policy requires us to try to achieve it. Governors contract should include price stability, but it should not be announced and highlighted as a tool of expectations management. This is because lags between monetary policy and inflation are long and variable, and key determinants in relationship are unknown, as established by international experience. Inflation targets are suitable as long term policy goals, but also require some specification of intermediate goals. Otherwise, public is asked to "trust us". No specification of intermediate goals is also a confession of lack of knowledge of the causal chain and mechanism. Also, exogenous events, like FX shock, oil shock, could result in movements which should not be countered to support inflation targets instead of price stability. Final recommendation of report - Conditional on no adverse external shocks, government should achieve 0-4% inflation by elections June 1990, and price stability 0-2% within its next term.

5.3 Targets were driven by political desire to display medium term policy favored, and not owned by Treasury or CB. However, internal models showed ability to achieve these goals of under 2% inflation by March 1993. Government announced target of 0-2% by December 1992, with no apparent public response, and no clear ownership of policy goal by CB. But Inflation target was created by osmosis - general consensus by silence.

6. Shaping Policy Target Agreements: Inflation target started as an attempt to manage public expectations. Medium term policy framework was part of governor's contract - an attempt to balance advance commitments, clear signalling, ex-post accountability, and independence. Exogenous shocks would require re-negotiation of the PTA (reluctantly agreed by Central Bank).

7. Early Refinements: Volatile oil price shocks results from Iraqi invasion of Kuwait in Aug 1990 led to reconsideration of the PTAs. Frequent re-negotiation would destroy the value of the PTA as a bedrock of policy. It was impossible to anticipate complex and variable shocks. Instead of outputs, accountability should be on judgment displayed by CB in response to shocks. In Dec 1990, revised PTA signed between MoF and CB, allowing for accomodation of policy to a list of shocks, and holding CB accountable for exercise of judgment. There was not much effect on public sentiment or expectations because: By crystallising the broad goal in place since 1984, the targets provided a discipline for the Bank’s own policy thinking and management, and a focus for its very considerable promotional efforts. But the Bank was neither author nor master of its own destiny. And so the targets – still only political promises rather than binding commitments - probably had relatively little direct impact on public or market behaviour or expectations until low inflation had been delivered.

8: Concluding Reflections: Inflation Targeting literature resulted from, and followed, experience. Experience was based on Principal-Agent theory to problem of creating independence for CB while maintaining accountability. Long and complex lags, and subjectivity to external shocks, make "inflation" outcomes less than ideal as policy targets.

Authors Concluding Paragraph: In a sense, that highlights two things. First, that the target itself originated primarily as a communications device – Roger Douglas’s desire to refocus expectations, and to convince people that the anti-inflation drive would be kept going. Secondly, that in complex areas of life, ideal accountability frameworks are rarely on offer. Ambiguity and uncertainty were - and are - facts of life, and have been taken on board in the design and operation of the Reserve Bank accountability arrangements. Balancing clear and comprehensible general goals, with the scope for judgement and need for flexibility that real macroeconomies demand in practice, is at the heart of the way the framework has settled.