By Amol Agrawal

Inflation targeting has its origins in New Zealand in 1990. In general, 35th anniversaries are not seen as an occasion for any celebration or reflection, but given the uncertain times there is a need felt for introspection.

After World War II, the focus of the world economy was to restore development and growth. The policy was buttressed by the findings of New Zealand economist Alban William Housego “Bill” Phillips. His Philips Curve showed that there was a trade-off between low inflation and low unemployment. Governments could choose between growth/employment and inflation seamlessly.

In the 1970s, the global economy faced supply shocks leading to both high inflation and high unemployment. Economists Milton Friedman and Edmund Phelps had warned even earlier that the trade-off was, at best, over a short run. Over a long run, the Philips Curve is vertical. They argued that high inflation feeds into inflation expectations, becoming a spiral. Based on this monetarism school of thought, central banks were advised to control inflation by targeting money supply. However, the banks struggled to target money supply as innovations in payment systems kept broadening the definition of money. The search for a new system led to the sudden discovery of inflation targeting in New Zealand, of all places.

Until the mid-1980s, New Zealand was suffering from both low growth and high inflation. The newly elected Labour government undertook public sector reforms to boost the economy. The reforms based on resolving the principal-agent problem had a three-pronged approach: specifying clear targets, granting autonomy, and holding executives accountable. The central bank, the Reserve Bank of New Zealand (RBNZ), was included in the reform as well.

The RBNZ governor was given an inflation target, autonomy to achieve the target, and an employment contract which specified inflation levels over a five-year term. The RBNZ was supposed to achieve the target by changing the interest rates, but not money supply. Inflation declined with this new framework. The government drafted a more formal Policy Targets Agreement in 1990, which laid the foundations of the inflation targeting framework (ITF).

Mervyn King, former governor of Bank of England, noted that the ITF is a case of “practice before theory”. The ITF was highly successful as it established a new set of monetary policy procedures and institutions. The communication policy of the central banks became highly transparent, and it transformed from being highly opaque and clandestine to transparent and open. The central bank published monetary policy statements and minutes of meetings on their website, conducted press conferences, delivered speeches, etc. Due to the internet, central bank communications today are streamed live to the public like sports. The other notable changes were enacting Monetary Policy Committees (MPCs) that shifted the onus of shaping monetary policy from the governor to a committee.

Not surprisingly, the seeds of the ITF were planted across the world. Nearly 40 central banks from both advanced and emerging economies have adopted it. The ITF was first implemented in small and open economies (Canada, Australia, United Kingdom, and Sweden) as they were more prone to monetary shocks. It was next adopted in crises economies — transition economies (Czech Republic, Poland), Southeast Asian nations (South Korea, Thailand), Latin American economies (Brazil, Chile), and Africa (South Africa, Uganda). The Federal Reserve and the European Central Bank have inflation targets but do not call themselves inflation targeting central banks due to broader mandates. India adopted the ITF in 2015 after much deliberation and forming many committees. The discussion to adopt it started from then RBNZ Governor Donald Brash’s LK Jha Memorial Lecture in 1999 and ended with the Urjit Patel Committee (2014).

The experience of all the ITF adapters was highly satisfactory with low and stable inflation. However, nothing lasts forever.

During the 2008 global financial crisis, the ITF faced serious criticism for pursuing the narrow objective of price stability and ignoring real economy and financial stability. Inflation remained lower than target for the next decade, only to increase to 40-year highs after the pandemic and the Russia-Ukraine war. The central banks responded by widening mandates. The RBNZ included employment, only to remove it in 2023. The Bank of England is responsible for financial stability, and the European Central Bank for climate change.

Given the background, it is natural that the 35th year of the ITF will lead to wide introspection. RBNZ chief economist Paul Conway has noted that the framework has served well in the highly challenging three and a half decades. However, one needs to constantly adapt and learn from new developments. In the future, supply shocks are going to become more prominent, posing the challenges that were faced in the 1970s. Demographics and climate change are additional riddles which will impact all forms of public policy, including monetary policy. Bank of International Settlements economists have said that the ITF’s flexibility in 35 years of evolution has led to its durability. International Monetary Fund economists have shown that countries that suffer from high inflation are more aggressive in their ITF frameworks.

It is incredible how an economic framework took flight all around the world from the land of flightless Kiwis. As RBNZ’s Conway has said, “…inflation targeting is probably the most well-being-enhancing big idea to come out of New Zealand. I know that (it is) a big call compared to jet boats, electric fences, and split atoms. But that is my contention”.

The writer teaches at Ahmedabad University.

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