June 22, 1998

NOTE TO EDITORS

NEW YORK --Central banks that adopt a fixed inflation target run the risk of creating considerable variability in output growth, according to an article in the June issue of the Federal Reserve Bank of New York's Economic Policy Review, published today.

In Policy Rules and Targets: Framing the Central Banker's Problem, Stephen Cecchetti, the director of research at the New York Fed, considers the difficulties faced by policymakers who must maintain steady economic growth while keeping inflation rates low. Because it is generally not possible to stabilize both output and prices around their optimal levels, Cecchetti notes, policymakers routinely balance the costs of output fluctuations against the costs of price fluctuations. But when a system of rigid inflation targeting is introduced, Cecchetti argues, "central bankers are implicitly altering the relative importance of inflation and output variability in their objectives, increasing the weight they attach to the former relative to the latter. This change in emphasis could have undesirable side effects."

Using data covering the 1984-95 period, he shows that the "output-inflation variability trade-off" is extremely steep: in other words, an effort to decrease inflation variability modestly causes output to deviate significantly from its optimal path.

Consequently, central banks that must keep a tight rein on price fluctuations to meet an inflation target may see a sharp rise in the volatility of GDP growth.

"Someone who cares about output variability is made substantially worse off by a decision to target the path of the price level," says Cecchetti. "As a result, when considering policies based on prices alone, policymakers must be very cautious and ask whether they really care so little about output and other real quantities."

Countries that do decide to adopt an inflation goal, Cecchetti notes, fare best when they give themselves latitude to respond to short- or medium-run real fluctuations in the economy.

According to Cecchetti, "The Reserve Bank of Australia states that its goal is to have inflation average between 2 and 3 percent over the business cycle."

Similarly, the central banks in New Zealand and the United Kingdom announce target ranges--rather than point targets--for inflation. By such means, Cecchetti says, a central bank retains the flexibility to stabilize output in the face of short-run shocks.

Contact: Douglas Tillett