ABSTRACT
It is now widely accepted that price stability should be a (if not the) primary objective of central banks. Even for central banks with dual mandates, such as the Federal Reserve, the achievement of price stability is often seen as a key prerequisite to the attainment of other mandated objectives such as maximum employment. In this chapter I look at how central banks should define price stability, starting with current practices. I consider three questions. First, should price stability be defined in terms of a relatively broad price index, such as the deflator for Gross Domestic Product, or in terms of a narrower measure, such as a Consumer Price Index (CPI)? Second, should price stability be defined in terms of a headline measure of inflation, or in terms of a core measure that routinely excludes or down-weights the prices of certain goods and services? And third, should price stability be defined as no change in the chosen price index, or as a positive rate of increase in the chosen price index? The choice of the horizon over which price stability is to be maintained is arguably as important as the manner in which price stability is defined, but I will not address that question here. I will touch briefly on the question of how asset prices should figure in the definition of price stability, but I will not visit the well-trodden ground of how monetary policy should respond to asset price developments. The Federal Reserve is perhaps unique among the major central banks in that it does not have an explicit numerical price objective. Former Federal Reserve Chairman Alan Greenspan famously defined price stability in qualitative terms as a situation in which ‘households and businesses need not factor expectations of changes in the average level of prices into their decisions’ (Greenspan, 1994a).2 However, as Table 4.1 shows, many central banks, even those that would eschew the label of ‘inflation targeter’ do have explicit numerical price objectives. In all cases, these price objectives are specified in terms of a measure of consumer price inflation. Furthermore, almost all are defined in terms of the headline rather than a core measure, although that was not always the case. The Reserve Bank of New Zealand (RBNZ), which pioneered inflation targeting, switched from defining its target in terms of core to headline CPI in 1997.3 In 1998, the Reserve Bank of Australia’s inflation target was also changed from referring to ‘underlying inflation’ (which removed volatile components of the CPI such as the prices of unprocessed food, as well as prices that were heavily
influenced by non-market developments, such as tobacco prices) to headline CPI inflation (but again excluding mortgage interest costs). The switch was made following changes to the construction of the CPI. And of course the Bank of England’s inflation target, which was originally defined in terms of the Retail Price Index excluding mortgage interest payments (the RPIX, a core-like measure) was redefined in terms of the headline CPI or HICP in 2003. Perhaps the only central bank (that I am aware of) to have gone from targeting a headline measure to targeting a core measure is the Bank of Korea. After adopting inflation target-
ing in 1998, and targeting a headline measure of the CPI for two years, the Bank of Korea switched to a core measure (CPI inflation excluding non-cereal agricultural products and petroleum-based products) in 2000. In 2006 the target was redefined in terms of headline CPI inflation. While almost all inflation-targeting central banks define their objective in terms of a headline measure of inflation, many if not all also assign an important role to measures of core inflation in their deliberations and communications with the general public. The importance assigned to core measures varies across countries. Some central banks, such as the Federal Reserve System, which does not have a formal definition of price stability, regularly publish forecasts of core inflation. Others, such as the Bank of England, which has a formal inflation target expressed in terms of a headline measure of inflation, completely eschew the publication of core measures in the regular communications.4 Yet others such as the Sveriges Riksbank, which has a formal inflation target defined in terms of a headline measure, publish a wide variety of core measures in its regular Monetary Policy Report.5 The last point to note from Table 4.1 is that all of the central banks listed define price stability as prevailing at a positive measured rate of inflation. Usually some reference is made to measurement problems in justifying this choice, but there are often additional reasons, such as the desire to provide some safety margin against the risks of deflation.
