29.8.07
 
Inflation Targeting Revisited
 
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Israel’s inflation environment has changed drastically in the last twenty years, falling from a level of about 20 percent to price stability, the norm in the advanced economies. This occurred together with a switch from a monetary policy based on the exchange rate as a nominal anchor to an inflation targeting regime in a floating exchange rate environment. Inflation targeting regimes are gaining popularity world wide. The number of countries operating their monetary policy in the framework of an inflation targeting policy has been rising in the last fifteen years, and has now reached twenty-four, and international organizations such as the IMF advise other countries to adopt this regime too. With the realization that high inflation harms economic growth, and that price stability is a necessary condition for continuous growth and low unemployment, there is a growing consensus that an inflation targeting regime is the right and most practical way of achieving those objectives. A credible inflation target provides an anchor for medium- and long-term inflation expectations, thereby making it easier for the business sector to function properly, boosting its growth, and allowing for more effective management of monetary policy.
At present, after several years of price stability under an inflation targeting regime, the time has come to re-examine the rules defining the regime in Israel. This paper incorporates a short review of inflation and inflation targeting in Israel, a description of other countries’ experience of inflation targeting regimes, and a discussion of and recommendations regarding the desired operative system for the inflation target.
Experience of inflation targeting in Israel and abroad:
  The first time an inflation target was set in Israel was in 1992. In the years since then, there has been less than complete success in achieving the target. Since 2003, inflation––in terms of change in the consumer price index (CPI) over the previous twelve months––has deviated from the target 75 percent of the time, and 75 percent of the deviations consisted of inflation undershooting the target. This is higher than the norm in other countries, and can be attributed in part to the high volatility of the exchange rate of the shekel and its rapid pass-through to prices.
  Many countries set an inflation target in order to achieve or maintain price stability, but their definitions of the target vary with regard to its level, the width of its range, and the aggregate used as the measure. Nevertheless, in most the target is defined in the area of 2 percent or 3 percent, with a range of ±1 percentage point, and it is measured over the previous twelve months.
  In most countries the target is defined in terms of the general (i.e., all-items) consumer price index. Some countries have moved from a target based on a partial index to an overall index; most countries incorporate the housing index in their consumer price indices.
  The conclusions may be summarized as follows:
  The inflation target should continue to be defined in terms of the CPI. This index is published monthly with a half-month lag by the Central Bureau of Statistics, and is not adjusted retroactively. This index has the advantage that the public is familiar with it, and it is accepted world wide. We recommend that the inflation target should continue to be set in terms of the general price index, and not a core index. Reducing volatility of the index by switching to a partial price index ought to improve the ability of monetary policy to achieve the inflation target with lower volatility of the interest rate. However, we found that the use of partial indices, i.e., indices that exclude the volatile components such as fruit and vegetables, does not reduce volatility and generally creates a bias relative to the general index. It is preferable not to use various statistical devices, such as filters, because they are complex, involve discretion, and are difficult to explain to the public, and therefore less credible. Over and above these considerations, since the inflation target in Israel has already been defined in terms of the CPI, which is widely used in contracts and agreements, changing the definition would incur a cost, and could harm its credibility.
  The midpoint of the target range should be kept at 2 percent. Most countries with an inflation target adopted a low, positive target of 2 percent to 3 percent, in part to avoid the problematic nature of zero inflation. As Israel’s current target is consistent with the above, there is no need to change it.
  The width of the range should remain two percentage points, similar to that in many other countries, i.e., the target range should stay at 1 percent to 3 percent inflation a year. Choosing a range rather than a single-point target emphasizes the fact that it is not possible to achieve an exact rate of inflation. The wider the target range, the easier it is to achieve an inflation rate within it, and this affords greater flexibility in conducting monetary policy, and in particular allows more attention to be paid to the secondary targets. On the other hand, a wide range impairs the credibility of the target as defining stability. As the Bank’s inflation targeting policy enjoys credibility, narrowing the range would reduce its flexibility without significantly improving the credibility. Despite the fact that the volatility of price changes in Israel is relatively high, so that deviations from the target are almost inevitable, widening the inflation target range could be interpreted as lessening the commitment to price stability.
  The target should be set as price stability at any point in time, as it is defined at present. The test of performance vis-?-vis the target should be a continuous one, i.e., performed on a monthly basis, with inflation measured over the previous twelve months.
  The Bank of Israel should be permitted to exercise flexibility with regard to the rate of convergence to the target, i.e., when shocks lead to a deviation of inflation from the target, the return to the range should be gradual, without the need to invoke a stringent monetary policy to achieve a speedy result1. It is known that the transmission mechanism from monetary policy to the rate of inflation does not operate immediately, but spreads over a period that can be up to two years, or even longer. Shocks affecting the rate of inflation in the short term do sometimes occur, but reacting with sharp changes in the interest rate may undermine stability in the financial markets and harm economic growth; hence, the horizon for the return of inflation to the target after such a shock should be one or two years, or even longer if necessary.
  To enable the performance vis-?-vis the target to be monitored on a continuous basis, we recommend that the Bank publish a quarterly inflation report, in which it will report on how well it has achieved the target and on deviations from it. If actual inflation deviates from the target in six consecutive months, the report should include an analysis of the reasons for the deviations, a description of the policy adopted and the expected time needed to bring inflation back to within the target range2. Three times a year, in April, July and October, the report will be concise and will describe the developments in inflation, the achievement of the target and the expected path of inflation. Soon after the end of the year, in January, the report will be more extensive, and will include an analysis of inflation, monetary policy, the background conditions, and in particular the macroeconomic environment.
 
* In a few of the countries that adopted inflation targeting, the practice is to measure performance against the target over the medium term, i.e., two to three years, to avoid sharp fluctuations in the interest rate in reaction to short-term shocks.
* In a few countries (including the UK and Iceland) the report on a deviation from the target takes the form of an open letter from the governor to the government. In some countries (Canada, Sweden, New Zealand) the report is included in the regular reports, and in others (including Australia, the Czech Republic and Norway) there are no rules concerning reports on deviations from the target.
 
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