Anchoring on gold

In the late 1800s and early 1900s, many of the world’s largest economies anchored their monetary system to gold under the “gold standard.” There was good reason for this, with possibly its most important benefit being that the gold standard forced monetary discipline on central banks and governments at a time when discipline was lacking in many countries.¹ Under a gold standard, any additional unit of fiat currency had to be backed by an additional unit of gold, so the system limited a government’s ability to produce inflation by simply printing more fiat currency for circulation in the economy.

The disruptions to the global economy caused by Word War I, the Great Depression, and World War II resulted in a few iterations of the gold standard. In 1944, after World War II, one of the last formal attempts was made to re-establish a form of a quasi-gold standard under the Bretton Woods Agreement. Under this agreement, many countries fixed their exchange rates to the US dollar. In turn, nations could exchange their US dollars for gold. However, as before, this limited the US government’s ability to manage its fiscal responsibility, especially in the 1960s and 1970s. Because of this lack of monetary policy flexibility, the US ended the convertibility of the US dollar to gold in August 1971. The end of US dollar convertibility effectively heralded the beginning of the modern monetary system, in which many currencies have flexible exchange rates that are not backed by gold, but rather by the trust that a government will not devalue currency against goods and services.²

A new set of rules to achieve a nominal anchor

The 1970s and early 1980s saw a period of high inflation. Without an anchor for the currency, there was a general lack of expectation that monetary and fiscal policy would credibly be able to maintain the value of fiat currencies and that buying power would not erode over time. Eventually, a set of rules of behaviour for monetary policy, known as inflation targeting, emerged in the 1990s. Inflation targeting provided a credible nominal anchor to economies that implemented this framework. New Zealand was the first country to adopt inflation targeting in 1990, followed closely by Canada in 1991, the UK in 1992, and Australia and Sweden in 1993. ³

The importance of having a nominal anchor in the economy is highlighted by the Bank of Canada, which states that “our job is to promote the economic welfare of Canadians. We target inflation because a low, stable and predictable rate of inflation is good for the economy. When people and businesses feel confident that they know what the rate of inflation will be, they can make long-range financial plans. That leads to an economy that functions better. Average economic growth is stronger, and employment is higher.” ⁴

Success in simplicity

Part of inflation targeting’s success since its widespread adoption in the early 1990s is its simplicity, in theory. The government sets a central bank target inflation rate. The central bank then forecasts inflation and compares this forecast path to its target inflation rate. Monetary policy is adjusted if there is a difference between the target and the forecast. Over time, a central bank can gain credibility by achieving its target, which further helps to anchor inflation expectations in an economy. Inflation expectations that remain anchored at the target improve the chance of success that a central bank hits its target over time and provide more flexibility to policy implementation. 

Since the first central banks shifted to an inflation targeting regime, many other countries, both developed economies and emerging market economies, have adopted a specific inflation target or an inflation targeting range and have successfully managed to keep inflation around their targets for most of two decades. Some of the adopters of inflation targeting regimes include Chile, Columbia, Hungary, Indonesia, Israel, Mexico, Norway, Poland, South Africa, and South Korea, to name a few. Inflation targets for countries vary—typically 2 percent for developed markets and slightly higher for emerging markets, typically in the 3 or 4 percent range.

Other central banks, such as the US Federal Reserve, have adopted many elements of inflation targeting but do not officially call themselves inflation targeting central banks, as they also consider the level of employment in the economy. However, they have adopted critical aspects of inflation targeting, including:

• Setting a quantitative target for inflation
• Having independence in setting monetary policy
• Indicating clearly to the public the importance and precedence that hitting its inflation objective holds in its policy response function

The modern-day golden standard

Many empirical studies have analyzed the pros and cons of an inflation targeting regime. Criticism of an inflation targeting regime flows from the inherent tension between inflation and cyclical unemployment—the inflation target is often achieved at the expense of higher unemployment. This criticism would be countered by the fact that monetary policy cannot change the structural levels of full employment in an economy. Therefore, a central bank that focuses only on inflation allows for a better long-run outcome of monetary policy. 

In general, the consensus on inflation targeting is that the framework allows central banks to successfully conduct independent monetary policy, if credible. Some have gone as far as to say that the credibility that a central bank builds up under an inflation targeting regime is as good as gold in anchoring inflation expectations over a long period.⁵ A significant difference, however, between a credible inflation targeting central bank and a central bank under the gold standard is that the former has more flexibility in conducting monetary policy in the short run. Monetary policy reactions during the financial crisis in 2008 and again in 2020 demonstrated the benefits of flexible monetary policy.  

Despite the short-run policy flexibility that inflation targeting provides a central bank, the COVID-19 pandemic has introduced unique challenges since 2020. Not only did supply-chain disruptions push prices higher starting in 2021, but the unprecedented fiscal and monetary policy stimulus, combined with pandemic-related restrictions, posed a challenge to measuring and forecasting inflation (which is already difficult under normal conditions). Since then, it has become apparent that the current high inflation in the post-pandemic world may challenge central banks’ resolve to fight price growth, especially given that lower inflation is likely to be at the expensive of higher cyclical unemployment. Evidence from the last 30 years suggests that strong credibility under an inflation targeting regime should serve central banks well in driving inflation back to the target levels.