Manfred Neumann (Univ of Bonn) has written a nice overview of Bundesbank’s (Germany Central bank) monetary targeting strategy (see this paper as well). The overview was presented at ECB colloquium held in honour of Otmar Issing.
Neumann begins by presenting the background on why monetary targeting was adopted:
The background to the adoption of monetary targeting was the systemic need for a reorientation of monetary policy after the break-down of the Bretton-Woods-System.
The move to flexible exchange rates freed monetary policy from having to stabilise the exchange rate vis-á-vis the dollar and provided central banks with the potency of controlling domestic money and credit creation. However, along with this potency goes the burden of responsibility for securing domestic price stability. It is not easy to fulfil this task successfully because the absence of a binding exchange rate constraint implies that monetary policy is not anchored anymore.
In the mid-1970s this analysis was not known, of course. Nevertheless, quite a few central bankers in Germany and, by the way, in Switzerland appeared to understand that the regime change from fixed to floating rates required a new policy strategy in order to be able to check inflation expectations. They concluded that it would be useful, if not necessary, to commit to some type of rule that credibly constrains monetary policy.
The historic opportunity to start monetary targeting came in 1974 when, due to the quadrupling of the oil price and a sharp monetary deceleration, the German economy began to cool down. The Bundesbank wanted to switch towards easing without giving labour unions a signal for higher wage demands. Announcing a monetary target appeared to be the solution.
He then touches brief on the type of targets – point target, annual average, range (planned growth rate of money stock looking at growth of this quarter over previous quarter).
He then points that monetary targets were missed quite a few times (1976,1977, 1978, 1986, 1987 and 1992). In all the years reason for missing the target was exchange rate considerations.
To sum up this brief review of historic cases: the largest misses of monetary targets were caused by the Bundesbank’s temporary subordination of monetary policy to exchange rate considerations either with respect to the dollar or/and with respect to EMS-currencies. An exception was 1986 when the Bank went for reflation but avoided a consistent increase of the target range.
So much so, debates were held whether to continue with monetary targeting or not.
Despite the misses, Bundesbank had an excellent inflation control record compared to other economies. However, the puzzle remained
But isn’t this a puzzle? Why got the Bundesbank away with its practice of deviating time and again from announced targets? Why was it able to keep nevertheless the credibility that it truly cared about price stability?
The answer, I believe, is that the Bundesbank was the first central bank that provided the public with an intelligible numerical framework that facilitated the evaluation of its policy course from the outside (Neumann, 1999; Lohmann, 2003). Naturally, the population at large does not understand much about central banking and hardly knew anything about monetary targeting or its implications for inflation. But there is and was an elite audience consisting of bankers, economists and financial journalists. By offering public monetary targeting, the Bundesbank invited to be put under closer scrutiny as regards its aims, its model of how the economy works, its implementation procedures, its capability to do a good job. It enabled the elite to differentiate more closely between monetary policy actions that were defensible and those that were not.
Interesting analysis. What it says is it was not as much with setting monetary targets but setting a monetary policy framework which was transparent and considered credible by the market participants.
To be sure, the institution of targeting as such was not sufficient. The Bundesbank needed to provide detailed reasoning for the numbers it offered and for the final outcomes. And that the Bank did from the outset. Each year the Bank explained in detail what its evaluation was as regards last year’s target fulfilment, on which expectations the target range for the following year was based on and on which particular developments it would aim at the upper or the lower region of the range. During the course of the year the Bank reported and commented on ongoing developments and the degree of target fulfilment and mid-year the Bank checked officially whether the target was to be kept or revised.
Finally, it may be noted that the Bundesbank, if not all times, for most of the time was quite frank in its explanations. Remember that the Bank had no scruple to point out that the target overshot of 1992 was an all-time high. It fits that the Bank even admitted lack of knowledge on several occasions.
Great insights. It also conveys indirectly that it does not matter what mon pol strategy you choose (now the debate has narrowed to inflation targeters vs non-inflation targeters), what matters is whether you are transparent and credible in your operations.