Monetary targeting

What Is Monetary Targeting?

Monetary targeting is a framework of monetary policy where a central bank aims to achieve its ultimate goals, typically price stability and sustainable economic growth, by publicly announcing and attempting to control the growth rate of a specific monetary aggregate, such as the money supply (M1, M2, or M3). The underlying premise of monetary targeting is that a stable and predictable relationship exists between the chosen monetary aggregate and key economic variables like inflation and nominal Gross Domestic Product (GDP). By influencing the quantity of money in circulation, central banks intend to indirectly steer economic activity and manage inflationary pressures.

History and Origin

The adoption of monetary targeting as a primary framework for monetary policy gained prominence in the 1970s, largely in response to the high inflation experienced by many industrialized economies following the breakdown of the Bretton Woods system of fixed exchange rates. Central banks sought new strategies to regain control over rising prices.

In the United States, under Chairman Paul Volcker, the Federal Reserve (Fed) shifted its approach in October 1979 from targeting the federal funds rate to explicitly targeting the quantity of money, specifically nonborrowed reserves, to combat surging inflation. This period, often referred to as the "Volcker disinflation," marked a significant change in the Fed's operating procedures, leading to increased volatility in interest rates but ultimately contributing to a sharp reduction in inflation.¹³, ¹⁴

Concurrently, the Deutsche Bundesbank in Germany pioneered monetary targeting, adopting it at the end of 1974. The Bundesbank's commitment to fighting inflation and its transparent communication of its monetary targets were hallmarks of its policy. It aimed for a low and stable inflation rate, typically below 2%, and successfully used monetary targeting to manage the money supply, even allowing for flexibility and official explanations when targets were overshot or undershot.¹¹, ¹² The Bundesbank's experience with monetary targeting is often cited as a successful example, influencing later monetary policy frameworks.¹⁰

Key Takeaways

• Monetary targeting involves a central bank setting public targets for the growth of a monetary aggregate to achieve macroeconomic goals.
• The strategy relies on a stable relationship between the money supply and key economic variables like inflation and output.
• It gained prominence in the 1970s as central banks sought to combat high inflation.
• Successful implementation requires the central bank to have effective control over the chosen monetary aggregate.
• Monetary targeting aims to provide transparency and accountability by clearly stating the central bank's objectives.

Interpreting Monetary Targeting

In a monetary targeting framework, the primary interpretation revolves around whether the actual growth rate of the chosen monetary aggregate is within or deviates from the publicly announced target range. If the money supply grows faster than the target, it might signal potential future inflationary pressures, prompting the central bank to tighten monetary policy, typically by raising short-term interest rates or conducting open market operations to reduce bank reserves. Conversely, slower-than-target growth could indicate a need for policy easing to stimulate aggregate demand and prevent disinflation or recession.

The effectiveness of interpreting monetary targets hinges on the stability of the relationship between the money supply and nominal income, often expressed by the velocity of money. Fluctuations in this velocity can make interpretation challenging and lead to incorrect policy responses if not properly accounted for.

Hypothetical Example

Imagine a hypothetical country, "Econland," where the central bank has adopted a monetary targeting framework. For the upcoming year, the central bank announces a target range for M2 growth of 4% to 6%, believing this rate is consistent with its long-term objective of 2% inflation and 3% real economic growth, assuming a stable velocity of money.

Throughout the year, the central bank monitors M2 growth.

• Scenario 1: M2 growth reaches 7%. The central bank observes that M2 is growing above its target range. This signals potential future inflation. In response, the central bank might decide to raise its policy interest rates, such as the benchmark lending rate to commercial banks. This action aims to reduce borrowing and slow down the expansion of the money supply, bringing it back within the desired range and mitigating inflationary risks.
• Scenario 2: M2 growth falls to 3%. If M2 growth consistently falls below the target, the central bank might interpret this as a sign of weakening economic activity or potential disinflation. To stimulate the economy, the central bank could lower its policy interest rates, making borrowing cheaper and encouraging banks to lend more, thereby increasing the money supply and supporting economic growth.

This ongoing monitoring and adjustment process is central to implementing a monetary targeting strategy.

Practical Applications

While less common as a sole framework today compared to its peak in the 1970s and 1980s, monetary targeting has been practically applied by several central banks, most notably the Bundesbank, before the advent of the Euro. The Bundesbank successfully used this strategy to maintain price stability in Germany for many years.⁸, ⁹

Even central banks that primarily use other frameworks, such as inflation targeting, often monitor monetary aggregates as important economic indicators and as part of their broader analysis of economic conditions and inflationary pressures. The Bank for International Settlements (BIS) notes that while many emerging market economies have adopted inflation targeting, they often still consider monetary and credit aggregates in their policy decisions.⁷ Some countries with less developed financial markets or those transitioning to more market-based monetary policy may still employ variants of monetary targeting, often focusing on reserve money as an operational target.

Limitations and Criticisms

Despite its initial success in some contexts, monetary targeting faces several significant limitations and criticisms that have led many central banks to abandon it in favor of other frameworks, particularly inflation targeting.

One primary criticism is the instability of the relationship between monetary aggregates and macroeconomic variables like inflation and output. Financial innovation, deregulation, and globalization can lead to unpredictable shifts in money demand and the velocity of money, making it difficult for central banks to accurately control the aggregate or predict its impact on the economy. For instance, the introduction of new financial instruments or changes in banking regulations can alter how the public holds money, thereby distorting the chosen monetary aggregate.⁵, ⁶

Another challenge lies in the central bank's ability to precisely control the targeted monetary aggregate. Factors such as banks' lending behavior, changes in reserve requirements, and capital flows can affect the money supply in ways that are difficult for the central bank to offset through its policy tools. Critics also argue that strict adherence to monetary targets can lead to excessive volatility in interest rates, which can be disruptive to financial markets and real economic activity.⁴ Furthermore, some argue that a singular focus on money supply might neglect other crucial aspects of economic stability, such as financial system health.³

Monetary Targeting vs. Inflation Targeting

Monetary targeting and inflation targeting are both frameworks for conducting monetary policy, but they differ fundamentally in their intermediate targets and transparency mechanisms.

While monetary targeting uses the money supply as an intermediate variable to achieve price stability, inflation targeting makes price stability the direct and explicit objective. Inflation targeters often use inflation forecasts as their primary guide for policy adjustments, with the central bank directly accountable for achieving the announced inflation goal. The International Monetary Fund (IMF) highlights that inflation targeting provides a clear yardstick for central bank actions and promotes accountability through transparency.² Many central banks, including those in emerging markets, have transitioned from monetary targeting to inflation targeting due to its perceived advantages in anchoring inflation expectations and its greater flexibility in a complex financial landscape.¹

FAQs

What is the main goal of monetary targeting?

The main goal of monetary targeting is to achieve macroeconomic objectives, primarily price stability and sustainable economic growth, by controlling the growth of a specific monetary aggregate.

Why did many central banks abandon monetary targeting?

Many central banks abandoned monetary targeting primarily due to the unstable relationship between monetary aggregates and economic outcomes, often caused by financial innovation and deregulation. This instability made it difficult to precisely control the money supply and predict its impact on inflation and economic activity.

How does a central bank implement monetary targeting?

A central bank implements monetary targeting by publicly announcing a target range for the growth of a chosen money supply measure. It then uses its policy tools, such as adjusting interest rates, conducting open market operations, or changing reserve requirements, to influence banks' lending behavior and steer the actual money supply growth towards the target.

Is monetary targeting still used today?

While less common as a primary framework, especially in advanced economies, some central banks, particularly in developing countries, may still use aspects of monetary targeting or monitor monetary aggregates as part of a broader monetary policy strategy. However, the dominant framework among major central banks today is inflation targeting.

What is the Quantity Theory of Money's relevance to monetary targeting?

The Quantity Theory of Money (MV = PQ, where M = money supply, V = velocity of money, P = price level, and Q = real output) provides the theoretical foundation for monetary targeting. It suggests that if the velocity of money and real output are stable or predictable, controlling the money supply (M) directly influences the price level (P) and thus inflation. This theory underpins the belief that controlling the money supply is key to managing inflation.