In this paper, I survey the existing literature and examine three related questions: (1) What inflation rate constitutes the appropriate target for the central bank? (2) What is an operational definition of price stability for the conduct of monetary policy? (3) What is the policy framework for pursuing price stability in practice? In doing so, I emphasize that it is crucially important for a central bank to seek to maintain a price environment that is neither inflationary nor deflationary and is consistent with stability of the economy in the long run. I propose two definitions of price stability, “measured price stability” and “sustainable price stability.” I argue that “sustainable price stability” should be the fundamental goal for monetary policy. Although, from the viewpoint of accountability, “measured price stability” is important as a quantitative yardstick by which to evaluate policy achievement, it should not be the justification for preventing the central bank from its pursuit of “sustainable price stability.” Since observed changes in price indices are affected by various types of external shocks and measurement errors, it is indeed quite difficult to assess whether the underlying rate of inflation is stable or not. Therefore, even if “measured price stability” seems to be maintained, a central bank may need to alter interest rates promptly if it judges that the maintenance of “sustainable price stability” is at risk. In this sense, it is deemed important to construct a framework for monetary policy designed to maintain policy flexibility with a high degree of transparency by properly ensuring consistency between “measured price stability” and “sustainable price stability.” The current policy framework adopted by the Bank of Japan can be viewed as aiming at a kind of “constrained discretion” by restricting pure discretion under open independence in line with this direction.
Keywords: Ultimate objective of monetary policy; Welfare costs of inflation and deflation; Measured price stability; Sustainable price stability; Constrained discretion
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.