Inflation Targeting and the Legacy of High Inflation

IMF Working Papers, April 11, 2025

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Inflation targeting (IT) has reached 35 years as a key institutional monetary framework for central banks.
Stark differences exist among inflation targeting countries in the conduct of monetary policy.
The legacy of a high inflation history is identified as a preponderant factor behind heterogeneity in monetary policy conduct.
A credibility puzzle is documented: the strength of a central bank’s monetary policy response to deviations from the inflation target remains broadly unchanged even as central banks gain credibility over time.
Key conclusion: a country’s inflationary past casts a long and persistent shadow on central banks.

The paper proposes a model that departs from existing IT workhorse models by:
- Adding path-dependence to a forward-looking model.
- Allowing for potentially imperfect central bank credibility.
Theoretical results:
- Achieving low inflation (hitting the target) requires more aggressive monetary policy when individuals’ past inflationary experiences shape their inflation expectation formation.
- Hitting the inflation target is costlier from an output point of view under such path-dependent expectation formation.

Empirical findings support the need for the two theoretical additions (path-dependence in expectations and imperfect credibility).
Countries that experienced a high level of inflation before adopting the IT regime tend to respond more aggressively to deviations of inflation expectations from the central bank’s target.
Evidence is consistent with a persistent influence of past inflation on current central bank behavior.

Central banks in countries with a history of high inflation may need to implement more aggressive policy responses to stabilize inflation expectations.
The output costs of returning inflation to target can be higher where agents’ expectations incorporate past high inflation episodes.
Strengthening central bank credibility over time does not necessarily reduce the aggressiveness of monetary policy responses to inflation-expectation deviations, highlighting a credibility puzzle policymakers should consider.