There is a widespread consensus that the policy goals for any central bank should be set through the legislative and political process. But should there be one goal or several? Should the goals be fixed or changing? Should the legislative and political process both set the goals and also tell the central bank how to implement those goals?
Starting in the mid-1980s, the central bank of New Zealand was the first country to adopt what became known as “inflation targeting.” In this approach to monetary policy, the legislative and political process determines that the central bank has a single goal: control of inflation. In the case of New Zealand, the goal was an inflation rate of 0-2% annually. Having set that goal, the legislative and political process then gives the central bank the independence to pursue that goal, free of political meddling. Canada followed New Zealand on the inflation targeting path, and then dozens of other countries around the world did so as well, including the European Cetnral Bank. But Oliver Sikes focuses on the original New Zealand experience in “How one Kiwi tamed inflation” (Works in Progress, June 12, 2025). He emphasizes that although economists would later provide justifications for inflation targeting, the original policy resulted as a political response to evident failures of other approaches.
In the mid- and late 1970s, countries around the world experienced a surge of inflation. New Zealand, as an oil importer, was especially affected by the OPEC-induced rises in oil prices; in addition, New Zealand lost preferential access for its exports to the UK market when Britain joined what what then called the European Economic Community (now evolved into the European Union).
At this time, the central bank of New Zealand, called the Reserve Bank, was essentially under political control. The usual pattern was that politicians called for the Reserve Bank to fight inflation, but then when the bank tried to do so, it would be overruled.
In general, the economy of New Zealand at this time had considerable government intervention. As Sikes writes:
The government controlled large portions of many industries, including banking, insurance, and utilities, and the agricultural sector was supported by generous subsidies, price guarantees, and low-interest loans. Imports of goods were also tightly controlled – Kiwis needed government approval to subscribe to an overseas magazine. … Unlike today’s central banks, which mainly control inflation through adjusting interest rates, New Zealand used direct regulatory controls on financial institutions. The government forced banks to hold specific amounts of government debt and set limits on interest rates for savers. It used capital controls to restrict money flows in and out of the country, allowing it to retain a fixed exchange rate. … Inflation began to fall in 1982, but only after [Prime Minister] Muldoon imposed a complete freeze on prices and wages, which then coincided with an economic contraction.
In short, New Zealand by the mid-1980s had substantial reason to distrust political control of the goals and methods of its central bank. Moreover, US inflation under had fallen from 13.5% in 1980 to 3.2% by 1983, with the US Federal Reserve under the leadership of Paul Volcker, which suggested that a central bank did have the power to reduce inflation–if it was allowed to use that power.
In keeping with a strain of economic thought often associated with the work of Milton Friedman, the Reserve Bank decided that it would target the growth of the money supply, with the idea that a low and steady growth rate for money would lead to a low and steady inflation rate. But it didn’t work well. All around the global economy, shifts in financial deregulation and financial innovation were changing what “the money supply” actually measured. So what to do next?
The New Zealand government decided that it would just set a numerical goal of 0=2% inflation, with the Reserve Bank to focus on that goal. Sike notes:
Michael Reddell, head of the Reserve Bank’s monetary policy unit, said it was settled on ‘more by osmosis than by ministerial sign-off’. … David J. Archer, a former Assistant Governor, said inflation targets were eventually chosen ‘as the least bad of the alternatives available’.
But now and then, a deeper wisdom is born from these kinds of political compromises. As economists would come to argue, central bank independence and inflation targeting were useful steps to address a political conflict-of-interest: specifically, current politicians always want lower interest rates to stimulate the economy, but will almost never vote for the higher interest rates needed to fight inflation. By taking the day-to-day politics out of monetary policy, households and firms in the economy can actually believe that the goal of low inflation will be pursued, and their expectations that low inflation will be pursued can help to “anchor” a lower rate of inflation when shocks and stresses inevitably occur.
The idea that a central bank should purely be governed by the single goal of inflation targeting has become more controversial over time, especially in the aftermath of the Great Recession of 2007-09. At that time, central banks around the world took on a set of tasks that had nothing to do with fighting inflation: specifically, the task of providing short-term support to financial markets, which otherwise seemed in real danger of collapsing and causing even more severe economic damage. For the US Federal Reserve, there was no legal conflict here, because the law governing the US Federal Reserve is often described as a “dual mandate”: “price stability and maximum sustainable employment.” In practice, even central banks with an inflation-targeting mandate commonly act as if they have a dual mandate: Keep inflation low, but in a financial crisis or economic recession, act as needed to stabilize markets.
