Looking at developing countries makes this point even stronger, since it can also apply to inventory management and other forms of common productivity shocks since the asynchronicity is much more significant. 2  BIS Review 74/2008  However, reforms regarding monetary policy have lagged noticeably in their adoption among developing economies. Central bank independence, inflation targeting and other related policy reforms have only materialized in developing economies beginning in the mid-90s which coincides with the fall in volatility in this group of countries. While structural changes, such as the increased openness, may have indeed helped economies become more stable, these changes must also include those related to monetary policy because the Great Moderation coincides with inflation control, suggesting that improved monetary policy has indeed played a major role. So, the relevant question is exactly how does monetary policy reduce the volatility of both output and inflation. We know that there is a tradeoff between output volatility and inflation variability, and monetary policy attempts to manage this tradeoff optimally. Policymakers have to decide how to reduce inflation to reach their goal. If they react forcefully to any inflation deviation, the outcome will be low inflation volatility, but large output volatility. Thus, in the long run, there is a tradeoff between inflation volatility and output volatility, although inflation has no effects on the full employment level of output. It is also possible to practice inefficient monetary policy, one which lags behind the output/inflation volatility frontier, making both of these inefficiently large.
The empirical evidence on this subject is mixed, but generally it has been found that inflation targeting does lower inflation and reduce its volatility. 5 There is some evidence for emerging economies that inflation targeting also reduces growth volatility (Gonçalves and Salles, 2008). Bad luck is back: the risks of inflation Recently, the world has faced one of the worst inflationary shocks in the last 60 years. First, it happened with oil prices, which started rising sharply at the beginning of the decade, and has climbed to record-high levels (figure 4). However, even with this shock, inflation and output have been much less volatile than in previous oil price cycles. Lower oil-dependence and countercyclical fiscal policy explain part of the milder effects. Better monetary policy has also contributed to substantially reduce the impact of oil shocks on output and activity. 6 However, the price of oil has kept increasing, and although its effects are smaller than in the past, the shock is becoming so large and persistent that it may have noticeable effects on inflation and output over the coming quarters. On the bright side, however, the better monetary policy frameworks that are used today limit these effects. On the other hand, more recently, we have seen an impressive increase in food prices (figure 5), with serious inflationary effects in many countries. Food prices have reached in some cases their highest levels in history.