Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 4 Monetary Policy and Inflation

Inflation Targeting

The choice of the nominal anchor is crucial for anchoring agents' expectations for maintaining price stability. Monetary regimes have evolved over time in order to reduce the inflationary bias in the economy through various refinements under the broader debate on 'rules' versus 'discretion' in policy making and more recently, "constrained discretion" which believes that the doctrines of 'rules' and 'discretion' are not mutually exclusive. In practice, there has been widespread use of either monetary or exchange rate targets as nominal anchors for policy. Since the mid-1980s, developments in financial markets and ongoing financial innovations brought about by financial liberalisation have rendered monetary targeting less effective. Exchange rate pegging aimed at controlling inflation by importing credibility from abroad (from a large successful low inflation anchor country) also turned out to be increasingly fragile, as countries opened their economies to external flows. The weaknesses with these intermediate targeting frameworks led to a search for alternative frameworks for ensuring price stability. One such framework that has become popular during the 1990s is 'Inflation Targeting'. Under this approach, central banks target the final objective i.e., inflation itself rather than targeting any intermediate variable. Inflation targeting is considered as a mechanism to overcome inflationary bias in monetary policy through transparency, accountability and credibility (Box V.4).

The experience of inflation targeting countries to date appears to have been satisfactory. This is evident in the case of emerging countries starting from high levels of inflation as well as for industrial countries with lower inflation. Inflation in IT countries is less persistent than those in non-IT countries. At the same time, the decade of the 1990s has also been one of a generalised fall in inflation worldwide. Even countries that have not adopted IT have seen a significant decline in inflation or have been able to maintain low inflation. There is no unique or even best way of monetary policy making and different approaches or frameworks can lead to successful policies by adapting better to diverse institutional, economic and social environments. Moreover, some evidence suggests that average inflation as well as its volatility in prominent non-IT industrial countries has, in fact, been somewhat lower than that in prominent IT industrial countries. IT is not found to have any beneficial effect on the level of long-term interest rates. Although transparency is a key feature of IT, most IT central banks are extremely reluctant to discuss concerns about output fluctuations even though their actions show that they do care about them.

The ongoing slowdown in global economic activity and the threat of deflation has weakened the analytical edifice of the IT framework. The relevance of a single inflation target for a large economy, in particular, can be debated. Regional disparities warrant different short-run monetary policy approaches to its objectives. Indeed, there is a growing sense that by the time the current phase of the global business cycle has run itself out, inflation targeting may not be seen to have stood the test of time. The effectiveness of inflation targeting regime is also debatable, given the stylised evidence that monetary policy decisions affect prices with a lag of around two years, and more exogenous shocks can occur in this period.

It is also argued that an IT framework reduces the flexibility available to a central bank in reacting to shocks. Although a number of EMEs have adopted IT, they face additional problems. These economies are typically more open and it exposes them to large exchange rate shocks which can have a significant influence on short-run inflation. Boom-bust pattern of capital flows can lead to substantial movements in exchange rate. Illustratively, Brazil was faced with a negative swing of US $ 30 billion - six per cent of its GDP - in net capital flows during 2002 that led to a sharp nominal depreciation of 50 per cent. Inflation rate reached 12.5 per cent, breaching the target of four per cent . EMEs may have to manage exchange rates more heavily since they are more commodity-price sensitive than advanced economies and commodity price fluctuations can wreak havoc with the forecastability of consumer price inflation. An empirical evaluation of the experience of EMEs that have adopted IT confirms that IT is a more challenging task in such economies compared to developed economies that have adopted IT. While inflation in EMEs was indeed lower after they adopted IT, their performance was relatively worse vis-ŕ-vis developed IT countries. Deviation of inflation from its targets is found to be larger and more common. The main strength of IT in EMEs is in its capacity to keep inflation under control once it is low (IMF, 2002). Inflation targeting by itself is not a sufficient condition for success. As with any other monetary regime, its success depends on the consistency and credibility with which it is applied. Erroneous or irresponsible fiscal, exchange rate and monetary policies will condemn to failure any monetary regime and inflation targeting is no exception.

In contrast to most recent papers which assess the performance of IT countries versus non-IT countries, Fatás, Mihov and Rose (2004) focus on the macroeconomic performance of the three key monetary regimes: exchange rate targeting countries, money growth targeting countries and IT countries. They find that what matters most for macroeconomic performance - low and stable inflation and output stability - is clear-cut quantitative goals by the monetary authority. Both having and hitting quantitative targets for monetary policy is found to be systematically and robustly associated with lower inflation. The exact form of the monetary target matters somewhat, but is less important than having some quantitative target. Successfully achieving a quantitative monetary goal is also associated with less volatile output

In a similar vein, Sterne (2004) makes a distinction between inflation targeting and inflation targets. While only around 20 central banks follow the inflation targeting approach, a large number of central banks - such as, India - make public some sort of loose inflation targets (which could take the form of inflation forecasts/projections rather than targets per se). According to one survey, out of 95 countries, as many as 57 countries had some sort of inflation target/ projection/forecast. Such inflation targets/ forecasts increase transparency and help to reinforce societies support for low inflation policies. They also provide a platform to the central bank to voice its independent opinion. In cases where inflation targets/ forecasts are missed, a central bank can provide analytical insights by identifying factors (say, fiscal dominance) contributing to missing the target. This can increase the costs to the government of ignoring the central bank advice. Explicit inflation targets and a credible commitment to them helps to stabilise financial markets. Gurkanyak, Sack and Swanson (2003) find that long-term forward interest rates in the US often react considerably to surprises in macroeconomic data releases and monetary policy announcements. In contrast, in the UK - which has an explicit inflation target - long-term forward interest rates demonstrate less excess sensitivity.

A stylised fact in regard to inflation is that it is highly persistent, i.e., if there is a shock that raises inflation today, inflation continues to remain high in the future and vice versa. High persistence (a unit root) indicates that inflation expectations are not well-anchored and policy efforts to reduce inflation will have to bear significant output losses. In this context, increased transparency in monetary policy formulation with priority to price stability as a key objective is expected to provide an anchor to inflation expectations and hence lower the persistence of inflation. This has an important implication: any future shock that raises inflation temporarily will not lead to a permanent rise in inflation expectations and actual inflation. Empirical evidence on persistence of inflation remains mixed. IMF (2002) suggests that inflation has become more predictable and less persistent. Levin, Natalucci and Piger (2004) find that IT anchors inflation expectations and, therefore, inflation is less persistent in IT countries than in non-IT countries. On the other hand, Cecchetti and Debelle (2004) and Marques (2004) argue that there has not been much change in persistence. Once a structural break in the mean of inflation is taken into account, there is no evidence that inflation persistence has been high in the previous decades.