What is meant by “inflation-targeting”? What difficulties do central banks have in pursuing such a policy?

Inflation targeting is a type of monetary policy that aims to achieve price stability in an economy. This policy is conducted in a way where the central bank of an economy estimates and publicly announces a targeted inflation rate, and then uses the interest rate mechanism to steer the price level towards that target. Historically, the New Zealand government was the first to implement inflation targeting. In the 1970s, New Zealand experienced high inflation. However, prices stopped being so volatile after the inflation targeting initiative got introduced via the policy framework established by the Reserve Bank Act of 1989 (Svensson, 2007). Subsequently, most of the countries in the Organisation for Economic Cooperation and Development (OECD) such as Canada, United Kingdom and Sweden also implemented frameworks for inflation targeting (Dotsey, 2006). The economic results of this policy for these countries have been favourable. For example, Britain’s inflation levels peaked at 27% in 1975, but in the subsequent 20 years after inflation targeting was introduced, inflation averaged at 2.1% (Svensson, 2007). However, these results have also been subjected to much debate. In this essay I will first explain how inflation targeting works in a macroeconomics framework. I will then provide the skepticisms and difficulties regarding inflation targeting and provide counter arguments to show that inflation targeting is actually a very effective plan to keep prices stable and to keep the economy ‘healthy’. In this essay I will argue that inflation targeting has worked in the past and can work in the future, as long that the policy remains flexible and contextually relevant.

 

  1. Inflation Targeting Mechanism

 

I will now start by explaining how inflation targeting works. As interest rates and inflation have an inverse relationship, the central bank can always use alterations in the interest rate to control the price level. For example, if the inflation rate (usually in the form of Consumer Price Index CPI) is too high, the central bank can raise interest rates and the mechanism will kick into place. The central bank can participate in open market operations to make this happen. In order to bring down inflation, the government will sell government securities and the supply of money will fall, causing the interest rate to increase. As it is now more expensive to borrow and spend, aggregate demand, which is the total demand for all goods and services, will fall, as people are less likely to spend now. As aggregate demand falls, the price level will also drop, bringing down inflation and vice versa. This can be illustrated in Exhibit 1 below. As aggregate demand falls from AD1 to AD2 from interest rate changes, the price level will drop from P1 to P2 and employment falls from Y1 to Y2.

Exhibit 1

Untitled

 

  1. Difficulties of Inflation Targeting

 

However, there are many complications that may affect the effectiveness of inflation targeting. The main difficulty that arises from Inflation Targeting is the delay in signals of inflation. Target inflation rates are usually predicted beforehand and then the central bank will try to steer the inflation rate to that target. However, there is a lag after the inflation targeting initiative gets implemented and announced. Just like any monetary policy, it takes a while before the changes in interest rates really affect aggregate demand and subsequently, the price level. This is because there is a time period before the information of the inflation target gets to the ears of the public and markets. There will be a delay before market participants react accordingly. In 1960, the American economist Milton Friedman conducted a useful research study on monetary policy and the time period needed for markets to react. He used data from the National Bureau in America for this study. He described the lags in monetary policy as quoted, “Monetary and fiscal policy is rather like a water tap that you turn on now and that then only starts to run 6, 9, 12, 16 months from now.” (Culbertson, 1960). Therefore, inflation targeting offers a technical difficulty to policymakers who aim to remedy an economic downturn as quickly as possible.

 

The next difficulty of inflation targeting is causing fluctuations in the unemployment rate due to the single mindedness and rigidity of the goals of this policy. If policymakers only focus on achieving price stability, other economic goals such as keeping output stable hence unemployment low may not be prioritized enough. The economy will be at risk of operating below its long run production potential capabilities, as resources such as the labour force is not fully utilized. This case can be best illustrated in the recent controversy involving the European Central Bank actions to try to control inflation. The unemployment rate in the European Union is now at 12.2%, which is the highest since the formation of the Eurozone monetary union. This is mainly due to the reluctance of the European Central Bank to cut interest rates to spark growth during the recent financial crisis, so that price levels are kept stable. It is argued that there is an irrational goal to keep prices low at any cost. As a result of this, the inflation rate has gone so low, even below its targeted 2%, at 0.7%. Therefore this shows that a fully rigid committed initiative to keep prices low will lead to the risk of ignoring the responsibility of keeping unemployment low, hence causing fluctuations in the unemployment rate (Elliot, 2013).

 

 

Another perceived problem with inflation targeting is it is so rigid and does not allow policymakers the freedom to react to exogenous shocks to the economy. For example, in an event of an unpredicted oil price hike, cost-push inflation will happen as costs of raw materials have increased. These shocks are almost impossible to predict and therefore the contemporary inflation target will not be realistic anymore, as prices of goods and services have changed suddenly. Another example of the unpredictability of the economy is an asset pricing bubble crash. As Greenspan noted, it is almost impossible to know if such a bubble really exists and when will it burst. Inflation targeting will not be effective during these times of crisis. Increasing interest rates can cause asset prices to fall but this may be ineffective in restraining bubbles, because market participants now expect such high rates of return from buying bubble driven assets, hence demand for these assets will increase and prices will keep on increasing regardless (Mishkin, 2011. Therefore, central banks should not take the initiative to ‘prick’ them. The point here is that the inflation target will be an unreliable benchmark as unpredictable economic phenomenon such as oil price hikes and asset bubbles will distort this inflation target. Policymakers will also not have the freedom to pursue other policies because they would have to adhere to the current inflation target, which may not be the most accurate.

 

Besides that, inflation targeting can also be ineffective if there is no responsibility on behalf of the government to instill fiscal discipline in its actions. This means that if the government is too dominant in its fiscal policies, this may deem inflation targeting to be ineffective. For example, if the economy is in fiscal deficit, the government will be spending more than its revenue from taxes. These fiscal deficits will then have to be monetized, in the end causing prices to increase. Referring to Tharaka’s case study on the relationship between budget deficits and inflation rates, Tharaka studied the time series data from 1950 to 2010 and concluded that Sri Lanka’s budget deficit was proven to be a catalyst of its rising inflation rate for the past 50 years (Devapriya, 2012). Therefore, efforts to adhere to the inflation target rate will then be useless as the government is still practicing irresponsible fiscal policy, overriding the objectives of inflation targeting.

 

  1. Counter Arguments and Justifications of Inflation Targeting

 

Now, I will provide counter arguments to these difficulties I’ve mentioned above. Inflation targeting has been criticized for being too rigid for policymakers to react in the face of an economic crisis/supply shock on time. However, I believe this argument ignores the possibility of a flexible strategy for inflation targeting. There are different approaches for central banks to adopt for targeting inflation when faced with an economic crisis. For example, if the price of oil increased from a supply shock, the central bank can instead adopt an inflation target that excludes price movements of certain goods and services (in this case, discounts the price movement of oil). Hence, the central bank will only take into consideration “core inflation”, discounting the possibility of the price level of getting affected by short run supply shocks in the economy. Therefore this shows that the central bank is flexible to change the way CPI is calculated based on the context of the economy situation. This has been proven to work as The Czech National Bank and the National Bank of Poland have implemented in this flexible inflation indicator to make sure inflation targets are realistic and consistent in times of crisis. The price levels in Czech Republic and Poland have been relatively stable as a result of this, I would argue (Wiesolek, 2013). Therefore, inflation target can still be successful after discounting the potential negative effects of exogenous shocks to the economy.

 

I will then address the second problem of inflation targeting, which is causing fluctuations in output. As inflation targeting only focuses on keeping prices stable, it has been criticized that this may overlook other important economic variables such as the unemployment level. Again, I believe the flexibility option of monetary policy can counter this problem. The Norges Bank of Norway is the best example of a central bank that adopts a more flexible strategy of inflation targeting. Norges Bank sets monetary policy based on the explicit trade off between ‘the deviation from inflation targeting’ and ‘real economic stability’. Therefore, this shows that Norges bank also takes into consideration the traditional stabilization and focuses on keeping inflation at a manageable level simultaneously. Another form of flexibility is that the Central Bank can alter the time period that it has to bring back inflation to its intended target, based on the economic situation of the country. Instead of quickly altering interest rates just to get prices back to its target (thus causing unemployment), the central bank can state that it will take a longer time to do that because this can avoid large fluctuations in the real economy/employment levels. Therefore, the inflation targeting process can be delayed to allow the government to take into consideration other factors that may affect the economy’s health, thus avoiding worsening the unemployment rate (Palmqvist, 2007).

 

The next difficulty that I can counter with is how inflation targeting does not guarantee fiscal responsibility by the government. I find this argument flawed because I believe the process of implementing inflation targeting requires a lot of transparency on the behalf of the central bank. The policy will be readily understood and communicated to and from the public. The authorities also publish certain reports to keep everyone updated on issues such as how the numerical values of the inflation targets were determined and how these inflation targets were to be achieved given current economic conditions. For example, Bank of England publishes the Inflation Report annually to keep the public updated on these issues.

 

These aspects of transparency and frequent feedback relates to the point of increasing accountability of the central bank. In order to gain public confidence on the central bank, the central bank can gain the support of the public by conducting monetary policy based on a preannounced and well-defined fixed target, and not based on political pressures. For example, the Governor of the Bank of England is legally obligated to write an open letter to the Chancellor of the Exchequer if the rate of inflation moves more than 1 percent on either side of the target, explaining the movements of the inflation rate (Freedman and Laxton, 2009). Another example of the obligated accountability of central banks is New Zealand’s strict legal framework to ensure the central bank is accountable for its actions regarding inflation targeting. The government in New Zealand has the right to dismiss the Reserve Bank’s governor if the inflation targets are breached (Mishkin, 2013). I believe this increased accountability of the central bank can counter the argument that inflation targeting cannot establish fiscal responsibility. With a more transparent approach, the public will be more learned with policy choices, hence they will demand irresponsible fiscal dominant policy makers to be held accountable. The central bank will be obliged to act responsibly in the fiscal department to complement monetary policies such as inflation targeting.

 

Conclusion

 

I have divided my essay into 3 different parts for the reader. First, I explained how does Inflation Targeting work via macroeconomic knowledge. Moving on, I presented the difficulties/criticisms associated to this policy initiative such as unpredicted output fluctuations and the rigidity of inflation targeting. Finally, I went into detail with the counter arguments to this and quoted academic articles that emphasized the ability of inflation targeting to be flexible to accommodate to changing economic contexts. As stated in the introduction, I believe that inflation targeting is beneficial for monetary policy decisions and communication tools. The transparency and flexibility of inflation targeting provide more advantages that outweigh its difficulties. Therefore, I have presented a clear and concise explanation on how inflation targeting has proven to work in the past and is still a valid alternative for policymakers to use, as long as we take into consideration different economic contexts when implementing this policy approach.

 

 

References:

 

 

 

  • Elliot, L. 2013, “Unemployment rise in eurozone puts pressure on European

Central Bank”, Guardian UK [online] 31st October 2013. Available through:

http://www.theguardian.com/business/2013/oct/31/unemployment-rise-eurozone-

pressure-european-central-bank

 

  • M. Culbertson, 1960 “Friedman on the Lag in Effect of Monetary Policy”,

Journal of Political Economy Vol. 68, No. 6 (Dec., 1960), pp. 617-621 Available through: http://www.jstor.org/discover/10.2307/1829948?uid=3738032&uid=2129&uid=2&uid=70&uid=4&sid=21103076093743 [Accessed 18th November 2013]

 

 

 

 

 

 

  • Mishkin, F, 2013 “The Economics of Money, Banking, and Financial Markets”, 10th Edition, Ediburgh, Pearson.

 

 

 

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