Over the past fifteen years, a significant number of industrialized and middle-income countries have adopted inflation targeting as a framework for monetary policymaking. As the name suggests, in such inflation-targeting regimes, the central bank is responsible for achieving a publicly announced target for the inflation rate.
This is especially important in emerging market countries because many of these countries routinely reported numerical inflation targets or objectives as part of the government's economic plan for the coming year and yet their monetary policy strategy should not be characterized as inflation targeting, which requires the other four elements for it to be sustainable over the medium term. Inflation targeting requires that a decision be made on what price stability means in practice. This definition of price stability is a reasonable one and operationally, any inflation number between zero and 3 % seems to meet this criterion.
Inflation targeting is a monetary regime that is subject to the following conditions:
– The central bank announces its mid-term inflation targets.
– In its monetary policy, the central bank gives priority to price stability.
– While setting monetary policy parameters, the central bank considers exchange rate, monetary aggregates, and other macroeconomic indicators.
– Monetary authorities continually communicate their decisions and the reasons behind them to the public.
– Monetary authorities are responsible to the public for reaching inflation targets.
This conventional definition of inflation targeting does not mention real output among the targeted parameters. However, the effects of inflation targeting on economic growth frequently become the subject of debate. A conventional argument against inflation targeting is that it may cause high volatility of the real output or exchange rate and sustain excessive interest rates, which could have a negative impact on investment and, ultimately, economic growth.
In practice, all inflation targeters have chosen long-run inflation targets above zero, with point targets or midpoints of target ranges between 1 and 3 %. Once inflation has reached low levels, inflation targeters have also made their inflation targets symmetrical, with undershoots of the targets considered to be as costly as overshoots. Indeed, inflation targeters have argued that symmetrical inflation targeting helps central banks to stabilize real output, because in the face of a weak economy, an inflation targeter can ease more aggressively without being worried that the easing will cause inflation expectations to rise. The above-mentioned critical rate of increase is about 3–4 % for developed economies and is a little above 10 % for developing ones.
The goal of inflation targeting is low and stable inflation. Thus, this regime may influence economic growth in the following way: the shift to inflation targeting decreases inflation and its volatility, while lower inflation in turn creates a favorable environment for economic growth.
Obviously, central banks can build credibility when they establish a good track record by hitting the announced inflation targets. In this context, all central banks engaged in inflation targeting release periodic monetary policy reports, or inflation reports, indicating central banks' intentions for the future course of monetary policy, as well as explaining discrepancies between actual and targeted inflation rates. To improve the public's understanding of the central bank's reasoning, these reports also contain a description of how inflation forecasts are generated (including an assessment of upside and downside risks), as well as an indication of how the central bank would react to a relevant set of contingencies. This advance notice reduces the likelihood that the central bank's reaction to these contingencies will be misunderstood.
Implementing inflation targeting requires the authorities to make several key decisions. First, they need to establish which measure of inflation to use. The two natural options are the consumer price index (CPI) and the GDP deflator. Although the latter measure is appealing because it more fully reflects the notion of «domestic» inflation, the CPI has clear operational advantages: it is the index most familiar to the public; it is usually available on a monthly basis and in timely fashion (and thus can be monitored regularly); and it is seldom revised.
The second issue is to decide on the target level of inflation. It is generally recognized that higher inflation rates have adverse effects on growth and may generate welfare and efficiency costs as well. But an inflation target of zero is not desirable either. For one thing, the presence of downward rigidities in nominal wages and prices would call for a positive rate of inflation to allow for needed changes in real wages and other relative prices. Zero inflation targets would also leave no room for real interest rates to become negative during the business cycle if this were required. Indeed, the recent Japanese experience indicates the need for achieving negative real interest rates to stimulate aggregate demand. Certainly, one of the advantages of inflation targeting is that it can prevent deflation by offsetting the effect of systematic, negative shocks to aggregate demand. In this sense, this regime treats inflation and deflation symmetrically: monetary policy should become more restrictive (expansionary) if actual inflation is systematically above (below) the inflation target.
A third issue is whether to adopt an inflation target point or target ranges—that is, inflation targets with predetermined ranges or tolerance bands. Owing to the difficulties in predicting inflation, as well as the uncertainty surrounding the precise time frame of the monetary transmission lag, point targets are more likely to be missed, with the attendant cost to credibility. Also, point targets may require greater fine-tuning of monetary policy to minimize the probability of their being missed.
The fourth issue is the choice of policy horizon — that is, how fast the decline of the target path should be. In practice, if the initial level of inflation is much greater than desired, then the speed with which policy moves inflation toward the target depends on an assessment of the transition costs of disinflation.
Inflation targeting can benefit developing countries in many ways, by providing a coordination device for inflation expectations as well as a yardstick of accountability for central banks. But developing countries have specific problems that can make inflation targeting more difficult for them to implement than it is for industrial countries. First, because many developing countries still have relatively high rates of inflation, it is more difficult to predict future inflation accurately. Consequently, the likelihood of missing inflation targets is higher than in more developed countries. Second, the degree of pass-through from exchange rate changes to prices (which tends to be higher in developing countries) and widespread explicit or even implicit indexation mechanisms lead to considerable inflation inertia. Third, one of the prerequisites for inflation targeting is commitment to no other nominal target. Because many developing countries have a sizable share of assets and liabilities denominated in foreign currencies, large exchange rate movements may have serious adverse effects on inflation. Fourth, in many developing countries, central bank independence is more a statutory than a de facto situation, because its decisions are still governed primarily by the need to finance the fiscal deficit, and some fiscal dominance persists.
In contrast to exchange rates and monetary aggregates, the inflation rate cannot be easily controlled by the central bank; furthermore, inflation outcomes that incorporate the effects of changes in instruments settings are revealed only after a substantial lag. Governments can still pursue irresponsible fiscal policy with an inflation targeting regime in place. In the long run, large fiscal deficits will cause an inflation targeting regime to break down: the fiscal deficits will eventually have to be monetized or the public debt eroded by a large devaluation, and high inflation will follow.
At the same time, the adoption of inflation targeting should not be expected to eliminate other negative factors, aside from sustaining economic growth, as Russia’s experience shows. A rational monetary policy contributes to economic development, but it should never be the key driver. Monetary policy cannot replace real and human capital accumulation, technological progress, and a well-developed institutional environment.
Inflation targeting has been a success in the countries that have adopted it. The evidence shows that inflation targeting countries have been able to reduce their long-run inflation below the levels that they would have attained in the absence of inflation targeting, but not below the levels that have been attained by some industrial countries that have adopted other monetary regimes.
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