Inflation Targeting As A Framework For Monetary Policy Economics Essay

Inflation targeting as a framework for monetary policy has proved to be a success. Discuss carefully with reference to empirical evidence.

Introduction

Empirical evidence supports the claim that since the 1960s several countries have successfully managed to reduce their inflation rates. This achievement has been accompanied by a commitment to price stability as a primary objective of monetary policy. Along similar lines, the high degree of transparency and accountability in the formulation, as well as implementation of relevant policies has further enhanced price stability and economic stimulation.

After introducing the theoretical foundations of the price stability mechanism we will identify whether such regimes have achieved to become the appropriate policy tool in realizing the primary objective of price stability. Experiences from countries that employ inflation targeting are used as a primary guide to policies of practicing and prospective inflation targeters. Such guidance is particularly important nowadays as an increasing number of developing as well as emerging economies consider adopting inflation target policies.

Monetary Policy

The key objective of the monetary policy mechanism is to stimulate the performance of the economy while enhancing efficiency and price stability across all sectors. Basically, there are three main monetary policy goals that are intended to promote an ideal state of macroeconomic performance (Laurence 1997):

Price stability

Economic growth

High employment

These goals are not always feasible and some evidence suggests that in common practice they may occasionally conflict. Negative correlations may also occur between high inflation and low employment levels, and vice versa. In theory, perfect equilibrium is required to maintain the successful implementation of the key objectives mentioned above. Both theoretical and empirical evidence suggests that monetary policy in the long run cannot directly affect the growth rate of output or the level of unemployment (Laurence 1997). It only affects variables such as price level and money aggregates while variables such as unemployment and growth are only affected indirectly. Monetary policy in the long run sets only the rate of inflation (The Economist 1995). It therefore makes sense to focus on price stability as the main long-run objective for monetary policy.

Price Stability

The fundamental task of the central bank is to stabilize the value of the domestic currency. The understanding of the centrality of price stability has evolved over the years – the cases of dramatically and unexpected rise in inflation during the 1970s and the case of hyperinflation in Germany in the 1920s are persuasive examples – and has become the primary objective of monetary policies worldwide (Stanley 1997). This objective is achieved through constant, and low, levels of inflation. Price stability is desirable because a rising price level (inflation) creates uncertainty in the economy and affects the level of investment. When the overall level of prices is changing, the information contained in goods and services is harder to interpret and as a result decision making by consumers, businesses, and government can be very difficult and misleading (Mishkin 1992). With a low inflation rate, price developments can be read more clearly, and economic decisions such as borrow or save, invest or consume, can be based on more transparent information. As a result, price stability forces individuals and firms to allocate their resources in a more efficient manner, which leads to long-run economic growth (Bank of England, 1998).

Following the above, the central bank is trying to achieve and maintain price stability by keeping the level of inflation low. However evidence shows that this is not always an easy task. Several countries have used different stabilization policies in order to achieve the above goals. Empirical evidence suggests that two elements are of importance for the effectiveness of these policies: central bank independence and central bank credibility. Inflation targeting, as a monetary policy strategy, is mainly addressing those elements and is becoming more widely used with the aim of achieving price stability.

Inflation Targeting

Inflation targeting is a monetary policy mechanism in which decisions are directly based on the future expected inflation rate relative to the announced target. After being disillusioned with monetary policy targets, inflation targets have been adopted in recent years by most countries whose main goal of monetary policy is price stability. Empirical evidence suggests that it has been most useful in cases where policymakers needed to establish a credible commitment to low inflation.

The advantage of inflation targeting strategies is that they are more easily understood by the public since they focus directly on the final target of price stability. They provide a transparent guide as to whether monetary policy is being conducted and committed to and the credibility of the central bankers is explained on the basis of whether the set targets have been achieved (IMF 1996). The main advantage of inflation targeting is that monetary authorities are able to base their policy actions on a forward-looking assessment of the likely direction in which inflation is headed and change their policy accordingly (King 2004). The main disadvantage is that since inflation is not under perfect control of the central bank, inflation targets in the cases of shocks may be exceeded which causes a negative impact on central bank credibility.

Transparency & Credibility

According to Arrowsmith & Taylor (1996), inflation targets have advantages in terms of transparency and are better understood by the public which make them more credible. In most inflation-targeting regimes, the central bank publishes regular, detailed assessments of the inflation situation, including current forecasts of inflation and discussion of the policy response that is needed to keep inflation on track (Bernanke and Mishkin 1997). The Inflation Report of the Bank of England and the Inflation Record of the Reserve Bank of New Zealand have increased the credibility and transparency of their central banks. The central banks of Canada and Sweden release similar documents. The use of such reports reflects a key objective of inflation targeting, which is improved communication with the public about monetary policy, its goals and, in particular, the long-run implications of current policy actions (Bernanke and Mishkin 1997). In addition to that, evidence suggests that the publication of future interest rate paths has influenced the market’s expectations of short-term interest rates. The central bank of Norway, Norges Bank, has been publishing forecasts of future interest rates since the end of 2005. “Transparency surrounding Norges Bank’s assessments on monetary policy trade-offs makes monetary policy more predictable and effective. This may promote stability in inflation and in output and employment” (Norges Bank 2007).

However, the transparency of policy associated with inflation targeting has tended to make the central bank highly accountable to the public. Sustained success in the conduct of monetary policy, as measured against a pre-announced and well-defined inflation target, has been instrumental in building public support for an independent central bank, even in the absence of a rigidly defined and legalistic standard of performance evaluation and punishment (Mishkin 2001). Walsh (1995) states that the trade-off between credibility and flexibility can be eliminated by setting a performance contract where the desired level of inflation is specified and where the central banker pays a penalty if he looses his target. This solution combines independence and accountability. New Zealand provides a good model for the above. The government sets an inflation target and the independent central bank tries to achieve it. “If the central bank fails to meet the goal, its governor can be sacked” (The Economist 1995). In other countries, “no explicit sanctions on the central bank for missing the target are given; presumably, however, missing the target badly would impose implicit institutional or personal costs in terms of lost reputation or prestige” (Bernanke, Mishkin 1997).

In order for inflation targeting to be effective a central bank must have a certain level of independence. Alesina, and Summers (1993) found a strong positive relationship between central bank independence and lower inflation. Countries with the most independent central banks (Germany and Switzerland) had the lowest average rates of inflation during the 1970s and 1980s (Lawrence 1993). There is also evidence that the greater independence won by central banks in New Zealand and in Canada together with explicit inflation targets have helped both countries to reduce inflation (The Economist 1992).

Experiences

Inflation targeting has been successfully adopted in several countries. New Zealand pioneered inflation targeting in 1989 and today many industrial countries employ this regime, for example Australia, Canada, Finland, New Zealand, Spain and the United Kingdom who have adopted inflation targets in the 1990s.

Inflation targeting has been considered to be successful due to its apparent benefit of policy transparency for the credibility of inflation targeting frameworks and, ultimately, for macroeconomic performance. The positive experience has also influenced emerging markets to adopt inflation targeting (Portugal 2007). Emerging markets began to practice inflation targeting in 1997 (for example Israel, which now is an industrial country and the Czech Republic) and many more have adopted it since (IMF Working Paper 2005).

The Experience of those industrial countries that have adopted inflation targeting are generally considered as having been successful in providing both policy credibility and flexibility, resulting in better inflation and growth performances, together with increased resilience to shocks. It is important to note that even in cases were targets have been missed no country has dropped inflation targeting. The resilience of inflation targeting appears to reflect the flexibility of the framework in handling shocks, high standards of transparency and accountability, as well as the lack of successful alternative monetary regimes (IMF Working Paper 2005).

Conclusion

It is too early to offer a final judgment on whether inflation targeting will be the ultimate framework for monetary policy. However, the transparency and credibility that has been gained by those central banks that used it enhanced by the track record of a successful monetary framework make us believe that it will not fade any time soon. Inflation targeting frameworks in many emerging markets and developing economies have been tested and are yet to be tested by the volatile global macroeconomic and financial market environment that we experience over the last couple of years. Further research should be conducted in order to understand whether the policy of inflation targeting has achieved better results than others. The case of Iceland during the financial crisis provides a good example for further research.