Inflation targeting

Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.

Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples:

• if inflation appears to be above the target, the bank is likely to raise interest rates. This usually (but not always) has the effect over time of cooling the economy and bringing down inflation.

• if inflation appears to be below the target, the bank is likely to lower interest rates. This usually (again, not always) has the effect over time of accelerating the economy and raising inflation.

Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.

Debate

The examples and perspective in this section deal primarily with the United States and do not represent a worldwide view of the subject. Please improve this article and discuss the issue on the talk page.

The US Federal Reserve's policy setting committee, the FOMC (Federal Open Market Committee) and its members, regularly publicly state a desired target range for inflation (usually around 1.5-2%), but do not have an explicit inflation target. This is under debate within the Fed, since inflation targeting is usually very successful in other countries because of its transparency and predictability to the markets.

However, some counter that an inflation target would give the Fed too little flexibility to stabilise growth and/or employment in the event of an external economic shock. Another criticism is that an explicit target might turn central bankers into what Mervyn King, now Governor of the Bank of England, had in 1997 colorfully termed "inflation nutters"^[1] - that is, central bankers who concentrate on the inflation target to the detriment of stable growth, employment and/or exchange rates. King went on to help design the Bank's inflation targeting policy ^[2] and asserts that the nuttery has not actually happened, as does Chairman of the U.S. Federal Reserve Ben Bernanke who states that all of today's inflation targeting is of a flexible variety, in theory and practice. ^[3]

For the moment, the Fed continues without the strict rules of an explicit target. Former Chairman Alan Greenspan, as well as other former FOMC members such as Alan Blinder, typically agreed with its benefits, but were reluctant to accept the loss of freedom involved; Bernanke, however, is a well-known advocate.^[4]

History and utilizing countries

Early proposals of monetary systems targeting the price level or the inflation rate, rather than the exchange rate, followed the general crisis of the gold standard after World War I. Irving Fisher proposed a "compensated dollar" system in which the gold content in paper money would vary with the price of goods in terms of gold, so that the price level in terms of paper money would stay fixed. Fisher's proposal was a first attempt to target prices while retaining the automatic functioning of the gold standard. In his Tract on Monetary Reform (1923), John Maynard Keynes advocated what we would now call an inflation targeting scheme. In the context of sudden inflations and deflations in the international economy right after World War I, Keynes recommended a policy of exchange rate flexibility, appreciating the currency as a response to international inflation and depreciating it when there are international deflationary forces, so that internal prices remained more or less stable.

Interest in inflation targeting schemes waned during the Bretton Woods system (1944-1971), as they are normally inconsistent with exchange rate pegs such as those prevailing during three decades after World War II. Inflation targeting was pioneered in New Zealand in 1990,^[5] and is now also in use by the central banks in United Kingdom (Bank of England), Canada (Bank of Canada), Australia (Reserve Bank of Australia), South Korea (Bank of Korea), Egypt, South Africa (South African Reserve Bank), Iceland (Central Bank of Iceland) and Brazil (Brazilian Central Bank), among other countries, and there is some empirical evidence that it does what its advocates claim. ^[6]

Shortcomings

Inflation is usually measured as the change in prices for consumer goods, called the Consumer price index (CPI). Inflation targeting assumes that this figure accurately represents growth of money supply, but this is not always the case. The most serious exception occurs when factors external to a national economy are the cause of the price increases. The oil price increases since 2003 and the 2007–2008 world food price crisis combined to cause sharp increases in the price of food and consumer goods, which in turn resulted in a sharp increase in CPI. This is especially true in the very emerging markets that often follow the new policy of inflation targeting, because they are often dependent on imported oil or food.

Under such conditions increases in inflation (CPI) is not necessarily coupled to any factor internal to a country's economy and adjusting strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so. Bernie Fraser, governor of Reserve Bank of Australia from 1989–1996, raised this concern in 2008 in response to another hike in their interest rates.^[9]

The most serious problem associated with inflation targeting is that it is not based on a coherent general dynamic theory. A relatively recent realist dynamic theory - the "dynamic-strategy theory" - suggests that inflation targeting damages the long-run dynamic mechanism. This is supported by the discovery of the growth-inflation curve.^[10] The downturn in the real economy of the USA in late 2008 was in large part an outcome of inflation targeting, and is exactly what the dynamic-strategy theory predicts.

A more essential objection to the strategy of inflation targeting is that it doesn't really comprise a specific set of monetary policy recommendations -as traditional monetarism, for example, did- but constitutes just an explicit statement of the aims of the monetary authority. Since the mid-1990s there have been theoretical attempts to add substance to inflation targeting by proposing explicit monetary rules which could lead to a low and stable inflation rate. One such proposal involves Central Bank intervention in the futures market for the CPI at predefined prices: if prices are expected to exceed the target, speculators would buy future contracts to the Central Bank at the preset prices, thus reducing the money supply until it reaches a level compatible with the target.^[11] Another proposal consists in fixing a band for Central Bank intervention in the CPI-indexed bond market. The Central Bank commits itself to selling (buying) unlimited amounts of indexed bonds whenever inflationary expectations, as measured by the difference between the non-indexed and the indexed bonds, exceed (are short of) the inflation target. Such an intervention would imply an automatic increase in the money supply whenever inflation expectations are below the target and an automatic fall in the money supply if inflation expectations exceed the target. Necessarily, the level of the money supply will always stand at a range that market participants consider compatible with the attainment of the inflation target.^[12]

South Africa

As an example, since 2006 South Africa – an adherent to inflation targeting – has dogmatically increased interest rates by five percentage points to track a rise in inflation (based on CPIX) even though the rise in CPIX was due to the aforementioned external factors of worldwide fuel and food price increases.^[13] This stands in stark contrast to major central banks such as those of the US, England, Canada, Japan and Europe keeping their interest rates steady over the same period (in some cases even lowering) even though they are exposed to the same global inflationary factors. Following the advent of the global financial crisis of 2007–2009 the prime lending rate was decreased to 2006 levels, but it still remains high at 7.5%. The reduction also came too late for the housing market and motor manufacturer and retail industry all of which suffered heavy losses due to the pressure on consumer borrowing. This in turn led to job losses in these sectors. In 2009 the Nobel Prize winning economist Joseph Stiglitz warned South Africa that inflation targeting should be a secondary concern amid the global financial crisis of 2007–2009.^[14]

Variations

Contrast to the usual inflation rate targeting, Laurence Ball proposed targeting on long run inflation targeting which takes the exchange rate into account^[15] and monetary condition index targeting. In his proposal, the monetary condition index is a weighted average of interest rate and exchange rate. It will be easy to put many other things into this monetary condition index.

See also

• Monetary policy
• Taylor rule
• Phillips curve

References