Inflation Targeting: Central Banks Should Not Go For It

Inflation Targeting: Central Banks Should Not Go For It

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A Project Report on
Inflation Targeting: Should Central Bank go for it?
Economic Environment and Policy
INFLATION TARGETING
Definition
Inflation targeting framework refers to a set of economic policies adopted by the central
bank wherein it announces a projected or "target" inflation rate and strives to achieve that
figure using measures like interest rate changes and other monetary tools.
Elements of Inflation Targeting[1]
· Announcement of an explicit quantitative inflation target or range for some period
of time.
· Central bank must show clearly and unambiguously that its most crucial aim is to
provide an environment with stable prices.
· Central bank should have powerful models to make inflation forecasts.
· The central bank must have a forward-looking operating procedure in which the
setting of policy instruments depends on the assessment of inflationary pressures
and where the inflation forecasts are used as the main intermediate target.
Prerequisites for Inflation Targeting[1]
· Central bank should be able to conduct monetary policy with a degree of
independence.
· Absence of another targeted variable such as wages, level of employment, or the
nominal exchange
· Existence of stable and predictable relationship between the monetary policy
instruments and inflation rate.
Issues with the implementation of Inflation Targeting
1. Time inconsistency situations
Time inconsistency situations may occur because the central bank would try to
reoptimize in the short term and lose sight of the long term goals. The bank may
start out with a particular policy and then keep changing its policy to suit some
short term requirements. Such a conduct wouldn’t have the desired effect. This
effect can be explained using a model for inflation targeting. [2]
2
p = pT-a(x-u)
p = inflation
pT = target inflation percentage
x= output gap (Y-Yn ) / Yn
u= fluctuations
a=l/ak
a= constant, k= measure of the cost of inflation fluctuation
l= measure of the cost of output fluctuation
Consider a case where the fluctuations, u=0. For a given value of ‘x’, the value of
p would change if the value of a changes. If the central bank continuously changes the
importance it attaches to its goal of achieving targeted inflation rate and maintaining zero
output gap, the value of a would vary and the achieved inflation rate would continuously
fluctuate thus causing inflation forecast errors
2. Volatility of the exchange rate
A study of the variability of exchange rate in countries who have adapted inflation
targeting shows that the though the variability decreased in the first 3 years of adoption of
the policy , the coefficient of variation has been huge when the overall period was
considered.(Ref. Table 1). Such huge depreciations of currency would increase the dollardenominated

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debt, mismatches between the various categories of assets and liabilities and
would increase the risk.
3. Price Indeterminacy[5]
One of the objectives of the inflation targeting is to let the investors, customers &
industry know the expected price level in the future. However, inflation targeting fails to
meet this objective, if the actual inflation rate is different than the targeted inflation rate.
Example: Suppose current price level is 1.0 and targeted inflation rate is 2 % per year
over a particular period. Then at the end of the period, the price level is supposed to be
1.02. However, if the actual inflation rate turns out to be 3 % instead of 2 %, then the
actual price level at the end of the period will be 1.03. Thus with inflation targeting it
becomes difficult to determine the price levels in future.
3
The alternative approach suggested to overcome this problem is Price-Level Targeting
(PLT). In the above example, suppose if the central bank targets the price level at 1.02 at
the end of the period, the policy decisions will be taken to maintain the price level. In
PLT, irrespective of inflation rate the price level will be maintained at constant level.
Hence the general people and the industry will have better idea about the future price
levels in PLT.
Comparative study of Inflation Targeting (IT) countries and Non Inflation
Targeting (NIT) Countries[6]
Laurence Ball et al. in their paper argued that on an average, there is no evidence that
inflation targeting improves performance as measured by the behavior of inflation,
output, or interest rates. To prove this point they compared the economic performance of
twenty OECD (Organization for Economic Co-operation & Development) countries
based on three parameters: behaviour of inflation, output and interest rates. Seven of
countries had followed Inflation targeting over a long period of time, while thirteen were
non inflation targeting countries. The comparison was made between three time periods
(Table 2).
The comparison showed that performance improved along many dimensions for both the
targeting countries and the non-targeters. In some cases, though the targeters improved by
more amount, these differences are explained by the facts that targeters performed worse
than non-targeters before the early 90s (Table 2). This proves that there is an effect of
regression to the mean. Laurence Ball et al. argued that once one controls for regression
to the mean, there is no evidence that inflation targeting improves performance. Hence, it
can be concluded that Inflation Targeting alone, is not responsible for the good economic
performance of the country as Non-targeting countries also showed the improvement on
economic measures.
4
Apart from the issues discussed, the Inflation Targeting also has following
disadvantages:
· Inflation targeting is too rigid,
· Inflation targeting allows too much discretion.
· Inflation targeting has the potential to increase output instability
· Inflation targeting requires a great deal of central bank independence
· It can cause a dent on the credibility of the central bank if the announced targets
are not met.
Summary
In conclusion, the central bank shouldn’t opt for an inflation targeting regime because:
1. To be effective, the process requires a highly independent central bank which is
not the case in many developing countries.
2. Inflation targeting causes volatile exchange rates which are harmful for the
balance sheets of firms.
3. Future price levels are difficult to determine using Inflation Targeting.
Also, the comparison between the countries which have and haven’t adopted Inflation
targeting shows that the economic betterment doesn’t depend on inflation targeting.
Reference
1. Eser Tutar, 2002, Inflation Targeting in Developing Countries and Its Applicability
to the Turkish Economy. Thesis (Master of Arts in Economics), Virginia
Polytechnic Institute & State University
2. Carl. E. Walsh, 2002, Teaching Inflation Targeting: An Analysis for Intermediate
Macro, Journal of Economic Education
3. Sheetal K. Chand
and Kanhaiya Singh, 2005,
How Applicable is the Inflation
Targeting Framework for India?, India Policy Forum Meetings, 2005
4. Fredric. S. Mishkin, 2000, Inflation targeting in emerging market countries”,
NBER Working Paper 7618
5. Eagle, David. 2006, The eventual failure and price indeterminacy of inflation
targeting, MPRA Paper No. 1883
6. Ball, Laurence and Niamh Sheridan. 2003, Does Inflation Targeting matter?,
NBER Inflation Targeting Conference, 2003
5
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