Essay on Inflation Targeting | Macroeconomics

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In recent years many of the world’s central banks have adopted some form of inflation targeting. Inflation targeting usually takes the form of spelling out the goals of monetary policy. For example, the RBI Act may tell the central bank to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices. In such a statement there is no mention of any other competing objective, such as stability in output, employment, interest rates, or exchange rates.

When using a strategy of inflation targeting the central bank (usually together with the executive branch of the government) announces the inflation rate that it will try to achieve over the subsequent one to four years. Thus, rather than targeting an intermediate variable (money growth), the central bank targets one of its ultimate goals, the rate of inflation.

A strategy of inflation targeting does not preclude the use of monetary policy to help stabilise output or other macroeconomic variables in the short run. However, by announcing an inflation target, the central bank signals that hitting that target in the longer run is its number one priority.

Inflation targeting is not just a pre-commitment to a policy rule. In truth, in all the countries that have adopted inflation targeting, the central banks are left with a considerable degree of discretion. Inflation targets are usually set as a range an inflation rate of 1 to 3%, for instance rather than a particular number. Thus, the central bank can take the liberty of choosing where in the range it wants to be.

It can stimulate the economy and be near the top of the range, or dampen the economy and be near the bottom. In addition, the central bank is sometimes allowed to adjust its targets for inflation—at least for a short period, if some external shock (such as oil price hike or exchange rate overshooting) pushes inflation out of the pre-fixed range. Inflation targeting does not qualify as a policy rule, in the strict sense advocated by Friedman, for two reasons.

First, it involves targeting a goal variable (inflation) rather than an instrument of policy, such as an interest rate or a monetary aggregate. Second, this approach allows the central bank to exercise some discretion in the short run, as long as it meets the inflation target in the longer run.

Thus inflation targeting, as a policy measure, enjoys some degree of flexibility in the sense that it seeks to achieve a pragmatic compromise between Keynesian presumption of monetary discretion and the monetarist presumption of monetary rule. It combines the credibility benefits of a strict rule with the advantage of having some degree of policy discretion. No doubt inflation targeting leaves the central bank with some discretion.

At the same time the central bank is constrained by policy regarding the use of this discretionary power. So it is a policy of constrained discretion. When a central bank is instructed just to “do the right thing”, it is difficult to hold the central bank accountable, because what is the right thing in any specific situation is a matter of continuous debate.

By contrast, when a central bank has announced a specific inflation target or even a target range it is fairly easy for the public to judge whether the central bank is meeting its objectives. Thus, although inflation targeting does not tie the hands of the central bank, it serves a very useful purpose. It increases the transparency of monetary policy and, by doing to, makes the central bankers more accountable for their actions.

The US Federal Reserve Bank has not yet adopted an explicit policy of inflation targeting. Yet Ben Bernenke, one of the leading macroeconomists has indicated that in near future the Fed may move toward inflation targeting as the explicit framework for monetary policy.

Relative to money-growth targeting, which is the current strategy of the RBI, inflation targeting offers two major advantages. Prima facie, inflation targeting sidesteps the problem of money demand instability. Under an inflation-targeting strategy, if money demand changes, there is hardly anything to prevent the central bank from adjusting the money supply to compensate.

Secondly, it is easier for the central bank to explain to the public that the central bank is trying to achieve a certain rate of inflation (which most people understand) than to explain that it is trying to achieve a certain growth rate of M₃ (which most people don’t understand).

In India M₃= M₁ plus time deposits. M₁ includes mainly:

(i) Currency notes and coins in circulation (but not those held by banks),

(ii) Deposits in current account, and

(iii) About 80% of the deposits in the savings bank accounts.

Better communication of the central bank’s goals should make the public and the financial markets less uncertain about what the central bank is going to do and may increase its credibility and accountability.

A major disadvantage of inflation targeting is that inflation responds to policy actions only with a long lag. This makes it increasingly difficult for the central bank to easily judge which policy actions are needed to hit the inflation target.

And it becomes difficult for the public to easily determine whether the central bank is living up to its promises. Thus inflation-targeting central banks may sometimes badly miss their targets, as a result losing credibility. It is not yet transparent whether inflation targeting will be the preferred strategy for monetary policy.

A Combination Strategy:

However, the use of interest rate as a policy variable will make monetary policy more effective because it will be a complement to inflation target.

Two general guidelines are outlined:

When inflation heats up the short-term interest (at which banks make loans to one another— called inter-bank call money rate) should rise. This will mean a smaller money supply and, eventually, lower investment, lower output, higher unemployment, and reduced inflation.

Second, when real economic activity slows—as reflected in real GDP or unemployment—the interest rate should fall. This will mean a larger money supply and, eventually, higher investment, higher output, and lower unemployment.

The RBI needs to go beyond these general guidelines, however, and decide exactly how much to respond to changes in inflation and real economic activity. In this context, a simple rule, proposed by John B. Taylor, for the short-term interest rate could be:

Nominal interest rate = Inflation + 0 + 0.5 (Inflation – 2.0) – 0.5 (GDP gap).

The GDP gap is the percentage negative deviation of real GDP from an estimate of its natural level.

If this simple rule is followed—the real interest rate—the nominal rate minus line rate of inflation—will respond to inflation and the GDP gap. The rule is that the real interest rate equals 2% when inflation is 2% and GDP is at its natural level.

For each percentage point by which inflation rises above 2%, the real interest rate rises by 0.5%. For each percentage point by which real GDP falls below its natural rate, the real interest rate falls by 0.5%. If GDP rises above its natural level, so that the GDP gap is negative, the real interest rate rises accordingly.

The above rule can be seen as a complement (rather than a substitute for) inflation targeting. In truth, inflation targeting offers a plan for the RBI in the medium term, but it does not lightly constrain its month-to-month policy decisions.

The rule appears to be a good short-run operating procedure for hitting a medium-term inflation target. According to this rule, monetary policy responds directly to inflation—as any inflation-targeting central bank must. But it also responds to the output gap, which can be treated as a measure of inflationary pressures.