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Discuss advantages and disadvantages of inflation targeting, with special references to the case of the UK.

1. 0 Introduction:

Prosperity, success and economic growth are largely perceived as created by free markets and private enterprise. However the need for government policy to promote economic growth as well as stability cannot be overlooked. Monetary policy has emerged as one of the most crucial government responsibilities this is due to a number of reasons. Firstly there is now a general agreement that low, stable inflation is important for growth and that ‘monetary policy is the most direct determinant of inflation’.

Secondly monetary policy has ‘proven to be the most flexible instrument for achieving medium term stabilisation objectives’. The use of monetary policy by central banks meant inflation has been lower in most countries and aside from the current economic downturn, recessions have largely been absent. Since good economic performance today does not guarantee good economic performance in the future central banks develop strategies that provide not just good economic performance today but also stability and growth in the future. One of those strategies is inflation targeting. [1]

1. 1 Definition:

The definition of inflation targeting is in itself part controversial. I will consider a few definitions given by the ECB, Ben Bernanke et al. and Mervyn King. The ECB defines inflation targeting as “a monetary policy strategy aimed at maintaining price stability by focusing on deviations in published inflation forecasts from an announced inflation target”. [2] Bernanke et al. ’s (1999) definition of inflation targeting, “Inflation targeting is a framework for monetary policy characterised by the public announcement of official quantitative targets for the inflation rate over one or more time horizons. He also states that ‘inflation targeting serves as a framework for monetary policy and not as a rule’. This is because treating inflation targeting as a policy rule could lead to poor economic outcomes for example Friedman and Kuttner (1996) state that it could lead to a highly unstable economy in the event of large supply side shocks. [3] Mervyn King defines an inflation targeting framework as constituting:

  • a precise numerical target for inflation in the medium term
  • a response to economic shocks in the short term.

[4] From above we can see that generally speaking inflation targeting is an economic policy in which the central bank estimates and makes public a target inflation rate. It then attempts to exercise actual inflation towards the target through the use of monetary tools.

1. 2 Elements of Inflation Targeting: According to Frederic Mishkin inflation targeting is a monetary policy that encompasses five main elements and they are as follows:

  1. The public announcement of medium-long term numerical targets for inflation.
  2. An institutional commitment to price stability as the primary goal of monetary policy.
  3. An information inclusive strategy in which many variables are used for deciding the setting of policy instruments.
  4. Increased transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives and decisions of the monetary authorities.
  5. Increased accountability of the central bank for attaining its inflation objectives. [5] These elements will be explained in further detail later on in the paper.

2. 0 Advantages of inflation targeting:

2. 1 Purpose and economic rationale for inflation targeting:

When talking about inflation targeting and in fundamental nature price stability we need to understand what we mean by price stability. Alan Greenspan has provided the definition of price stability as a rate of inflation that is sufficiently low so that households and businesses do not have to take it into account in making everyday decisions. Operationally any inflation number between 0 and 3% seems to meet this criterion.

The primary long run goal of monetary policy is price stability. Bernanke et al. give three reasons for why this is the case:  Economists and policymaker are considerably less confident monetary policy can be used effectively to moderate short-run fluctuations in the economy. Furthermore in the long run the inflation rate is the only macroeconomic variable that monetary policy can affect.  High rates of inflation are harmful to economic efficiency and growth. Inflation targeting serves as a ‘nominal anchor’ for monetary policy.

It therefore provides a focus for the expectations of financial markets and the general public. [6]

2. 1 Benefits of Inflation Targeting: Inflation targeting has several advantages, one being that it is easily understood by the public and thus highly transparent so inflation targeting enhances transparency. Following on from this having an explicit numerical target for inflation increases the accountability of the central bank, inflation targeting has the ability to reduce the likelihood that the central bank will fall into the time-inconsistency trap.

Time inconsistency, ‘describes a situation where a decision-maker’s preferences change over time, such that what is preferred at one point in time is inconsistent with what is preferred at another point in time’. [7] Time inconsistency forces the authorities in considering long term consequences of short term actions. This is because inflation targeting has the advantage of ‘focusing on what a central bank can do in the long-run i. e. control inflation rather than what it cannot do, such as raise output growth, lower unemployment etc’.

The inflation-targeting system also puts great pressure on the ‘need to make monetary policy transparent’ and to maintain regular and good communication with the public. As illustrated in Bernanke, et. al. (1999), ‘inflation-targeting central banks have frequent communications with the government, and their officials take every opportunity to make public speeches on their monetary policy strategy’. The central banks also publish Inflation Reports to clearly present their views about the past and future performance of inflation and monetary policy.

The announcement of inflation targets informs the central bank’s intentions to the financial markets and the public. By doing this ‘reduces uncertainty about the future course of inflation’. Uncertainty about inflation intensifies the volatility of relative prices and ‘increases the riskiness of non-indexed financial instruments and contracts set in nominal terms’ several of the costs of inflation arise from ‘its uncertainty or variability rather than from its level’.

Furthermore by making explicit the central bank’s medium-term policy intentions, ‘inflation targeting improves planning in the private sector’ and increases the accountability of the bank. [8] Since interest rates and the inflation rate tend to be inversely related, whether the central bank will raise or lower interest rates become clearer under the policy of inflation targeting. For instance if inflation appears to be above their target the central bank is expected to raise interest rates. This will then over time bring down inflation.

On the other hand if inflation appears to be below the target the bank will probably lower interest rates. This over time will accelerate the economy and raise inflation. Under this policy investors know what the central bank considers the target inflation rate to be. Therefore they may be able to easily feature in likely interest rate changes in their investment choices. This is viewed as leading to increased economic stability. Inflation targeting in contrast to an exchange rate peg, enables monetary policy to focus on domestic concerns and to respond to shocks to the domestic economy.

In contrast to monetary targeting, inflation targeting has the advantage that a stable relationship between money and inflation is not significant to its success. [9] A well designed inflation targeting system can cope with supply shocks reasonably well. Aggregate supply shocks presents a worse problem for inflation targeting because once hit by a severe supply shock keeping inflation close to the target maybe very costly ‘in terms of lost output and employment’. But inflation targeting in most countries is ‘designed to exclude at least the first round effects of certain supply shocks’.

Another way of with supply shocks is that there are ‘escape clauses’ that allow the central bank to change its medium-term targets in response to any ‘unexpected developments’. Inflation targeting in addition gives the central bank ‘better chance of convincing the public that the effects of a supply shock will be limited to a one time rise in the price level’ instead of creating a lasting rise in the inflation rate. [10] Inflation targeting in addition provides better nominal anchor for monetary policy and inflation expectation.

It has been observed that the countries that adopted inflation[pic] targeting, are getting greater gains then rest of the countries in the world. It has also been observed that the countries that adopted a numerical inflation target, succeeded in maintaining a low inflation rate. One of the most important benefits of inflation targeting is that it helps the central banks to maintain low inflation and low inflation eventually promotes long term growth. Some of the numerous benefits of using inflation targeting are as follows: ? Enhanced financial growth ? Reduced relative price variability Less arbitrary redistribution The inflation targeting strategy promotes convergence in forecasting errors as it helps in cutting down inflation and inflation expectations which in turn facilitates in predicting inflation, it then has the ability to lower the inflation forecast errors. Moreover it has the ability to maintain price stability and prevent one-time shocks to inflation. [11]

2. 2 Benefit of low inflation: Having price stability as the primary goal of monetary policy is believed that low inflation helps to promote economic efficiency and growth in the long run.

High inflation has proven to be very detrimental to the economy and countries experiencing high inflation usually have poor economic performance. There are many costs associated with high inflation. Firstly the ‘over-expansion of the financial system’ since businesses and individuals dedicate more of their resources ‘to avoid the effects of inflation on their cash holdings’. Secondly the ‘increased susceptibility to financial crisis’ because of the difficulties in adjusting to high inflation make the financial system more weak.

Another costs is ‘poor functioning of products and labour markets’ due to the volatility in prices it no longer serves as unit of account, a good measure of relative economic values of goods and services. There is also the cost of regular re-pricing along with the costs of having to monitor the prices of suppliers and competitors. Fischer (1993) and others showed that ‘macroeconomic stability, including control of inflation, is an important precondition for economic growth’. [12]

2. 3 Reference to the UK: The United Kingdom was one of the first introducing an inflation target regime.

It adopted inflation targets in the ‘aftermath of a foreign exchange rate crisis, in order to strengthen the credibility of monetary policy’ and to provide an alternative nominal anchor. [13] Since then, as indicated in Figure 1 inflation has been both low and fairly stable particularly when viewed in the perspective of the UK’s past inflation performance. In addition that has not come at the expense of other macroeconomic indicators. Economic growth has also been really steady and close to trend (see Figure 2), while unemployment has fallen almost continuously (see Figure 3). It should be stressed that this performance should not be only attributed to the adoption of an inflation target as other factors may well have contributed to this performance. In the first two issue of the Inflation Report two main arguments were discussed. The depreciation of sterling and the governments increasing budget deficit, both of these had the possibility of raising inflation. Official interest rates had been reduced ‘from 10% August 1992 to 6% January 1993’ but ‘sterling had depreciated by 14. 5%’ five months after the UK’s exit from the ERM.

In addition the Bank feared ‘possible future monetization of government debt as a source of increased inflation expectations’. Despite all these fears and the fact that the economy was in recovery the Bank’s inflation projections in these first two issues continued to fall. In the November Inflation Report the Bank stated there was a ‘slight probability that inflation would exceed the target in the near term’. What’s more it also stated the potential for a ‘nominal wage push if headline inflation rose to the upper limit of the 4% target range’.

The chancellor then lowered rates by 0. 5%. Until May 2007 inflation targeting was conducted by the government not a central bank and as a result it was not always clear ‘what motivated a decision to move or not move interest rates’. Regardless of this inflation targeting before ‘May 1997 produced low and more stable rates of inflation in the UK’. Inflation targeting has been a success in the UK and this has been attributed as a result of the Bank of England’s ‘focus on transparency and its reliable explanation of monetary policy strategy’. 14]

3. 0 Disadvantages of inflation targeting:

3. 1 Arguments against inflation targeting: Mishkin in ‘Inflation targeting’ states that critics have noted seven major disadvantage of this monetary policy strategy. Four of these are to do with the idea that ‘inflation targeting is too rigid, it allows too much discretion, it has the potential to increase output instability and that it will lower economic growth’. These points were discussed in Mishkin (1999) and in Bernanke et al. 1999) but he states that ‘in reality these are not serious objections to a properly designed inflation targeting strategy’. [15] An inflation target, if rigidly interpreted may lead to ‘greater output variability, although it could lead to tighter control over the inflation rate’. For instance a negative supply shock that increases the inflation rate and reduces output would ‘induce a tightening of monetary policy to achieve a rigidly enforced inflation target’. The result would be a decline even further. [16]

The fifth disadvantage put forward by Mishkin is that inflation targeting can only ‘produce a weak central bank accountability because inflation is hard to control’ and also because there are ‘long lags from the monetary policy instruments to the inflation outcome’. Inflation cannot be easily controlled by the central bank in contrast to ‘exchange rates and monetary aggregates’. Moreover the difficulty of controlling inflation ‘creates a severe problem when inflation is being brought down for relatively high levels’.

In those situations inflation forecast errors will possibly be large, and ‘inflation targets will tend to be missed’. This suggests that ‘inflation targeting is likely to be a more effective strategy if it is phased in only after there has been some successful inflation’ as noted by Masson, et al. (1997), Bernanke, et al. (1999) and mishkin and Savastano (2001). [17] Another disadvantage of inflation targeting is because of the uncertain effects of monetary policy on inflation, monetary authorities cannot easily control inflation as mentioned earlier.

Thus it is much harder for ‘policymakers to hit an inflation target with precision than it is for them to fix the exchange rate or achieve a monetary aggregate target’. Furthermore because ‘the lags of the effect of monetary policy on inflation are very long’ it is a while before a country can evaluate the success of monetary policy in achieving its inflation target. This problem does not arise with either a fixed exchange rate regime or a monetary aggregate target again as mentioned before. [18]

A further shortcoming of inflation targeting is that it ‘may not be sufficient to ensure fiscal discipline’; governments can still follow ‘irresponsible fiscal policy with an inflation targeting regime in place’. This may cause a run of large fiscal deficits and in the long run large fiscal deficits will cause ‘an inflation targeting regime to break down’ the fiscal deficit will ultimately have to be ‘monetised or the public debt eroded by a large devaluation’ and as a result high inflation will follow.

This one of the concerns the central bank noted in the UK’s first two Inflation Reports. [19] The potential disadvantage of an inflation-targeting regime that ‘ignores output stabilization has led some economists to advocate the use of a nominal income growth target instead’. A nominal income growth target has many characteristics similar to having an inflation target. In addition it has many of the same advantages and disadvantages. It evades the problems of ‘the time-inconsistency problem and allows a country to maintain an independent monetary policy’.

On the other hand ‘nominal income is not easily controllable by the monetary authorities’ and much time must go by before evaluation of the monetary policy’s success in achieving the nominal income target is possible, similar to inflation targeting. [20] Finally a large degree of ‘dollarisation’ may produce a serious problem for inflation targeting. Inflation targeting essentially requires ‘nominal exchange rate flexibility’ but exchange rate fluctuations are unavoidable.

However large and sudden depreciations may increase the burden of ‘dollar denominated debt’ and through a huge deterioration of balance sheets there is an increased risk of a financial crisis. As a result ‘emerging market countries cannot afford to ignore the exchange rate when conducting monetary policy under inflation targeting’. [21]

4. 0 Conclusion: Inflation targeting has been a success in the countries that have adopted it and evidence has shown that those countries that have an inflation targeting regime in place have been able to reduce their long run inflation.

The independence of central banks has also been ‘reinforced with inflation targeting while monetary policy has been more clearly focused on inflation under inflation targeting’. Even with the success of inflation targeting it is in the words of Mishkin ‘no panacea’. As it still requires that ‘basic institutional infrastructure with regards to fiscal policy and the soundness of financial institutions be addressed’ in order to achieve and maintain low and stable inflation. [22]

[1] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press, page 3

[2] (European Central Bank (2004, 2nd edn), The Monetary Policy of the ECB, ECB, p. 113).

[3] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press, page 4

[4] King, Mervyn (2005), “Monetary policy: practice ahead of theory”, (2005, section 3) , http://www. ankofengland. co. uk/publications/speeches/2005/speech245. pdf

[5] Frederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

[6] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press page 10

[7] http://en. wikipedia. org/wiki/Dynamic_inconsistency

[8] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press page 23

[9] Frederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

[10] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press page 24

[11] http://www. economywatch. com/inflation/targeting/benefits. tml

[12] [13] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press page 16

[14] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press page 145

[15] Bernanke, Ben, Laubach, Thomas, Mishkin, Frederic, and Posen, Adam (1999), Inflation targeting: lessons from the international experience, Princeton University Press chapter 7

[16] Frederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

[17] http://www. newyorkfed. org/research/epr/97v03n3/9708part1. pdf

[18] Frederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

[19] Frederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

[20] http://www. newyorkfed. org/research/epr/97v03n3/9708part1. pdf

[21] Frederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

[22] F rederic S. Mishkin, Inflation Targeting, Graduate School of Business, Columbia University and National Bureau of Economic Research, July 2001

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