Inflation Targeting

H T Parekh finance forum Inflation Targeting

At the heart of the concept of the inflation targeting problem [Svensson 1999] is the following equation:

πt + 2 t − π* = −Φ y∆t +1 t

International Experience and Prospects for India The inflation targeting framework has been successfully implemented in several developed and developing countries. However, the success of this system requires equal commitment from the government and the central bank. In the case of India, targeting inflation is politically sustainable given the overwhelming preference of the population for lower headline inflation. KANHAIYA SINGH

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long list of empirical research shows that low and stable inflation1 is conducive to economic growth [see, for example, Mishkin 1997; Barro 1995; Fischer 1993; Feldstein 1996]. In the case of India, a positive variation in inflation at any level above 3 per cent is found to be detrimental to growth [Singh and Kalirajan 2003]. The negative aspects of inflation volatility are transmitted through relative price distortions and loss of credibility of the central bank and the government in responding to inflation shocks and thereby inducing expectations of higher inflation. In this context, Goodfriend (1995) considers the underlying mandate of the central bank to be a level of inflation so low that “the expected rate of change of the general level of prices ceases to be a factor in individual and business decision-making” [Goodfriend 1995:122]. A consensus is strongly building towards long-term price stability (read low and stable inflation) as the key (or even the only) objective of monetary policy [BIS 1998].

Transition in Monetary Policy Framework In order to achieve the monetary objectives, central banks have attempted in the past a number of nominal anchors including exchange rate, monetary aggregates, and nominal income growth, which ultimately have led to disappointments in one way or the other. Financial innovations and velocity instability have made

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money demand growth unpredictable. Many economies which opted for exchange rate pegs as the instrument of price stability, became excessively vulnerable to large swings in capital flows. Nominal income targeting could not sustain some of the theoretical scrutiny (model inconsistency) and implementation problems arose out of lags in information on price and nominal income as also the effects of productivity shocks.2 However, of late it appears that the central banks have finally discovered their favourite anchor in “forecasted inflation” under the newfound regime of “inflation targeting” (IT), even while some academicians remain sceptical about the efficacy of this regime. The first country to adopt IT was New Zealand in 1990 and by the end of 2005, the list of countries following IT has increased many fold, which includes several emerging market economies.

What Is Inflation Targeting? Inflation targeting involves a public announcement of a medium-term numerical target for forecasted inflation that the central bank is pre-committed to, based on its own assessment (forecast). However, in practice the central bank is assigned a socially optimal inflation target by the government to be achieved in the medium term, while the bank has the freedom to choose its instruments. Svensson (1997) claims inflation forecast to be an ideal intermediate target as it is by definition the current variable that is most correlated with the goal.

where, π* is the long-run unconditional and socially optimal inflation target; y ∆t is output gap (log actual relative to potential output); πt = pt – pt–1 is inflation rate; Φ is a positive parameter which is a function of the weight on output stabilisation, discount factor of the inter-temporal objective function and supply function parameter of the output gap; and pt is log of price level. The equation requires selecting the instrument such that deviation between the two-year conditional inflation forecast is Φ times the negative of the one-year output-gap forecast. The above relationship is derived involving both inflation and output forecast and it implies: (a) all else equal, lower the expected inflation, lower will be the inflation today and (b) lower the expected inflation the higher today’s output gap can be without resulting in higher inflation today. Thus, it is better for the central bank to keep expectations of the private sector towards lower future inflation. In a strict inflation targeting framework Φ = 0, which leads to the inflation tar* geting rule, πt + 2 t = π , and there is no consideration for output stabilisation. On the other hand, in a more general form, the policy rule could include other goals such as exchange rate or interest rate smoothing. The process of IT involves the central bank taking actions whenever the expected rate of inflation is likely to miss the longrun target inflation and the intensity of the action and hence the length of interval at which the forecast of future inflation would return to the unconditional longrun target will depend on the overriding importance of maintaining inflation over other goals (determined by Φ). In this sense, IT is also a flexible policy, compatible with monetary policy objectives of any central bank in general. However, The H T Parekh Finance Forum is edited and managed by Errol D’Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.

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most of the successful IT countries prefer not to emphasise anything other than the performance in achieving inflation stability around the long-term target in order to keep a “credible commitment to price stability” [Rybinski 2006]. With such strong commitment one typical problem raised is about the response of IT during supply shocks or recession and liquidity trap [Gramlich 2000]. With supply shocks, such as in oil prices, inflation increases with falling output. Any control of inflation, a natural course of action for an IT country, would further reduce output, while restoration of output would lead to higher inflation. Similarly, in the case of a liquidity trap, the IT countries have to raise the inflation target along with private sector’s expectation and look towards fiscal and other monetary means as a contingency plan. Another set of potential problems arise due to institutional weaknesses leading to high fiscal and financial imbalances and exchange rate fluctuations, particularly in a developing country, where an IT central bank could misjudge the actual source of shocks and apply instruments too early or too soon in order to contain inflationary expectations. Here again it is important to follow prudential norms and transparency with respect to fiscal management, external exposure of private and public sector and financial institutions. In practice, IT has intricate design and operational features such as a choice between price or inflation as the target, the level of the target, the target band, inflation model, time dependence, monetary transmission lag, instrument instability, central bank independence, transparency and credibility. Most of the inflation targeting countries target underlying (and in many cases headline) a consumer price index-based inflation level varying between 1-6 per cent depending upon their past history and the target bands vary between 0 and 2.5 per cent. No country is reported to target zero inflation or price level. This means bygone is bygone. The target ranges are to be achieved within an announced time horizon of between one and two years or more depending upon the level of initial inflation and the acceptable trade-off in the short run. The central banks in IT countries use the short-term interest rate as their main operating instrument. Knowledge about the lags in monetary transmission is critical because the central bank’s inflation Economic and Political Weekly

forecast must be formed in advance by a period at least equal to the lag in monetary transmission. In most cases the inflation targets have been set by the government either solely or jointly with the central bank [Tuladhar 2005] and most monetary authorities publish inflation reports for public information, which invariably includes the inflation forecast, reasons for deviations if any and the time path to bring back inflation to the required level. Recently, the Reserve Bank of New Zealand and Norgesbank have started publishing interest rate forecasts also in order to increase transparency and efficient management of expectations. The success of inflation targeting also hinges on the efficiency of the inflationforecasting model. Forecasting errors associated with model specification, identification of true shocks, projection of exogenous variables and probability distribution of inflation are critical. Efficient forecasting may thus require experimenting with structural changes in model and off-model information. In the IT framework, the credibility of the central bank is a central issue. “In today’s context a ‘credible’ central bank is one that is believed to be firmly committed to low inflation. And in parallel, a ‘transparent’

policy means one that the public understands to be ‘credibly’ committed to low inflation” [Friedman 2002]. In order to acquire credibility, the central bank must enjoy independence to select required instruments and choose its level of aversion to inflation. However, the independence of monetary policy is also linked to fiscal dominance, particularly associated with the developing countries.

Assessment of Success of IT With inflation as the target of monetary policy, several countries have registered impressive success in reducing inflation or maintaining it at low levels [Bernanke, Laubach, Posen and Mishkin 1999; Mishkin 1999]. However, Ball and Sheridan (2003) argue that the performance of IT countries is overstated because targeters and non-targeters both performed better during the 1990s as compared to the years before the early 1990s and if the targeters seem to have reduced inflation by a greater amount, that is due to the fact that they had a poorer record earlier. The key evidence in favour of the success of the IT framework lies in the fact that none of the IT countries have opted out of this framework. Rather, more countries are joining the bandwagon and

Table: Coefficient of Variation of Exchange Rate in US, Japan, India and Selected Inflation Targeting Countries (up to December 2004) ITF Date

Brazil Chile South Africa Israel Peru Czech Republic Iceland New Zealand Hungary Australia Sweden Switzerland Norway Colombia Mexico Poland Canada Korea UK Thailand US* India* Japan*

Q2-1999 Q1-1991 Q1-2000 Q1-1992 Q1-1994 Q1-1999 Q1-2001 Q1-1990 Q1-2001 Q4-1994 Q1-1995 Q1-2000 Q1-2001 Q3-1999 Q1-1999 Q4-1998 Q1-1992 Q1-1998 Q1 1993 Q2-2000 Q1-1995 Q1-1995 Q1-1995

CPI Inflation (Mean) Exchange Rate Variation During During First During Full During During First During Full 3-Year 3-Year Period 3-Year 3-Year Period before ITF after ITF after ITF before ITF after ITF after ITF 6.83 19.45 6.60 18.64 721.51 8.84 3.41 9.17 11.27 1.61 3.46 0.54 2.64 17.42 23.56 16.11 3.14 4.95 6.02 3.62 2.87 9.80 1.36

6.78 17.69 7.04 11.90 15.21 3.60 4.36 2.57 6.41 2.32 0.98 1.06 1.98 8.14 10.38 7.77 1.21 3.09 2.51 1.39 2.50 8.87 0.70

8.34 7.25 5.51 2.03 6.49 2.58 4.12 2.28 11.32 2.68 1.16 0.92 1.82 7.49 7.80 5.02 1.83 3.51 2.52 1.72 2.46 6.41 -0.05

20.86 11.17 13.15 9.07 40.44 10.00 8.77 5.70 12.47 6.06 15.20 5.40 7.52 21.90 10.86 12.67 5.78 30.26 8.25 4.70 2.49 9.37 10.48

17.08 7.81 20.25 8.35 6.95 4.79 14.18 0.07 13.33 6.59 7.35 8.60 12.59 10.57 2.66 5.99 5.63 8.28 2.78 3.72 5.04 7.71 13.26

24.28 23.57 22.70 19.23 16.67 16.29 16.18 15.89 15.41 15.21 14.76 13.78 13.67 13.39 8.15 7.73 7.72 7.57 6.74 4.73 6.14 12.56 10.50

Notes:

All variations are reported with respect to US$. In the case of US the variation is reported with respect to SDR. Chile had crawling peg before 1991. Mexico has oil fund. * Countries are noninflation targeting framework countries. Source (basic data): IFS.

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new features are being added to the inflation report of the IT countries. The table includes the performance of countries with a history of high inflation such as Peru, Brazil, Chile, Mexico, Colombia, Israel and Poland; all have performed well despite weaknesses in their fiscal and financial systems. It appears that the key reason for the success of the IT framework lies in the very structure of the framework, which calls for close coordination between the government and the central bank. IT starts with a contract between the central bank and the government to reduce inflation as an overriding objective function of monetary policy, but in the process it has implicit guaranteed support from the fiscal authorities because the framework requires the initiative to start from the government in the form of a directive to the central bank or legislation to that effect. Commitment of fiscal policy to economic reform and macroeconomic management is critical. In the case of New Zealand, Mikek (2004) argues that New Zealand could not have been successful in inflation targeting without a shift in the fiscal regime, whereby debt was kept at a prudent level. The recent experience of Brazil with IT is a test case of another such resolve, where

it is strongly reflected that IT can play a crucial role in macroeconomic stabilisation [Minella, Freitas, Goldfajn and Muinhos 2003]. Brazil adopted IT in 1999 with a multi-year inflation target and met the 1999 and 2000 targets but missed the 2001 target marginally despite real depreciation during 1999. However, in 2002, the increasing probability that the left wing candidate, Luiz Inacio Lula da Silva, would be elected, led to an acute macroeconomic crisis in Brazil. The rate of interest on Brazilian government dollar-denominated debt increased sharply, reflecting an increase in the market’s assessment of the probability of default on the debt. In October 2002, Lula was indeed elected. The Brazilian real exchange rate depreciated sharply against the dollar and inflation rose to 12.5 per cent overshooting the target of 3.5 per cent set for 2003. The Brazilian central bank responded in an extremely transparent and pragmatic manner and for its part, the government committed itself to a high primary surplus, a reform of the retirement system, and a revised inflation target. This in turn convinced the financial markets to obtain a better fiscal outlook leading to a decrease in the perceived probability of default, a real appreciation, and a decrease in inflation to 5.5 per cent by the middle

of 2004 [Mishkin 2004]. Thus simultaneous commitments of the central bank and the government are key to success of this framework.

If India Were to Adopt IT After demonstrating considerable interest in the IT framework during late 1990s, the Indian monetary authorities appear to have abandoned this idea for some time. Kannan (1999) first reviewed the possibility of inflation targeting in the Indian context and argued for completing financial sector reforms before its implementation. Kannan’s concerns were timely. However, since then the first phase of financial reforms are almost complete, Basel-I has been implemented and the RBI is fast moving on Basel-II [see, for example, Reddy 2005]. Automatic monetisation is abolished and most of the deposits and lending rates are free. There have been significant developments in application of market-oriented policy instruments since the adoption of full-fledged liquidity adjustment facility. In addition the call money rate is found to act as a good intermediate target [Singh and Kalirajan 2006 (forthcoming)], which could be linked to inflationary expectations through yield structure of

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long-term bonds. The macroeconomic performance in terms of both the level of inflation and level of interest rate have been stable for some time now. All these conditions are favourable to an inflation targeting framework. However, in the light of the foregoing discussion, there are several issues that need to be taken care of before actual IT can be adopted in India and it is important to address them sooner rather than later. (1) Although the policy statements of the RBI invariably state price stability as its main monetary policy objective, the same is not enshrined in law. The preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as: ...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. http://rbi.org.in/ scripts/AboutusDisplay.aspx#EP1

The above objective means little to an IT framework. Therefore, a change in RBI related laws is essential to make its objectives consistent with modern day practice of conducting monetary policy. (2) In the Indian debate, inflation is not considered entirely a monetary phenomenon. It is believed that inflationary pressure builds up from both the supply as well as the demand-side. In the IT context the implications are important as noted in Chand and Singh (2005). “A more cautious approach to inflation targeting in the Indian context would rely on both monetary and fiscal instruments and be closely coordinated with other instruments such as government buffer stock and other supply- side operations. If the forecast rate of inflation were to exceed the target rate, both the fiscal deficit and its monetary financing and the general availability of credit flows would be reduced, but without necessarily raising interest rates. Of course, simply reducing the monetary financing would not be adequate, and safeguards will need to be built in so as to ensure that political expediency does not lead to a watering down of the commitment to restraining inflation” [Chand and Singh 2005]. (3) There has been little liberalisation in the area of directed credit. Commercial banks are required to direct 40 per cent of their commercial advances to the priority sector. At present the percentage of directed credit appears to be too high and needs to be narrowed down to highly focused areas. Economic and Political Weekly

(4) With the combined fiscal deficit of central and state governments remaining in the range of 8-10 per cent of gross domestic product (GDP), more than 25 per cent of the time and demand liability of the banking sector held in government securities as SLR and the ratio of gross to net borrowing of the government resting above 0.60, the central bank independence is de facto compromised and therefore, the role of the government in committing to the IT framework is no less than that of the RBI. (5) Even if it is a long way off from adopting IT, the RBI should without delay start publishing a full-fledged inflation report on the lines of IT countries to bring in transparency in its operations leading to a smooth transition. (6) The government should establish an inflation committee comprising the ministry of finance, the RBI and academicians,backed by an inflation research project team under the purview of an inflation committee to prepare an exhaustive inflation report. EPW Email:[email protected]

Notes 1 Taking into account the measurement errors, price stability means an inflation level of the order of 2-3 per cent. 2 However, in the case of India, McKibbin and Singh (2003) have shown that nominal income targeting does better than both monetary targeting and inflation targeting, while inflation targeting performs better than monetary targeting.

References Ball, Laurence and Niamh Sheridan (2003): ‘Policy Rules for Open Economies’, NBER Working Paper Series 9577, Cambridge, MA. Barro, Robert J (1995): ‘Inflation and Economic Growth’, NBER Working Paper 5326, Cambridge, MA. Bernanke, Ben S, Thomas Laubach, Adam S Posen and Frederic S Mishkin (1999): Inflation Targeting: Lessons from the International Experience, Princeton University Press, Princeton, NJ. BIS (1998): ‘The Transmission of Monetary Policy in Emerging Market Economies’, Bank for International Settlements, Policy Paper No 3, Basle. Chand, Sheetal K and Kanhaiya Singh (2005): ‘How Applicable Is the Inflation Targeting Framework (ITF) for India? Annual conference of India Policy Forum, jointly organised by the Brookings Institute Washington and the NCAER, New Delhi, Habitat Centre, New Delhi, held July 25-26. Feldstein, Martin (1996): ‘The Costs and Benefits of Going from Low Inflation to Price Stability’,

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NBER Working Paper 5469, National Bureau of Economic Research, Cambridge, MA. Fischer, Stanley (1993): ‘The Role of Macroeconomic Factors in Growth’, Journal of Monetary Economics, 32 (1993): 485-512. Friedman, Benjamin M (2002): ‘The Use and Meaning of Words in Central Banking: Inflation Targeting, Credibility, and Transparency’, NBER Working Paper W8972, National Bureau of Economic Research, Cambridge, MA. Goodfriend, Marvin (1995): ‘Acquiring and Maintaining Credibility for Low Inflation: The US Experience’ in L Leiderman and L E O Svensson (eds), Inflation Targets, Centre for Economic Policy Research, London. Gramlich, Edward M (2000): ‘Inflation Targeting’: http://www.mortgagebankers.org/brief/2000/ 0113f.html (Accessed: July 21, 2005). Kannan, R (1999): ‘Inflation Targeting Issues and Relevance for India’, Economic and Political Weekly, XXXIV(3 and 4): 115-22. Mikek, Peter (2004): ‘Inflation Targeting and Switch of Fiscal Regime in New Zealand’, Applied Economics, 36: 165-72. Minella, Andre, Paulo Springer de Freitas, Ilan Goldfajn and Marcelo Kfoury Muinhos (2003): ‘Inflation Targeting in Brazil: Constructing Credibility under Exchange Rate Volatility’, Journal of International Money and Finance, 22: 1015-40. Mishkin, Frederic S (1997): ‘Strategies for Controlling Inflation’ in P Lowe (ed), Monetary Policy and Inflation Targeting, Proceedings of a Conference, Reserve Bank of Australia, Sydney. – (1999): ‘International Experiences with Different Monetary Policy Regimes’, Journal of Monetary Economics, 43: 579-605. – (2004): ‘Can Inflation Targeting Work in Emerging Market Economies’, NBER Working Paper 10646, National Bureau of Economic Research, Cambridge, MA. Reddy, Y V (2005): ‘Banking Sector Reforms in India: An Overview’, Address by Dr Y V Reddy, Governor, Reserve Bank of India at the Institute of Bankers of Pakistan, Karachi on May 18, 2005. Rybinski, Krzysztof (2006): ‘Inflation Targeting and the Challenges Ahead’, BIS Review 42. Singh, Kanhaiya and K P Kalirajan (2006) (forthcoming): ‘Monetary Transmission in the Post-Reform India: An Evaluation’, Journal of Asia Pacific Economy. Singh, Kanhaiya and K P Kalirajan (2003): ‘The Inflation-Growth Nexus in India: An Empirical Analysis’, Journal of Policy Modelling, 25: 377-96. Svensson, Lars E O (1997): ‘Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets’, European Economic Review, 41: 1111-46. – (1999): ‘Inflation Targeting as a Monetary Policy Rule’, Journal of Monetary Economics, 43: 607-54. – (2000): ‘How Should Monetary Policy Be Conducted in an Era of Price Stability’, NBER Working Paper 7516, National Bureau of Economic Research, Cambridge, MA. Tuladhar, Anita (2005): ‘Governance Structures and Decision-Making Roles in Inflation Targeting Central Banks’, IMF Working Paper, WP/05/183.

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