The H T Parekh Finance Forum is edited and managed by Errol D\u2019Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.
tion1is 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 trans- mitted 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 \u201cthe expected rate of change of the general level of prices ceases to be a factor in individual and business decision-making\u201d [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].
In order to achieve the monetary objec- tives, central banks have attempted in the past a number of nominal anchors includ- ing exchange rate, monetary aggre- gates, and nominal income growth, which ultimately have led to disappointments in one way or the other. Financial innova- tions and velocity instability have made
money demand growth unpredictable. Many economies which opted for exchange rate pegs as the instrument of price sta- bility, became excessively vulnerable to large swings in capital flows. Nominal income targeting could not sustain some of the theoretical scrutiny (model incon- sistency) 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 \u201cforecasted inflation\u201d under the newfound regime of \u201cinflation targeting\u201d (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.
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). How- ever, in practice the central bank is as- signed a socially optimal inflation target by the government to be achieved in the medium term, while the bank has the free- dom to choose its instruments. Svensson (1997) claims inflation forecast to be an ideal intermediate target as it is by defi- nition the current variable that is most correlated with the goal.
At the heart of the concept of the inflation targeting problem [Svensson 1999] is the following equation:
output gap (log actual relative to potential output);\u03c0t=pt\u2013pt\u20131 is inflation rate;\u03a6 is a positive parameter which is a function of the weight on output stabilisation, dis- count factor of the inter-temporal objec- tive function and supply function param- eter 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\u03a6 times the negative of the one-year output-gap forecast. The above relation- ship 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\u2019s output gap can be without result- ing in higher inflation today. Thus, it is better for the central bank to keep expec- tations of the private sector towards lower future inflation.
, 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 long- run 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 long- run target will depend on the overriding importance of maintaining inflation over other goals (determined by\u03a6). In this sense, IT is also a flexible policy, com- patible with monetary policy objectives of any central bank in general. However,
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.
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\u201ccredible commitment to price stability\u201d [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\u2019s expectation and look towards fiscal and other monetary means as a contingency plan. Another set of po- tential 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 expecta- tions. Here again it is important to follow prudential norms and transparency with respect to fiscal management, external ex- posure 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 trans- mission 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 criti- cal because the central bank\u2019s inflation
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 infor- mation, 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 inter- est 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 inflation- forecasting model. Forecasting errors associated with model specification, identification of true shocks, projection of exogenous variables and probability dis- tribution of inflation are critical. Efficient forecasting may thus require experiment- ing with structural changes in model and off-model information.
In the IT framework, the credibility of the central bank is a central issue.\u201cIn today\u2019s context a\u2018credible\u2019 central bank is one that is believed to be firmly committed to low inflation. And in parallel, a\u2018transparent\u2019
policy means one that the public under- stands to be\u2018credibly\u2019 committed to low inflation\u201d [Friedman 2002]. In order to acquire credibility, the central bank must enjoy independence to select required instruments and choose its level of aver- sion to inflation. However, the indepen- dence of monetary policy is also linked to fiscal dominance, particularly associated with the developing countries.
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 suc- cess of the IT framework lies in the fact that none of the IT countries have opted out of this framework. Rather, more coun- tries are joining the bandwagon and
new features are being added to the infla- tion 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 de- spite weaknesses in their fiscal and finan- cial 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 govern- ment 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 authori- ties 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.
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\u2019s 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 transpar- ent 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 simulta- neous commitments of the central bank and the government are key to success of this framework.
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\u2019s 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 adjust- ment 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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