No Nonsense
Monetary policy and inflation targeting
MY August 2 piece "Dichotomy of inflation and credit expansion" argued that inflation inhibits growth through dissuading investment -- and governments (where the central bank isn't independent) must create a favourable credit expansion environment through adopting inflation managed economic growth policy framework. This article sheds some light on that framework.
For several years now, monetary economists and central bankers around the world have expressed increasing interest and attention in inflation targeting (IT) as a framework for activist monetary policy. This framework has been adopted by a number of central banks (CBs), including those in Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the UK.
Most recently, a full-fledged IT framework was adopted by 13 transition economies, notably the Czech Republic, Hungary, and Poland -- and many others studying the pros and cons of IT are considering their next move.
Central banks that have switched to IT have generally been pleased with the outcomes they have obtained. A June 2005 study by Goldman, Sachs & Co. found that countries that implemented IT tended to stabilise their inflation rates while keeping economic growth on an even keel. Non-IT economies, such as the US and Japan, have experienced relatively more volatility in stock and bond markets -- possibly reflecting investor unease and uncertainty about the direction of inflation.
For clarity, IT refers to policy actions in which the CB makes an explicit pledge to achieve a publicly announced inflation target within a pre-set time frame. For example, at the start of 1993, Sweden's CB announced that it would contain inflation (percent change in consumer price index) within a band of 1 to 3% by 1995.
The precise definition of an IT regime, however, entails some ambiguity, partly because its implementation has diverged somewhat from one IT country to another -- most remarkably with regard to how the target is set and how deviations from the target are tuned and tolerated.
In a 2003 Policy Conference in Washington DC, former Federal Reserve governor (now chairman), Ben Bernanke, articulated three notable misconceptions about IT:
- It's mechanical, rule-like policymaking. As discussed below, IT is a policy framework -- not a rigid rule.
- It focuses solely on control of inflation and ignores output and employment objectives.
- It's incoherent with the central bank's obligation to maintain financial stability.
Bernanke has also outlined two essential elements in a far-sighted successful IT initiative. He argued:
"Inflation targeting, at least in its best-practice form, consists of two parts: a policy framework of constrained discretion and a communication strategy that attempts to focus expectations and explain the policy framework to the public. Together, these elements promote both price stability and well-anchored inflation expectations; the latter, in turn, facilitate more effective stabilisation of output and employment. Thus, a well-conceived and well-executed strategy of inflation targeting can deliver good results with respect to output and employment as well as inflation."
Make no mistake: IT wouldn't necessarily impose a rigid rule on CBs; instead, IT could employ some discretion to respond to special shocks and adverse non-policy noises. However, given that monetary policy affects the economy with long and variable lags, policy indicators would be focused on inflation and inflation expectations.
Inflation targeting doesn't necessarily require that price stability or low inflation be the predominant goals of monetary policy. Indeed, most inflation targeting CBs focus on several goals. In New Zealand (an exception), IT is legislatively mandated, while in Canada such legislation was never passed (as is more typical). In essence, IT can be used as an operational framework for monetary policy -- not as an unaccommodating stance of ultimate policy goals.
Justifiably, few macroeconomists believe that expansionary monetary policy can permanently reduce the average rate of unemployment; instead, such a policy only results in higher average inflation rates. However, IT would provide a clear path for the medium-term inflation outlook and ,hence, forecasting inflation would be easier, helping real and financial investment decisions and more informed, less risky planning.
Critics argue that IT would unduly hamstring CBs to respond to new economic developments in an unpredictable world. That is, IT imposes some constraints on the discretionary actions of CBs. However, experience has shown that such constraints can be quite propitious in countries like Bangladesh where monetary policy has performed poorly, showing sustained adverse inflationary tendencies.
Given that inflation is running over 9%, Bangladesh Bank (BB) may consider setting an IT band of 6 to 8%, and once it succeeds in confining inflation in this band it may revise the band downward to between 4 and 6%, and so on. Implementing such an IT policy, however, would demand continuous data gathering and state of the art forecasting methodology. The pertinent question: Is BB ready for this?
BB's monetary policy formulating expertise hasn't evolved significantly over the last 35 years or so. The only noticeable change is that, over the last 12 years, the three consecutive governors --each with a PhD in economics (none with specialisation in monetary economics, macroeconomics or financial economics) -- provided leadership in central banking and monetary policy. As smart as they are, all three came from years of civil service jobs (some with World Bank experience unrelated to central banking), having little or no central banking experience per se.
While studying physics, I was fascinated by the idea of landing a job in BB -- perhaps the greenish glass-walled executive building of BB may have allured me. After my BSc (Hons) exam result, I had a meeting with Professor M.N. Huda, the then Dhaka University Economics Department Head, for possible admission to do MA in economics instead of MSc in Physics.
At the time, I was disappointed that there was no such provision or precedence for switching from physics to economics. Looking back -- should I feel sorry that my dream of landing a job at Bangladesh Bank never materialised?
Dr. Abdullah A. Dewan is Professor of Economics at Eastern Michigan University, USA.
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