Inflation Targeting and Government Behavior

Inflation Targeting and Government Behavior

 

Introduction

            It is now widely accepted that the primary role of monetary policy is to maintain price stability. Price stability obtains when economic agents no longer take account of the prospective change in the general price level in their economic decision making. This is often thought to correspond to an annual rate of inflation in the low single digits ( 1999; 2001; 2002; 2004; 2004).

            Inflation targeting has continuously become popular as a monetary policy strategy. In the 1990s, a number of countries have introduced what has become known as “inflation targeting” frameworks. One of these countries is Australia which also includes New Zealand which is the first from the list, Canada, United Kingdom, Sweden and Chile. Inflation targeting frameworks usually specify an explicit quantitative target for the rate of change in a price index, set a tolerance range around the target, and set a time interval in which the target must be hit ( 1995).  

            Monetary economists have concluded that monetary policy cannot do much more than achieve some desired level of inflation. Even to the extent that monetary policy can have an influence on real activity, this lever should be used only with great caution, as it may endanger the reputation to effectively fight inflation over the longer-term horizon, if used opportunistically.

            The argument of  and  (1977) that monetary policy pursuing short-term goals in a discretionary, opportunistic manner is worse than a policy committed to and sticking to an a priori well-chosen course of action–is fundamental and well understood. Inflation targeting is often advertised as a way for monetary policy to achieve an additional degree of this desirable commitment. Inflation targeting is furthermore sold as an effective communications policy, as it makes the public focus on inflation as the macroeconomic that is most effectively influenceable by monetary policy. In short, inflation targeting is an appealing idea on a priori theoretical grounds.

            Although the strategy does not affect price stability, it is an efficient tool for central banks in making use of economic forecasts and information to meet inflation targets. Inflation targeting also provides businesses with an easy access to information to examine whether central banks are able to meet economic expectations.       

            With the author’s definition of inflation targeting as a framework opposed to a rule, IT fits somewhere between the extremes which feature in the “rules versus discretion” debates. Inflation targeting is not automatic or central bank full discretion but rather in a form of constrained discretion. As according to  (1999), “imposing a conceptual structure and its inherent discipline on the central bank, but without eliminating all flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with those ascribed to discretion.”

 

Rules versus Discretion

 

            In the last 20 years, the there has been continuous debate on the context of “rules versus discretion”. At one time, it was widely believed that discretion could accomplish anything that a rule could accomplish. The monetary authority could exercise its judgment to produce whatever policy a rule might specify in advance if the rule were the best policy. If a deviation from the policy that would be imposed by the rule were desirable, the monetary authority’s hands would not be tied if it had discretion.

            Rules legitimize policies however they can constrain a monetary official’s responses to the economy’s current performance. On the other hand, discretions give the monetary officials a greater hand in making decisions that affect the economy. A balance of both rules and discretions is needed to achieve harmony.

             (1936) first raised this issue as a choice between rules and authorities, terms little different than those used in recent discussions. He stresses the value of a rule, such as a law, instead of reliance on an authority’s discretion because “definite, stable, legislative rules of the game as to money are of paramount importance to the survival of a system based on freedom of enterprise.”

With discretion, a monetary authority is free to act in accordance with its own judgment. For example, if legislation directed the Federal Reserve to do its best to improve the economy’s performance and gave the monetary authority the instruments that it has, the Federal Reserve would have a discretionary monetary policy (1993).

However, in the context of monetary policy, a rule is a restriction on the monetary authority’s discretion. A rule involves the exercise of control over the monetary authority in a way that restricts the monetary authority’s actions. Rules can directly limit the actions taken by a monetary authority. For example, one simple possible rule would be that the monetary authority holds the monetary base constant ( 1993). This clearly restricts the use of judgment. A rule need not be as simple as that though. Rules can attempt to limit the objectives pursued by the monetary authority. Another example, one possible rule would be that the monetary authority announces a target for monetary base growth over some period to further some well-defined goal and then to hit the target unless predetermined exceptional circumstances arise ( 1993).

Most proposed rules restrict the monetary authority’s discretion but do not eliminate it. (1936) proposed a rule that the monetary authority keep the price level constant. Though this rule would restrict the monetary authority’s discretion, the authority could still exercise substantial discretion in pursuing this goal.  Moreover, even with the choice of the particular price index determined and even if the monetary authority had only one possible instrument, the authority would still have to estimate the growth rate of the monetary base consistent with a constant price level.

            There two leading arguments on the issues of rules and discretion. These are the desirability of having elected representatives makes choices and economic implications of committing policy.

           ‘ (1936) choice was for monetary policy largely determined by elected representatives rather than by a monetary authority. Modigliani (1977) argued that expert economic judgment can contribute to better policy.

            The second argument has two components ( 1993). The first component is whether, even if policy actions usually would be the same with or without a rule, there are benefits or costs of committing policy. The second component is whether, given the current state of economic knowledge, policy actions that depend on the current state of the economy are likely to improve the economy’s performance.

            According to  (1993), a common observation, some 15 year ago or so, was that discretion could be used to produce the same values of policy instruments as would be feasible with any restriction, thus a rule could not improve on discretion. As  advocated that a monetary authority exercising discretion could accomplish desirable outcomes. Furthermore,  (1977) noted that because discretionary policy can produce the same values of the instruments as a rule, a discretionary policy can be no worse than a rule and in fact can be better.

            In the analyses of  and (1977) and  (1978) of time consistency of policy, it shows that general argument against rules is wrong. Various studies shows that such a policy can result in worse outcomes than will result from a rule determining current and future monetary policy (1977; 1978; 1983). That is, when the economy adjusts to this method of determining monetary policy given the monetary authority’s incentives, the economy’s actual performance can be worse with discretion than with a rule.

            Discretion means that the monetary authority’s future actions are not restricted. As a result, policies that require a commitment to a particular sequence of actions can be impossible to implement, even if they clearly are preferable. If a monetary authority or a government can commit monetary policy credibly, the net benefits of such commitment can be positive. Such commitment might take the form of a law, but it does not necessarily have to be embodied in a law.

 

Inflation Targeting

Inflation targeting is one of the operational frameworks for monetary policy aimed at attaining price stability. In contrast to alternative strategies, notably money or exchange rate targeting, which seek to achieve low and stable inflation through targeting intermediate variables, for example, the growth rate of money aggregates or the level of the exchange rate of an anchor currency, inflation targeting involves targeting inflation directly.

 There are several definitions from different literatures (1995;1999; 1999).  In practice, however, inflation targeting has two main characteristics that distinguish it from other monetary policy strategies.

In inflation targeting, the central bank is mandated, and commits to, a unique numerical target in the form of a level or a range for annual inflation. A single target for inflation emphasizes the fact that price stabilization is the primary focus of the strategy, and the numeric specification provides a guide to what the authorities intend as price stability.

            In addition, the inflation forecast over some horizon is the de facto intermediate target of policy. For this reason inflation targeting is sometimes referred to as “inflation forecast targeting” (1998). Since inflation is partially predetermined in the short term because of existing price and wage contracts and/or indexation to past inflation, monetary policy can only influence expected future inflation. By altering monetary conditions in response to new information, central banks influence expected inflation and bring it in line over time with the inflation target, which eventually leads actual inflation to the target.

 

Advantages of Inflation Targeting

 (2003) argues that inflation targeting argue that it yields a number of benefits relative to other operating strategies. According to  (2003), inflation targeting can help build credibility and anchor inflation expectations more rapidly and durably. In inflation targeting, low inflation is the primary goal of the monetary policy which involves greater transparency to compensate for greater operational freedom. Inflation targets are also intrinsically clearer and more easily observable and understandable than other targets since they typically do not change over time and are controllable by monetary means. In this way, inflation targeting can help economic agents better understand and evaluate the performance of the central bank, anchoring inflation expectations faster and more permanently than other strategies.

            In addition, inflation targeting grants more flexibility. Since inflation cannot be controlled instantly, inflation targeting is interpreted as a medium-term goal. This implies that inflation-targeting central banks pursue the inflation target over a certain horizon. Short-term deviations of inflation from target are acceptable and do not necessarily translate into losses in credibility (2005). The scope for greater flexibility could reduce output gap variability.

            Finally, inflation targeting involves a lower economic cost in the face of monetary policy failures. The output costs of a failure to meet the inflation target are limited to temporarily higher-than-target inflation and temporarily slower growth, as interest rates are raised to bring inflation back to target.

 

Disadvantages of Inflation Targeting

            However, critics argue that inflation targeting has also its important disadvantages. First, inflation targeting offers too little discretion and so it unnecessarily restrains growth. Inflation targeting constrains discretion inappropriately: it is too confining in terms of an ex ante commitment to a particular inflation number and a particular horizon over which to return inflation to target. By obliging a country to hit the target so restrictively, inflation targeting can unnecessarily restrain growth (2002; 2003).

            In addition, inflation targeting cannot anchor expectations because it offers too much discretion over how and when to bring inflation back to target and because target cannot be changed as well. Moreover, it implies high exchange rate of volatility because it elevates price stability to the status of the primary goal of the central bank. Furthermore, it cannot work n countries that do not meet a stringent set of preconditions which makes it unsuitable for the majority of emerging market economies.

 

The Taylor’s Rule

The Taylor’s rule recommends a target for the level of the nominal federal funds rate that depends on four factors (1967; 1988; 1993; 1996). The first factor is the current inflation rate. The second factor is the equilibrium real interest rate. When these two factors are added together, they provide a benchmark recommendation for the nominal federal funds rate. The third factor is an inflation gap adjustment factor based on the gap between the inflation rate and a given target for inflation. This factor recommends raising the federal funds rate above the benchmark if inflation is above the target for inflation and lowering the federal funds rate below the benchmark if inflation is below the target. The fourth factor is an output gap adjustment factor based on the gap between real GDP and potential real GDP. This factor recommends raising the federal funds rate above the benchmark if the gap is positive and lowering the federal funds rate below the benchmark if the gap is negative. These factors summarize several important aspects of policy.(5)

The sum of the first and second factors provides a benchmark recommendation for the federal funds rate that would keep inflation at its current rate, provided the economy is operating at its potential. Because the benchmark recommendation rises one-for-one with the current rate of inflation, the higher current inflation is, the higher the rule recommendation will be, all else equal. This relationship between current inflation and the benchmark recommendation for the nominal federal funds rate keeps the implied real interest rate constant.

The use of the equilibrium real rate in the Taylor rule emphasizes that real rates play a central role in formulating monetary policy. Although the nominal federal funds rate is identified as the instrument that policymakers adjust, the real interest rate is what affects real economic activity. In particular, the roles clarify that real interest rates will be increased above equilibrium when inflation is above target or output is above its potential.

The third and fourth factors in the Taylor rule summarize two objectives of monetary policy. These are targeting a low and stable rate of inflation while promoting maximum sustainable growth. These adjustment factors can also be seen as incorporating both long-run and short-run goals. The inflation gap adjustment factor incorporates the central bank’s long-run inflation goal. The output gap adjustment factor incorporates the view that in the short-run policy should lean against cyclical winds. Weights in the adjustment factors embody a presumed attitude toward the short-run tradeoff between inflation and output.

The output gap adjustment factor may represent another aspect of policy. Some analysts have argued that the output gap adjustment factor brings a forward-looking, or preemptive, motive to policy recommendations. According to this view, a positive output gap signals likely future increases in inflation. Consequently, funds rate recommendations that reflect an output gap adjustment may correspond to policy actions designed to preempt an otherwise anticipated increase in inflation.

In addition, Taylor rule is also is based on several assumptions. Assumptions of some form are necessary to move from a framework for policy to a role that provides quantitative recommendations.

 The specific role discussed by Taylor takes the following form:

(1) Funds rate (t) = GDP price inflation (t) + 2.0 + 0.5 x (GDP price inflation (t)-2.0) + 0.5 x (output gap (t)).

In this expression, the benchmark recommendation is the sum of GDP price inflation and the 2.0 percent equilibrium real rate. The third term on the right side of the expression is the inflation gap adjustment, which raises the funds rate target by one-half of the gap between GDP price inflation and the 2.0 percent inflation target. The fourth term on the right side of the expression is the output gap adjustment, which raises the funds rate target by one-half of the output gap, where the output gap is defined as the percent deviation of the level of real GDP from the level of potential real GDP.

Taylor-rule recommendations in a given quarter are based on the output gap in the same quarter and on inflation over the four quarters ending in the same quarter. In the Taylor rule, monetary policy targets GDP price inflation measured as the rate of inflation in the GDP deflator over the previous four quarters. The equilibrium real rate, represented by the second term on the right side of the expression, is assumed to equal 2.0 percent. The inflation gap adjustment incorporates a weight equal to one-half. The policy target for inflation is assumed to equal 2.0 percent. The output gap adjustment incorporates a weight equal to one-half. And, the output gap is constructed using a series for potential real GDP that grows 2.2 percent per year.

 

Should central bank be goal or instrument independence or both?

            Inflation-targeting regimes generally identify price stability as the primary objective, usually in the context of a hierarchical mandate. They set an explicit numerical target for inflation and set a period over which any deviation of inflation from its target is to be eliminated, although some regimes provide escape clauses and other flexibility related to the pace of return to price stability.

            The inflation target is sometimes set as a point and sometimes as a range. In most cases, the inflation objective is set for a measure of overall consumer price inflation. Among inflation-targeting regimes, there is a mix of practices with respect to who sets the numerical target for inflation. In almost all cases, the government identifies price stability as a target, either as the single target or as part of a hierarchical mandate. In about half the cases, the explicit numerical target for inflation is set by the government, typically the finance ministry, generally in consultation with the central bank; in about half the cases, the target is set by the central bank, often in consultation with the finance ministry. Inflation targets should be established with regard to a country’s particular economic climate and forecasts.

            Although there is a strong rationale for the price stability goal and an explicit nominal anchor, it is still a question if central bank should be goal independence or instrument independence?

             and  (1994) and (1994) made a distinction between goal independence and instrument independence. Goal independence is the ability of the central bank to set its own goals for monetary policy, while instrument independence is the ability of the central bank to independently set the instruments of monetary policy to achieve the goals.

            The public must be able to exercise control over government actions and that policymakers must be accountable, so basic to democracy, strongly suggests that the goals of monetary policy should be set by the elected government. In other words, a central bank should not be goal independent. The corollary of this view is that the institutional commitment to price stability should come from the government in the form of an explicit, legislated mandate for the central bank to pursue price stability as its overriding, long-run goal.

            The source of the time-inconsistency problem is more likely to be embedded in the political process than it is in the central bank. Once politicians commit to the price stability goal by passing central bank legislation with a price stability mandate, it becomes harder for them to put pressure on the central bank to pursue short-run expansionary policies that are inconsistent with the price stability goal. Furthermore, a government commitment to price stability also is a commitment to making monetary policy dominant over fiscal policy, ensuring a better alignment of fiscal policy with monetary policy.

             (1985) suggested “granting both goal and instrumenting independence to a central bank and then appointing conservative central bankers to run it, who put more weight on controlling inflation than does the general public.”  According to him the result will be low inflation, but at the cost of higher output variability than the public desires.

            The same principles that suggest that the central bank should be goal dependent, with the commitment to the price stability goal mandated by the government, also suggest that the commitment to an explicit nominal anchor should be made by the government. In the case of an exchange-rate target, the government should set the target or in the case of an inflation target, the government should set the numerical inflation goal. The fact that the government sets these targets so that the central bank is goal dependent does not mean that the central bank should be cut out of the decision-making process. Because the central bank has both prestige and expertise in the conduct of monetary policy, governments will almost always be better served by setting these targets in consultation with the central bank. As documented in  (1999), the target rarely is changed once price stability is achieved.

            Although the arguments above suggest that central banks should be goal dependent, central banks should also be instrument independent. Allowing central banks to control the setting of monetary policy instruments provides additional insulation from political pressures to exploit short-run tradeoffs between employment and inflation. Instrument independence means that the central bank is better able to avoid the pursuit of time-inconsistent policies in line with the third guiding principle. Recent evidence seems to support the conjecture that macroeconomic performance is improved when central banks are more independent (1993, 1992, 1994).

 

Inflation Targeting in Australia

            Australia operates under a dual mandate, according to which monetary policy is directed at promoting both full employment and price stability, with no priority expressed, and with the central bank responsible for balancing these objectives in the short run. Inflation-targeting countries generally operate under hierarchical mandates, one in which price stability is identified as the principal objective, and central banks are restricted in pursuing other objectives unless price stability has been achieved. Australia has a dual mandate along with an explicit inflation target. The explicit inflation target, 2 percent to 3 percent, is set by the central bank and applies to the average inflation rate over a business cycle.

Political Business Cycle

            Elected officials have incentives to deliver benefits before the next election even if the associated costs might make them undesirable from a longer-term perspective. This phenomenon has been called the political business cycle in which pre-election stimulus leads to higher inflation followed by monetary restraint after the election.

            The political business cycle (PBC) model as developed by  (1975) suggests incumbent politicians have an incentive to stimulate the economy to bolster their reelection chances. This coincides with empirical evidence that favorable economic conditions impact upon incumbent popularity (1978; 1985;1990) and voting patterns ( 1971; 1978; 1990) in an advantageous manner. If voters do behave in this fashion, politicians should be aware of this and consequently help themselves by spurring growth prior to an election.

            There are only two Australian papers that examine the relationship between macroeconomic factors and electoral outcomes.  and (1994) examine the post-war electoral record, using annual inflation, unemployment and GDP growth data. Their study find no strong evidence that macroeconomic performance affects electoral outcomes, although given the point estimates of the impact of inflation and unemployment on incumbent voteshares, they conclude that the 1993 election result, where the incumbent Labor Party won, was surprising given the high unemployment rate then prevailing.

            (1992) uses the proportion of people who are happy with how the Prime Minister is doing his job as his dependent variable. He regresses this on a ‘misery index’ constructed using quarterly data from 1983 to 1989.  finds that the quarterly changes in inflation and unemployment affect popularity, but the levels of these variables do not seem to affect popularity.  (1993) argue that it is not the levels of inflation, unemployment and GDP growth that affect electoral outcomes, rather the departure from the expected value of these variables. Voters do not reward good luck in government, but rather vote on the basis of rational predictions of how well the economy has done relative to expectations.

 

Conclusion

            It is now widely agreed that the main objective of the monetary policy is price stability. Economic policies that target inflation management have emerged among strategists as the most commonly supported method of sustaining consistent growth and ensuring price stability in a variety of economies. Inflation targeting is continually been popular as a monetary policy strategy.

            Central banks differ over whether they should set an explicit inflation target and whether they should acknowledge and take responsibility for other objectives, specifically full employment or output stabilization. Central banks as explained in the paper should be goal dependent while being instrument independent.  Central banks were recommended to adopt a long-term objective for the price level to stabilize business-cycle fluctuations. Central bank has to have a flexible policy process that focuses on inflation but also cares about other variables, such as employment, output growth, and the behavior of a short-run policy guide such as the federal funds rate or an exchange rate.

           

           

 

 

 

 

 

 

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