Independence of Central Bank (10%)


Independence of Central Bank (10%)

Central Bank independence is one of the key pre-requisites for effective inflation targeting.

Kahn (2009) states that although monetary policy goals must be set by the democratic government, their implementation should be the mandate of the central bank to avoid the time-inconsistency problem or a political monetary policy cycle. This mandate may not be made into a law, but what matters is past credibility and a continued commitment to the goal of price stability. On other hand, Charles Freedman et al (2010) argues that legislating this mandate is important, particularly in emerging economies where there is a history of government control of monetary policy. For example, the government may resort to populist measures and change the target when central bank has to take unpopular steps. This takes away the basic advantage of inflation targeting- anchoring expectations and increasing predictability and credibility (Kahn, 2009).

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Guy Debelle et al (1998) argues that fiscal policy must not dominate or dictate monetary policy. This means:

  1. Very low or no borrowing by government from the central bank
  2. Well-developed domestic markets that can absorb public debt (e.g. treasury bills)
  3. Broad base of government revenue so that there is minimal dependence on seigniorage revenues

In presence of fiscal dominance, fiscal policy based inflationary pressures will reduce the effectiveness of inflation targeting as central banks will be forced to accommodate government demands such as lowering interest rates to aid fiscal goals.

To avoid discretion by governments with regards to monetary policy, transparency and strong communication are important in central banks. In South Africa, monetary goals are set by government by setting the target while constitution guarantees instrument-independence of central bank. (Kahn, 2009)

Limitations ofInflationTargeting(10%)

  1. Limitation in analyzing its effectiveness is since it is difficult to differentiate between the overall impact of general economic reforms and the more specific impact of inflation targeting. Sarwat Jahan (no year)
  1. According to CA Sims (2003) “Inflation targeting may do more harm than good if there is a substantial chance that the central bank cannot in fact control inflation”. This implies that in countries with history of inflation control problems, usefulness of inflation targeting may be limited. Alan Bollard (2008) in his speech said that “Inflation targeting is not an elixir for stabilization. Independence and accountability arrangements for central banking lead to heightened expectations of what monetary policy is actually able to achieve.” So, it will not be effective as a standalone policy. A prerequisite for inflation targeting is co-ordination with fiscal policy.
  1. Inflation targeting commitment may not be sustainable under certain conditions. In some cases, what may appear as initial success can lead to adverse impact in future, particularly when required fiscal backup is missing. Similarly, if the inflation target projections cannot be supported with credible explanation of how central bank intends to achieve the desired target, it will undermine its credibility and worsen the situation. For example, if central bank is at zero bound of its policy rate and has no room to influence inflation. Thus, Inflation Targeting is therefore not recommended for the Bank of Japan. (CA Sims, 2003). So, every country must assess its economic conditions and determine if it’s a suitable policy or if it can be tailored to suit their conditions. For example, in open economies where the exchange rate impacts output and inflation, the effectiveness and implementation of inflation targeting must be carefully analyzed. (Sarwat Jahan)
  2. Other Limitations:
  1. Central Bank may overlook more pressing issues like unemployment, exchange rate fluctuations and other macroeconomic variables.
  2. During financial crisis, inflation targeting, particularly if rule-based, may restrict central bank’s ability due to reduced flexibility.
  3. Possible instability in case of large supply-side shocks
  4. Since inflation targeting success depends on anchored expectations, lack of public support can undermine its effectiveness
  5. Monetary policy impacts inflation with a substantial delay (CA Sims, 2003). So, policy decisions are based on projections and unexpected events may hinder achievement the desired target.
  6. Although a much debated point, some argue that higher inflation may be good for economy at times and lower inflation may not always imply stability.

OptimalInflationRate (5-10%)

Currently, there is no consensus among the a various economic researches about the optimal inflation rate. Most economists agree that inflation should not fall below zero since the costs of deflation are high. They, however, disagree about how much ‘above zero inflation’ should a central bank target.

Many central banks, however, have a similar policy: an inflation target around two percent. These include the Federal Reserve (which calls two-percent inflation a “longer-run goal”), the European Central Bank (which aims for inflation rates “below, but close to, 2%”), and most other central banks in advanced economies (Laurence Ball, 2014).

The criterion to set optimal target will depend on the country’s the monetary transmission mechanism model and on the stabilization objectives of the monetary policy. (Giannoni et al,2003)

References:

Challenges of inflation targeting for emerging market economies: The South African case. InConference Papers on Challenges for Monetary Policy-makers in Emerging Markets, South African Reserve Bank.

Sarwat Jahan: https://www.imf.org/external/pubs/ft/fandd/basics/target.htm

Guy Debelle et al: https://www.imf.org/external/pubs/ft/issues/issues15/

Allan Bollard: https://www.bis.org/review/r080731c.pdf

Laurence Ball: https://www.imf.org/external/pubs/ft/wp/2014/wp1492.pdf

Marc P. Giannoni,Michael Woodford: https://www.nber.org/papers/w9939.pdf

https://www.imf.org/external/pubs/ft/fandd/2010/03/pdf/roger.pdf

https://www.imf.org/external/pubs/ft/wp/2008/wp08234.pdf

https://www.imf.org/external/pubs/ft/wp/2013/wp1321.pdf

https://www.bis.org/review/r131205g.pdf

https://www.imf.org/external/pubs/ft/sdn/2012/sdn1201.pdf

Important Elements for Inflation Targeting for Emerging Economies: Prepared by Charles Freedman and Inci Ötker-Robe

https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp026.pdf

https://www.nber.org/chapters/c9562.pdf

https://www.newyorkfed.org/research/epr/97v03n3/9708part1.pdf

https://siteresources.worldbank.org/PGLP/Resources/Session8.pdf

https://www.economicshelp.org/blog/5397/inflation/inflation-targetting-pros-and-cons/

Appendix

Targeting inflation

There are 28 countries that use inflation targeting, fixing the consumer price index as their monetary policy goal. Three other countries—Finland, the Slovak Republic, and Spain—adopted inflation targeting but abandoned it when they began to use the euro as their currency.

Country

Inflation targeting adoption date

Inflation rate at adoption date (percent)

2010 end-of-year inflation (percent)

Target inflation rate (percent)

New Zealand

1990

3.30

4.03

1 – 3

Canada

1991

6.90

2.23

2 +/- 1

United Kingdom

1992

4.00

3.39

2

Australia

1993

2.00

2.65

2 – 3

Sweden

1993

1.80

2.10

2

Czech Republic

1997

6.80

2.00

3 +/- 1

Israel

1997

8.10

2.62

2 +/- 1

Poland

1998

10.60

3.10

2.5 +/- 1

Brazil

1999

3.30

5.91

4.5 +/- 1

Chile

1999

3.20

2.97

3 +/- 1

Colombia

1999

9.30

3.17

2 – 4

South Africa

2000

2.60

3.50

3 – 6

Thailand

2000

0.80

3.05

0.5 – 3

Hungary

2001

10.80

4.20

3 +/- 1

Mexico

2001

9.00

4.40

3 +/- 1

Iceland

2001

4.10

2.37

2.5 +/- 1.5

Korea, Republic of

2001

2.90

3.51

3 +/- 1

Norway

2001

3.60

2.76

2.5 +/- 1

Peru

2002

–0.10

2.08

2 +/- 1

Philippines

2002

4.50

3.00

4 +/- 1

Guatemala

2005

9.20

5.39

5 +/- 1

Indonesia

2005

7.40

6.96

5 +/- 1

Romania

2005

9.30

8.00

3 +/- 1

Serbia

2006

10.80

10.29

4 – 8

Turkey

2006

7.70

6.40

5.5 +/- 2

Armenia

2006

5.20

9.35

4.5 +/- 1.5

Ghana

2007

10.50

8.58

8.5 +/- 2

Albania

2009

3.70

3.40

3 +/- 1

Sources: Hammond, 2011; Roger, 2010; and IMF staff calculations.

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