David Barnwell | Inflation targeting? Why?
I take issue here with the expressed intention of the monetary authorities to 'advance', in the near term, towards an inflation-targeting model of fiscal and monetary management for Jamaica.
An inflation target is classified as one of the 'nominal anchors' for managing a country's macroeconomic affairs via a pivotal objective in the form of a performance indicator that is connected to, and interdependent with, other key macroeconomic and social policy performance indicators.
The 'nominal anchor' is selected, among other properties, for its potential to rally the support and active, willing cooperation of the economy's micro units - households (people) and firms - around those measures that are supportive of the maintenance of the anchor and, ultimately, supportive of the macroeconomic and social goals for whose desirability a national consensus exists.
Macroeconomic stability, in particular price stability, is a key objective of the anchor and indeed a key ingredient of successful macroeconomic management practice.
The nominal anchor can be an inflation target, a money-supply aggregate, a real growth rate target, or an exchange rate target. But the inflation target has evolved as the nominal anchor in most developed countries, beginning with New Zealand in 1990.
An inflation target correctly stresses the extreme importance of the inflation rate, or, more directly, price stability, for all other indicators of macroeconomic performance, including real GDP growth, external competitiveness, and balance of payments and has historically been set at approximately 2%.
The target should be understandable and be an indicator that is easily communicable to the public and with which the public can establish an 'easy' emotional association. Based on all these characteristics, I suggest that an exchange rate target, or an exchange rate target range, is a more suitable nominal anchor within our current social and economic realities than the inflation rate. I suggest also that any nominal anchor should be 'surrounded' by broad-based macroeconomic management practices that apply all the tools - fiscal and monetary - in concert with the quantified anchor.
An instance of successful enactment of this flexibility was Germany's highly successful aggregative monetary targeting regime under finance ministers Helmut Schmidt and Hans Apel, who were not hesitant in reflating the German economy after the second negative supply shock consequent on the oil price increase of 1980 (the first was in 1973). Within this policy flexibility, inflation was 'allowed' to rise from 3.5% to 4%, even though it placed temporary upward stress on the aggregative monetary target.
'Full court' strategy
In any case, I believe that our monetary and fiscal authorities are already committed to this 'full court' strategy. The only issue, therefore, is whether the inflation rate, or another indicator such as the exchange rate, is more qualified to be the 'policy vanguard'.
In a presentation in 2003 on the efficacy of an inflation target for the US economy, Ben Bernanke, then a member of the board of governors of the Federal Reserve System, bifurcated the inflation targeting approach between:
- The 'policy framework' of inflation targeting; and
- The 'communications strategy' of inflation targeting.
The 'policy framework' involves the formation of principles governing the decisions concerning the key instrument(s) of monetary policy, typically a short-term signal interest rate. The 'communications strategy' covers the 'central bank's regular procedures for communicating (to) the political authorities, the financial markets, and the general public' the quantified policy objectives with timelines, and discussions of the bank's decision making.
This very important part of the process is meant to garner and nurture public trust, through transparency, of the bank's commitment to its 'anchor' objective, and, ultimately, its commitment to stability and to progressively institutionalise public expectations of low inflation. These are the general credentials demanded of any 'nominal anchor', but they should adjust to the specific circumstances and challenges of the time and place which they serve.
I had mentioned earlier that New Zealand was the first country to adopt an inflation target as a nominal anchor (3%-5% in 1990 and subsequently 2% by 1996). This policy decision was triggered by an unacceptably high inflation rate prior to 1990 of above 5%. The 'target' regime succeeded in reducing the rate of inflation to 2% by 1992 and contributed to a real GDP growth rate since 1992 in excess of 5%.
But this success was preceded by a deep recession and a sharp increase in unemployment that reached 10.7% in 1992. Canada's experience with an inflation-targeting regime (2%-4% in 1992) bore stark similarities to New Zealand's, with success in reducing the rate of inflation from above 5% to less than 2% at a cost of soaring unemployment (above 10%) in the period 1991-1996.
In the UK, unemployment, also rose after inflation targeting was adopted in late 1992 but was followed by impressive real GDP growth thereafter. So the story of inflation targeting in these developed countries was uniformly characterised by a period of sharp increases in unemployment as the rate of inflation was reduced, followed by impressive real growth performances.
Our rate of unemployment currently stands at 9.7%, with youth unemployment at 22.3%. This reduction in the rate of unemployment is attributable, in part, to the growth of the BPO sector. Despite progress in implementation of macroeconomic policies with regard to fiscal discipline, economic growth and other social outcomes continue to lag. Real growth has averaged 0.9% over the duration of the IMF standby arrangement. An inflation-targeting regime would not, in general terms, be supportive of growth if the targets are to be adhered to, and, therefore, seems now ill-timed in the context of our current low-growth reality.
Furthermore, current BOJ observation, based in empirical reduced-form association, is that the exchange rate is the main transmission channel through which the implementation of monetary policy, as reflected in signal interest rates, is passed through to inflation with an average time lag of two to three quarters (six to nine months).
The relationship between inflation and the exchange rate is intuitively understood by almost all Jamaicans, and exchange rate stability would, therefore, engender expectations (by both buyers and sellers) of low inflation and general price stability. The expectations developed around a direct inflation target would not be as well formed and the indicator would convey less transparency.
The buy-in of the main micro units - firms and households - is vital for the efficacy of the nominal anchor as a bulwark against the so-called time inconsistency problem. On the other hand, adherence to a path towards an inflation target might involve, depending on the prevailing short-run economic conditions, adjustment to a signal central bank rate, which could change or destabilise the exchange rate, along with expectations concerning price stability.
Any tendencies to fiscal adventurism on the part of the political decision makers can more easily be dissuaded, with the support of households and firms, if it is shown by the monetary authorities that this fiscal adventurism would threaten the stability of the exchange rate.
The decision, therefore, to adopt an inflation-targeting regime is premature and effectively squanders the opportunities still available through the targeting of an exchange rate or a narrow exchange rate range. In any case, by the BOJ's reckoning, the exchange rate is now stable within a narrow range. The possible threats to growth and employment inherent in an inflation-targeting regime, as displayed by history, should be cautionary, especially at this time.
Given the current healthy level of reserves, the monetary authorities can, with sufficient clarity, signal a willingness and ability to defend the exchange rate target range (even without a formal peg). A deterrent, therefore, to speculative attacks, which is one of the possible weaknesses of a target exchange rate, can be mounted and sustained.
If the central bank were to continue to 'lean heavily against the wind' in a tightly managed float, the possible effects of any temporary supply price shocks such as a spike in oil prices triggered by a geo-political storm can be suppressed.
The suppression of inflationary expectations can be best achieved, in our 'historical' environment, by a stable exchange rate, which would be a clear demonstration, transparent to all agents, of functional stability.
- David Barnwell is a lecturer in economics at the University of Technology, Jamaica. Email feedback to email@example.com.