Densil Williams | Is inflation targeting the answer?
There seems to be general consensus in policymaking circles that the International Monetary Fund (IMF)-inspired inflation targeting technique is the most suitable nominal anchor for the Jamaican economy at this time.
A nominal anchor is generally used to tie down price levels in the economy in order to ensure greater levels of certitude in economic planning and, among other things, stimulate investments to drive higher levels of economic growth.
Inflation targeting is mostly used in contexts where inflation is high and running uncontrollably to some point that can result in the extreme outcomes such as social and political unrest as people's purchasing power is eroded.
Surely, in the case of Jamaica, this has not been the case for more than a decade. Since 2008, Jamaica has been seeing a steady decline in inflation. Today, inflation is at a historically low level at 5.2% for 2017. This is not to say that given our mercurial relationship with this variable, it cannot find its way back to the dreadfully high double-digit levels in the 1980s and 1990s.
However, with the directionality within the macroeconomic policymaking environment and the level of institutional strengthening taking place, moving back to the days of high and runaway inflation is not a likely outcome in Jamaica.
So if we accept that inflation targeting is aimed at removing high inflation and generate greater certitude in economic planning, since we are not in an environment of high inflation, and the chance of getting back there is very, very slim, the question is: Is inflation targeting the most appropriate nominal anchor for Jamaica given its contextual realities?
Currently, almost 30 countries worldwide are using inflation targeting as the nominal anchor in their monetary policy framework. These countries, starting with New Zealand in 1989, adopted inflation targeting as the goal of monetary policy when they had a problem with high inflation. Canada, the United Kingdom, Poland, and Colombia all had inflation in high single digit and some in double digits when they moved to adopt inflation targeting to keep down prices in their economies.
Prior to a direct targeting of inflation, central banks, to control inflation, targeted the growth of money supply. However, recognising that there was not much success in dealing with runaway inflation, they went for another option.
The early adopters of inflation targeting, therefore, went to direct targeting of inflation as they recognised that they could not predict and control, with any great level of accuracy, the growth of money supply given the complexities in the financial markets that make the demand for money quite volatile.
Directly targeting inflation instead of the money supply, the argument goes, will give a better outcome because policymakers have a better understanding of the link between monetary policy instruments and inflation. In other words, there is greater understanding of the transmission mechanism from policy instruments to inflation compared to how the money supply works.
So in essence, directly targeting inflation as the aim of monetary policy works best in countries where policymakers have a good understanding of the transmission mechanism through which money flows. Unfortunately, it is not clear to me that this mechanism is clear and well understood in the context of Jamaica. A clear example is the speed with which the BOJ reduces interest rates, but the less-than-favourable matching of this speed at the level of commercial banks.
Openess and infation targeting
The success of targeting inflation in the context of a highly import-dependent economy is not always clear. In the context of a small, open, highly important dependent economy where almost everything we consume, we have to import, an unstable exchange rate will definitely have a big impact on the price for basic goods and services that we consume.
When the exchange rate moves from J$120 to J$137 to US$1, my holiday on the north coast, which was costing me J$120,000 three weeks prior, is now costing me J$137,000, a whopping J$17,000 increase in less than one month.
This same scenario can be used to illustrate the unexpected costs that thousands of small businesses buying raw materials overseas in order to produce and sell locally face when the exchange rate fluctuates. So, although inflation is targeted at, say, 4%, with the exchange rate depreciating by 14% in three weeks, the unintended costs that businesses and consumers face will be more than 4% in nominal terms.
The heavy burden of the deprecation will have to be passed on to the consumers in the form of higher prices, and some of it will also have to be absorbed by the enterprises. The intended outcome of keeping prices low, using inflation as the nominal anchor, will not always be achieved in this context.
Stabilising exchange rate
It appears to me that a direct outcome of monetary policy in the context of Jamaica should be exchange-rate stability. The impact of volatility in the exchange rate is definitely more devastating to businesses and consumers than marginal movements in the inflation rate.
The nominal anchor that policymakers should be using to tie down price levels, therefore, in the context of Jamaica, is the exchange rate. This is much more useful given our context. For, if inflation targeting is to be successful, it will require full independence of the central bank and that the central bank focus exclusively on inflation and not target other variables such as wages, employment levels, or the exchange rate.
It means that in our context, if the exchange rate is left to be fully flexible, businesses will, more than likely, face much greater uncertainty in their cost structure, given the heavily import-dependent nature of our industrial sectors.
It would be prudent, in Jamaica, that the central bank, through its monetary-policy framework, play a key role in ensuring stability in the currency as this variable seems to be more critical, in the current environment, in delivering stronger levels of certainty to businesses and consumers, than the inflation rate. The monetary policy framework on the choice of nominal anchor, therefore, will have to be discussed in greater detail.
But surely, it cannot be a hard targeting of inflation without any direct focus on the exchange rate. I am not advocating for a pegged exchange rate system as it would give less flexibility to use monetary policy to stimulate the economy in turbulent times, especially given the limited fiscal space of the Government. However, it cannot be left to extreme volatility as well.
While inflation targeting has been practised successfully by a number of countries since 1991, it has not been a panacea to their growth problems. Indeed, in Jamaica's case, the exchange rate seems a more critical variable to be targeted. As such, it should not be subordinated to inflation as the outcome of monetary policy.
A broader debate on the role of the exchange rate, especially the real effective rate in the economy, is needed.
- Densil A. Williams is professor of international business at the UWI.