Tue | Sep 25, 2018

Briefing | Inflation targeting can reduce social welfare

Published:Wednesday | September 5, 2018 | 12:00 AMDr Andre Haughton
The Bank of Jamaica

The Bank of Jamaica (BOJ) continues with the Inflation Targeting strategy, let us explore why, as well as the advantages and disadvantages of doing so.


Elements of inflation targeting


According to Mishkin (2001) in order for the strategy of inflation targeting to be effective it must contain the following key elements:

1) The BOJ must publicly announce its medium-term numerical targets for inflation; for Jamaica its five per cent.

2) The BOJ must commit to price stability as the primary goal of monetary policy, to which nominal exchange rate controls and other goals are secondary.

3) Monetary policy must become more transparent through regular communication with the public and the markets about the plans, objectives, and decisions of the BOJ.

4) Increased accountability of the BOJ to attain its inflation target.


Much more than announcing a numerical target


According to Mishkin (2001), the elements outlined above should clarify that the process of inflation targeting is much more than a public announcement of numerical targets for inflation for the coming years. He outlines that many emerging market economies routinely reported numerical inflation targets or objectives as part of the government's economic plan for the coming year. Yet, their monetary policy strategy and the functioning of the economy does not reflect the elements of proper inflation targeting. As a result, their inflation target may not be credible over time.

If you look at the elements closely, all resemble the art of moral suasion, none appear to be an occurrence of the real economy. The central bank has two tools available to it - the money supply and interest rates, which impact the real economy through the monetary transmission mechanism.

In order to properly target inflation, the interest rate channel must be fluent, where commercial banks pass through benefits earned from a lower BOJ policy rate to consumers and investors. Prior to Jamaica adopting the inflation-targeting strategy, Haughton and Iglesias (2013) found evidence to suggest a weak pass-through rate in Jamaica and many other Caribbean countries. Mukherjee and Bhattacharya (2011) have found evidence to suggest that the adoption of inflation targeting, a monetary policy tool in emerging market economies, has not significantly affected the interest channels and, by extension, the fluency of monetary policy in emerging market economies.

This means that there is no guarantee that inflation targeting will increase the fluency of the monetary transmission mechanism and, as a result, might not improve the ability of the BOJ to achieve its objectives.


Why target inflation?


Inflation targeting is based on the premise that stable prices contribute to stable output over the medium to long term.

Inflation targeting is based on the government's aspirations to achieve a symmetric progression in output, so therefore, fluctuations above a specific inflation target is equally as bad as fluctuations below the inflation target, as it is price stability that will maintain output stability.

Inflation targeting is a medium-term phenomenon, so fluctuations in the short term are irrelevant. It makes no sense justifying quarterly or monthly deviations; the inflation target is for at least a one-year period.

Inflation targeting is based on core inflation, so it normally omits consumer items whose prices change easily.

It enables domestic monetary policy to respond flexibly to domestic shocks.

Inflation supposedly reduces politicising of monetary policy.

Disadvantages of inflation targeting:

Many economists have found evidence to suggest that inflation targeting might not be the correct strategy for developing and emerging market economies. According to Mishkin (2001):

- Inflation targeting might be too rigid.

- It allows too much discretion.

- It has the potential to increase output instability.

- It has the potential to lower economic growth.

These, Mishkin (1999) and Bernanke, et al (1999), outline are not so detrimental if the country's inflation targeting instrument is properly designed. But the following can be dangerous for emerging market economies:

- Inflation targeting weakens the accountability of the central bank because inflation is a real-life occurrence that is hard to control, and because there are long lags from the monetary policy instruments to the inflation outcome; this is an especially serious problem for emerging market countries.

- Inflation targeting might correspond to extreme exchange-rate flexibility that might cause financial instability.

Davis and Fujiwara (2015) have found evidence to suggest that inflation targeting works best in small, closed economy that does not participate much in international trade. For small, open economies who participate immensely in international trade, the overall welfare of the country increases if the central bank targets the nominal exchange rate.