2909 hits from the invisible hand

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Perspectives on inflation targeting after a
difficult year


Stan du Plessis Department of Economics University
of Stellenbosch stan_at_sun.ac.za
Parliamentary Committee on Finance 20 October,
2002
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Issues covered

• Recent concerns about domestic inflation
• The present debate on inflation targeting
• Reasons for inflation targeting
• Evaluating inflation targeting
• Some suggestions for domestic policy

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Present problems I

• Moderate (but rising) domestic inflation
• undermines the credibility of the framework for
  monetary policy
• SARBs track record and hence credibility harmed
• Government (having set the target) also suffers
  credibility loss

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Recent international inflation experience
Green indicates an inflation targeting country
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Present problems II

• Inflation forecasts not credibly within the
  target range in years to come
• undermines the credibility of policy making at
  the SARB
• however, there are no expectations of runaway
  inflation

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Result credibility deficit for monetary policy
BER survey of CPIX inflation expectations (in 3rd
quarter of 2002)
Sector 2002 2003 2004
Finance 9.2 7.1 6.2
Business 8.3 7.9 7.5
Labour 7.9 7.9 7.3
Target Range 3-6 3-6 3-5
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Issues covered

• Recent concerns about domestic inflation
• The present debate on inflation targeting
• Reasons for inflation targeting
• Evaluating inflation targeting
• Some suggestions for domestic policy

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Present debate on inflation targeting

• Three broad camps
• Group A
• Against inflation targets
• arguing that governments priorities are wrong
• Group B
• Targets are good, but the present targets are not
• some arguing that the target should be higher
  in a developing country
• Hence the SARB is (forced into) setting policy
  incorrectly
• Group C
• The present targeting regime is good
• Hence the SARBs decisions are sensible
• (Except that it may be time for the escape clause)

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Background to the debate on inflation targeting

• 3 observations about modern Central Banking
• Increasing adoption of explicit targets for
  monetary policy
• Also in developing countries
• Central Banks are gaining independence
• Associated with lower inflation
• At no cost to growth
• Helping the poor (who cannot hedge against
  inflation)
• Credibility increasingly recognised as crucial to
  the success of monetary policy
• Inflation targeting incorporates all of the above
  in a disciplined framework for monetary policy

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Reasons for adopting inflation targeting as a
framework

• Negative reasons
• Lack knowledge for fine tuning monetary policy
• Ensures consistent monetary policy over time
• Experience
• Capital flows cause problems for alternative
  anchors (for example, exchange rate targets)
• Positive reasons
• Solves the democratic deficit
• The problem of a (very) powerful, unelected,
  policymaking institution in a democratic country
• Helps to build credibility
• Good track record internationally

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Inflation targeting is an increasingly popular
tool for building credibility
Source Mishkin and Schmidt-Hebbel, 2001
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Evaluating inflation targeting

• Distinguish a number of different aspects of
  inflation targeting
• A. Ultimate objectives
• B. Transparency
• C. Final responsibility
• (the institutional design, accountability and
  independence of the MPC does not concern this
  meeting directly)
• (Government decisions have been underlined on the
  following slides)

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A. Ultimate objectives

• 3-step procedure
• Government defines clear goals for Central Bank
• goal dependence
• e.g. an inflation target
• Empower the SARB to pursue those goals
• Instrument independence
• Hold the SARB accountable for the achieving the
  goals
• Reasonableness of the target affects the
  governments credibility
• Present situation
• SARB has instrument independence
• Treasury sets the inflation target

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B. Transparency

• Public must be able to monitor the goals
• Major problem - control lag in monetary policy
  implies separate evaluation of
• The policy framework
• evaluated with the track record (mainly on
  inflation)
• Policy stance, given the framework
• forward looking evaluation using the inflation
  forecast
• SARBs credibility affected by both the framework
  and the stance of policy

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B. Transparency at SARB

• Fair degree of formal transparency
• But some shortcomings
• lack of openness
• No published model, no information of
  conditioning variables
• Policy signal of the fan chart cannot be
  monitored
• Hence, public cannot evaluate the stance of
  policy
• The choice of a band as opposed to a point target
• and narrowing of the range in 2004 by 33
• Hardening of the ranges upper edge
• does not reflect uncertainty of transmission
  mechanism
• undermines the evaluation of the policy framework
  and the credibility of the SARB

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International experience with the design of
inflation targets
Country Target Type Inception Escape clause
Mexico 4.5 Point Jan 1999 No
Chile 3 Point Jan 1991 No
Israel 1-3 Range Jan 1992 No
Korea 3 Point Jan 1998 No
New Zealand 0-3 Range March 1990 Yes
UK 2.5 Point Oct 1992 No
RSA 3-6 (2003) Range Oct 1992 Yes
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Further shortcomings

• MPC implements a forecast target
• specified as an average over a calendar year
• this does not give a clear policy signal
• and makes timing difficult as monetary policy is
  set continuously and not for periods matching the
  calendar year
• Further, the average inflation rate over a
  calendar year is a derived concept, and hard
  for the public to understand

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• MPCs target is tied to the calendar year
• would be preferable to have a rolling horizon
  (say 2 years) for the forecast target
• This would reflect the duration of the
  transmission mechanism more precisely than
  calendar year averages
• Allows for adjusting the target when opportune
• as opposed to tying these adjustments to calendar
  years

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Issues covered

• Recent concerns about domestic inflation
• The present debate on inflation targeting
• Reasons for inflation targeting
• Evaluating inflation targeting
• Some suggestions for domestic policy

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Recommendations

• Clarify the target as point-target with tolerance
  range
• new target could be 6 at a rolling 2 year
  horizon
• with 2 tolerance range on either side
• (Presently, the SARB is aiming at the upper end
  of the 3-6 range)

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Benefits of this clarification

• Provides a clear policy signal to the MPC for
  setting the stance of monetary policy
• in contrast with the target as calendar annual
  averages
• SARB target remains 6
• But takes account of uncertainty in the
  realisation of inflation on both sides of the
  target
• allowing credibility to be built for monetary
  policy
• allowing scope for lowering the target at an
  opportune time
• Removes the need for an escape clause
• Avoiding the associated credibility problem

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Credibility costs of these adjustments

• Government
• Effectively the forecast target remains unchanged
  at 6
• Government not seen to reverse policy in hard
  times
• Avoid impression that goal posts have been
  shifted
• SARB
• Cost in re-educating public about adjusted
  framework for monetary policy
• Have to emphasise the forward and backward
  looking aspects and 2 year rolling policy horizon
• But long term gain in credibility of improved
  target design

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The end