Inflation targeting
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Inflation targeting is a monetary policy in which a central bank attempts to keep inflation in a declared target range —typically by adjusting interest rates. The theory is that inflation is an indication of growth in money supply and adjusting interest rates will increase or decrease money supply and therefore inflation.
Inflation targeting was pioneered in New Zealand in 1990,[1] and is now also in use by the central banks in United Kingdom (Bank of England), Canada (Bank of Canada), Australia (Reserve Bank of Australia), South Korea (Bank of Korea), Egypt, South Africa (South African Reserve Bank) and Brazil (Brazilian Central Bank), among other countries, and there is some empirical evidence that it does what its advocates claim. [1]
Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting.
Example A) if inflation appears to be above the target, the bank is likely to raise interest rates. This usually (but not always) has the effect over time of cooling the economy and bringing down inflation.
Example B) if inflation appears to be below the target, the bank is likely to lower interest rates. This usually (again, not always) has the effect over time of accelerating the economy and raising inflation.
Under inflation targeting, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.
The US Federal Reserve's policy setting committee, the FOMC (Federal Open Market Committee) and its members, regularly publicly state a desired target range for inflation (usually around 1.5-2%), but do not have an explicit inflation target. This is under debate within the Fed, since inflation targeting is usually very successful in other countries because of its transparency and predictability to the markets.
However, some counter that an inflation target would give the Fed too little flexibility to stabilise growth and/or employment in the event of an external economic shock. Another criticism is that an explicit target might turn central bankers into what Mervyn King (Governor of the Bank of England) termed "inflation nutters"[2] - that is, central bankers who concentrate on the inflation target to the detriment of stable growth, employment and/or exchange rates. King asserts that this has not happened in practice.
For the moment, the Fed continues without the strict rules of an explicit target. Former Chairman Alan Greenspan, as well as other former FOMC members such as Alan Blinder, typically agreed with its benefits, but were reluctant to accept the loss of freedom involved; current Chairman Ben Bernanke, however, is a well-known advocate of inflation targeting.[3]
[edit] Shortcomings
Inflation is usually measured as the change in prices for consumer goods, called the Consumer price index (CPI). Inflation targeting assumes that this figure accurately represents growth of money supply, but this is not always the case. The most serious exception occurs when factors external to a national economy is the cause of the price increases. The oil price increases since 2003 and the 2007–2008 world food price crisis combined to cause sharp increases in the price of food and consumer goods, which in turn resulted in a sharp increase in CPI. This is especially true in the very emerging markets that often follow the new policy of inflation targeting, because they are often dependant on imported oil or food.
Under such conditions increases in inflation (CPI) is not necessarily coupled to any factor internal to a country's economy and adjusting strictly or blindly adjusting interest rates will potentially not be ineffectual and restrict economic growth when it was not necessary to do so. Bernie Fraser, governor of Reserve Bank of Australia from 1989–1996, raised this conern in 2008 in response to another hike in their interest rates.[4]
As an example, since 2006 South Africa – an adherent to inflation targeting – has dogmatically increased interest rates in excess of 4% to track a rise in inflation even though the inflation continued to increase as it was due to was due to the aforementioned external factors of worldwide fuel and food prices increase. This stands in stark contrast to major central banks such as those of the US, England, Canada, Japan and Europe keeping their interest rates steady (in some cases even lowering) over the same period even though are exposed to the same global inflationary factors.
[edit] See also
[edit] References
- ^ Andrew G Haldane, Targeting Inflation, 1995
- ^ As quoted on page 158 of Poole, W. (2006), ‘Inflation targeting,’ speech delivered to Junior Achievement of Arkansas, Inc., Little Rock, Arkansas, 16th February 2006. Published in Federal Reserve Bank of St. Louis Review, vol. 88, no. 3 (May-June 2006), pp. 155-164.
- ^ See his many published works on the subject, for example: Bernanke, B. S. and Mishkin, F. S. (1997), ‘Inflation targeting: a new framework for monetary policy?’ in The Journal of Economic Perspectives, vol. 11, no. 2 (Spring 1997), pp. 97-116.
- ^ Ingemarsson, Petter. "Australia:inflation debate continues".
