The Hindu Business Line : A teenage concept for the staid old bank

A BUBBLY 15-year-old in the field of economics is inflation targeting. It was born in 1989 when New Zealand rewrote its Reserve Bank charter and brought in the need to make public announcement of official targets for the inflation rate. "For historical completeness" there is an acknowledgement on www.rbnz.govt.nz that "Italy, Greece and Portugal had all used published targets for inflation at times during the early 1980s, and Sweden had briefly operated a form of inflation targeting in the 1930s."

Yet, credit goes to Kiwis for "completing the first codification of inflation targeting as a framework for the conduct and evaluation of monetary policy," as Mr Edwin M. Truman acknowledges in a new book on the subject from Viva (viva@vivagroupindia.net).

The author identifies "six principal strands of thought" as intellectual origins of the concept. First is the ancient argument of microeconomic costs of inflation. Next comes the "political recognition that higher inflation is associated with lower than higher growth in the medium term." Third, there has been a perpetual search for `a better anchor', even as the ship of economy is let down by other pet theories. Fourth, studies of alternative monetary policy regimes have focussed on "expectation formation" and emphasised on transparency. Fifth comes "a favourable global macroeconomic environment" after New Zealand opened the score. And, lastly, there is the need for "a defence against the growing risk of deflation", so inflation targeting could lead to "a more proactive rather than reactive policy posture".

There are four principal elements of inflation targeting framework. These are the stated goal of price stability (and, at times, currency stability), target number or sequence of targets so inflation is a point or range, time horizon for achieving the targets, and mechanism to evaluate if the goal has been reached.

To know how inflation targeting is in practice, let us look at some recent developments. For instance, on http://business.iafrica.com, economist Mr Helmo Preuss has written how inflation targeting in South Africa "has delivered with a vengeance" because "the annual average consumer inflation rate of 1.4 per cent in 2004 was the lowest since 1963".

Turkey is planning to shift to a formal policy of inflation targeting from early 2006, reports www.portalino.it. An interesting story on http://quote.bloomberg.com is on Bernanke vs Greenspan on `inflation goal'. In Zambia, the central bank Governor, Mr Gideon Gono, has succeeded in his inflation-targeting plan: Annualised rate of inflation declined "from a peak of 622.8 per cent in January 2004 to 132.7 per cent by December 2004", as www.fingaz.co.zw informs; and if that makes you giddy already, Mr Gono's target for this year is 20-35 per cent.

More than 20 countries, making up about 10 per cent of the membership of the IMF and "more than 20 per cent of world GDP measured on a purchasing power parity basis," have adopted inflation targeting. The list includes Australia, Brazil, Canada, and so on, but not India. Mr Truman calls G3 (Euroland, Japan, and the US) and Switzerland "de facto inflation targeters," because they are committed to low inflation; something they have etched into their monetary policies. Yet, he thinks of a scenario when all the three embrace inflation targeting jointly. Though such a collective move is not sine qua non for the international financial system, Mr Truman is positive about the advantages, especially because "downside risks are minimal."

The author groups 22 inflation-targeting countries and "46 other countries that might be considered potential inflation targeters" into four categories. Thus, `maintainers' have had stationary inflation, at an average of less than 5 per cent a year. `Convergers' are "well on their way to achieving stationary inflation". There are `squeezers' who are bringing down double-digit inflation rates to single-digits. And last come `reversers' whose inflation rate is negative; they are "seeking to raise inflation to a low positive rate on a sustained basis."

On what the pre-requisites ought to be for inflation targeting, there is some input you can cull from Economic Survey 2001-02. "It is imperative that the central bank should not be constrained to finance the Government Budget and must have an effective monetary policy instrument like the short-term interest rate that is fully market determined." Further on, the Survey talks of desiderata for the central bank — such as transparency, accountability, and "ability to forecast inflation and to assess the impact of monetary policy on inflationary expectations".

A logical question would be whether India is ready for inflation targeting. The Survey concedes that there is no technical difficulty, but there are at least three constraints. "First, the debt management function gets inextricably linked with the monetary management function while steering the interest rates. Second, in the absence of fully integrated financial markets, which remain still imperfect and segmented, the transmission channel of policy is yet to evolve fully. Third, a fully dependent measure of inflation for targeting purposes needs to be developed."

Before dismissing the idea, we may have to pay heed to what Mr Jarle Bergo, Deputy Governor of Norges Bank (central bank of Norway), said about two weeks ago: That Norway's current economic policy, with an inflation target for monetary policy and a fiscal policy rule, "is partly based on the insights of Finn Kydland and Edward Prescott," the two who won the 2004 Nobel Prize in economic sciences "for their theoretical studies in the 1970s on economic policy rules and the importance of anchoring economic agents' expectations".

To reinforce, while commenting on a paper titled The Macroeconomic Effects of Inflation Targeting by A. T. Levin, F. M. Natalucci and J. M. Piger, Prof Harald Uhlig of Institute for Economic Policy, Humboldt University, observes, "The argument of Kydland and Prescott, that monetary policy pursuing short-term goals in a discretionary, opportunistic manner is worse than a policy committed to and sticking to an a-priori well-chosen course of action, is fundamental."

However, Prof Uhlig would conclude saying that inflation targeting "is an addition to current communications and discussions about monetary policy" offering some improvement to debate on monetary policy choices. Mr Truman is not categorical either, about the positives: "Inflation targeting may improve overall economic performance in many but not all cases, but the evidence on this point is not fully conclusive."At worst, therefore, inflation targeting may be a good PR exercise for the central bank. But first, you need to sell the idea to our policy makers and leaders.

Economics@TheHindu.co.in

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A teenage concept for the staid old bank