Setting an inflation target

  • Business
  • Thursday, 24 Nov 2005

Capital Talk: A comment by Tan Teng Boo, CEO, Capital Dynamics Sdn Bhd. 

BEN Bernanke, the incoming chairman of the US Federal Reserve, has openly said he favours inflation targeting. The outgoing chairman is opposed to conducting monetary policy in this manner.  

In a conference held at the Federal Reserve Bank of St Louis in October 2003, Bernanke said he thinks there is an optimal, long-run inflation rate “that achieves the best average economic performance over time with respect to both the inflation and output objectives”.  

He favours announcing an explicit target of around 2%, provided that the Federal Open Market Committee (FOMC) makes no particular commitment to a timetable for reaching the optimal rate. This proviso is important in conducting monetary policy, as it would make sure that there are “no unwanted constraints on short-run monetary policy”.  

In suggesting a numerical target near 2%, Bernanke emphasised that very low levels of inflation are generally preferred, but the inflation rates cannot be so low that the FOMC would face an unacceptably high risk of encountering the zero lower bound on nominal interest rates, as Japan experienced in the 1990s and the last few years.  

Otmar Issing, a European Central Bank executive board member and also a participant in the said conference, also thinks that 2% is reasonable because it offers “a sufficient safety margin against the risk of deflation”. What is inflation targeting?  

Ben Bernanke

i Capital on Feb 24, had already anticipated a switch in the way US monetary policy would be conducted. For this column, it would reiterate what it wrote at that time, as it appears that inflation targeting will be practised by the Federal Reserve.  

Briefly, inflation targeting is the adoption of explicit inflation targets as the defining principle underlying the conduct of monetary policy. The Reserve Bank of New Zealand has been a pioneer in inflation targeting when it was made responsible for maintaining New Zealand’s inflation within a specified range in 1990.  

With that, it became the first central bank in the world to be transparent about its policy objectives. Since then, many other central banks have also announced specific inflation targets. These include the Bank of Canada, the Reserve Bank of Australia, the Bank of England, Sweden, Switzerland, South Korea and also from emerging economies like Brazil, Chile, Hungary, Mexico, Peru, the Philippines, Sri Lanka, Thailand, Turkey, Czech Republic and many more.  

Inflation targeting has frequently occurred when the economic or pricing situation is sufficiently bad. In New Zealand’s case, her inflation record before 1990 was dismal.  

In contrast, given the strong sustained economic growth coupled with a controlled inflation rate in the last two decades or so, the need for the US to target inflation is not there. But with the impending retirement of Alan Greenspan, the need for ensuring and maintaining price stability is never greater.  

Unlike other central banks, the Federal Reserve has dual mandates. The Federal Reserve Act requires the Governors and the FOMC “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” In short, achieve price stability so that robust economic growth can be sustained. Can inflation targeting help achieve this? 

The advantages of inflation targeting are obvious. Economists nowadays agree that monetary policy cannot do much more than achieve some desired level of inflation and that its impact or influence on the real economy is unpredictable and should be used with caution.  

Arguments have been made that a monetary policy with short-term goals and conducted in a discretionary manner is worse than a monetary policy that sticks to a well-chosen course of action. Targeting inflation helps monetary policy to be committed to such a course of action.  

In addition, the explicit inflation targets make for an effective communications policy to the public. By defining what is meant by price stability, market participants would be better informed. In targeting inflation, the central bank must spell out:  

·Whether the target is a single number or a range; 

·What is the time interval for the target to be set; and  

·What measure of inflation should be targeted.  

In so doing, there is transparency over the objectives of monetary policy, clarity about current monetary policy actions and transparency about future policy actions.  

With the appointment of Bernanke, many uncertainties arising from Greenspan’s replacement have been greatly reduced. At the same time, energy prices have climbed down from their peaks and headline inflation rate should be less worrying in 2006. These should help assure the US equity markets and allow more time for the debate on the pros and cons of inflation targeting. 

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