Should Inflation Targeting Be Abandoned in Favour of Nominal Income Targeting by Plessis and Rietveld - Article Example

Should inflation targeting be abandoned in favour of nominal income targeting? The modern economy operates under the money economy, where the value of money is not determined by any other commodity, other than money itself (Plessis & Rietveld, 2013:3). This therefore necessitates that the central bank has to take the full responsibility for controlling money, including the regulation of the money in circulation, regulating the credit conditions, controlling the rates of inflation and creating financial sustainability within the economies (Plessis & Rietveld, 2013:3). Thus, the central banks have adapted various rules known as monetary anchors, both formal and informal, for the purposes of effecting this monetary regulation. However, the monetary policies applied by the central banks have been associated with some limitations. Thus, experiments have been undertaken by monetary theorists and practitioners, and the final result was the adoption of inflation targeting system by many countries in the 1990s, as the tool for inflation and price control for central banks. Despite the limitations that have been associated with the inflation targeting system, its proponents have argued that it is an effective method of addressing the inflation issue within economies. This is because; it anchors the public expectations on the future developments, thus ensuring that the magnitude of the tradeoffs that the central banks will be forced to make, such as balancing output volatility and employment of resources in the economy, are not high (Plessis & Rietveld, 2013:10). Nevertheless, the inflation targeting mechanism has found major critics, owing to its various shortcomings, who in turn advocate for the application of the nominal income targeting as the alternative. Nominal income targeting has gained renewed attention, following the increasing rate of global financial crisis, as the best alternative that can be applied in place of inflation targeting, considering that inflation targeting has been associated with various inadequacies. Nevertheless, the application of nominal income targeting as an alternative to inflation targeting has established a big debate, since both methods are associated with some individual strengths and weaknesses. Thus, inflation targeting is associated with the weaknesses of lack of robustness in addressing supply shocks, its inadequate concern for financial instability and the worry regarding the accountability of the inflation targeting central banks (Plessis & Rietveld, 2013:5). On the other hand, nominal income targeting is argued to be capable of applying positively to the current macroeconomic environment, while still safeguarding the gains that have been made through inflation targeting (Plessis & Rietveld, 2013:5). A further criticism has been added, that inflation targeting is based on delusion that monetary policy can be able to influence inflation distinctly from the concept of nominal growth. Such critics observe that it is only the sum of real income growth and inflation that is responsive to the monetary policy, as opposed to any single factor (Plessis & Rietveld, 2013:5). The advantage that is being flaunted for the application of the nominal income targeting is that; in the current turbulent global economic system where recession is the order of the day, nominal income targeting will be able to stimulate economic growth. This is because; it will boost the aggregate demand in the economy, through creating lower real interest rates (Plessis & Rietveld, 2013:17). The stimulation of aggregate demand through the nominal income targeting can be achieved by raising inflation expectation in the economy, which will enhance demand, and then reducing the same when the demand in the economy has been increased. This will serve to boost the economy in the short run, on the event of a recessionary crisis (Plessis & Rietveld, 2013:11). The international financial crisis that faced many world economies in 2008-09 serves as the major reason that the nominal income targeting debate has gained a new momentum (Plessis & Rietveld, 2013:5). Thus, the concept of financial stability in the modern economies, as well as the role played by the modern central banks has become a subject of recent research. It has been argued that the role of the central banks in history has been the application of the monetary policy, with an assumption that financial stability would follow after the prices within the economy have been stabilized. This has resulted in ignoring the core function of central banks, which is achieving and sustaining financial stability (Plessis & Rietveld, 2013:6). Nominal income targeting has been proposed as the method capable of addressing the risks associated with the occurrence of modern financial crises. However, there are various deep seated issues that have not been addressed by the nominal income targeting proponents, which are fundamental to the achievement of the financial stability as the key factor in addressing international financial crises. First, the inappropriate financial regulation by the central banks has been the major cause of the international financial crises. Further, the application of interest rates as the sole tool for regulating inflation, achieving price stability and financial stability has proven inadequate (Plessis & Rietveld, 2013:16). It is the high gearing and the increasingly interlinked nature of the modern financial institutions globally that has been responsible for the international financial crises. Therefore, the need to establish new financial regulations to suit this new development is significant for the achievement of global economic stability (Plessis & Rietveld, 2013:9). Further, the capital flow policies of the developed economies have had the negative effect of causing the excessive flow of capital to the emerging markets in the short-run, causing the loss of competitiveness in the export markets. Secondly, there are several areas in which the theoretical models guiding the monetary policy need to be revised. The theoretical monetary policy models have been unable to anticipate the risks that are associated with financial crisis, since the asset markets and the financial sector have played no role in those models. Therefore, the major theoretical challenge facing the modern generation is the development of new theoretical models, in which the financial sector and the asset markets will be significantly studied (Plessis & Rietveld, 2013:7). During the occurrence of financial crises, the central banks have implemented policy measures that have not applied solid theoretical models, resulting in the unintended consequences due to a lack of the necessary theoretical framework. The inclusion of the effect of asset price bubbles is another major area that needs to be incorporated in the new theoretical models, since the financial crises that has hit the global economy have indicated that distinct policy tools for asset bubbles need to be established, which are different from those applied to achieve price stability (Plessis & Rietveld, 2013:8). Therefore, it can easily be observed that the nominal income targeting concept does not address the fundamental issues of returning to the core of the central bank function of sustaining financial stability. Therefore, there is a need to address the issue of reverting to the core function of the central banks, but not through applying nominal income targeting as the alternative. This is because; the concept of inflation targeting by itself does not address the above fundamental issues, and the nominal income targeting has also failed to address these fundamental shortcomings of the modern global economy (Plessis & Rietveld, 2013:12). Nominal income targeting has been advocated as the means that can help in the joint attainment of price stability and full employment. The major role of central bank is to keep the rate of inflation close to the numerical inflation target or target range, and to keep the economy growing at the potential rate (Plessis & Rietveld, 2013:11). The prudent application of the monetary policies by the industrialized countries in the 1980s and the rise of central banks in the emerging economies during this period serve to indicate that the inflation targeting tool can be effective in controlling inflation and achieving financial stability (Plessis & Rietveld, 2013:13). Further, inflation targeting has largely succeeded to anchor inflation expectations, while also succeeding in delivering price stability, without introducing high costs in output volatility or real output. Therefore, it is apparent that substituting inflation targeting for nominal income targeting does not address any of the fundamental issues that are related to the achievement of the financial stability (Plessis & Rietveld, 2013:17). The positive argument for nominal income targeting holds that real interest rates can only be lowered, where the inflation expectations are pushed higher (Plessis & Rietveld, 2013:18). Where there is a low or zero expected growth rate, the announcement of an income nominal target will have the effect of raising demand in the economy during the short-run period, since the expectation of higher inflation arising from this announcement would lower the real interest rates, stimulating the demand needed to boost the economic growth again. Therefore, under the nominal income targeting, it is possible for the central bank to apply the forward guidance strategy, where the banks can consistently maintain low rates of interests to create inflation expectations, and thus make it possible to stimulate economic growth in the periods of high recession (Plessis & Rietveld, 2013:20). In addition, through the nominal income targeting, it is possible for the central banks to apply the quantitative easing tool, which entails the use of the central bank’s balance sheet in purchasing assets, which can then be applied to stimulate the economy later (Plessis & Rietveld, 2013:21). However, one thing that does not remain clear with the nominal income targeting strategy, is how the inflation expectation will be raised without adjusting the interest rates (Plessis & Rietveld, 2013:22). In addition, the practical challenges associated with the implementation of the nominal income targeting, such as the mismatch in the availability of the GDP data and the inflation data will cause a miscommunication, which will in turn affect the central bank’s ability to control inflation and prices (Plessis & Rietveld, 2013:22). Further, nominal income targeting places a higher burden of communication on the central bank, meaning that the clarity and ease of communication of concepts like the GDP, which are well understood under inflation targeting, will be reduced with its implementation (Plessis & Rietveld, 2013:21). Therefore, with both practical and theoretical challenges surrounding the nominal income targeting, the case for its implementation, compared to the way inflation targeting has been implemented, is weak. Reference Plessis, S. D. & Rietveld, M. (July 2013) ‘Should inflation targeting be abandoned in favour of nominal income targeting?’ Stellenbosch Economic Working Papers: 12/13. 1-28. Read More