Inflation Targeting - Coursework Example

Inflation targeting Introduction In today’s era when the dominated strategies have been replaced by market oriented reforms, free markets and private enterprises are the ones working more towards economic growth and government is playing its role by creating fiscal, regulatory, trade and environmental policies and building physical and institutional infrastructures for the market. Monetary policy is one of the key responsibilities of the government as it the direct determinant of inflation and a low stable inflation is important for market driven growth. Thus central bank works to create monetary policies which would contribute to stability and growth of a country and one such is the inflation targeting policy. Inflation targeting is an economic policy in which a central bank estimates and sets public a project inflation rate and then tries to push the actual inflation towards the target by using interest rate changes and other monetary tool. As the interest rate and inflation rate are inversely related the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. The scenarios are; when inflation rates are above the target, the bank raises interest rates, this usually (but not always) affects over time on cooling the economy and bringing down inflation. And the opposite, when inflation appears below the target, the bank lowers interest rates, this usually (again, not always) affects over time on accelerating the economy and raising inflation. The first country to adopt inflation targeting was New Zealand. Soon other countries also joined. The European Central Bank alludes to inflation targeting in its strategy statements, as do many countries in Eastern Europe that hope to join the European Union. Presently there is no country that has introduced inflation targeting and then abandoned it. Basic aspects of inflation targeting The central bank controls the inflation rate of the country, price shocks such as indirect taxes, commodity prices, or interest rates themselves are usually excluded in the calculation of inflation targets. There is also flexibility given in pursuing other goals like output stabilization through the commitment of central bank to control inflation. The central bank is operating not against current inflation but expected inflation in the near future. Inflation targeting rests on following 3 foundations, first the provision of a nominal anchor for policy, transparency, and credibility. Second a nominal anchor may be required if countries permit their exchange rates to vary and if they do not target either the growth of monetary quantities or nominal income. And third governments or their central banks may need such an anchor to stabilize inflation, and they can generate the anchor by announcing an inflation target and then doing what they must do to hit that target. Role of bank of England and monetary policy In 1997 the bank of England was given independence to set interest rates by the new government. This changed the policy framework, no longer the interest rates were setup by politicians. The inflation target was set by the chancellor and the government no longer interfered. The bank was accountable to parliament and the public. This decision was made official in 1998 Bank of England Act. The goal of policy was set by the government and amongst the goal primacy was given to price stability. Monetary policy decisions in the UK are made on monthly cycles by the nine people in the monetary policy committee (MPC).the member include, 5 insiders (the Governor, two Deputy Governors and two of the Bank’s Executive Directors) and 4 outsiders. Out of these 9 members, 7 are appointed by the government and 2 by the bank. MPCs have to give explanations of their deeds in many ways like through the published minutes of their monthly meetings; Through published quarterly Inflation Reports; Through appearances by MPC members before Parliamentary committees (including after the publication of the Inflation Report); through the Bank writing to the Chancellor in the event of the inflation target being breached by one percentage point in either direction; And through an override (of the Bank’s interest rate decision) clause, which allows the Chancellor to exercise interest rate control in extreme economic circumstances. This inflation targeting step has shown many benefits; credibility measured by inflation expectations relative to target has improved throughout the periods. In 1992 inflation expectations were 5-7% at maturities 10 to 20 years ahead well above the inflation target at the time of 1-4%. By April 1997, five years of rule, inflation expectation had ratcheted down to 4%. In 1997 the banks became independent and there was a further fall in inflation expectations across all maturities. By the end of 1998, inflation expectations at all maturities along the inflation term structure were around the UK’s 2.5 % inflation target. They have remained at that level since then. Operational issues The key operational issues that rise at the time of implementation of inflation targeting are; defining the targets, choosing the numerical values for the targets, time horizon over which the target is relevant, the conditions (if any ) under which the targets can be modifies, how to go about hitting the targets and how to handle unintentional target misses. Communication issues On setting up inflation targets the central bank need to communicate with the public to maintain credibility. It has to provide timely information about the economy, bank’s monetary policy and its policy intentions. It has to explain inflation targeting polices and strategies, the report and analysis of inflation indicators including both private sectors forecast and central banks forecast. Thus this is all a complicated issue. Measures of inflation The first step in designing inflation targeting is to choose a price index whose rate of change is targeted. The price index should be one with which people are familiar with and one which is broad based, accurate and timely. This will increase its transparency. The index should rule out price changes and one time price jump which can effect core inflation. The central bank measures the rate of inflation by reference to consumer price index. Price stability is stressed out when choosing numeral value for inflation target. The central choice of target affects the trade-off between flexibility and transparency. The tighter the targets are specified over shorter terms the less ambiguity there is the communication between central bank and the public, but in the short run there is a restriction on the freedom of the central bank. Another choices which the central bank has as make is to whether announce its targets at a single point or around range of points at some midpoint. If a range is chosen by the central bank then a narrow range will communicate a higher commitment by the central bank to nearing its inflation goals then does a broader range. It also reduces the bank’s ability to respond to unforeseen events. The damage of credibility of missing a target range is greater than that of missing a target point. Specifications of the inflation targeting In UK the inflation targets are accepted by the government on an annual basis. The countries inflation rate is 2.5%. The reasons for choosing 2.5% rate are; There are well-known measurement biases in the UK’s CPI; they estimate these biases to be around 1% on an annual basis in line with other developed countries An inflation rate of 2-3 % is in line with the current inflation norm in other developed countries, and the other inflation-targeters. And most important, 2-3 % seems to be close to the general public’s preferred inflation rate in the UK (Haldane 2000). Inflation adversely affects the GDP, not necessary its growth rate. An example has been provided by Feldstein (1997); he considers the welfare costs of inflation’s interaction with the capital income taxation system in the U.S. Feldstein estimates the GDP-equivalent welfare gains from reducing inflation from 2 % to zero in the U.S. to be around 1% of GDP. Similar-sized numbers have recently been found for the UK, Spain, Germany, New Zealand and elsewhere as shown in table; US UK Germany Spain 0.68 0.21 0.85 1.47 (Haldane, 2000) Monetary policy committee The bank has created new committee to set interest rates known as monetary policy committee (MPC). Its current members are Mervyn King, Governor, Charles Bean, Deputy Governor, Paul Tucker, Deputy Governor, Kate Barker, Spencer Dale, Paul Fisher, David Miles, Adam Posen and Andrew Sentance. They are all experts in economics and monetary policy. They are independent to vote for setting suitable interest rates. The MPC’s decision reflects the votes of each individual member of the committee. Treasury representative is also present with the committee at the time of the meeting so that the chancellor is fully informed about the monetary policy. MPC’s meetings are held every month to set interest rates. The Bank of England throughout the month sends briefings about the economy to the MPC. The nine members of the Committee are made aware of all the latest data on the economy and hear explanations of recent trends and analysis of important issues. The MPC has to explain its thinking and decisions, their meetings are published 2 weeks after the interest rate decision. The Bank publishes its inflation report quarterly, giving the analysis of UK economy and factors influencing policy decisions. Dealing with uncertainty While forecasting Inflation, there are many errors to deal. The benefits of presenting an inflation forecast are; publishing a forecast distribution means that the general public is not focused on a single point inflation forecast. The central bank is thereby not open to criticism for having got the forecast wrong when, given shocks; this is an expected part of the forecasting process, and Distribution quantifies the extent of likely forecast uncertainties, how likely it is that inflation will miss its target, the distribution also embodies asymmetries. It allows inflationary risks at different horizons to be unbalanced. And a quantified distribution allows policy to be exercised in an explicitly probabilistic fashion. There is a principal in UK that, if inflation deviates from the inflation target by more than 1% point in either direction, then the MPC have to write an open letter to the Chancellor. The letter will contain an explanation of why the deviation from target has occurred; an explanation of what the MPC intends to do about it; and a statement of the time horizon over which inflation is to be returned to target. Through the time horizon and output objectives the policy choices under the inflation targeting are frame worked. A partly another impact of inflation targeting was on estimated risk premium on sterling assets versus a synthetic euro asset (comprising France, Germany and Italy). It went from positive in mid-1996 to strongly negative at the end of 1996 and through 1997. This is constant with the approval of sterling driven by reducing its perceived risk relative to euro currencies. Is inflation targeting a successful policy? The first three countries to experience inflation targeting were New Zealand, United Kingdom and Canada. Germany also joined the league. History has shown that the best time to implement inflation targeting policy is when inflation is threatening and out of control. Therefore it has been evident that inflation targeting has been a successful policy to adopt. It has been successful in increasing the transparency of monetary policy making and in reducing the rate of inflation in these countries without any negative consequence for outputs. The key elements for success of inflation targeting are flexibility and transparency which are adopted by most of the countries. At the time in 1990 when New Zealand was prone to high and volatile inflation it adopted inflation targeting regime which resulted in countries low inflation rate and high economic growth rate. Canada was more comfortable with inflation targeting with less rigid institutional structure. Inflation targeting in Canada has kept inflation low and stable. The key component of Canada’s success is strong and increasing commitment to transparency and the communication of monetary policy strategy to the public. After the foreign exchange crises in 1992 in United Kingdom, it adopted inflation targeting to restore a nominal anchor and to lock in past disinflationary gains. After its official acceptance it produced lower and more stable inflation rates. The Bank of England also focuses on transparency; it developed innovative ways of communicating with the public through inflation reports. UK’s central banks have set up examples for other countries to follow. The GDP over the years of UK was as follows; 1964 1969 1973 1979 1981 1990 2005 GDP 58.7 66.4 74.9 80.0 76.5 100 140.7 (Wall, 2007) Thus the GDP rose to a greater extent after 1998. The countries adopting the policy of inflation targeting have shown best practices in the operation of inflation targeting regime. Transparency and flexibility are two elements making the policy successful by lowering inflation rates. Additionally the policy does not abandon other economic indicators such as exchange rate of rate of economic growth. In the long run the inflation targeting has not produced any undesirable effects but came out with positive economic growths. Work cited 1. Ammer, John, and Richard T. Freeman, Inflation Targeting in the 1990s, The Experiences of New Zealand, Canada, and the United Kingdom, Journal of Economics and Business, 47:165-192, 1995. 2. Andrew Haldane, Ghostbusting: The UK Experience of Inflation Targeting, IMF publication, 2000. 3. Frederic S. Mishkin & Adam S. Posen, National bureau of economic research, Inflation targeting: Lessons from four countries, 9-110, Vol. 3, no. 3, August 1997. 4. Griffiths A. & Wall S., Applied Economics, 11th edition, Prentic Hall England. 5. Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, Adam S. Posen, Inflation targeting: lessons from the international experience, 1999, Princeton University Press. Read More