DEENA KHATKHATE

I

The whole debate on inflation targeting has revolved around the possible shape of the so-called Phillips curve. Reactive inflation targeting owes its origin to the evaporation of the relationship between inflation and unemployment – the famous Phillips curve which explained on the basis of UK unemployment and price data in the 1960s that a percentage reduction in unemployment would lead to a certain rise of some magnitude in the inflation rate. Derived from this trade-off was an activist monetary policy – a policy well suited to political authorities and subservient central banks.

However, the relationship between inflation and unemployment broke down during the 1970s. Its place was taken by the concept of non-accelerating inflation rate of unemployment (NAIRU) introduced by Milton Friedman and Edmond Phelps, which ruled out reliance on the inflation-unemployment trade-off. Any expansionary monetary policy would trigger a pressure from the workers for raising their wages and hence inflation without any impact on the level of unemployment.

It was in the context of such a desideratum that the inflation targeting framework evolved. The rationale is that if a central bank sets an inflation target which is any point numerical value or a range of values, depending upon the monetary history of the country in question and its political economy, and then adjusts its monetary policy, principally the short-term interest rate, to keep prices near the target, the economic agents would conduct their profit-maximising productive activities without being distracted by relative price distortions. It is a sort of commitment and communicative device constructed with the prior agreement with the government, thereby demarcating the fiscal and monetary policy domains. If the forecast inflation rate based on an implicit or explicit model of the central bank exceeds the targeted inflation rate, the central bank steps up the short-term interest rate, so that the forecast rate remains in a targeted zone and vice versa.

However, recent developments arising mainly from growing globalisation seem to have revived the inflation-unemployment trade-off, indicating that the nonaccelerating rate of unemployment is moving downward without any pressure on prices thereby reviving a semblance of the Phillips curve. Only difference is that the newly invented Phillips curve is more flat than downward sloping [Economist 2006]. However the revival of the Phillips curve has not overshadowed the relevance of the inflation targeting framework. A headline inflation which includes volatile commodity prices is rising as a result of rapid globalisation, which suggests a need for a hike in interest rates. There is however, one major difference. After the revival of a flattened Phillips curve, the measure of inflation rate target followed by most of the inflation targeters seems to have changed from core to headline inflation rate, as will be discussed later in this article.

In discussions on inflation targeting, its one important dimension is passed over. If stable prices are indispensable for raising growth and employment, what would be the consequences of an onset of deflation? The logic of inflation targeting might imply an expansionary monetary policy to reverse the deflationary forces but the Japanese experience in the 1990s belied this logic. There is a certain asymmetry

– restrictive monetary policy can help to control inflation but expansionary monetary policy would not in a situation of a liquidity trap.

Misconception

There is a misconception about inflation targeting which needs to be clarified before proceeding to assess its empirical validation, or the inter-country comparisons of experiences in regard to the implementation of inflation targeting policy. It is argued that inflation targeting focuses on a narrow target of inflation to the exclusion of employment, growth, poverty alleviation and income distribution, which are dominant objectives in emerging or developing countries [Jalan 2000; Jha 2006]. A little digression is warranted to show why stabilising inflation also helps employment and output growth. The modern theory of monetary policy is based on the premise that monopolistically competitive firms set their product prices at

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Economic and Political Weekly December 9, 2006 a mark-up over marginal production cost so that their profits are maximised over time. This implies a monetary policy directed at low inflation ensures that the production costs rise at the targeted rate of inflation. As Goodfriend and Eshwar Prasad (2006) have so well put it:

The reasoning is as follows: First, an economy with a stable inflation rate must be one in which firms maintain their profitmaximising mark-ups on average, otherwise actual inflation would deviate from targeted inflation as firms attempt to restore their profit-maximising mark-ups. Second, an economy in which monetary policy sustains the profit-maximising markup would operate as if firms sustained the profit-maximising mark-ups themselves, by adjusting product prices flexibly, and continuously. Third, targeting inflation thus makes actual output conform to potential output, i e, the level of aggregate output determined by supply factors in an environment of perfectly flexible prices. Fourth, this reasoning implies that monetary policy geared to targeting inflation yields the best cyclical stabilisation of employment.

This holds true, when prices of production of the monopolistically competitive firms are relatively stable in prices. However there are some products like oil, food, etc, which are more flexible, being open to supply and demand shocks and this impacts heavily on the overall inflation. This suggests that the nominal anchor for monetary policy should be a core and not the headline inflation rate [Goodfriend and Prasad 2006]. On the basis of this rationale of monetary policy, inflation targeting stabilises not only the price level but also employment and output, thereby obviating a need for setting multiple targets for operating monetary policy.

There is a strong belief held that certain preconditions have to prevail in economies if they have to take recourse to inflation targeting framework. These are: institutional independence of the central bank, well-developed technical infrastructure, i e, a capacity to devise a forecasting model, fully deregulated prices and exchange regime and a healthy financial system [Eichengreen et al 1999]. However, this is not supported by the survey results of the IMF for 21 inflation targeting and 10 non-inflation targeting countries. “No inflation targeter had all these preconditions in place prior to the adoption of inflation targeting although unsurprisingly, the industrial country inflation targeters were generally in better shape than the emerging country inflation targeters at least in some dimensions” [IMF 2005, pp 176-77]. Only one-fifth of the emerging market targeters had central bank independence; they also faced a wide variety of fiscal imbalances; they had a higher level of public debt; most of them had little or no forecasting capability and no forecasting models at all; they were all sensitive to the exchange rate and commodity prices volatility; most of them had weak financial systems at the time of adoption of inflation targeting, low risk-weighted capital adequacy ratio, low capital market capitalisation, small size of the bond market and banks foreign currency open position [IMF 2005]. Thus, the absence of the preconditions by itself did not appear to militate against their adopting inflation targeting. What is surprising is that once these countries adopted inflation targeting, there was also improvement in their institutional structure, data availability and the forecasting capability. This raises a very interesting question: whether acceptance of inflation targeting framework itself was not instrumental in paving a way for a developed financial system and more autonomy for the central banks.

There is likewise a considerable debate about how inflation targeting impacts on the outcome – inflation, output, employment and their variability. Until recently the most-cited empirical studies on this issues showed that for the industrial country targeters, inflation targeting on the whole has been beneficial in regard to inflation reduction and output expansion but the statistical significance is limited [Ball and Sheridan 2003; Levin, Nattalucci, Piger 2004; Truman 2003; Hyvonen 2004]. But no firm conclusions can be drawn because the number of comparators against which their performance was evaluated was limited, their inflation performance had improved not necessarily due to the monetary policy in the 1990s, and most importantly, many of the countries in the group had already contained inflationary pressures as a preparation to joining the European Economic and Monetary Union.

In order to get more reliable empirical results about the impact of inflation targeting, the IMF analysed the data for 13 emerging market inflation targeters, and compared them against the remaining 22 emerging market countries drawn from the JP Morgan EMBI Index plus seven additional countries [IMF 2005]. The conclusions are the following: (i) Though the inflation rate declined both in the inflation-targeting and non-targeting countries, the fall in the former was much sharper; (ii) Transition of high and variable inflation that prevailed before adopting inflation targeting to low and stable prices was rapid and well sustained and this performance was superior to that of the non-inflation targeters; and (iii) There is no evidence that inflation targeters met their inflation objectives at the expense of real output.

Of course, all these results are subject to a caveat that it is very difficult to establish a firm causal relationship between inflation targeting and its final outcome in absence of the counterfactual. But this shortcoming is universal in all statistical exercises and for that reason, the conclusions based on

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Economic and Political Weekly December 9, 2006

them should be interpreted with due caution and should be supported from other available sources.

This impact analysis however differs from the results of Fraga, Goldfajin, Minella (2003) for the emerging market inflation targeters which are taken by some economists as more definitive proof of the inappropriateness of inflation targeting for the emerging market economies [Jha 2006]. However, the results of Fraga et al are not comparable with those of the IMF. For one thing, the IMF compares the inflation targeting emerging countries with the non-inflation targeting emerging market economies, while Fraga and his coauthors have different comparator countries, i e, the industrial country inflation targeters.

For all this sophisticated econometric analysis with allowance for nuances of data, institutional background and the financial system development and structure, one wonders whether the country experiences are really comparable. In the IMF study, the inflation anchor is the consumer price index (CPI) but nowhere is it clarified whether it is a core or the headline index. A comparison can be valid only if the countries concerned adopt the same monetary anchor. In fact, the practices vary among the inflation targeting countries. It is known that in the inflation targeting framework of monetary policy, it is crucial whether a headline or a core CPI is chosen for fixing a target and the forecast exercises. And if a country chooses one and the other or changes the measure of inflation midstream during the implementation of the inflation targeting-based monetary policy, the impact results will not be comparable, let alone the validity of the generalisations based on them.

Several of the inflation targeting countries have alternated between one or the other measure and sometimes even a combination of the two as pointed out by Malan Rietveld (2006). The majority of inflation targeting central banks now target headline CPI. Some central banks, including those in Australia, New Zealand and the Czech Republic have switched from targeting a core measure to headline CPI. In practice, however, these central banks still make extensive use of various measures of core inflation as a tool in evaluating the monetary policy stance. Some like the Bank of Canada, the Norges Bank and the Central Bank of Chile, even give core inflation central position in their communication framework. These groups can therefore be identified as: “pure headline targeters”, “headline targeters with a focus on core indices for operational and communicative purposes” and “core targeters”. Among the emerging market inflation targeters, Korea and Czech Republic switched from a headline to a core inflation target, but not fully, Chile does the same, Brazil adopts a headline inflation, Colombia sets an overall inflation target but pays attention to the core measure in its analysis. If the measures of inflation are so diverse and varying, how is it possible to get comparable empirical evidence about whether the inflation targeting based monetary policy succeeded or not.

There is also another conundrum. As observed earlier, the stabilisation of inflation is seen as a key to the stabilisation of employment and to economic growth. But this is based on the assumption that the nominal anchor for monetary policy is core and not headline CPI. When central banks move on to the headline inflation for fixing targets, then what happens to the benign impact of the inflation targeting on employment and output growth?

These are not purely academic questions in a country like India. It has been long recognised since the 1960s that the prices of food and other wage goods are the kingpin of the inflationary pressures [Khatkhate 1959; Joshi and Little 1994; Desai 2006]. But monetary policy is not a determinant of inflation in India. Furthermore, the political economy of Indian development is such that there is a low threshold for inflation tolerance, even though India is known to be a relatively low-inflation country. If inflation tends to rise even moderately by a percentage or two, there is often a reflexive hue and cry, and the political parties get into a frenzy.

Though the sources of inflation in India are non-monetary such as changes in food output, marketed surplus, lax fiscal policies and so on, the Reserve Bank of India has to be on the alert to maintain its credibility and authority. Added to this is the onset of globalisation which has made the Indian economy more sensitive to price level changes and therefore those of real interest rates. Any benign neglect on the part of the monetary authorities in regard to prices will accentuate volatility of capital flows – both portfolio and short-term

– into and out of the country. The implications of this are clear. If India ever contemplates initiating inflation targeting as an operational strategy, it will have to rely on the headline and not the core CPI.

Currently, there is no all-India CPI, which therefore has to be constructed. India therefore has to lean largely on nonmonetary economic policies and only to a limited extent on monetary policy to stabilise the inflationary pressures and to ensure output growth.

EPW

Email: dkhatkhate@aol.com

[The author thanks Anand Chandavarkar for his helpful comments on an earlier draft of this paper. Errors, if any are mine.]