Basics about inflation targeting

Basics about inflation targeting

What is monetary policy framework?

Inflation targeting is a monetary policy framework. A clear idea about monetary policy and its working is possible only if we understand the concept of monetary policy framework. Monetary policy framework as its name suggests, refers to the mechanism of monetary policy design and its execution. According to McNees (1987, p.3), a monetary policy framework comprises “the institutional arrangements under which monetary policy decisions are made and executed.” The monetary policy framework involves

  • The way how the RBI identifies a monetary policy intervention problem, so that a response is needed
  • The selection of monetary policy instruments on tackling the problem
  • The relationship between monetary policy instrument and the target or in other words, the assumed working of the instrument to influence the target

           Monetary policy framework is thus a collective concept encompassing the relevant variable which the RBI would like to target (often referred as the target; for example – inflation), the way in which the target is to be influenced by the use of a particular instrument (for example repo or short term interest rate). Monetary policy framework thus assumes a type of relationship between targets (like price stability) and the instruments (like repo) to be used. This relationship is tailored on the basis of a given operating economic environment for monetary policy.

Changes in the monetary policy framework

           The manner in which the monetary policy influences the economy depends upon the economic environment as well. When the prevailing economic environment changes, it requires changes in the way in which we deploy monetary policy instruments as well. In India, the monetary policy framework has changed from the simple monetary targeting framework in the 1980s to multiple indicator approach in late 1990s to the now inflation targeting framework.  

           Deepak Mohanty has made the following observation about the changing monetary policy framework in India. “In practice, the nature of the framework is contingent upon two important considerations. First, the level of development of financial markets and institutions; and second, the degree of openness of the economy to trade and capital flows.”

           As mentioned, changes in the operating environment of monetary policy need to be accommodated by making sufficient changes in the monetary policy framework as well. In the context of the changes in the operating environment, the relationship between the instruments and targets also may have changed. To make the monetary policy more effective and the transmission of monetary policy signals more accurate, changes are necessary regarding monetary policy framework. For example, to control inflation a direct instrument like the CRR may have lost its efficiency and repo or short term interest rate may be more effective.

Inflation targeting

Inflation targeting was first adopted by New Zeeland and many central banks are following it. One and important feature of inflation targeting is that the RBI will have only one target- price stability (means targeting level of inflation) by using only one instrument – short term interest rate or what is called repo.

A major prerequisite of IT is that the central bank should have sufficient autonomy to execute it. The ECB defines inflation targeting a monetary policy strategy aimed at maintaining price stability by focusing on deviations in published inflation forecasts from an announced inflation target.

Bernanke (Ben Bernanke) defines inflation targeting: “Inflation targeting is a framework for monetary policy characterised by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy’s primary long-run goal. Among other important features of inflation targeting are vigorous efforts to communicate with the public about plans and objectives of monetary authorities, and in many cases, mechanisms that strengthen the central bank’s accountability for attaining those objectives.” Bernanke believe that inflation targeting is best characterized as a framework, not as a rule.

The RBI was keen on launching inflation targeting and with the budget decision it has got the consent of the government. This means that in future, the government should give sufficient autonomy to the RBI in pursuing inflation targeting

 But notable successful inflation targeting countries are advanced countries. In other developing countries where inflation is introduced, some have abandoned it or some countries are not sticking full-fledged implementation.

 The disadvantage of inflation targeting is that it makes price stability as the only macroeconomic priority by disregarding other important priorities like employment, economic growth etc. More importantly, the working of inflation targeting produces income, growth and welfare losses. This is because to contain inflation, the central bank should increase rate of interest. Increased interest rate depresses consumption, investment and thus income of the people. The reduced income leads to lower demand and hence reduced prices. Sacrifice of a little bit of growth is necessary to ensure price stability under inflation targeting. In this respect, the inflation targeting has an element of unsuitability in the growth seeking phase of the economy.