Tony Cavoli and Ramkishen S. Rajan
Despite decades of academic research, all we are left with is the rather unsatisfying conclusions that when it comes to the choice of appropriate exchange rate regime, all that can really be said is that there exists a broad spectrum of choices. It is not a black-or-white issue; shades of grey abound. All that can be said with any certainty is that in the absence of strong capital controls, currency intervention ought not be framed as a specific target for the exchange rate. Such targets inevitably tempt speculators by offering them the infamous one-way option. Thus, exchange rate and monetary policy strategies must involve a “fairly high” element of flexibility rather than a single-minded defense of a particular rate.
One way of introducing greater exchange rate flexibility is for a country to adopt an open economy inflation targeting arrangement, something that has been advocated strongly by the IMF and many other observers buoyed by its apparent success of inflation targeting in industrial countries in the early 1990s. There is a growing body of empirical evidence that finds inflation targeting arrangements to have improved the macroeconomic outcomes in emerging market economies in terms of lower and more stable inflation and lower output volatility without the fragility of pegs. (This said, critics of inflation targeting have argued that it has co-existed with relatively tranquil conditions and the regime appears to be failing the test in current turbulent period of stagflation and financial crises.)
Since the East Asian financial debacle of 1997-98, a handful of countries in the region — Korea, Indonesia, Thailand and the Philippines — have instituted monetary policy arrangements fashioned around an inflation objective. Each of these countries has passed legal and institutional legislations supporting their respective inflation targeting arrangements. These legislations so passed provide for many facets of the new monetary policy regime including the appointment of key personnel and their tenure (five year terms in Korea and four years each in Indonesia and Thailand), the independence and autonomy of the monetary authority, the stated objectives of monetary policy and the responsibilities and accountability with respect to the achievement of those objectives.
Some observers have suggested that the Reserve Bank of India (RBI) should also adopt an inflation targeting arrangement. Most recently, the Raghuram Rajan report of the Committee on Financial Sector Reforms (CFSR) made the following recommendation: “The RBI should formally have a single objective, to stay close to a low inflation number, or within a range, in the medium term, and move steadily to a single instrument, the short term interest rate (repo and reverse repo) to achieve it.” This in turn has fuelled a great deal of debate, particularly at a time when prices in India have been rising at an accelerating rate (despite increased fuel and food subsidies to cushion the impact of commodity price rises, inflation based on the Wholesale Price Index (WPI) exceeded 8 percent in the first half of 2008).
Critics have argued that the RBI’s monetary policy in recent times has been inconsistent and, thus, a source of some confusion to observers and market participants. More specifically, the RBI remains very elusive as to what is being targeted and how the target is being attained. Rather, the RBI’s monetary policy framework has been based on a rather ad hoc combination of sterilized foreign exchange intervention (via Monetary Stabilisaion Scheme (MSS) bonds), interest rate changes along with nonmarket mechanism (hikes in the cash reserve ratio (CRR), ad hoc capital controls etc). Such an arrangement has also been recommended for China as it continues along it gradual path of allowing greater currency flexibility.
But what exactly does an Inflation targeting arrangement entail? Clearly it is not just about public pronouncement of an inflation target/range. Important features of an inflation target arrangement include the definition of what type of inflation is being targeting, the inflation target range, the use of exclusion clauses or caveats (i.e. under what circumstances the central bank is able to overshoot its target), and the target horizon. All of this information needs to be publicly available and fully transparent. By making the inflation target/range explicit and committing the central bank to attaining the objective over a pre-determined period, the central bank is less likely to pursue time-inconsistent policies or be pressurized by political masters while also acting as a nominal anchor for inflationary expectations
For the most part, inflation targeting is conducted in conjunction with a monetary policy rule (MPR). In general terms, a MPR is one element of a strategy employed by the monetary authority as part of its overall monetary policy. More specifically, the MPR should specify how the instrument of monetary policy is to be changed given the characteristics of the macroeconomy and the policy objectives of the monetary authority. The instrument of monetary policy is most commonly an interest rate, usually a short-term cash rate or repo rate. However, other policy instruments could also be used. In an inflation targeting regime, MPRs implicitly assume that the instrument of monetary policy will always react strongly to inflation (or some forecast of future inflation). It is important to stress that, while obviously connected, there are basic differences between MPRs and inflation targeting. The two are different elements of a general monetary policy strategy. The MPR provides a guide to the policymaker for how to manipulate the instrument of monetary policy; the inflation target simply makes a statement of what the instrument is being ultimately used for.
It is commonly believed that implementation of a successful inflation targeting arrangement requires a laundry list of stringent preconditions such as central bank independence, strengthening the financial sector and developing a well-functioning currency and bond markets (both important for effective monetary policy transmission), the extent of fiscal dominance, inflation forecasting and modeling ability of the central bank, etc. While these are all important, a detailed IMF report on inflation targeting arrangements in selected countries in 2006 suggests that some of the importance of these preconditions can be overstated. As the report notes:
Our findings also suggest the need for a more nuanced, less “mechanical” view of necessary, as opposed to desirable, conditions for successful adoption of inflation targeting. Most of the conditions viewed as essential for successful inflation targeting are important for any successful monetary policy framework, and some may be more important for other frameworks than for inflation targeting. The evidence suggests that meeting tough technical preconditions may be less important to successful adoption of inflation targeting than the sustained pursuit of improvements once the framework has been adopted.
Some commentators in India and elsewhere appear to think that an inflation targeting regime must to be accompanied by a completely flexible exchange rate, with the interest rate used as the monetary policy instrument. However, an open economy MPR could involve incorporating movements in the exchange rate in a way that need not compromise the attainment of the inflation target. This said, there are limits to the extent to which exchange rates should be managed under an inflation targeting arrangement. Why? First, if one attempts to control the inflationary effects of exchange rate changes, it effectively implies raising interest rates during periods of exchange rate weakness to and vice versa during periods of exchange rate strength, The concern is that responding too heavily and frequently to currency movements in the short-term could risk transforming the flexible inflation target to a de facto soft currency peg which in turn tends to be crisis-prone. Second, insofar as interest rate changes have a lagged effect on the economy on the one hand, and pass through from exchange rates tends to be fairly immediate on the other, the central bank will have to forecast short-term exchange rate movements. This is near impossible to do on a consistent basis.
This leads us to a broader issue as to whether an inflation targeting arrangement errs on the side of policy rigidity and discipline or discretion and flexibility? While the exact balance between flexibility and rigidity will no doubt vary between countries (and possibly over time within a country), broad rules of thumb suggest: (a) the less credible the central bank (i.e. poorer its inflation-fighting track record); (b) the less its technical ability; and (c) the lower its political independence, the more advisable it is to pre-commit to a “strict” or “hard” inflation target (i.e. preference of a rule over discretion).
Regardless of the extent of flexibility or “constrained discretion” that is pursued, it is imperative that the inflation targeting monetary authority clearly articulate to the public the lexicographic ordering of its objectives (with inflation taking precedence over all others over time), as well as the time-frame over which the monetary authority is committed to returning inflation to its target.
Tony Cavoli is a Lecturer, School of Commerce and Centre for Regulation and Market Analysis at the University of South Australia.
Ramkishen S. Rajan is Associate Professor, School of Public Policy at George Mason University.
The article draws on a paper by the authors entitled “Open Economy Inflation Targeting Arrangement and Monetary Policy Rules: Application to India”.