Relevance of Inflation Targeting for Developing Countries in the New Normal: A Case of Nigeria

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Thursday, March 03, 2016 09:10 AM / CBN

There has been widespread consensus in the literature about the role of inflation and the reaction of monetary theory. First, the experiences of developed countries during the 1970s and 1980s showed that a high rate of inflation does not lead to high growth and employment. High and volatile inflation deters productive investment and employment generation, and may worsen inequality.

Second, there is increasing recognition of the benefits of low and stable inflation as well as the cost of high and volatile inflation; to the extent that low inflation has become a public good. In addition, the literature has increasingly stressed the importance of inflation expectations in monetary policy.

Inflation targeting has been considered in the literature as most suitable approach for effectively anchoring inflation expectations (Sivak, 2013). Simply, inflation targeting encompasses a monetary policy framework in which the central bank sets an explicit target for future inflation (usually low inflation rate) and work towards achieving this goal (Agenor and Pereira da Silva, 2014).

Consequently, the inflation rate serves as the nominal anchor on which the central bank relies to maintain price stability. Typically, inflation targeting requires five key elements including a (Sivak, 2013): Public announcement of medium-term numerical targets for inflation; an institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal; an information-inclusive approach in which many variables are used in making decisions about monetary policy; increased transparency of the monetary policy strategy through communication with the public; and increased accountability of the central bank for achieving its inflation objectives.

Indeed, since the first adoption of inflation targeting by the New Zealand in 1990, several countries from developed and emerging market economies as well as developing countries have adopted the framework. The policy framework proved to be quite successful in the previous two decades.

However, the recent global financial and economic crisis has put a severe dent to this monetary policy framework. During the crisis, most central banks fell into the liquidity trap as the target interest rates were cut to the zero bound to stimulate the economy. When there was no incentive for a further lowering of the nominal interest rate, unconventional monetary policy was adopted evidenced by several rounds of quantitative easing followed.

Yet, unemployment remained very high indicating that the steps taken were not sufficient to reverse the recessionary trend. In spite of the persisting unemployment and low growth, inflation rates in most advanced economies such as the US remained very low. It was obvious that the achievement of the low inflation target, with low interest rate and low volatility, did not guarantee favourable growth and improved employment. At this point, economists began to question the wisdom in the inflation targeting framework.

Under this abnormal environment, termed by some analyst as the new normal, unconventional monetary policy appeared more successful in addressing the imbalances in the economy. In the new normal, central banks have the additional mandate of maintaining financial system stability and economic growth in addition to the price stability objective of monetary policy.

In the particular case of developing economies with substantial output gap, we query the continued relevance of the conventional focus of monetary policy. What is the continued relevance of inflation targeting as opposed to growth focused monetary policy on price stability? Is inflation targeting still relevant in a growth focused monetary policy? This study attempts to explore the continued relevance of inflation targeting by central banks in developing countries as opposed to embracing medium to long term growth targeting.

We thus examine a countercyclical monetary policy stabilization focus is more appropriate in the post global financial crises era than a medium to long term growth objective. The rest of the paper is organized as follows. Section one introduces the paper and presents a brief review of basic concepts.

Section two reviews the conceptual as well as theoretical and empirical literature, while, section three looks at the methodology and estimation technique. Section four analyzes and discusses the data. Conclusion and policy recommendations are presented in section five.

Inflation targeting
Conceptually, an inflation target is a nominal anchor that is expected to constrain price movement to a particular point or within a pre-agreed band. More specifically, inflation targeting as a means of operationalizing the price stability objective focuses solely on inflation stability as opposed to targeting the other prices within the price stability framework such as exchange rate and interest rate or money supply target (Batini et al 5 2005).

Inflation targeting as a monetary policy framework has various benefits and downsides. The key benefit is improved credibility of the central bank, built around increased communication, leading to improved market expectations. However, the major shortfall of the framework is that central banks become obsessive over inflation objectives/targets in the wake of more pressing macroeconomic problems that could be addressed using available policy instruments (Bernanke and Mishkin, 1997).

In the wake of the 2007/2008 financial and economic crisis, many central banks were faced with the more pressing financial stability issues than monitoring gradual creeps in inflation. The Bank of England (BoE) and The United States of America Federal Reserve Bank (US Fed) who have the dual mandate of maintaining an inflation objective and low unemployment were observed to have relaxed their rein on inflation in favor of maintaining low unemployment.

In Europe, however, the European Central Bank (ECB) stuck dogmatically to its inflation target even when the high policy rate applied to stave off inflation was hurting the recovery and pushing most European economies into double deep recession.

The ECB, however, subjectively relaxed its inflation target in favor of growth and recovery, by lowering its policy rate to an all-time low of 0.15% in June 2014 and its overnight rate to -0.1%.

This implied that commercial banks had to pay for their overnight deposits rather than earn a spread. This is a policy initiative directed at forcing commercial banks to lend directly into the economy in order to jump start economic activities. Evidence from the literature suggests that an inflation targeting framework is likely to be most successful when certain prerequisites are met; central bank independence, adopting price stability as the sole objective of monetary policy and the existence of a well-developed technical infrastructure.

In addition, the impact of fiscal dominance as well as financial, structural and external sector dominance should be kept at the barest minimum. The independence of a central bank is guaranteed when its monetary policy decisions are not subjected to review by any governmental authority.

Such level of independence allows central banks to always have the free will to deploy their policy instruments to target inflation in order to keep it within the agreed band or on the specific target. The new normal paradigm thrusts monetary policy with additional objectives that will require more instruments to enable policy makers cope with policy implementation (Bayoumi et al, 2014).

Under the new normal paradigm, with central banks saddled with additional mandates, the expanded function of central banks may conflict with the pristine role of some governmental agencies who may, as a result, question the continued relevance of central bank independence (Bayoumi et al, 2014).

Can central banks still pursue inflation targeting if independence is curtailed or lost entirely? In general, a central bank that adopts inflation targeting as a framework of monetary policy would pursue an independent monetary policy and an open capital account while allowing the exchange rate to float.

In the new normal, there is the likelihood that central banks may attempt to pursue an independent monetary policy, maintain an open capital account and manage exchange rate through interventions in the foreign exchange market. Focusing solely on a price stability objective may, however, lead to some short run losses in employment and output goals (Mishkin, 2001).

A robust forecasting skill is required for inflation targeting central banks to engage in a high degree of accuracy in forecasting inflation in the short to medium term (Mishkin 2001, Batini et al, 2005).

Most developing countries’ central banks have weak financial, fiscal and monetary institutions, thus making the application of inflation targeting in these countries considerably difficult. Weak institutional structures can also amplify the susceptibility of an economy to external shocks (Mishra and Mishra, 2013).

The above prerequisites will ultimately address some of the conditions listed below such as fiscal dominance, financial dominance, structural dominance and external sector dominance.

Fiscal Dominance
For inflation targeting to be successful, a strong level of coordination must be established between the monetary and fiscal authorities. Fiscal authorities must buy into the price stability objective of the monetary authorities and behave in such a manner as to minimize the fiscal dominance of monetary policy.

Fiscal dominance is defined as a situation whereby the fiscal authorities, due to a high level of irresponsibility, incur high levels of debt such that the monetary authorities are forced to monetize the debt, leading to increased money supply and inflation. In an open economy, government debt becomes more attractive when a central bank increases the real rate of interest.

This is applicable as the appreciation in the real rate causes aggregate demand and output to decrease, thus lowering the level of inflation. The 7 reverse reaction is however applicable if the increase in the real rate is as a result of an increase in the government default premium, resulting normally from a perception of the financial markets that government debt is too high.

This will lead ultimately to a depreciation in the real rate and subsequent rise in inflation as government debt becomes less attractive. In the second scenario, considering that the initial increase in interest rate was a response to rising inflation in an inflation targeting environment, the depreciation in real rate due to the high propensity of default by government will cause a further rise in inflation.

Under this circumstance, monetary policy under an inflation targeting framework will continue to exert an upward pressure on inflation. Fiscal policy is, therefore the most feasible approach to deal with rising inflation (Woodford 2003, Blanchard 2004).

Financial Dominance
Financial dominance is characterized by a weak financial system constituting an obstacle to the effective deployment of short term interest rate as a policy instrument to target inflation. A robust financial and banking system is therefore strategic to effective inflation targeting (Mishkin, 2004). In the event that the monetary authorities attempt to use the policy rate to target inflation in a financially weak economy, the resulting effect could range from a financial crisis to a collapse of the financial system and even the currency (Fraga et al 2003).

Structural Dominance
Structural dominance is a common phenomenon in developing countries. The situation arises where the economy is characterized by poor infrastructure and structural weaknesses which prevent the smooth transmission of the monetary policy to the real economy.

The economy is, therefore, said to be susceptible to supply side shocks which the monetary authorities have to take into consideration before raising interest rates to target rising inflation. The central bank will normally take these shocks into consideration by adjusting money supply upwards thus accommodating a higher level of inflation than earlier anticipated (Mishra and Mishra, 2013).

External Sector Dominance
In an open economy, the relevance of the external sector cannot be overlooked as various transmission mechanisms could create a pass-through of external shocks to the domestic economy. Significant variables of impact include the exchange rate, the interest rate and 8 the inflation rate.

External dominance is, therefore, defined as the propensity of external shocks to derail the monetary authorities from the achievement of their inflation target due to large external shocks impacting on the domestic economy (Mishkin, 2004).

A movement in the exchange rate is, therefore, considered to be an external shock and the percentage change in the interest rate and the rate of inflation is considered to be a measure of external dominance (Fraga et al, 2003).

The New Normal
Prior to the 2007-2008 financial and economic crisis, there was a robust asset price bubble, fuelled primarily by an overheating housing market across the United States of America (USA) and most European Union (EU) countries. Following the standard focus of monetary policy which is price stability with an underlying assumption that growth will occur under a low inflation environment, policy makers in the USA and the EU moved to curtail the rise in price levels (inflation) by raising policy rates.

Over time, inflation was stabilized by the high policy rates and economic activity slowed to near equilibrium levels. In the wake of the crisis, a severe credit crunch was experienced across most economies, thus leading to a major economic crisis. Policy rates reduced to an all-time low in the USA and EU, causing the build-up in a new asset price bubble driven primarily by the portfolio market.

Raising policy rates to stabilize this emerging bubble would only lead to the twin problem of deflation (because of the already too low inflation rate) and a double deep recession (due to the fragile recovery). From this development, policy makers in the developed economies learnt that apart from the regular price stability focus of monetary policy, a financial stability focus was required to address stability issues with the financial system.

This twin monetary policy objectives, was tagged the new normal. In the emerging economies, the growth sub-objective linked directly to low inflation was decoupled from the price stability objective to stand as a sole objective of monetary policy. This invariably gives three broad objectives of monetary policy in the new normal.

The proposed instruments for the financial stability objective would be macro-prudential measures and guidelines. These guidelines will serve to ensure that the flow of credit is supplied only to prime borrowers who will channel these funds to productive economic activities (Bayoumi et al 2014).

Subbarao (2010) amongst others argue however that the central bank may not be well equipped with the appropriate instruments to address 9 financial stability issues which cut across two broad areas of interest rate and exchange rate volatility and financial system illiquidity.

The current ‘lender of last resort’ instrument was adopted in the wake of the last financial crisis to ease the credit crunch facing financial institutions globally but these institutions hung on to the liquidity without passing it on to the financial and capital markets. Subbarao therefore is of the view that the central bank should develop an additional instrument ‘purchaser of last resort’ to enable it mop up toxic assets within the system.

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