Inflation Targeting

wealthymattersWhen printing presses started making currency notes, there was trouble. It was too easy to be irresponsible, and print too much “fiat money”.Every currency needs a “nominal anchor”: something that pins fiat money down to reality. There are exactly three choices for this nominal anchor: gold, a foreign currency like the dollar, or the consumer price index (CPI) basket of goods.

The gold standard — where the US dollar was pegged to 35 ounces of gold — fell apart in 1973. Since then, the world has been looking for a new nominal anchor. Pegging to a foreign currency works well in some places, e.g., for Hong Kong. But pegging the Indian rupee to the US dollar is not a viable option, as this is tantamount to handing over the Indian monetary policy to the US Federal Reserve. This is inappropriate as the Indian business cycle is quite different from the US’. 

That leaves inflation targeting. That’s it. There is no other game in town other than gold, dollar and CPI. We have to choose one. Inflation targeting would anchor the Indian rupee to the price of the CPI basket.

In US law, the Federal Reserve is not an explicit inflation-targeting central bank. But this law was drafted in 1913, when these things were not understood. In 1979, Paul Volcker shifted the US Fed to a 2% inflation target, but this was done by the Fed without a change in the law. Since 1979, de facto, the US Fed has delivered an inflation target of 2%.Inflation targeting that’s written into the law began with New Zealand in 1990. From that point, there was a steady procession of countries adopting it.The Eurozone is bound to an inflation target operated by the ECB. Major milestones are UK (1992), Sweden (1993), Australia (1993), Mauritius (1996), Israel (1997), Brazil (1999), Chile (1999), South Africa (2000), South Korea (2001), Mexico (2001), Indonesia (2005) and Turkey (2006). After the global crisis, inflation targeting has been adopted by Botswana (2008), Albania (2009), Georgia (2009), Moldova (2010) and Uganda (2011). In 2012, the US Fed made the first formal statement in its history, that it has an inflation target of 2%.

A key attraction of inflation targeting is that it’s a durable solution. Having no nominal anchor gives macroeconomic instability of the kind seen in India, or worse. Pegging to the dollar gives external sector crises, as seen in the Asian crisis. Inflation targeting is a stable, long term solution. No country that adopted inflation targeting has ever walked away from it. Inflation targeting has not collapsed in a crisis, as currency pegs have often done. After the gold standard, inflation targeting has risen as the stable long-term solution that anchors fiat money in most of the world. China and India are the only important countries left that do not have inflation targeting.

So how do we interpret the plethora of new things that we hear from the US Fed or the Bank of England (BoE), such as quantitative easing, forward guidance and linkages to the unemployment rate? The first point is that nowhere have the Fed or the BoE abandoned the 2% inflation target. Longterm inflationary expectations in the US and UK are well anchored. In a downturn, an inflation-targeting central bank finds itself with a forecast that inflation will be below its target, and cuts rates. What is it to do when the policy rate has dropped to zero, and cannot be cut any more? That is where quantitative easing (QE) comes in. QE is the means to achieve the target, and inflation targeting is the framework that guides and shapes the magnitude of the QE. The Fed is tapering as forecasts are now showing that in the coming two years, there will be a slight increase in inflation in the US. Forward guidance is a set of statements through which the central bank commits itself to low rates in the future. These statements have specified how the central bank will listen to the unemployment rate and modify course. Unemployment data is being used to forecast inflation. The BoE has inflation targeting written into its law, and could not undertake such forward guidance if it was not consistent with it.

About Keerthika Singaravel

Please Leave Me Your Comments!I Love Reading Them!

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: