Revisiting the inflation targeting mandate

The recent era of global inflation has reminded us of the Volcker period. In this context, it is worth looking back at the historical background of the inflation-targeting and how successful the regime remained. Borrowing from remarks made by Laurence H. Meyer, Member of the Board of Governors of the US Federal Reserve System, to the University of California at San Diego Economics Roundtable, San Diego, California, 17 July 2001, “Central banks typically operate under one of two types of mandate. A hierarchical mandate makes price stability the primary objective for monetary policy and subordinates other potential objectives. A dual mandate recognizes two objectives—price stability and full employment—and puts them on an equal footing. Either regime could make the price stability objective more precise by setting an explicit numerical target for inflation.”
New Zealand in 1990 became the initial country to start a formal inflation-targeting regime. Canada pursued in 1991, the United Kingdom in 1992, and Australia and Sweden in 1993. Afterwards, Finland and Spain espoused inflation targeting (before becoming members of the European Monetary Union) and after that various developing countries have adopted this approach.

The inflation target is every so often set as a point and sometimes as a range. Often, the inflation objective is set for a measure of overall consumer price inflation, the point or midpoint of the ranges is generally around 2%, and the ranges (where employed) are generally 2 percentage points wide: typically, 1-3%. The time prescribed for return to the inflation target following departures is sometimes explicit and sometimes not, generally in the range of eighteen months to two years. Kristie M. Engemann, a senior coordinator in the St. Louis Fed External Engagement and Corporate Communications Division, has explained in an article titled as “The Fed’s Inflation Target: Why 2 Percent?” (16 January 2019) that the Federal Open Market Committee (FOMC) interprets an inflation rate of 2% as consistent with price stability, and adopted an explicit inflation target of 2% in January 2012. In the 2016 version of the statement on longer-run goals, the FOMC added: “The Committee would be concerned if inflation were running persistently above or below this objective.” Though the FOMC didn’t overtly name an inflation target until 2012, St. Louis Fed President James Bullard has argued that the US had “an implicit inflation target of 2% after 1995. The target is based on the annual change in the overall, or “headline,” PCE price index as the FOMC will target the headline inflation rate as opposed to any other measure (e.g., core inflation, which excludes food and energy prices) because it makes sense to focus on the prices that US households actually have to pay.”
In New Zealand, the first inflation-targeting regime, the numerical target is set jointly by the Minister of Finance and the Governor of the central bank and is currently a range of 0% to 3%, the widest of any of the ranges in inflation-targeting regimes. In US, the Fed has a Congressional mandate of maximum employment and price stability. The FOMC conducts monetary policy by setting the target range for the federal funds rate, and uses its monetary policy tools to implement the policy, which guides market interest rates toward the Fed’s desired setting of policy. Typically, the measure impacts both corporate and housing borrowing costs (average 30-year mortgage rate). As a fallout of the long-term interest rates increase, the cost of borrowing money for households and businesses have increased, and by dampening aggregate demand and incentivizing towards savings, the Fed tries to reach out to their target inflation rate. (as also highlighted by the Governor Philip N. Jefferson in his speech, 27 March 2023).

There could be many side-effects of the inflation targeting framework, as Paul Davidson in the Journal of Post Keynesian Economics (Vol 28,No-4, 2006) highlighted that after Milton Friedman’s “natural rate of unemployment” thesis, classical theory recognized that inflation targeting could only be achieved by affecting the unemployment rate. Keynes’s theory argues that the central bank can target inflation only via installing an “incomes policy of fear.” Prof Rakesh Mohan, the former RBI Deputy Governor, has highlighted in the book titled “Monetary Policy in a Globalized Economy” (2009, Oxford India Paperbacks) that “inflation nutting” to borrow a term from Mervyn King, Governor, Bank of England, can easily lead to neglect of important signs of macroeconomic and financial imbalances. In the Euro area, for instance, setting the inflation target at close to 2% is associated with weakening economic activity. Further, the relevance of a single inflation target for a large economy can be debated. A major source of uncertainty in conducting monetary policy is the lack of a clear understanding of the inflationary process as it has unfolded in recent years.
Nevertheless, inflation targeting is a crucial objective for any economy, since any standard economy cannot afford to be a “hyperinflation” country like Argentina, Turkey, Lebanon, Sudan, Zimbabwe, Venezuela since such a situation completely jeopardizes a country’s financial stability and triggers extreme hardship for its citizens. However, for effective inflation targeting, there is a need of healthy co-ordination between the fiscal and monetary authorities. In this context, Prof Ashok Gulati in his article “Why RBI should resist further interest rate hikes” (20 March 2023) has emphasized the need for government intervention in certain products showing high inflationary trends in recent times. The point here is, we need to understand what factors are causing higher inflation in certain items like cereals, milk, spices etc; whereas we are privileged to have negative inflationary trends for vegetables and onions which historically earlier exhibited much higher inflation, and here the government probably can play a proactive role, say by providing export/import incentives to smooth out domestic demand supply imbalances.

Vipin Malik is Chairman & Mentor, Infomerics Ratings. Sankhanath Bandyopadhyay is Economist at Infomerics

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