Stan du Plessis Department of Economics University of Stellenbosch [email protected]

SAdP September 2002 1

Stan du PlessisDepartment of EconomicsUniversity of Stellenbosch

[email protected]

Parliamentary Committee on Finance20 October, 2002

Perspectives on inflation targeting after a

difficult yearInflation rate

CPIX 10.80% Aug, 2002

CPI 11.60% Aug, 2002


Issues coveredRecent concerns about domestic inflationThe present debate on inflation targeting Reasons for inflation targeting Evaluating inflation targetingSome suggestions for domestic policy


Present problems: IModerate (but rising) domestic inflation undermines the credibility of the

framework for monetary policy SARB’s track record and hence credibility

harmed Government (having set the target) also

suffers credibility loss


Recent international inflation experience

-5

0

5

10

15

20

25

30

35

40

CPI

infla

tion

Singapore

Peru

Malaysia

Czech R

ep

Chile

Korea

Poland

Israel

Philippines

Mexico

India

Hungary

Brazil

RS

A

Venezuela

Turkey

Emerging market inflation

Green indicates an inflation targeting country


Present problems: IIInflation forecasts not credibly within the target range in years to come undermines the credibility of policy

making at the SARB…however, there are no expectations of runaway inflation


Result: credibility deficit for monetary policy

Sector 2002 2003 2004Finance 9.2% 7.1% 6.2%Busines

s8.3% 7.9% 7.5%

Labour 7.9% 7.9% 7.3%Target Range

3-6% 3-6% 3-5%

BER survey of CPIX inflation expectations (in 3rd quarter of 2002)


Present debate on inflation targeting

Three broad camps Group A

Against inflation targets …arguing that government’s priorities are wrong

Group B Targets are good, but the present targets are not

… [some] arguing that the target should be higher in a developing country

Hence the SARB is (forced into) setting policy incorrectly Group C

The present targeting regime is good Hence the SARB’s decisions are sensible (Except that it may be time for the escape clause)


Background to the debate on inflation targeting

3 observations about modern Central Banking Increasing adoption of explicit targets for

monetary policy Also in developing countries

Central Banks are gaining independence Associated with lower inflation

At no cost to growth Helping the poor (who cannot hedge against inflation)

Credibility increasingly recognised as crucial to the success of monetary policy

Inflation targeting incorporates all of the above in a disciplined framework for monetary policy


Reasons for adopting inflation targeting as a framework

“Negative” reasons Lack knowledge for ‘fine tuning’ monetary policy Ensures consistent monetary policy over time Experience:

Capital flows cause problems for alternative anchors (for example, exchange rate targets)

“Positive” reasons Solves the “democratic deficit”

The problem of a (very) powerful, unelected, policymaking institution in a democratic country

Helps to build credibility Good track record internationally


Inflation targeting is an increasingly popular tool for building credibility

Source: Mishkin and Schmidt-Hebbel, 2001


Evaluating inflation targeting

Distinguish a number of different aspects of inflation targeting A. Ultimate objectives B. Transparency C. Final responsibility

(the institutional design, accountability and independence of the MPC does not concern this meeting directly)

(Government decisions have been underlined on the following slides)


A. Ultimate objectives3-step procedure: Government defines clear goals for Central Bank

“goal dependence” e.g. an inflation target

Empower the SARB to pursue those goals “Instrument independence”

Hold the SARB accountable for the achieving the goals Reasonableness of the target affects the government’s

credibilityPresent situation SARB has instrument independence Treasury sets the inflation target


B. TransparencyPublic must be able to monitor the goalsMajor problem - control lag in monetary policy implies separate evaluation of: The policy framework

evaluated with the track record (mainly on inflation) Policy stance, given the framework

forward looking evaluation using the inflation forecast

SARB’s credibility affected by both the framework and the stance of policy


B. Transparency at SARBFair degree of “formal” transparencyBut some shortcomings: lack of openness

No published model, no information of conditioning variables

Policy signal of the fan chart cannot be monitored Hence, public cannot evaluate the stance of policy

The choice of a band as opposed to a point target …and narrowing of the range in 2004 by 33% “Hardening” of the range’s upper edge

does not reflect uncertainty of transmission mechanism undermines the evaluation of the policy framework and

the credibility of the SARB


International experience with the design of inflation targets

Country Target Type Inception Escape clause

Mexico 4.5% Point Jan 1999 NoChile 3% Point Jan 1991 NoIsrael 1-3% Range Jan 1992 NoKorea 3% Point Jan 1998 NoNew Zealand

0-3% Range March 1990

Yes

UK 2.5% Point Oct 1992 NoRSA 3-6%

(2003)Range Oct 1992 Yes


Further shortcomingsMPC implements a forecast target… specified as an average over a

calendar year this does not give a clear policy signal and makes timing difficult as monetary

policy is set continuously and not for periods matching the calendar year

Further, the average inflation rate over a calendar year is a ‘derived’ concept, and hard for the public to understand


MPC’s target is tied to the calendar year would be preferable to have a rolling

horizon (say 2 years) for the forecast target This would reflect the duration of the

transmission mechanism more precisely than calendar year averages

Allows for adjusting the target when opportune as opposed to tying these adjustments to calendar

years


Recommendations:Clarify the target as point-target with tolerance range new target could be 6% at a rolling 2

year horizon … with 2% tolerance range on either

side(Presently, the SARB is aiming at the upper end of the 3-6% range)


Benefits of this clarification: :Provides a clear policy signal to the MPC for setting the stance of monetary policy in contrast with the target as “calendar annual

averages”SARB target remains 6%But takes account of uncertainty in the realisation of inflation on both sides of the target allowing credibility to be built for monetary policy allowing scope for lowering the target at an

opportune timeRemoves the need for an escape clause Avoiding the associated credibility problem


Credibility costs of these adjustments

Government: Effectively the forecast target remains

unchanged at 6% Government not seen to reverse policy in ‘hard times’ Avoid impression that goal posts have been shifted

SARB Cost in re-educating public about adjusted

framework for monetary policy Have to emphasise the forward and backward looking

aspects and 2 year rolling policy horizon But long term gain in credibility of improved

target design


The end

Stan du Plessis Department of Economics University of Stellenbosch [email protected]

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