Compare and Contrast Inflation Targeting

Topics: Monetary policy, Central bank, Inflation Pages: 7 (2795 words) Published: May 10, 2013
Compare and contrast “inflation targeting” with the experience of the US Federal Reserve Inflation targeting as the name suggests does not necessarily mean that the bank has only one agenda - correct rate of inflation to target. On the contrary, inflation targeting allows the central bank to have an explicit target for the rate of inflation which as a result helps the individuals, households and markets form inflation expectations for the future. Secondly, targeting inflation means that the central bank will place more weight on controlling inflation and keeping it within the boundary that they set. This target is very small and in Britain it is 2% ± 1%. However, the ECB sets an asymmetric target of <2% which of course coincides with the attitude that Germany has with inflation. Further, the US Federal Reserve has set its long-term inflation target between 1.7-2%. Finally, an explicit target allows the central bank to increase its transparency, be evermore independent in its actions. This forms a framework for price stability in the markets as well an opportunity to achieve short term goals for the economy. Historically, the central banks or the government would control the growth rate of money supply but this in practise seems to be very inefficient and the result is higher inflation and output variability. Rudebusch and Svensson (2002) found that monetary targeting to be very inefficient for the Euro system. Their research was based on US data from the years 1986 to 1996. More importantly, they found that the federal funds rate moved very closely with the velocity of M2. However, after 1990 this relationship broke down the velocity of M2 increased significantly. Some of the reasons for this could be due to the increase in liquidity for bonds and stocks. Further, they point out that the strict money growth targeting does in fact lead to an increase in the variance of inflation. Yamada and Osaka (2013) found that whilst reviewing emerging and developing countries that inflation targeting works well in a fixed regime to lower the inflation rate. They note however that in the recent years they struggle to find a relationship between inflation rate and inflation targeting. Inflation targeting especially with the use of interest rates has a lag in which the full impact of a change would be noticed. This typically varies but usually is approximately 18-24 months when the impact has been felt on the economy. When there is no explicit inflation target then individuals would have to make an estimate forecast of the future. This is effectively backward looking and results down to the mean (or average) rate of inflation in the past. Capistran & Ramos-Francia (2010) found that the long run inflation expectations appear to be lower under regimes which undertake inflation targeting than the ones that do not. More precisely, such regimes have an inflation band targeting (UK for instance) and this still has a smaller dispersion of inflation expectation variance than those that do not undertake inflation targeting. Gonḉalves & Carvalho (2009) found that during a study of OECD economies the ones that did carry out inflation targeting suffered smaller output losses during disinflation than those that did not. Additionally, it is worth noting that with a high right of inflation the government debt level decreases in real values. They also note in their paper that if a country has suffered from high inflation and lower debt levels then it increases the probability that they will undertake inflation targeting. The evidence from probit results supports this view for the 30 OECD economies data that is used. They have 17 economies which are the “treated group” and 13 which are the “control group”. However, Brito (2010) didn’t support the view from Gonḉalves and Carvalho (2009) and showed that their results were not robust enough. He further went on to control only for the time-varying conditions and the Maastrict Treaty which resulted...

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Capistran, C, & Ramos-Francia, M (2010), “Does Inflation Targeting Affect the Dispersion of Inflation Expectations?”, Journal Of Money, Credit, And Banking, 42, 1, pp. 113-134.
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Yamada, H (2013), “Does the Exchange Rate Regime Make a Difference in Inflation Performance in Developing and Emerging Countries?: The Role of Inflation Targeting”, Journal Of International Money And Finance, 32, 1, pp. 968-989.
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