Inflation targeting

Are central banks dealing with inflation as if they were hunting bears with a howitzer? The simple answer is no, though a growing number of academics will say otherwise.
Six industrialised nations and at least 20 developing ones use inflation targeting as the cornerstone of their monetary policies. Eight others, including the Federal Reserve, European Central Bank and Bank of Japan, unofficially target inflation, according to Morgan Stanley. Yet, the strategy is too restrictive, bordering on mechanistic, critics say. And by rigidly focusing on inflation, it ignores other central bank responsibilities, such as growth, employment and financial market stability.
The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much effect on inflation; it will only make the task of surviving in these conditions more difficult.
The bottom line is: developing and developed countries should abandon inflation targeting. With a target, a government or central bank identifies a specific inflation level or range it wishes to achieve and explicitly acknowledges that low and stable inflation is the paramount goal of monetary policy.
Other attributes of inflation targeting include stepped-up public communication of the bank’s aims and in increased accountability for attaining those objectives.
Anchoring monetary policy around a well-thought-out inflation target is better than none at all, which may leave markets confused. It helps to insulate a central bank from political interference, while enhancing its credibility. A target also provides explicit criteria against which to measure monetary policy and a central bank’s performance.
And it helps institutionalise sound policy. That hasn’t silenced the critics. Inflation targeting can promote damaging mechanical policy making, as happened with money supply targeting in the late 1970s. Inflation-targeting central banks have tended to select a low target, when a slightly higher one may lead to “higher real wages, lower unemployment and possibly faster growth.”
Inflation, particularly in developing countries, is the imported product of surging food and energy prices, not policy mismanagement. The cure markedly slower growth and high unemployment “would be worse than the disease” and possibly ignite riots and protests in some nations.

History shows that during the past half century, the highest inflation was associated with the lowest growth, namely the oil crisis-induced stagflation of the 1970s. The tight monetary policies adopted by the Fed and other central banks in the 1980s eventually resulted in lower inflation, faster growth, more employment and higher investment. Companies were rewarded with larger profits and declining costs of capital, investors with rising stock markets and low financial market volatility, and consumers with enhanced purchasing power.

Inflation is now returning in the form of rising energy and food prices. Still, that shouldn’t be a reason to abandon inflation targeting and the tight monetary policies it implies.

Prices can only rise if money is printed to finance them. Central bankers are to blame for high commodity prices, like they ultimately must be for all forms of inflation. Any attempt to absolve them of their responsibility for fighting inflation will ensure that wrong policies are followed.

Some economists are wrong in suggesting that inflation infecting developing countries is an external phenomenon. That ignores the subsidies that emerging market nations grant their populations, their inefficient use of energy and the practice of many central banks in Asia and the Middle East of pegging currencies to the dollar, importing the Fed’s monetary policy. Nor must targeting be as inflexible as academics contend. Inflation targeting does not represent an iron-clad policy rule. Inflation targeting is better understood as a policy framework, whose major advantage is increased transparency and coherence of policy.

An inflation target should be realistic. Central banks using one must be disciplined and free of political influence, and their policies ought to reflect a citizenry willing to withstand the pain associated with enforcing the target. There’s only one thing to do with today’s accelerating inflation: Fight it.