inflation targeting

Inflation targeting strategy has emerged as the result of new pursuits and re- searches actualized due to insufficiency of monetary policies—implemented for price stability by the central banks until 1990s—in reaching the required consequences in both developed and developing countries, and this strategy had initially been implemented in New Zealand. As this strategy has indicated a successful performance since its implementation, it has become a targeting strategy that many countries struggling with high inflation—including Tur- key—prefer and put into practice. In this study, the inflation targeting poli- cy’s conformity to country’s economic cycle, its success, and its effect on ma- croeconomic factors were analyzed via the model formed by the use of GDP, exchange rate, CPI, interest rate, output gap, and crude oil prices. Inflation targeting regime was examined for the period of 1996:1-2018:4 via the VAR Model, Granger Causality Test, and action-reaction analyses. The results ob- tained have indicated the presence of expectation and cost inflation, and that it is triggering the inflation. Moreover, it has been observed that inability to reach the targeted value, and inclining trend of inflation are causing uncer- tainty of inflation.

Abstract: The mainstream inflation-targeting literature makes the strong assumption that the central bank can exactly target the interest rate which affects investment and consumption decisions and hence the money supply plays no role in the monetary policy strategy. This assumption is equivalent to admitting the perfect credibility of inflation target announced by the central bank, the perfect functioning of money and financial markets and that the central bank is willing to inject as much liquidity as the economic agents demand. Neither of these assumptions corresponds to the reality. In effect, the inflation expectations can not be easily anchored by the cheap talk of central bankers. On the other hand, the central bank may have many difficulties to target, in a context of financial instability, the interest rates which affect the real and financial decisions of private agents. We suggest that under inflation-targeting regime, money and credit markets vehicle the inflation expectations that can be anchored with a well- specified feedback money growth rule. The latter, in contrast to the Friedman’s k percent money growth rule, can help managing the inflation expectations in a manner to guarantee the dynamic stability of the economy. Furthermore, the model can be easily used to discuss the implications of the zero interest rate policy and the quantitative easing policy.

Indeed, significant shocks, such as increases in the price of regulated utilities and the exchange rate, have been one of the main challenges faced by the BCB. Since the implementation of the Real Plan, in July 1994, for a variety of reasons, regulated- price inflation has been well above the market prices inflation. Considering since the start of the inflation targeting period, the ratio of regulated prices to market prices rose 31.4% (1999:7 - 2003:2). As long as there is some downward rigidity in prices, changes in relative prices are usually translated into higher inflation. If these increases are treated as a supply shock, monetary policy should be oriented towards eliminating only their secondary impact on inflation, while preserving the initial realignment of relative prices. Therefore, the efforts of the BCB to quantify the first-order inflationary impact of the regulated-price inflation have become particularly important, since it helps to implement monetary policy in a flexible manner and without losing sight of the larger objective of achieving the inflation targets.

Since the 1990s inflation targeting (IT) has been adopted by several central banks as a strategy for monetary policy. It is expected that the adoption of this monetary regime can reduce inflation and inflation volatility. His practice was marked by a large observed at the beginning of the 90s and 2000 stability a debate emerges on efficiency and economic performance of the scheme. Many studies have focused on this question has no authority to reach a final consensus. In the context of a simple empirical model, estimated with panel data for 17 emerging markets using both IT and non-IT observations, we find a significant and stable response running from inflation to policy interest rates in emerging markets that are following publically announced IT policies. By contrast, central banks respond much less to inflation in non-IT regimes. IT emerging markets follow a “mixed IT strategy” whereby both inflation and real exchange rates are important determinants of policy interest rates.

OALibJ | DOI:10.4236/oalib.1101450 2 April 2015 | Volume 2 | e1450 economies. It has to be said, however, that this standpoint remains popular despite the fact that evidence on the effectiveness of inflation targeting is mixed. One key study [3] showed that, when compared with economies that did not adopt inflation targeting, its use by a group of developed economies could not be credited to bring- ing down inflation and inflation volatility. For “emerging” economies, adoption of inflation targeting did not re- ceive empirical support for boosting economic growth [2]. Our study adds to skeptical literature: We take Bra- zilian data and find that its inflation targeting is unlikely to succeed when private forecasters rely on anchoring heuristics. This result was evident after we adopted a new cognitive psychology perspective in connection with the traditional macroeconomic approach of bounded rationality with adaptive learning in the inflation forecasts.

In column 3, we focus on non-advanced countries and replicate a result previously presented by Blanchard and Faruqee (2010) that short-term external debt was a very important risk factor for GDP contractions: an additional 10 percentage points of GDP of short-term external debt in 2007 implies on average a 3 percent reduction in growth rates in the first semester of 2009. It is also true that short-term external debt/GDP ratio accounts for more variation in economic activity in the crisis aftermath than any other variable we analyzed. In column 4, we find that openness to trade, measured as average ratio of exports and imports of goods and services to GDP over 2003-2007 has a negative effect, marginally insignificant, while we control for inflation targeting. However, changes in the commodity terms of trade and trading partners GDP growth are not significant once we control for inflation targeting.

The present study was motivated by the idea that inflation targeting differs from other disinflation policies in important respects. In particular, a strict interpretation of an inflation target allows the policymaker to tolerate no devi- ations from target. But adjusting the policy instrument such that the inflation target is attained and defending the new target rigorously may preserve infla- tionary distortions such as wage and price differentials to an exceptional degree. The implications of these distortions might be severe for both real activity and volatility in the economy. In order to formalize this idea, we have used an open economy Dynamic General Equilibrium Model with wage staggering of the type suggested by Taylor (1979a) to consider a rather extreme case of a disinflation policy: an immediate and permanent reduction in the rate of CPI inflation to a newly set target. We found that the disinflation policy not only creates a slump in output on impact, but can additionally generate oscillatory behavior in both nominal and real variables along their post-disinflation adjustment path. These oscillations can be permanent when the economy is closed and the returns to labor in the production function are constant. This is also the only case in which the economy does not gradually converge to a new steady state. Moreover, we showed that the size of the initial slowdown in real activity and the magnitude of the oscillations are positively related.

Abstract: The mainstream inflation-targeting literature makes the strong assumption that the central bank can exactly target the interest rate which affects investment and consumption decisions and hence the money supply plays no role in the monetary policy strategy. This assumption is equivalent to admitting the perfect credibility of inflation target announced by the central bank, the perfect functioning of money and financial markets and that the central bank is willing to inject as much liquidity as the economic agents demand. Neither of these assumptions corresponds to the reality. In effect, the inflation expectations can not be easily anchored by the cheap talk of central bankers. On the other hand, the central bank may have many difficulties to target, in a context of financial instability, the interest rates which affect the real and financial decisions of private agents. We suggest that under inflation-targeting regime, money and credit markets vehicle the inflation expectations that can be anchored with a well-specified feedback money growth rule. The latter, in contrast to the Friedman’s k percent money growth rule, can help managing the inflation expectations in a manner to guarantee the dynamic stability of the economy. Furthermore, the model can be easily used to discuss the implications of the zero interest rate policy and the quantitative easing policy.

In our study, we employ panel-data estimation techniques to evaluate inflation persistence for 46 African countries. We consider this research as being worthwhile since, to the best of our knowledge, no other study has conducted a panel data analysis of inflation persistence solely for African countries. Furthermore, we spilt our sample data into two categories, namely; inflation targeting and non-inflation targeting countries. The rationale behind examining inflation persistence between the two sets of data is quite simple. If inflation targeters are found to exhibit lower levels of inflation persistence in comparison to non-inflation targeters, then inflation targeting in African countries provides Central Banks with a greater degree of control over the inflation process. If the opposite holds true, then inflation targeting is not suited for African countries and other alternative monetary policy frameworks, such as exchange rate targets, are more compatible for African countries.

the best of our knowledge, no other study has conducted a panel data analysis of inflation persistence solely for African countries. Furthermore, we spilt our sample data into twocategories, namely; inflation targeting and non-inflation targeting countries. The rationale behind examining inflation persistence between the two sets of datais quite simple. If inflation targeters are found to exhibit lower levels of inflation persistence in comparison to non-inflation targeters, then inflation targeting in African countries provides Central Banks with a greater degree of control over the inflation process. If the opposite holds true, then inflation targeting is not suited for African countries and other alternativemonetary policy frameworks, such as exchange rate targets, are more compatible for African countries.

The same conclusion arises from the Daianu and Lungu (2004) study of the performance in the three East European inflation targeters. The central banks in all three countries have had limited success in hitting inflation targets. Moreover the inflation volatility has become larger. The authors point out several possible explanations. First, the difficulty in these countries to disentangle the source of the shock, which stems from the fact that the effects of structural changes these economies undergo overlap with those brought about by external causes. Second, there is the possibility for monetary policy to pursue multiple objectives. Fearing political tension these countries might assign higher weights to economic growth than the central banks would acknowledge and thus deviate in fact from the inflation targeting framework. Third, fiscal policy, on an unsustainable path, might play a damaging role in influencing inflation expectations.

It is worth noting that even though the optimal dynamic responses shown in Figure 2 for the case of large γ confirm the conventional wisdom of inflation-targeting central bankers with regard the desirability of a gradual return of the inflation rate to its long-run target level following a cost-push shock, the optimal target criterion for this model does not involve a “medium-term” inflation forecast rather than a shorter-run projection. Even in the case that we suppose that the central bank will often have advance information about disturbances that will shift the aggregate-supply relation only a year or more in the future, the robust description of optimal policy is one that indicates how short-run output-gap projections should modify the acceptable short-run inflation projection, rather than one that checks only that some more distant inflation forecast is still on track. Of course, a commitment to the achievement of the target criterion (1.12) each period does imply that the projection of inflation several quarters in the future should never depart much from the long-run inflation target; but the latter stipulation is not an equally useful guide to what should actually be done with interest rates at a given point in time.

The third, but not less important precondition for in- flation targeting is closely connected to the credibility. Under the inflation target regime, the country should incorporate transparency and accountability into the cen- tral bank’s function. Both, accountability and transpar- ency are dominantly determined by the quality of central banks communication to the public. It is very important for the central bank to inform the public about every cir- cumstance connected to its policy, in order to make its goals and instruments clear and controllable. The public can use this information to form better expectations about future policy actions and keep track of the central bank’s performance. In addition, the increased account- ability of inflation targeting enables the monetary au- thority to monitor and enhance the understanding of ex- pectations. It also decreases the possibility of a time in- consistency trap, which leads to deviations from mone- tary authority’s long-term objective. Moreover, it pro- vides a good benchmark that can easily be observed by the agents in the economy [21] 10 . A transparent monetary

I would argue, however, that monetary policy does not operate in a symmetri- cal way under these circumstances. In other words, the central bank under inflation targeting would in general react more strongly to exchange rate depreciations than to exchange rate appreciations. The reason for this behavior is the weight of infla- tion stabilization in the central bank’s reaction function: when the domestic cur- rency is depreciating, prompt reaction is needed if the inflationary effects of depre- ciation are to be offset; when the currency is appreciating, the deflationary effects are not counterbalanced with the same intensity, since they may help the central bank to achieve the target for inflation, especially in periods of disinflation or after the economy has suffered negative supply shocks.

Abstract: In this paper we examine the macroeconomic stability in a simple dynamic open economy model, in which monetary authorities adopt an flexible inflation-targeting regime in an environment with a liberalised capital account and flexible exchange rates. In this respect, inflation targeting is an essential part of a three-part policy (or trinity) that also includes flexible exchange rate and capital mobility. We show that a low degree of inflation targeting flexibility (i.e., central bank’s response is aggressive toward inflation) with a high degree of capital mobility implies a dynamically unstable solution in this simple rational expectations model. In contrast, when central bank adopts a high degree of inflation-targeting flexibility (accommodative central bank), stability can be ensured under any degree of capital mobility. Finally, under low degree of inflation targeting flexibility, it seems necessary to limit the degree of capital mobility in order to maintain stability in countries opening their economies to international capital flows, mainly in emerging market and transition economies.

In this section, we analyze inflation targeting (IT) in an economy with a finite horizon. By carefully counting the number of equations and unknowns, we find that the price level is not determined under IT when the central bank pegs the nominal interest rate. In some situations, we find no equation includes the current inflation rate, which means that there is no equation and hence no mechanism by which the current price level could be determined. Even when an equation does contain the current inflation rate, it represents how the current inflation rate affects the central bank setting the nominal interest rate, not a mechanism that can determine the current inflation rate, not a mechanism that can determine the current price level.

The advantages of a public target when the private sector must otherwise fore- cast future policy by extrapolating from experience are shown in a recent analysis by Orphanides and Williams (2003). In the Orphanides-Williams model, private agents forecast inflation using a linear regression model, the coefficients of which are con- stantly re-estimated using the most recent observations of inflation. The assumption of forecasting in this manner (on the basis of a finite time-window of historical obser- vations) rather than a postulate of rational expectations worsens the tradeoff between inflation variability and output-gap variability that is available to the central bank. Allowing inflation variations in response to “cost-push” shocks for the sake of output- gap stabilization is more costly than it would be under rational expectations, because temporary inflation fluctuations in response to the shocks can be misinterpreted as indicating different inflation objectives on the part of the central bank. Orphanides and Williams then show that a credible commitment to a long-run inflation target — so that private agents do not need to estimate the long-run average rate of infla- tion, but only the dynamics of transitory departures from it — allows substantially better stabilization outcomes, though still not quite as good as if private agents were to fully understand the equilibrium dynamics implied by the central bank’s policy rule. This provides a nice example of theoretical support for the interpretation given by Mervyn King (2003) and others of practical experience with inflation targeting, which is that tighter anchoring of the public’s inflation expecations has made possible greater stability of both real activity and inflation.

For the IT period, the basic Taylor Rule provides a good fit, and even more so when we augment it to account for interest rate smoothing. The coefficient on the output gap is significantly positive, suggesting that the inflation targeting regime followed by the SARB has indeed been flexible. As previously noted, a positive coefficient on the output gap is also evidence that the Reserve Bank has tended to react countercyclically to demand shocks but has tended to accommodate supply shocks. In the IT regressions, the coefficient on the real exchange rate is weakly statistically significant but small in magnitude, while those on asset prices are not significant, suggesting that monetary policy has paid little attention to these variables under inflation targeting. CPI and CPIX inflation provide similarly good fits, while the fit of the specification using core inflation is relatively worse, despite core inflation’s tendency to be a better predictor of future headline inflation.

Most economists favor a low positive and stable inflation because low inflation can reduce the "severity" of the economic recession and the risk of destabilization of the economy (Stockman, 1981)and (Phelp, 1967) High inflation is unsustainable. This statement is known as the theorem “Friedman”. The theorem shows the relationship between economic growth and inflation without including uncertainty, while the second way studies this relationship including both inflation and economic growth uncertainty (Friedman, 1997), (Phillips, 1958). Most countries use inflation targeting to bring inflation in low levels. Economists argue if inflation targeting has a positive or negative impact in economic growth. Recent studies bring mixed effects.

After two decades of applying inflation targeting, the challenges faced have increased massively. Especially after the 2008 financial crisis and the European debt crisis. The monetary authorities find it more difficult to keep their credibility with the public in providing data and forecast related to macroeconomic performance that is a pillar for keeping inflation targeting. Another problem is that the 2008 crisis has caused severe deflation demand shocks that decline inflation to zero rate (Schmidt-Hebbel, 2010). In addition, the asset pricing controlling failure after the 2008 crisis is another challenge for inflation targeting, asset prices fluctuations due to regulation consistency along with bank behaviours. One of the solution to overcome the asset pricing swings is to combine fiscal and monetary policies to cure the imbalances. Relying on inflation targeting will not solve the issue due to restriction in central bank independency in times of crises. Some argue that inflation targeting could increase asset prices due to increase in interest rates. Low growth could be associated with high interest rate if there was no fiscal intervention. However, a large fiscal injection could cause a deficit and decrease interest rates to very low interest rates. That should not be a reason for the failure of inflation targeting, it is the global imbalances that should be addressed – which is beyond central banks’ control (Allsop, 2010).