6 Ocak 2013 Pazar

Inflation Targeting and How to Target Inflation

There are some monetary policies that have been adopted by the central banks in the emerging and developed economies. These are all used for stabilizing the economy and increasing the welfare through the country. These policies can be stated in the following four topics:

Targeting Monetary Base: These policies are trying to stabilize the inflation through controlling monetary bases.
Targeting Interest rate: In this policy, the central bank is targeting the interest rate which reflects the general trend of the economy and tries to decrease the interest rate without applying daily policies rather than long term strategies.
Targeting Foreign Currency Rate: If the increases in the currency rates affect the prices, the central bank try to stabilize the currecy rate by pegging the national currency unit to the foreign exchange unit. This helps stabilizing the increase in the costs that depend on the currency rates but sometimes it may ruin the state budget by decreasing the export / import ratio.
Inflation targeting: We will be discussing this as follows

Therefore it is understood that the main target in to stabilize the increase in the price level but the element or main factor in doing this can be changed from economy to economy and from time to time. But it being popular that, if the economies that had been practising fixed or pegged currency system release their currency unit to fluctuate against foreign currencies, inflation targeting becomes to be a very popular targeting method in decreasing the inflation.

Beside these, all of the above strategies are used for decreasing the inflation to reasonable levels. Other than the above efforts, the following issues must be also taken into account:

Decreasing or stabilizing the public sector sepending: Governments use this activity in several cases. Therefore government starts to be more conservative in spending by not making income increases in public sector, decreasing the costs or expenditures in the public offices. The government starts to control the expenditures.
Increasing the public sector income: the governments try to increase the efficiency of the public sector by decreasing the costs and increasing the income. These offices start to work like the private organizations and the government audits their revenues from time to time.
Increasing the tax revenue: The most important revenue item for the government is the taxes. Therefore they can make increases in the taxes. For Turkish economy, the tax in oil consumption, in salaries, in purchase of ordinary and also in luxury goods create very important tax income for the economy.  Furthermore there are the fees that the state offices can get from the individuals
Increasing the debt of the state: In order to decrease the inflation in short terms the government may want to issue bond to absorb the liquidity from the economy.
Therefore the government should choose one technique from the inflation reducing policies and try to use this by applying the above stated principles.

After we have discussed the use of this policies and how to use them, we must go back to our main topic which is inflation targeting. If we want to define this, we can say that, inflation targeting is defined by the following features:
Non-equivocal commitment to price stability as the overriding objective of the monetary policy, ahead of the other traditional objectives (economic growth, increase in external competitiveness, coverage of the fiscal gaps or reduction of unemployment)
Transparency of the monetary policy strategy by communicating the monetary policy objectives and decisions to the public
Increase in the central bank’s accountability for attaining the inflation target
Dependence on having in due time a whole set of information on relevant variables concerning the four macroeconomic areas (real, monetary, fiscal and external areas).

If we summarize the inflation targeting, we can say that, “inflation targeting is an economic policy in which a central bank estimates and makes public a projected or targeted inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools”

From this definition, we can understand that the central bank has the determining role in decreasing or increasing the inflation. For example, if inflation appears to be above the target, the central bank will raise interest rates. This application cools the economy and brings the inflation down. If inflation appears to be below the target, the bank will lower the interest rates. This application gives a momentum to the economy by accelerating and raising the inflation.

How to Apply Inflation Targeting

Since it is changing country to country the inflation targeting policy may be pursued in different types. This is mostly because of the characteristics of the counry and the level of the inflation. If we talk about all inflation targeting techniques there will be several common characteristics that are stated below:
An announced quantitative inflation target, varying across countries between 1.5 and 2.5 % per year, in most countries with a tolerance band of plus/minus 1% point around the target;
No explicit rule on how the central bank shall set its instrument
A floating exchange rate (except for Finland and Spain, which are members of the Exchange Rate Mechanism, although the wide exchange rate bands there so far have not created any conflict between the inflation target and the exchange rate target) and
A high degree of transparency and accountability.

After stating the common characteristics of inflation targeting policies we must also define the institutional requirements that are necessary for adapting this policy into the economy. These requirements are listed in the following:
Priority for the inflation objective: The central bank must give the priority for the inflation over other objectives such as economic growth, external competitiveness or increase in employment.
Independence of central bank: From the experiences it has been proven that the independence of central banks is essential in fighting against inflation.
Harmonisation of monetary policy with fiscal policy: The monetary policy must be inline with the fiscal policy. Therefore the government and the central bank must work paralel to each other.
A well-developed financial system: The economies encountering difficulties in accessing international capital markets, with low savings and a thin financial system, limit the government possibilities to borrow on the domestic market. Therefore the central banks may encounter difficulties in applying this policy when the financial system has not been well deveoped yet.
Flexible exchange rate: The flexibility of the nominal exchange rate is a condition of the inflation targeting regime which stems from setting the inflation target as the overriding objective.
Transparency and accountability: Monetary policy transparency is extremely useful to a central bank that has a strong antiinflationary position. If the bank pursues a consistently anti-inflationary way, the public communication of its objectives, instruments, procedures, decisions and projections enhances its credibility and its accountability towards the general public.

Also beyond the above requirements, adopting an inflation targeting policy requires some technical issues like in the following:
·         Choosing an adequate price index
·         Explicit setting of a quantitative target and a fluctuation band
·         Building of an effective model for inflation forecasting by the central bank.
The Lessons Learned from Inflation Targeting Experiences
The lessons what we have learned from these experiences are stated below:
  • The single explicit goal of price stability can be successfully implemented.
  • Targets for price stability can take the form of inflation targets rather than price level targets.
  • The consumer price index (CPI) can be used as the inflation target.
  • Inflation targets should take the form of bands rather than point estimates.
  • Establishing the credibility of a price stabilizing monetary policy takes time.
  • Inflation objectives should be multi-year in nature so as to allow for a gradual adjustment to price stability.
  • Inflation targets should be accompanied by more open, transparent monetary policy reporting by central banks.
  • The inflation targets for monetary policy should be consistent with other macroeconomic policies of the government.
  • Mandating the goal of price stability should not be accompanied by directives on specific procedures as to how the central bank should achieve price stability.

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