Ask Mint | How are central banks around the world fighting inflation?

Ask Mint | How are central banks around the world fighting inflation?
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First Published: Mon, Sep 10 2007. 12 10 AM IST

JAYACHANDRAN/MINT
JAYACHANDRAN/MINT
Updated: Mon, Sep 10 2007. 12 10 AM IST
One fine morning, Johnny reached office dressed like a hunter, totally unmindful of the curious glances he was attracting. He was also carrying a handgun. Jinny was also surprised to see him dressed up like a hunter. Could this be one of his numerous gimmicks? Or was he dressed like a hunter for some purpose? Jinny decided to ask Johnny himself.
JAYACHANDRAN/MINT
Jinny: Hi, partner. Why are you geared up like this today? Found some drama company on your way to office? Or have you finally decided to shoot your boss today?
Johnny: Why will I shoot my boss? May God give him a long life! But I am definitely on a mission. A mission called SIN. Have you heard about it?
Jinny: SIN? Don’t tell me that you are on a mission to shoot all sinners one by one.
Johnny: Well, my mission SIN stands for Shoot Inflation Now. Central banks around the world are known for doing that only. Why are you surprised if I’m trying to do this in my own way?
Jinny: Fantastic! The catchphrase Whip Inflation Now (WIN) was a roaring success in the 1970s and now you have come up with an idea of straightaway shooting inflation. But are you sure you can shoot it with a handgun?
Johnny: Well, I’m not sure, but tell me, how do central banks around the world do inflation targeting?
Jinny: Definitely not with a handgun. We’ll talk about the ways and means later, But first you should know what inflation targeting is all about. Some central banks follow a focused agenda of controlling inflation at a certain point. It makes an explicit commitment to meet a publicly announced inflation target. The bank has to hit the target, come what may. There is no room for error. Some countries follow a single-point target, while others follow a more flexible approach of controlling inflation within a range. The institutional arrangements for fixing the target, and also for dealing with deviations from the target, differ from country to country. In some countries, if the central bank misses the target, the chairman or governor has to publicly explain why it is so. Inflation targeting has been adopted by a number of central banks, including those in New Zealand, Australia and the UK. Since inflation targeting requires rigorous discipline, there must be certain prerequisites, too.
Johnny: Prerequisites? I think the only prerequisite is that the central bank of that country must be armed with a loaded gun.
Jinny: The loaded gun is not a prerequisite. But it is important that the central bank must have full control over important monetary policy instruments such as short-term interest rates, that must be fully market determined. In the absence of effective instruments, you will end up holding a gun without cartridges.
Further, the central bank should have full autonomy in the conduct of the monetary policy. For better transparency and accountability, it would be desirable that the central bank is not involved with the debt management of the government. The single focus should be monetary management, without being constrained in any manner. Further, inflation targeting may turn out to be elusive if the economy is vulnerable to supply-side shocks. Monetary weapons of the central bank can’t control any price rise due to shortages of supply of goods and services.
Johnny: But what kind of monetary policy strategy do we follow in India? I hear the central bank in our country provides some sort of range for inflation.
Jinny: The Reserve Bank of India (RBI) does not practise inflation targeting. However, it does focus on a desirable range of inflation. You may have noticed that in the last annual policy statement, RBI talked about keeping inflation close to 5% during 2007-08. However, over the medium-term, the range of inflation indicated by RBI has been between 4% and 4.5%. Controlling inflation is always given top priority, but it is not the only priority. RBI follows a multiple goals approach, like the US. Apart from the inflation range, RBI also indicates a range for the growth of the gross domestic product (GDP). The projected GDP growth for 2007-08 is around 8.5%. Further, ensuring financial stability is also one of the assigned objectives of our monetary policy. Sometimes, we have to trade off one for the sake of the other. The central bank has to exercise its judgement in choosing different policy goals. For instance, acceleration of growth may require commensurate liquidity in the market.
In that case, increase of money supply by the central bank may cause you to miss the inflation target. If the central bank tightens the screws for controlling inflation, then you may miss out on your growth target. So, in a multiple goals approach, you have to do a tightrope walk. You can’t just start shooting inflation like a sharpshooter.
Johnny: But just watch your prey “inflation” closely and take proactive action to keep it under control.
(The rest of the chat will continue next week.)
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
What: Inflation targeting as main objective of monetary policy.
Who: Many?central?banks,?like?those of New Zealand, Australia, and the UK, practise inflation targeting.
How: By keeping inflation at a pre-announced target. In case the central bank misses the target, it has to publicly explain why it is so.
Why: Low inflation helps in keeping the economy stable.
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First Published: Mon, Sep 10 2007. 12 10 AM IST