Ask Mint | Inflation targeting is a challenging business for central banks

Ask Mint | Inflation targeting is a challenging business for central banks
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First Published: Mon, Sep 03 2007. 01 00 AM IST

Shailaja and Manoj K Singh
Shailaja and Manoj K Singh
Updated: Mon, Sep 03 2007. 01 00 AM IST
Jinny is surprised to see Johnny come to office dressed like a hunter. But unmindful of the raised eyebrows, Johnny proclaims that he is on a mission called SIN: Shoot Inflation Now. He wants to kill inflation like a professional shooter. Johnny feels that many central banks in the world are busy shooting inflation in the name of inflation targeting. So why can’t he also do the same in his own way with his handgun? Jinny tries to convince him that inflation can’t be shot with a handgun. Jinny further explains the implications of inflation targeting approach and its important prerequisites. She adds that India’s central bank follows a multiple targets approach in its monetary policy, which requires sound exercise of judgement by the central bank. Here is the concluding portion of their chat on inflation targeting:
Johnny: Tell me, what kinds of skills do central banks need to have to successfully target inflation?
Shailaja and Manoj K Singh
Jinny: Well, inflation targeting requires skills better than a sharpshooter. First of all, you need to choose a time horizon within which you seek to achieve the desired rate of inflation. Your time horizon depends upon many factors. One of them is the difference between the desired rate of inflation and the actual rate. Then you need to predict in advance what the rate of inflation is likely to be in future. Since all your instruments of monetary policy show the desired results with a time lag, you have to use your weapon in advance. You have to fire your shot even before seeing the enemy. If inflation is able to rear its head before you can use your instruments, you are out of the game. However, if you fire your shot on a false alarm, then you may unintentionally hurt some other target. Too many missed shots may take the sheen out of the growth in your gross domestic production or may lead to a high unemployment rate. Further, keeping inflation under control is an ongoing process. You have to wage a permanent war. The moment you blink, inflation makes a comeback. This is one of the most basic challenges associated with targeting inflation.
Johnny: No doubt inflation targeting is a challenging business. But I have my own methods of fighting it. Guess what? If the prices of vegetables are getting high, I will ask people to grow vegetables in their backyard. If the prices of petrol and diesel are touching the sky, I will ask people to use their bicycles. So asking people to stop all unnecessary consumption will be my style of shooting inflation. But leave my methods of fighting inflation aside and tell me, what are the benefits that inspire central banks to explicitly target inflation?
Jinny: There are many benefits. First, aiming for explicit inflation targets makes monetary policy more transparent. Having a single goal makes it easier for people to judge the performance of the central bank. You can know for sure how far the central bank has been successful in achieving its objective. The central bank can also conveniently focus on a single target instead of chasing multiple targets. Second, explicit inflation targets help in containing inflationary expectations. Today, inflationary expectations are treated as a bigger enemy than inflation itself. If you tame inflationary expectations, half of your battle is already won. In planning for the future, all of us are influenced by our expectations about the rise in prices in the future. Explicit inflation targets make you feel safe. Will you not be comfortable if you know that your guard is keeping a loaded gun ready for your enemy? Likewise, inflation targeting acts as a great assurance to the market and helps in planning for the future.
Johnny: If inflation targeting helps so much, then why don’t all central banks practice it?
Jinny: Many central banks do not follow inflation targeting due to several reasons. For one, many central banks prefer the flexibility afforded by the multiple targets approach. You can change your policy stance as per your desired goal. Inflation targeting approach ties your hands. It seriously restricts your judgement in evaluating different policy goals. It simply puts you in the league of “inflation nutters”. You always have to keep your finger ready on the trigger. Second, it is felt that the approach of inflation targeting requires you to place overbearing reliance on inflation forecasts. All your actions are strictly determined by your forecast of what is going to happen tomorrow. In case your forecast goes wrong, then your entire plan may backfire. And lastly, many central banks have been able to achieve the goal of low inflation even without adopting inflation targeting approach. So what’s the point in becoming a proclaimed trigger-happy sharpshooter? You simply keep doing your job like a silent killer.
Johnny: What a style of doing the job! By the way, I just realized that we have also to get down to our own jobs, otherwise we may soon see our boss targeting us.
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
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First Published: Mon, Sep 03 2007. 01 00 AM IST