Inflation Targeting-Understanding CBOT-2

Inflation targeting has some obvious general advantages, and some potentially serious problems. The general advantages include focusing monetary policy directly on achieving the goal of low and stable inflation. With a specified quantitative target, it provides an ex-post post measurement of monetary policy performance, namely realized inflation relative to the inflation target. It also provides measurement of the credibility of monetary policy, in the form of measures of inflation expectations relative to the inflation target. Both these measurements simplify the evaluation of monetary policy and thereby the accountability of monetary policy is increased. By increasing accountability, inflation targeting may serve as a potential commitment mechanism, reduce or eliminate any inflation bias (for instance, due to the reasons examined in Barro and Gordon (1983)) and increase the likelihood of achieving and maintaining low and stable inflation, as well as anchoring and stabilizing inflation expectations. Accordingly, in CBRT case, the forecasts of inflation and the real economy are then conditional on the central bank’s view of the transmission mechanism, an estimate of the current state of the economy and a forecast of important exogenous variables, such as oil and global food prices. The CBRT uses all relevant information that has an impact on the forecast of inflation and the real economy. In this framework, the CBRT takes financial conditions such as credit growth, asset prices, imbalances, potential bubbles and so on into account only to the extent that they have an impact on the forecast of inflation, resource utilization and output gap. Inflation and resource utilization are target variables here, that is, variables that are arguments of the central bank’s loss function. However, financial conditions are not target variables. Instead, they are only indicators, as they provide information about the state of the economy, the transmission mechanism and exogenous shocks to the central bank. Financial conditions then affect policy rates only to the extent that they have an impact on the forecast of inflation and resource utilization.

However, inflation targeting faces some potentially serious problems with regard to both its implementation and its monitoring. First, inflation targeting may be difficult to implement, for the simple reason that central banks, in CBRT case also, have imperfect control over inflation. Current inflation is essentially predetermined by previous decisions and contracts, which means that central banks can only affect future inflation. Long and variable lags, and variable strength in the effect of monetary policy on future inflation make decisions on current instrument setting inherently difficult. Inflation is also affected by other factors than monetary policy, in particular disturbances that occur within the ‘control lag’ between the instrument change and the resulting effect on inflation. Second, the imperfect control over inflation makes monitoring and evaluation of monetary policy by the public inherently difficult. For instance, with a control lag of 1.5-2 years, it appears that current monetary policy cannot be evaluated until realized inflation has been observed 1.5-2 years later. However, that observed inflation is the result of several other factors than monetary policy, in particular disturbances that monetary policy cannot respond to due to the control lags. Thus, measuring monetary policy performance is not straightforward. A central bank may argue that a particular deviation of realized inflation from the inflation target is due to factors outside its control, and that it should hence not be held accountable for the deviation.

In practice, much of interest rate setting is not driven by looking at inflation and growth forecasts at all horizons, but is based on rules of thumb. In particular, inflation-targeting is usually based on inflation forecasts 1-3 years out, often with a focus on a fixed horizon such as two-years. This can have the effect that asset price misalignments get an insufficient weight in policymaking so presumably and practically, meaning that CBRT should also incorporate asset price misalignments. Suppose, however, that a large asset-price increase is deemed to be fragile and a possible bubble, with a significant risk for a future collapse. Suppose further that a future collapse is deemed to have undesirable consequences for future inflation and resource utilization. Then the bank faces a delicate situation. It is possible that a policy-rate path with a higher policy-rate in the near future will be deemed to dampen asset-price increases in the near future and also reduce the risk or size of a collapse in the more distant future, thus undershooting the inflation target in the near term but providing a more stable development of inflation and resource utilization in the medium and longer term. These are examples of situations when the central bank may choose to respond to asset-price developments. However, the reason for these responses is that the central bank is concerned with the repercussions for inflation and resource utilization, not with the asset prices as such. That is, asset prices are not target variables; they do not enter the loss function. Asset-price movements and asset-price bubbles may directly threaten financial stability and cause the financial-stability constraints on monetary policy to bind. Thus, the central bank may want to respond to asset price developments that increase the risk of financial instability in the future. Again, in many realistic situations, the difficulty in making such judgments will be very great and there will be insufficient information for taking such preemptive action in many cases.