Econs Primer: Inflation targeting, a central bank policy for price stability

Practice, Practice...on the medium term!

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Definition:

Inflation targeting is a commitment by the central bank to keep the inflation rate close to an agreed level as a tool of monetary policy, and making this commitment known publicly.

Inflation targeting was started by New Zealand 20 years ago when it announced that it was making controlling inflation its primary policy objective while emphasizing transparency and accountability in achieving that target. Many other developed economies have followed the example of New Zealand, including the United Kingdom and Japan.

Other countries like the United States who have not followed it as of today, March 2015, have imbibed the spirit of inflation targeting in her policy pronouncements.

Goals of Inflation targeting:

1. Price stability.

When the target inflation is known by all the stakeholders in the economy, it helps them in planning for now and the future. Therefore, prices do not move erratically based on the expectations of the market.

2. Operational autonomy:

A central bank that is accountable to the public is usually given a wide margin of operational autonomy by the government to operate freely unless public opinion turns against it. This implies the central banks pursue a unintended policy of public relations with the citizenry in mind. There is a fear that this might politicize the process inadvertently.

3. Avoid high inflation.

Many of the countries with an inflation target, notably the UK, stick to an inflation target of 2%+/- 1.0. High inflation which can destabilize the economy and bring about high unemployment is hence avoided or fought quickly. High inflation also increases the inequality in the country.

4. Effective monetary policy.

By making stakeholders in the economy part of the central banks policy briefings through a transparent and accountable process, its effectiveness in driving monetary policy is enhanced.

Benefits of inflation targeting:

• Policy transparency and accountability.

It is a fact that inflation targeting brings about a progressive increase in policy transparency and accountability. Communication becomes the key of providing public accountability. In the light of the fact that central banks gain a high degree of autonomy, this is the advisable course of action.

• Avoiding recessions.

If high inflation is curtailed, recessions and depressions are avoided. A recession though somewhat ambiguous refers to a period of reduced GDP growth and elevated unemployment while a depression is a large and protracted recession.

• Low inflation expectations.

When have low inflation expectations and they believe it is reasonable to do so, they put less pressure on wages and salaries, thereby prices and margins which firms set become reasonable.

• Central Bank flexibility.

Although inflation targeting is the primary policy objective of the central bank, it gives it the ability of pursuing other objectives like smoothing output. Inflation targeting is usually set within a medium term framework i.e two-to-three years horizon, hence, while the timeline ticks, it pursues other objectives in the short term which would help make its medium term goals, notably low inflation expectations, well anchored.

Challenges of adopting inflation targeting:

Some of the challenges encountered over the 20 year history of inflation targeting are:

• There is a debate over what role the exchange rate will play in an inflation targeting framework.
• The question remains on how to reconcile monetary policy responsibilities and objectives with a responsibility to maintain the stability of the financial system.
• Inflation targets become a “religion” at the expense of other pressing problems. The fixation on inflation and the level of inflation on a daily basis becomes a disadvantage while other problems like unemployment or supply-side shocks suffer. Supply-side shocks and unemployment are also a subject of the medium term.
• The central bank is faced with an uphill task if it faces public opposition.

Macroeconomics primer: How quantitative easing affects loans, cash, investments and the economy

Definition:

Quantitative easing can be defined as the introduction of new money into the money supply of an economy. In a central banks’ balance sheet, it has the option of either purchasing or selling government bonds in the open market. Rather than utilize this traditional monetary option, the central bank decides to buy the bonds of banks and debt instruments of other corporations.

Learning doesn't end.

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Why implement quantitative easing

When the economy is in a crisis and the conventional attempts to revive it using monetary or fiscal policies have failed, the central bank might be called upon to experiment with a quantitative easing.

As the central bank buys corporate bonds and assets, the prices of these instruments rise while their yields fall. Therefore, the cost of borrowing for businesses and households falls. It is expected that when the banks and other financial institutions lend these money, investments will increase.

These fall in cost of borrowing and availability of easy money for lending increases liquidity in the economy. Liquidity refers to the availability of liquid cash in the economy. As we know, cash is an engine for activity. Availability of these cash is expected to revive the already comatose economy.

On the consumers’ side, there is much money to buy new houses and non-durable goods like cars, toys, computers, laptops, video players etc. Therefore, demand on the aggregate in the economy is expected to rise.

This expected rise in aggregate demand makes businesses borrow money in order to anticipate high demand for their products. Therefore, competitive pressures increases and many companies reduce the prices of their goods in order to gain market share and make more profit.

Eventually, when businesses start making profits, employees or workers start asking for an increase in salary. Eventually, producers raise their prices in order to meet up with the increased wages they are paying and prices rise again. Employees once again ask for higher salaries and to meet up the demand, producers increases the prices of their goods. Eventually, the increase in prices is expected to stabilize.

Therefore, inflation, a general increase in prices and fall in the purchasing value of money, is what central banks expect when quantitative easing programs are introduced.

The above scenario is what makes the economy vibrant after it has been tepid following a financial crisis.

But sometimes it doesn’t work out as in a fairy tale!

Sometimes, it doesn’t work out as calculated.

1. Cash hoarding:

Instead of spending the extra cash in their hands, businesses and households might decide to hoard it. That is, they might decide to amass it. Don’t blame them. After going through a financial crisis where money is hard to find, having easy money is too good to be true and losing it becomes a difficulty. When cash is hoarded, the economy finds itself in a liquidity trap. The expected increase in demand does not kick off.

2. Inequality increases:

It might increase inequality in the economy. The rich in any economy own more stocks and shares; they own more property like houses; they have access to bonds and corporate debt instruments. As the prices of these items increase, their wealth increases, increasing the inequality gap in the country.

3. Extraneous factors:

If eventually fall in prices is not in response to quantitative easing but due to something else, like a fall in the prices of commodities or resources used in the production process, inflation, or the increase in prices as predicted by the central bank, might not really be boosted. Instead, the existence of easy money might cause deflation, a reduction in the general level of prices, rather than inflation.

Overall, quantitative easing is introduced by central banks only when all other conventional monetary policy options have failed or will fail.

Central Bankers quantitative easing programs – a hint of financial or currency wars?

The Bank of Japan (BOJ) launched its quantitative easing program two years ago with the intention of recovering from the global financial crisis which rocked it along with other major economies in 2007-08.

America also implemented a quantitative easing program for the same objective. It has made the dollar stronger than other major currencies and it is still going strong. Falling oil prices and the favorable unemployment ratio for 2015 are considered one of the best points of its economy this year.

There are no war bonds in the market!

Credit: Wikimedia Commons

The Eurozone under the European Central Bank kicked off its quantitative easing program earlier this month. This week, there were signs that earlier than expected, production in European factories is at a four-year high, the euro is appreciating and investing in European debt instruments is very attractive.

Is it likely that the Central Bankers in the world’s major economies are at the center of currency wars? Not likely. If you listen to the rhetoric from the BOJ, the Feds and ECB, they are concentrating on a recovery from the global crisis of circa 2008. Quantitative easing is not a sure and tested response for a recovery. Quantitative easing is a response that is accepted when other fundamental monetary policy responses have failed.

If you take a look at the balance sheet of Central Bankers, you will notice that government bonds are one of its major assets. Rather than sell more bonds and increase interest rates, when monetary discipline involves sticking to a target inflation figure (i.e 2%), by buying corporate bonds and bank financial instruments, they are drawing down rates across board and increasing their exposure to foreign investment.

By the way, have you noticed that none of the central banks have the idea of overseas quantitative easing? They think local, only of the banks and the financial situation within their jurisdiction, not with respect to any other.

So, as some writers have propounded on the Internet, it is unlikely that a currency war is going on. The euro’s recent appreciation, this week, is favorable to the Feds. Else, why did the Fed not hike up interest rates as expected in order to stem the expected movement of investors to Europe?

Oil price uncertainty (1): Monetary and fiscal policies might arrive too late to be effective.

The slightly more than fifty percent (50%) fall in oil prices since June 2014 seems etched in stone. Oil prices are dipping. To shore up prices, oil exporters are relying on supply side economics. The market is not well understood. When major OPEC countries are sticking to their guns rather than implement expected production cuts, it could only be opined that uncertainty rides the market.

The steep fall of oil prices since June 2014!

Source: Investing.com

For the past nine months, the news is beset with falling oil prices followed by reduction in energy bills – gasoline prices have fallen, fuel prices at the stations have fallen, prices of non-durable goods have also followed suit. Consumers seem to be having a good time. Income after taxes and transfers, what is called disposable income, is now worth more. Globally, the fall in oil prices have benefited consumers. It is estimated that the increase in global GDP due to a decline in oil prices should be around 0.7-0.8%.

But it’s not alright on the economic front for both oil importing and exporting countries despite the burgeoning demand. The sweet story resides in the short-term. What really matters is the medium and long-term effects of a sustained and unrelenting fall in oil prices. What would a Central Banker do if reducing costs of production passes through declining inflation?

According to Raju Huidrom, “the U.S. Federal Reserve has typically chosen to respond vigorously to inflation increases triggered by higher oil prices but has responded less to unexpected declines in inflation following oil price declines.” Expected monetary expansion are already been put in place.

The European Central Bank’s quantitative easing program will give more liquidity to the banks and make the prices on corporate assets rise while their yields fall, therefore kicking in expected increases in investment. It is rumored that Israel might start a quantitative easing program soon.

But the problem, as foreseen in the recent OECD’s interim assessment report that was released last week is that expected investment increases might not be in the right channels. Increased capital expenditures and increased consumption of durable goods is a monetary policy goal but the market might not give them victory on a platter of gold. According to the OECD, the market is not operating on fundamentals.

Therefore, it is advised that fiscal policy should be used to strengthen and safeguard monetary policy. Reduction in the budget deficits of most developed countries and the BRIC countries would be desirable. Spending cuts in government are not easy to implement. It takes a long time. It takes strong political willpower. Even Nigeria, one of the foremost oil exporting member of OPEC, has been rumored to warn civil servants that to kick in spending cuts, they might have to accept some retrenchment.

If oil prices continue to remain adamant, the market will have to surrender to uncertainty. Except OPEC countries like Saudi Arabia agree to production cuts that should prop up oil prices.

Next in the series: Oil price uncertainty (2): Attired as a bear.