Development Central Banking, Part 1

What’s Wrong with Inflation Targeting?

Gerald Epstein

This is part 1 of a two-part series by regular contributor and Political Economy Research Institute (PERI) co-director Gerald Epstein, adapted from his recent International Labour Office (ILO) working paper “Development Central Banking: A Review of Issues and Experiences.” This post focuses on the “inflation targeting” central-bank policy pushed on developing countries under the “Washington Consensus” and what is wrong with it. Part 2, next week, will follow with answers to the principal mainstream objections to a broader “development central banking.”

In its strict form, “inflation targeting” posits that central banks should have only one objective—low and stable inflation—and should utilize only one policy instrument—usually a short-term interest rate. As a corollary, the conventional wisdom usually promotes the idea that central banks should be “independent” of the government, in order to enhance their ability to reach the inflation target. This is usually justified on the basis of avoiding time inconsistency and resisting pressures from governments to finance fiscal deficits. No matter how much policy makers such as Olivier Blanchard question inflation targeting in the rich countries, as they have in recent years, it is still widely seen as the current “best practice” for developing countries.

Even if one believes that this general approach is a good one, a key question arises: what is the appropriate inflation rate? The standard practice is that countries should try to maintain inflation in the low single digits (Anwar and Islam, 2011). Where does this number come from? One might expect that a number designed to guide the making of monetary policy in many parts of the globe would come from rigorous research and a broad consensus that the optimal rate of inflation for developing countries is in the low single digits. However, nothing could be further from the truth.

The theoretical case for an optimal inflation rate in the low single digits is very weak, largely because inflation plays no central role in the fundamental general equilibrium models that underlie most welfare analysis. In terms of growth theory, the results are ambiguous. Early work by James Tobin (1965) and Foley and Sidrauski (1971) shows that higher inflation can lead to higher economic growth by lowering the rate of return on financial assets relative to real capital and thereby leading to more investment. Under some model parameters or different model structures, though, the impact can go the other way. Hence the issue comes down to an empirical question.

On the empirical front, however, there is no credible evidence that inflation in the low single digits is the optimal inflation rate for developing countries. Bruno and Easterly (1996) find little evidence of a negative relationship between inflation and growth with inflation rates less than 40%. More recent studies, including those that look at nonlinearities and threshold effects find that, for developing countries, growth starts declining on average when inflation rates hit between 14% and 18%. (Pollin and Zhu, 2009; Anwer and Islam, 2011). This is a far cry from 4-6% or less, which is a typical target range for developing countries.

This raises the question of why inflation targeting regimes identify such a low inflation rate as the optimal rate, even though there is no evidence that this is valid in the case of developing countries. There is accumulating evidence that a long-standing suspicion about group preferences with respect to inflation, going back at least as far as Keynes, is true: namely, that the financial sector has a stronger dislike of inflation than other groups in society (see, for example, Jayadev, 2008), and that this dislike of inflation helps to explain central bank behavior (Epstein, 1994; Posen, 1995).

This inflation aversion of the financial sector also points to a problem with so-called central bank “independence”. In a democratic society, there is no such thing as political independence. All institutions are political in nature and need political constituencies to protect their authority and prerogatives. “Independent” central banks typically nurture close relationships with finance for support, leading to a political and economic symbiosis (Epstein, 1994). As Milton Friedman noted decades ago, independent central banks are likely to be too close to the “commercial banking” sector rather than making policy in the public interest (Friedman, 1962). As a result, independent central banks often tend to pursue excessively anti-inflationary policies.

Choosing the wrong target would not matter if undershooting had no negative impacts on important economic variables, such as employment, wages and growth. In practice, however, it would seem that excessively restrictive monetary policy can lead to excessively high real interest rates, and, with open capital markets, can lead to capital inflows, overvalued real exchange rates, and harm exports and reduce employment and growth (Epstein and Yeldan, 2009; Rodrik, 2008).

In practice, targeting inflation with increases in interest rates might be a startlingly incorrect assignment of instruments to targets. Much inflation in developing countries is due to supply or external shocks (Heintz and Ndikumana, 2010; Anwar and Islam, 2011). Responding to a supply shortage or an external price increase with a policy designed to reduce domestic demand can sometimes add insult to injury. It could worsen the problem by reducing capacity further or, in the case of external shocks, create collateral damage by leading to an over-valued exchange rate.

A further key problem for inflation targeting in developing countries, is that the transmission mechanism between traditional monetary policy and the macro-economy in many developing countries is weak (Mishra et al., 2010; Mishra and Montiel, 2012). The main problem is that when the central bank increases the money supply to try to lower interest rates and expand credit, the banking system is not very responsive. It often fails to lower interest rates on loans proportionally, thereby allowing interest margins to rise. This increases their profits but does not commensurately lower the cost of credit. Moreover, the financial system often fails to provide new credit to relatively underserved groups, such as small businesses (SMEs) or small farmers. On the other hand, when the central bank increases interest rates in an attempt to slow inflation, the commercial banks are quick to increase rates and widen interest rate margins.

Clearly, a restructuring of the financial system will be required if monetary policy is to be more effective in achieving any targets, including inflation control. These examples illustrate a key flaw in the conventional arguments for inflation targeting: the idea that by delivering a low and stable inflation rate, inflation targeting central banks will help deliver both macroeconomic stability and economic development objectives to developing economies. The conventional argument is that stable prices will be sufficient to provide macroeconomic stability and that if there is macroeconomic stability (and other appropriate market institutions such as appropriate property rights) then private investment will flourish and economic development is likely to follow. (In the extreme version of this argument, inflation targeting and appropriate property rights enforcement is sufficient to deliver both macroeconomic stability and economic development).

However, as the previous examples illustrate, inflation targeting by central banks does not necessarily deliver macroeconomic stability. In developing economies with liberalized domestic financial markets and with economies integrated into global capital markets, inflation targeting can be associated with de-stabilizing capital flows and outflows (sudden stops), cycles of over-valued exchange rates and crashes, destabilizing allocation of credit to real estate and other types of speculation. The consequence is short-term investment cycles that hinder long-term investment in industries associated with dynamic comparative advantage, upgrading and long-term employment generation (Epstein and Yeldan, 2009; Galindo and Ros, 2009).

In other words, macroeconomic policy focused on inflation targeting is likely to deliver neither macroeconomic stability nor economic development. Partly as a result of these problems, many central banks implement inflation targeting more in the breach than in the practice. Missed inflation targets have become commonplace even in countries that claim to adhere strictly to their target. While some take this as evidence that central banks are losing discipline, it might be more accurately taken to reflect that inflation targeting is an inappropriate framework for macro-policy guidance for countries trying to navigate the treacherous waters of a financialized global economy. What is the advantage of pretending to adhere to strict inflation targeting when, in fact, like their counterparts in the developed world, developing country central banks are innovating and experimenting out of necessity to deal with the economic problems they face.

Would it not be better for these central banks to admit that achieving a moderate level of inflation is an important goal, but only one of several important issues facing their economies? In that case, central banks could play a more active role as part of government initiatives to confront the major macroeconomic challenges facing their economies.

Sources

Anwar, S. and Islam, I. 2011. “Should developing countries target low, single digit inflation to promote growth and employment?” Employment Sector Employment Working Paper No. 87, ILO, Geneva.

Bruno, M. and W. Easterly, 1996. “Inflation and Growth: In Search of a Stable Relationship” in Federal Reserve Bank of St. Louis Review, 78 (3), pp. 139-46.

Epstein, G., 1994. “A political economy model of comparative central banking”, in New perspectives in monetary economics: Explorations in the tradition of Hyman Minsky., G. Dymsky and R.N. Pollin , Ann Harbor, University of Michigan Press, MI, USA.

Epstein, G. and Yeldan, E. eds. 2009. Beyond inflation targeting: Monetary policy for employment generation and poverty reduction. E. Elgar Press, Northampton.

Foley, D. K. and Sidrauski, M. 1971. Monetary and fiscal policy in a growing economy. Macmillan, New York.

Galindo, L., and Ros, J. 2009. “Alternatives to inflation targeting in Mexico”, in Epstein, J. and Yeldan, E. (eds.), Beyond Inflation Targeting, Edward Elgar Publishing.

Heintz, J. and Ndikumana, L, 2010. “Is there a case for formal inflation targeting in Sub-Saharan Africa?” PERI Working Paper.

Jayadev, A. 2006a. “Differing preferences between anti-inflation and anti-unemployment policy among the rich and the poor”, in Economics Letters. 91. pp. 67–71.

____________ 2006b. “The class content of preferences towards anti-inflation and antiunemployment policies”, PERI Working Paper, www.peri.umass.edu

Mishra, P.; Montiel, P. J. and Spilimbergo, A. 2010. “Monetary transmission in low income countries.” IMF Working Paper, wp/10/223, International Monetary Fund Washington DC.

_____________ 2012. “How effective is monetary transmission in low-income countries? A survey of empirical evidence”, IMF Working Paper WP/12/143, International Monetary Fund Washington DC.

Pollin, R. and Zhu, A. 2009. “Inflation and economic growth: A cross-country non-linear analysis”, in Epstein, G. and Yeldan, E. (eds.), Beyond inflation targeting, Edward Elgar Publishing.

Posen, a. S. 1995. Central bank independence and disinflationary credibility: a missing link? Federal Reserve Bank of New York Staff Reports 1.

Friedman, M., 1962. “Should there be an independent monetary authority?” in Leland B.Yeager (Ed.), In search of a monetary constitution, Harvard University Press, Cambridge.

Tobin, J. 1965. “Money and economic growth”, in Econometrica 33: pp 671–84.

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