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Inflation targeting: What’s the point?
Fri 13 Jun 2008 by Matt Nolan in Monetary policy

Following the Reserve Bank’s Monetary Policy Statement earlier this month, some economists are questioning the need for the Bank to maintain a strict inflation target.  Some have gone so far as to say that inflation targeting has failed to improve New Zealand’s economic wellbeing and should be done away with altogether.

Such attitudes are scary – inflation targeting by a credible central bank is a vital part of sound economic management.

Inflation is costly for a number of reasons: it reduces the purchasing power of those on fixed incomes, punishes savers, increases the volatility of prices, and forces firms to constantly update their price schedules.  All of these consequences represent a waste of resources and effort which lower our wealth and welfare.

However, the main cost of high inflation relates to the inability of some prices to move when others do.  The main purpose of a price is to illustrate the value of one product or service relative to another.  Inflation reduces the clarity of those price signals and leads to an inefficient allocation of resources, reducing national wealth.

Even if we accept that inflation is inherently bad for the economy, some people may still question whether using an inflation target is an effective way of controlling inflation.  Setting an explicit inflation target provides a clear signal of where inflation is likely to head over the medium term.  From time to time, prices for some individual goods and services will rise more quickly or slowly due to specific economic factors (petrol and food prices are current examples).  But if people believe the Reserve Bank’s commitment to fighting inflation is credible, then they will expect such price "shocks" to be only transitory.  Sometimes headline inflation will be above the target, and sometimes below, but a credible central bank will generally maintain average inflation close to its target over the medium term.

Inflation, and inflation expectations, have a self-fulfilling element that comes in at this point.  If people believe average prices are only going to rise in line with the Reserve Bank’s target rate then, in the absence of specific shocks to their business, they will set their prices (and wages) in a way that is consistent with this belief.  This behaviour helps to keep overall inflation low without having to bump up interest rates and slowdown the economy.

Recent economic events (drought and higher petrol prices) have raised questions about the Reserve Bank’s flexibility to respond to shocks to the productive side of the economy, given the current inflation targeting regime.  Cutting interest rates now seems out of step with the inflation pressures coming from higher food and petrol prices.  But if price setters believed that the Bank was credible in fighting inflation, average price and wage setting behaviour would continue in a manner consistent with the Bank’s explicit inflation target.  The shocks would eventually be worked through and inflation would return towards its target.

The underlying confidence that inflation is "anchored" would in fact allow the Bank to reduce interest rates and help prevent a more pronounced slowdown in economic activity.  In other words, the combination of an inflation target and the Bank’s reputation as an inflation fighter should give them the room to cut interest rates in the face of shocks to the productive side of our economy.

The problem that the Reserve Bank faces in cutting interest rates this year is that its inflation-fighting credibility is under a cloud.  Although the Bank has said that it believes "inflation expectations remain anchored", our graph suggests otherwise.  Adjustments to the policy targets agreement in 1999 and 2002, statements by Dr Cullen suggesting that monetary policy may need to change, and policy decisions from the Reserve Bank that have allowed domestic inflationary pressures to consistently build over the last five years have damaged this credibility and led to higher inflation expectations.

Inflation expectations are now closer to the top of the Bank’s 1-3%pa target band than the middle, implying that wage and price-setting will be conducted in a way that is consistent with higher inflation expectations.  Once again the element of self-fulfilment arises, ultimately leading to inflation being sustained at higher levels.

If the Bank decides to rapidly cut interest rates now in order to boost consumer sentiment, the medium-term results will be even greater levels of inflation, higher inflation expectations, and a far costlier re-adjustment period if the Bank wants to get inflation back down again in the future.

So although drought and other external shocks mean that economic growth will be weak over the next 12 months, instead of laying the blame on the Bank’s inflation targeting regime, we should be criticising the policy changes that have gradually eroded the Bank’s credibility and are now preventing the achievement of this mandate.

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