'Inflation Targeting: Art or Mantra?', 26 April, 2004.

Strongly associated with the European monetary-policy establishment and the International Monetary Fund, the idea of inflation targeting is perhaps not without admirers in India. However, what is inflation targeting anyway? Even a practicing economist may be forgiven for asking this question for has inflation not been a legitimate focus of monetary authorities the world over, since at least the early 70s when following the first oil shock endemic inflation appeared to have become entrenched in the industrialised countries? The use of the term inflation targeting, however, is intended not so much as to re-emphasise the enduring concern with inflation as much as to convey that the monetary authority will now act on the inflation rate directly, rather than upon some intermediate target such as the rate of growth of the money stock. Thus inflation targeting signifies a shift from targeting the money stock to targeting inflation directly. While this may sound eminently sensible and convey the impression of the triumph at last of the practical approach over allegedly arcane debates on the determination of inflation and the role of monetary policy, actually, it begs the question of how inflation is to be controlled at all. There are, of course, egregious instances of successful inflation targeting. Indeed by studying these episodes, and thus inevitably recognising their extreme specificity, we would be able to see what inflation targeting may lack as a generic policy prescription.  

The most commonly rustled up example of a country where inflation targeting has been successful is New Zealand. New Zealand has an independent central bank requiring to turn in an inflation rate within a mandated range. It is also correct that New Zealand has managed a steady and low inflation rate for a fairly long period by now. And how has this been achieved? It has been by managing the exchange rate. As a lower exchange rate translates into a lower rate of increase in the price of imports it dampens any imported inflation thus restraining the price level, an average of domestic and world prices, weighted appropriately. However, this rosy picture is not without blemishes. A low exchange rate must immediately render domestic goods less competitive in world markets. Or, simply put, exports suffer even as the national inflation rate is lower than it would be otherwise. Despite any generally negative impact on output inflation targeting has been quite popular in New Zealand and some European countries, notably the Scandinavian ones. The distinctive nature of the club is not without a significance. Note that these are all small open economies. Small open economies cannot have prices too far removed from world prices. The only wedge available is the exchange rate. By effectively pegging the exchange rate, small open economies can manage their national inflation rate. This is about all that inflation targeting amounts to in the context. There is little of art here, for the inflation control is based on the accounting relation that the national price level, for such an economy, is merely the world price multiplied by the exchange rate. In a large and relatively less open economy inflation targeting cannot be much more than a mantra, for as the emperor was found to be wearing no clothes the central banker may be found to be without instruments. And I am not harking back to the technicality that for a country with a fixed exchange regime there can be no independent monetary policy, the idea that won Robert Mundell the Nobel Prize some years ago. More substantially, for a less open economy a given change in the exchange rate would pass through to a smaller range of goods. A perfect instance of this is happening right now before our eyes. 

China is said to be exporting inflation currently. It is interesting that the pundits were till only recently seeing it as an exporter of deflation in the world economy by exporting huge amounts at worsening terms of trade. Anyway, it is now exporting inflation as it overheats, having gone into overdrive building physical infrastructure. American and Indian steel companies are among the beneficiaries of this building spree. You may even have noticed how steel scrips are shining on the Indian bourse nowadays. As the inflation rate, driven by higher price of food, rises in China and the price of steel rises in India their central bankers are left without much at their disposal to check national inflation rates. Certainly pegging the exchange rate does not help one bit. Inflation can only be controlled by managing the supply of food in China and steel in India. These are clearly beyond the realm of possibility of central banks. Speaking of inflation targeting gives the impression of sophistication and may appear to endow the monetary authority with resolve but in effect it is no more than mantra.