Inflation targeting is the new gold standard

Economic Times, 13 February 2014

Urjit Patel's Committee has proposed a framework for monetary policy. Some have argued that the intellectual framework of this report is obsolete: inflation targeting (IT) was tried and discarded on an international scale after the global crisis. This is incorrect. No country that adopted IT has ever abandoned it, and there is a steady flow of countries taking it up even after the global crisis. After the breakdown of the gold standard in 1973, IT constitutes a long-term solution to the problem of setting up a local currency.

When printing presses started making currency notes, this gave trouble. It is too easy to be irresponsible, and print too much `fiat money' - money that exists by fiat. Every currency needs a `nominal anchor': something that pins fiat money down to reality. There are exactly three choices for this nominal anchor: Gold, a foreign currency like the dollar, or the CPI basket of goods.

The gold standard (where 35 US dollars was pegged to one ounce of gold) fell apart in 1973. Ever since that, the world has been looking for a new nominal anchor. Pegging to a foreign currency works well in some places - e.g. for Hong Kong. But pegging the Indian rupee to the US dollar is not a viable option, as this is tantamount to handing over Indian monetary policy to the US Federal Reserve. This is inappropriate as the Indian business cycle is quite different from the US business cycle.

That leaves inflation targeting. That's it. There is no game in town other than gold, dollar and the CPI basket. We have to choose one. Inflation targeting anchors the Indian rupee to the price of the CPI basket.

In US law, the Federal Reserve is not an explicit inflation targeting central bank. But this law was drafted in 1913, when these things were not understood. In 1979, Paul Volcker shifted the US Fed to a 2% inflation target, but this was done by the Fed without a change in the law. From 1979 onwards, de facto, the US Fed has delivered an inflation target of 2%.

Inflation targeting that's written into the law began with New Zealand in 1990. From that point onwards, there has been a steady procession of countries that adopted it. Eurozone is bound to an inflation target operated by the ECB. Major milestones are UK (1992), Sweden (1993), Australia (1993), Mauritius (1996), Israel (1997), Brazil (1999), Chile (1999), South Africa (2000), South Korea (2001), Mexico (2001), Indonesia (2005), Turkey (2006).

After the global crisis, we have had adoptions of IT at Botswana (2008), Albania (2009), Georgia (2009), Moldova (2010) and Uganda (2011). In 2012, the US Fed made the first formal statement in its history, that it has an inflation target of 2%.

A key attraction of IT is that it's a durable solution. Having no nominal anchor gives macroeconomic instability of the kind seen in India, or worse. Pegging to the dollar gives external sector crises as seen in the Asian crisis. IT is a stable, long-term solution. No country that adopted IT has ever walked away from it. IT has not collapsed in a crisis, as currency pegs have often done. After the gold standard, IT has risen as the stable long-term solution that anchors fiat money in most of the world. China and India are the only important countries left which do not have IT.

How do we interpret a plethora of new things that we hear from the Fed or the BOE, such as quantitative easing, forward guidance, and linkages to the unemployment rate?

The first foundation is to see that nowhere have the Fed or the BOE abandoned the 2% inflation target. Long-term inflationary expectations in the US and UK are well anchored.

In a downturn, an IT central bank finds itself with a forecast that inflation will be below its target, and cuts rates. What is it to do when the policy rate has dropped to 0, and cannot be cut any more? That is where quantitative easing (QE) comes in. QE is the means through which the target is achieved, and IT is the framework that guides and shapes the magnitude of the QE. The Fed is tapering as forecasts are now showing that in the coming two years, there will be a slight increase in inflation in the US.

Forward guidance is a set of statements through which the central bank commits itself to low rates in the future. These statements have specified how the central bank will listen to the unemployment rate and modify course. Unemployment data is being used to forecast inflation. The Bank of England has IT written into its law, and could not undertake such forward guidance if it was not consistent with IT.

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