Inflation Targeting and Nepalese Context

Abstract

Inflation targeting is a monetary policy regime. It involves the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets. Adoption of inflation targeting is not just a policy declaration. For that certain pre-requisites must be fulfilled. Focusing monetary policy on inflation does not imply that inflation targeting is indifferent to the performance of the real economy is simply incorrect. In Nepalese context, to switch monetary policy towards inflation targeting, central bank should have to fulfill pre-requisite first. Basically autonomy of central bank, public communication are the most important pre-requisite that Nepal must have to fulfill. Top of all the existing exchange rate system with Indian currency must be addressed so that economy can move towards inflation targeting.

Key words: Inflation Targeting, Monetary Policy Framework.

1. Introduction

Inflation targeting is a monetary policy regime has been used in monetary arena after 1990s. According to International Monetary Fund(IMF) inflation targeting involves the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets. Additional key features include increased communication with the public and the markets about the plans and objectives of monetary policymakers and increased accountability of the central bank for attaining its inflation objectives. Monetary policy decisions are guided by the deviation of forecasts of future inflation from the announced target, with the inflation forecast acting (implicitly or explicitly) as the intermediate target of monetary policy (Acharya, 2012).

Policymakers used to anchor their monetary policy by targeting a monetary aggregate, with expectation that controlling the demand for and supply of money, would enable them to bring down the rate of inflation. Unfortunately, monetary aggregate targeting proved unsuccessful because of instability in the money demand function. As a result to bring down the rate of inflation and to maintain it at a low level central bank adopted a policy with flexible exchange rate, is finally termed as Inflation Targeting Framework (ITF) (Freedman and Laxton, 2009).

The first country to formally adopt inflation targeting was New Zealand in December 1989. Since then, many countries have joined the club including both industrialized countries (such as Australia, Sweden, Switzerland, and the United Kingdom) and emerging economies (such as Brazil, Chile, Columbia, Czech Republic, Iceland, Israel, Mexico, Peru, the Philippines, Poland, and South Africa), with the US being the most recent addition to the list in January 2012. Many other countries are in the process of establishing a full inflation-targeting regime; while others, like European Central Bank (ECB) remain implicit targeters. Only three countries, Finland, Spain and Slovakia, have abandoned inflation targeting and this was due to their adoption of the euro which, as governed by the ECB (www.centralbanking.com). There are four Asian countries namely South Korea, Thailand, Philippine and Indonesia, has endorsed IT as a new monetary policy regime. (Ito and Hayashi, 2004).

The objective of this paper is to review the current situation of inflation targeting and its prospects in Nepal. This paper is organized as follows. After the brief literature review in section two, third section provides a glimpse of prospect analysis in Nepal. and final section concludes the work.

2. Literature Review

2.1 Pre-requisite of Inflation Targeting

Inflation targeting is a monetary-policy strategy that is characterized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast. It has been called forecast targeting, and a high degree of transparency and accountability. It means adoption of inflation targeting is not just a policy declaration. For that certain pre-requisites must be fulfilled. Major pre-requisites suggested in literature are discussed as below.

2.1.1 Sole Target

One of the most important pre-requisite for adopting the inflation targeting is the absence of another targeted nominal variable such as wages, level of employment or nominal exchange rate. Having more than one target may destroy the credibility of both anchors and there might be conflicts among the objectives. Before declaring inflation targeting target must be define very lucidly whether it is point or band. If bans then what should be the width of that band. Moreover time horizon and choice of the price index must be maintained very properly (Tutar, 2002).

2.1.2 Autonomy of Central Bank

Debelle et.al (1998) argued for independency of central. The independence does not mean the full independence but implies at least instrumental independence which permits greater discretion in the conduct of monetary policy and which mainly implies that the central bank cannot finance the government budget. In the same manner, the central bank should not be required to attain low interest rates on public debt or to maintain a particular nominal exchange rate. There should not be any political pressure on the central bank to raise the rate of economic growth in such a way that is inconsistent with the achievement of the inflation target.

2.1.3 Effectiveness of Monetary Policy

Having autonomy of central bank does not mean that there is effectiveness of monetary policy. Effectiveness indicates to establish stable relationship between the inflation outcomes and monetary policy instruments. According to Jonsson (1999) in inflation targeting regime, monetary authorities have to be able to model inflation dynamics in the country and to forecast the inflation to a reasonable degree. So, the monetary authorities should have access to policy instruments that are effective in influencing the macroeconomic variables.  

  

2.1.4 Accountability and Transparency of Central Banks

A notable feature is found in New Zealand, whereby the governor who must report on inflation performance twice each year, may be dismissed prior to the end of his five year term  if the inflation rate falls outside its specified target band (McCallum, 1996). This shows the accountability of the respective authority which is most important factors for inflation targeting countries. Aliyu and Englama (2009) also demand to be informed about the process and progress made by central bank.

The increased accountability of the inflation targeting enables the monetary authority to monitor and enhance the understanding of expectations. It also decreases the possibility of time inconsistency trap, which leads to deviations from monetary authority's long-term objective. Moreover, it provides a good benchmark that can easily be observed by the agents in the economy (Hazirolan, 1999).

By means of transparency, private sector agents can monitor and question the authorities. advice, analysis, and actions. So, this forces the authorities to get their analysis right. Since private sector agents can easily observe any myopic policy strategy under a transparent monetary policy framework, there are severe constraints to surprising the public (Hazirolan, 1999).

2.1.5 Development of Financial Institutions

Aliyu and Englama (2009) categorized the inflation targeters on the basis of development of financial institutions. Proper functioning of financial institutions leads to degree of succession of inflation targeting because instruments used by central banks transmitted through the financial institutions. Thus, sound bank and financial institutions as well as effective management of monetary and capital market is prominently expected to have on the respective economy. 

2.1.6 Flexible Exchange rate System

Debelle et.al (1998) and Mishkin (2000) strongly argues flexible exchange rate as a one of the most important pre-requisite for inflation targeting. If exchange rate system is fixed then it is impossible to any government to maintain both exchange rate as well as inflation under control. Thus, to attain desirable rate of inflation, exchange rate must be flexible.

2.1.7 Effective Communication

Effective communication increases transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of the monetary authorities (Miskin, 2000). This is possible if central bank makes public announcement about the policy of targeting so that to attain the targeted band or point. 

2.1.8 Macroeconomics Indicators

Aliyu and Englama (2009) expect to have stable employment situation, satisfactory growth on GDP, desirable BOP and proper regulation over public expenditure. Autonomy of central bank and proper coordination between monetary fiscal and financial policy leads towards the desirable macroeconomic situations.

2.2 Types of Inflation Targeting

Aliyu and Englama (2009) have identified three category of inflation targeting they are;

2.2.1. Full Fledge Inflation Targeting (FFIT)

When a country is ready to adopt IT as its single nominal anchor upon which macroeconomic stability would be achieved. Full Fledge IT (FFIT) is suitable in a country with a sound financial environment and transparency, accountability and highly committed central bank. These elements are desirable to the attainment of the goals of Full Fledge IT.

2.2.2 Electic Inflation Targeting(EIT)

When a country pursues IT along with other monetary policy objective in a stable financial environment Electic IT is suitable. However, in such a condition central bank is relatively less accountable and transparent.

2.2.3 Inflation Targeting Lite (ITL)

ITL category is suitable to those countries, which have a low profile due to lack of strong or credible macroeconomic environment. ITL adopting countries usually float their exchange rate and announce an IT. But they usually do not attain the stated inflation target. 

One of the important thing about the inflation targeting is that it is not just a framework, which only focuses on maintaining inflation within targeted band. It concerns about the fluctuation on output and employment. Focusing monetary policy on inflation, according to them, does not imply that traditional stabilization goals are ignored. The monetary policy makers under inflation targeting are indifferent to the performance of the real economy is simply incorrect. Central banks, which are responsible for inflation targeting, continue to be concerned with fluctuations in output and employment in all the countries they have studied. They have found that the output and employment continue to remain concerns of policy makers after switching to inflation targeting. In fact it can be seen in all the inflation targeting countries have invariably undertaken disinflation only gradually (Bernanke et. al. , 2011).  

3. Contextualization

Nepal Rastra Bank's Strategic Plan (2006-2010) has disclosed about inflation targeting in its Functional Strategies. Neither second strategic plan (2012-2016) has reported progress about inflation targeting nor any research has been archived in Nepalese context. One empirical study has been conducted by Acharya (2012) using ARDL to cointegration to evaluate feasibility of inflation targeting in Nepal. 

Central bank of Nepal has enacted Nepal Rastra Bank Act -2058 and has been continuously formulating monetary policy annually. By laws, central bank is considered as an autonomy institution but significant dominance has been made by fiscal policy. Due to this reason effective implementation of monetary policy always in limbo. It impact adversely on all fiscal, monetary as well as financial institutions.

Regarding the relation between real GDP on price level theoretically it is assumed that there is negative relationship between real GDP and Price Level. But in fiscal year (FY) 2010/11, when food production (it includes paddy, maize, millet, buckwheat, wheat and barley.) has increased by 10.87% and reached to 8606742 metric tons. Due to an increase in food production it was expected by using the general rule of economics a decline in price of those goods. At the same fiscal year the price of food and food products has increased by 13.4% (Economic Survey 2011/12). It means rise in production does not show negative relation with the price level in Nepal which contradict the theory (Acharya, 2012).

Empirical result suggested by NRB(2007), Ginting (2007) and Acharya (2012) found that wholesale price index of India has positive impact on Nepalese price level. This result shows that Nepalese economy import inflation from India. It may be due to high trade concentration with India, pegged with Indian currency and open boarder between these two countries.

Nepal has been facing the sharp appreciation of the US dollar in this two years. It is not because of export fluctuation but due currency fixed with Indian currency. Nepal has not faced any direct impact, so far, from the global financial crisis too. This is because, its financial market is not open to short-term portfolio investments from abroad. Exports will fall faster as competitiveness of Nepalese products is going lower as other countries producing similar goods face the downturn for their export to the industrial nations (Pokheral, 2009). This is one of the most restrictive situation in Nepal to switch towards inflation targeting.

4. Conclusion

To switch monetary policy framework towards inflation targeting, central bank should have to fulfill pre-requisite first. Basically autonomy of central bank in real sense and build up transparency as well as good public communication are the most important pre-requisite that Nepal must have to fulfill. Moreover, government should have to solve the structural problems and need to address on the problem of market imperfection to upgrade its macroeconomic indicators. Top of all the existing exchange rate system with Indian currency must be addressed so that economy can move towards inflation targeting. 

References

Acharya, Santosh. (2012). Feasibility of Inflation Targeting in Nepal. Unpublished Master Thesis, Central Department of Economics, Tribhuvan University, Nepal.

Aliyu, Shehu. U. R, and Englama. (2009). Is Nigeria ready for inflation targeting? Journal of Money, Investment and Banking. 11: pp.27-41.
Bernanke, S. Ben., and Mishkin, F.S. (1997). Inflation targeting : A new framework for monetary policy. Working Paper-5893, National Bureau of Economic Research, Massachusetts Avenues, Cambridge.

Central Banking. (2012). Available: .

Debelle, Guy., Masson, Paul., Savastano, Miguel., and Sharma, Sunil. (1998). Inflation targeting as a framework for monetary policy. International Monetary Fund.

Dotsey, M. (2006). A review of inflation targeting in developed countries. Business Review. Available: < www.philadelphiafed.org>.

Ministry of Finance. (2011). Economic Survey 2011/12. Kathmandu: Ministry of Finance.
Freedman, Charles., and Laxton, Douglas. (2009). Why inflation targeting? IMF working paper, WP/09/86, Research Department, IMF.

Gamayel, Edward. R., Jahan, Sarwat., and Peter, Alexandra. (2011). What can low income countries expect from adopting inflation targeting? IMF Working Paper, WP/11/276. Strategy Policy and Review Department.

Ginting, E. (2007). Is inflation in India an attractor of inflation in Nepal?. IMF Working Paper, WP/07/269. Asia and Pacific Department, IMF.

Hammond, Gill. (2011). State of the art of inflation targeting-2012. CBSS, Hand Book No. 29. Bank of England.

Hazirolan, U.(1999). Inflation Targeting: Japanese case and prospects for Turkey. Undersecreteriat of the Treasury, Ankara, Turkey, Mimeo.

Heikensten, Lars. (2011). Inflation targeting-the Swedish experience.(n.p.)

Ito, T., and Hayashi, T. (2004). Inflation targeting in Asia. Hong Kong: Hong Kong Institute for Monetary Research.

Jonsson, G. (1999).The relative merits and implications of inflation targeting for South Africa. IMF Working Paper WP/99/116, Washington D.C.

Kamal, M. (2010). Inflation argeting in Brazil, Chile and South Africa: An empirical investigation of their monetary policy framework. The William Davidson Institute, WP, No 1004. University of Michigan.

Lin, Shu., and Ye, Haichu. (2009). Does inflation targeting really make a difference? The other side of the story from developing countries.(p.n.).

McCallan, T, Bennette. (1996). Inflation targeting in Canada, New Zealand, Sweden, the United Kingdom and in general. NBER Working Paper Series, WP 5579. National Bureau of Economic Research, Cambridge.

Mishkin, F. S. (2000a). From monetary targeting to inflation targeting: Lessons from the industrialized countries. Graduate School of Business and National Bureau of Economic Research, Columbia University. New York.

Mishkin, F.S. (2000). Inflation targeting in emerging market countries. American Economic Reviews. 90(2): pp.105-09).

Mukherjee, S., and Bhattacharya, Rina. (2011). Inflation targeting and monetary policy transmission mechanism in emerging market economies. IMF Working Paper, WP/11/229. Middle East and Central Asia Department.

Nepal Rastra Bank. (2007). Inflation in Nepal. Nepal Rastra Bank, Baluwatar, Kathmandu Nepal.

Samimi, Ahamad., and Motameni, Mani. (2009). Political stability and of inflation targeting: New evidence. Australian Journal of Basic and Applied Sciences. 3(2): 1319-1322.

Tutar, Eser. (2002). Inflation targeting in developing countries and its applicability to the Turkish economy. MA Thesis of Economics, VPI and State University, Blacksburg, Virginia.

Categories: Articles