Gazi Erçel: Focus on inflation targeting
Opening remarks by Mr Gazi Erçel, Governor of the Central Bank of the Republic of Turkey, made at
the Conference on Inflation Targeting which was organized by the Central Bank of the Republic of
Turkey in Ankara on 19 October 2000.
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I am very honored to present the opening remarks at this conference on Inflation Targeting (IT)
Framework. First I would like to extend our appreciation to the lecturers of the Conference who came
a long way geographically, and considering the state of the economy they reach. The issues that are
going to be addressed will be of great interest, particularly for developing and dis-inflating countries.
The attendance of so many speakers from the Central Banks and international institutions is
particularly motivating. This Conference will review the country experiences on inflation targeting,
particularly touching on the best ways to design policy objectives, responses, and implementation
issues. Some papers will consider not only inflation targeting framework, but also the case of
economies during the shift to low inflation.
Let me begin my remarks by focusing on a framework that has been widely validated among
academics and policymakers during the last 10 years.
Inflation targeting is an innovative approach to monetary policy being applied by a growing number of
central banks of not only industrial but also emerging market countries of the world.
Now, more than ever, businesses are operating in a rapidly changing world. Even the marginal
uncertainties have become important. Rapid changes in technologies, globalization and increasing
competition are the challenges of the day for the business community.
In the dynamic economic environment of the 1990s, business communities have been taking not only
the risks of their new investments on technology, but the risk of inflation as well. In an inflationary
environment, businesses and individuals end up spending more time and money either protecting
themselves against inflation or trying to benefit from it.
The rapidly changing environment affected not only the business decisions but the monetary polices as
well. The traditional anchors for monetary policy and of central bank accountability - exchange rate
targets and money aggregate targets - have fallen victim to liberalized capital mobility, inter-dynamic
markets namely, by the introduction of new financial instruments, technology, financial globalization,
and as a result unstable money demand.
At this juncture, the role of the central banks and the framework of the monetary policy needed to be
drawn more clearly. The ultimate goal of monetary policy has become reasonable price stability,
which is generally understood to point the inflation at rates low enough not to affect economic
decisions.
Thus, the rise of an inflation targeting monetary framework is not a surprise but it is a natural reaction
to a dynamically changing economic environment.
Here I would like to briefly review the footsteps of inflation targeting framework. The first issue that I
would like to touch on is the time-inconsistency problem in monetary policy.
Monetary policy works with relatively long lags. Any action taken by a central bank today must be
based largely on considerations about the rate of inflation one to two years down the road. So even
though the underlying rate of inflation has been lower, central banks have to consider what is likely to
happen to prices in the future. Long and variable lags made it difficult to know what the appropriate
policy was at each moment for the purposes of fine tuning future economic activity. In addition,
political pressures tended to emphasize the immediate or short-term benefits of stimulating the real
economy at the expense of long-term increases in inflation from such policies (myopia). The
combination of these lags and myopia imparted an inflationary bias to policy with the result that in the
long run inflation was higher than it otherwise would have been, with no gain in real output. The more
systematically monetary policy was used to fine-tune economic activity, the more the inflationary
consequences of such policies were anticipated. An anticipated monetary stimulus would be passed
through immediately to prices with no affect on real output.
A second problem of the monetary policy is the need for a nominal anchor.
If monetary policy could not be expected to dampen business cycles by fine tuning, it might do so by
stabilizing inflation expectations as the result of a clear and credible commitment to a nominal anchor
that is believed to stabilize prices on average in the long run.
Such a policy has two goals: the first is to provide the market with reliable information on what the
rate of inflation will be so that investment, wage setting, and other market decisions can be made with
greater confidence in what the future price level will be.
The second is to ensure that the inflation rate is very low in order to improve the quality of price
signals. Such a policy might minimize the gap between actual and expected inflation that spill over to
the real economy. By removing the inflation bias of discretionary policy, nominal interest rates would
be lower, and by diminishing uncertainty over the future price levels, a credible nominal anchor would
reduce the inflation risk premium in both nominal and real interest rates.
Here, there is a need for clear operational rules to know what short-run stance of policy would be
appropriate for the future. The purest examples of such rules are a fixed exchange rate and a fixed rate
of growth in a monetary aggregate. Either rule provides a clear anchor for inflation expectations.
A credibly fixed exchange rate is the most transparent nominal anchor. A floating exchange rate with a
money growth rule as the nominal anchor is also easy to monitor, if somewhat more difficult to
achieve. Both anchors suffer, to some extent, from being indirect routes to the real objective of
monetary policy, which is price stability. Targeting the price level directly, however, was generally
considered not possible since the linkages between policy instruments and prices were somewhat
uncertain and contained the long and variable lags.
These problems led to two new issues which brought about a revolution in the approach to central
banking. These are transparency and improved forecasting.
Clearly, monetary policy is most effective in the presence of a firmly established nominal anchor, and
the more understandable that anchor is to the public the better. An effective commitment to long-run
price stability is just such a nominal anchor that the target rate of inflation communicates to the public
the price level the central bank is aiming to achieve at specified dates in the future.
Any move away from policy rules for long periods must face and deal with long and variable lags in
the economy's response to changes in policy stance. Improved modeling and forecasting is giving
central banks increasing confidence in basing current policy decisions on expected future outcomes.
When we sum up these developments in monetary policy, we need a monetary framework which
includes the following components. It should be:
• transparent;
• accountable;
• predictable and easy-to-monitor; and
reliable.
•
This is also why the IT (inflation targeting) countries introduced these institutional and operational
features into their monetary policy frameworks.
Before passing to the key issues for the success of IT regime, I would briefly like to focus on the basic
key requirements of the inflation targeting framework in the literature. These are:
• The public announcement of medium-term numerical targets for inflation with due advance
notice.
• The recognition of price stability as the sole objective of monetary policy without other
nominal targets.
• Increased transparency of the monetary policy strategy through communication with the
public and the markets about the plans, objectives and decisions of the monetary authorities.
• An independent central bank both in the context of the institutional and operational arena.
Development of appropriate policy instruments and a clear understanding of the underlying
•
monetary policy transmission mechanism or at least a reliable model for forecasting medium
to long-run inflation.
The announcement of inflation targets communicates the central bank's intentions to the financial
markets and to the public, and in doing so helps to reduce uncertainty about the future course of
inflation. Many of the costs of inflation arise from this uncertainty or variability rather than from its
level; for example, uncertainty about inflation exacerbates the volatility of relative prices and increases
the riskiness of non-indexed financial instruments and contracts set in nominal terms.
By making explicit the central bank's medium-term policy intentions, inflation targets improve
planning in the private sector, enhance the public debate about the direction of monetary policy, and
increase the accountability of the central bank.
Under an inflation targeting regime the central bank would be forced to calculate and publicize the
long-run implications of its short-run actions, thus ensuring that they would be subject to public
scrutiny and debate. To the extent that the central bank governors dislike admitting publicly that they
may miss their long-run inflation targets, the existence of an inflation targeting framework provides an
incentive for the central bank to limit its short-run opportunism.
The advantage of the inflation targeting regime is its great emphasis on the regular communication
with the public and transparency. This property plays an important role in the success of inflation
targeting, particularly in the industrialized countries. The policy makers in the developed countries use
every opportunity to communicate with public speeches, and takes a step further by way of inflation
reports.
Transparency and openness of the operating framework of monetary policy can bring important
credibility gains, and institutional arrangements such as greater independence of the central bank can
be helpful in this regard. European Central Bank and central banks in the EU zone are good examples
for a model. Hence, it is perhaps not surprising that in many countries the adoption of official inflation
targets has been accompanied by moves toward central bank independence and accountability.
Nowadays, central banks are increasingly publishing information on their policies that they would
have considered state secrets only twenty years ago, like minutes of board meetings and policy
models.
The key for the success of inflation targeting is the existence of a strong institutional commitment to
price stability. This is particularly important in emerging markets that have had a past history of
monetary mismanagement. The institutional commitment involves having a central bank that: 1) is
insulated from political interference; 2) has full and exclusive control over the setting of monetary
policy instruments and 3) has a mandate to achieve price stability as its primary goal.
To conclude with, I will stress once more that the IT approach appears to be very propitious for
emerging market countries in converging with international levels of inflation. However, concrete
macro fundamentals still remains the indispensable condition for preserving price stability under any
monetary policy framework.
Now, I would like to leave the floor to Mr Douglas Laxton who is one of the senior economists in the
Research Department of the Fund.
Thank you.