The great recession, whose deleterious effects were felt in the last decades, saw individuals and families lose their jobs and homes. The adverse effects have not completely been eradicated; recovery though slow is still in progress. Poverty levels in America increased, new individuals and families entered poverty. The aftermath of poverty can still be felt by low-income Americans to date. The great recession period was characterized by over the charts rates of inflation, this brought about inflation targeting. Inflation targeting was the policy makers’ solution to high inflation; it was first implemented in New Zealand in 1990. Inflation targeting involves setting official target ranges for the inflation rates with the primary goal of a low and stable inflation.
Objectives and mechanisms involved in inflation targeting are provided for by the central bank with great clarity. For implementation and evaluation purposes, a nominal anchor is usually provided. In the past, inflation targeting has been successful but after the global economic crisis, its ability to handle boom-bursts and inflation has been under debate. The Questions expressed by Federal Reserve policy makers is whether it is responsive to macroeconomic shocks and whether its adoption would come at a high cost to the economy. Some economists such as Fraust and Svension have been for inflation targeting (IT); they suggest that IT enables central banks to anchor future expectations. Studies tend to suggest that countries that have adopted IT have been successful in stabilizing the levels of inflation.
Such countries include Turkey, Australia, Israel, Sweden, Czech Republic and New Zealand. There are generally two main types of inflation targeting; Implicit (applied in the U.S0 and Explicit (applied in the U.K) inflation targeting. From research, it is logical to adopt the inflation targeting policy; however the costs in terms of low flexibility cannot be ignored. With this in view, experts still believe inflation targeting is important in this post-Great Recession period (Bernanke and Michael 400).
Principal premise behind inflation-targeting
Economics such as, Fraust and Svension, suggest that the principal premise for inflation targeting is to act as a tool of communication between the central bank and the public. It acts as a framework for increasing transparency in the central bank. Economic behavior depends largely on the public’s expectations. Economics for IT have come out to show that central banks which adopt IT are the most transparent. This has been under constant attacks by critics who suggest that such an assumption is simply false. They argue that inflation variability is not well communicated in IT; it is only efficient in setting the mean inflation. An example, according to critics, is the Bank of England and the Bank of Canada. Their reports, they (critics) say, exhibits anti-transparency. If this is the case, then it shows us the level of ignorance with regards to the teachings of one of the most influential economists- Paul Volcker. In the Volcker years, despite critics and protests, inflation targeting proved to work. This is also evident today in countries whose central banks have adopted IT in their monetary policy. I would say that the objective of transparency has been achieved. IT does not guarantee an easy path; it only specifies the goals of the monetary policy (Bléjer 57).
Money Supply and Inflation Targeting
The relationship between supply of money and prices may be best explained by the equation of exchange (theory of money). It was generally observed that increase in money supply would result to increases in prices. In the money supply question, inflation rates are dependent on the price level, money balances and the exchange rate. The relationship is as follows: raising interest rates would result to a supply shock this will in turn bring the inflation rate back to a specified target. In cases of low interest rates the opposite happens; money supply increases hence exerting an upward force on inflation. Central banks adopting IT have achieved greater control of inflations by achieving the desired targets. The have improved the way of coping with supply shocks (Freedman and Douglas 20).
An Ideal Rate of Inflation
After the great recession, with the inflation rates much lower, the question of what rate of inflation to target is still on debate. Some policy makers and economists suggest that inflation rates should not fall below zero. The reason behind it is to prevent deflationary costs, which may be too high. In IT what inflation rate to target is of substantial importance to the central banks. The optimal inflation rate should be chosen in such a way that it maximizes the public’s economic well-fare and minimizes costs. In the U.S, under the PCE price index, the optimal inflation rate is estimated to be between 0.7 and 1.4 per annum. At a low rate of inflation above zero, employment can be maintained, effects of negative inflation are evaded and the nominal interest rates fall to almost zero. The measures of inflation such as the PCE (personal consumption expenditure) price index and the consumer price index are not 100 percent accurate; they are prone to errors (Samuelson 801).
They are imperfect and usually tend to favor the upper side; this is another reason why the inflation rate should be slightly above the zero mark. At a zero rate of inflation, companies in an attempt to lower employees’ wagers may turn to laying off workers. This is because the companies may find it impossible to reduce the workers’ wages when faced with a decline in demand. This increases the unemployment rate. The cost of deflation may be higher than that of the equivalent inflation. This may be attributed to the impacts of deflation which include: a decline in nominal asset values, increase in the cost of servicing debts, rapid fall in prices and financial distress among the financial institutions like banks. With all these factors, the central bank must select an inflation rate which is not too high as well as too low.
Effectiveness of Policy Makers
Policy makers are faced with a challenge, they are forced to choose between what they have learned in the past and what current research indicates. They have an obligation to the public, they have to implement and evaluate the mechanisms with care. Any mistake and it will be the great recession all over again. Inflation targeting may not always work and this acts like a beeping danger signal not to be over dependent on the policy; research should be carried continuously. The Bank of England policy makers have recently learned from their ignorance and are implementing measures to cure the aftermath. The Bank of England’s new objective is to prevent output volatility; this was as a result of the county’s inflation rate rising to above 2%. The U.S’s Federal Reserve recently announced adoption of the inflation targeting policy aiming at 2% inflation rate (Cobham et al. 371). These examples show flexibility. They show that policy makers are becoming more innovative and demonstrate an extensive understanding of the factors affecting inflation
Bernanke, Ben and Michael Woodford. The Inflation-Targeting Debate. University of Chicago Press, 2006. Print.
Bléjer, Mario. Inflation Targeting in Practice: Strategic and Operational Issues and Application to Emerging Market Economies. International Monetary Fund, 2000. Print.
Cobham, David, Oyvind Eitrheim, and Stefan Gerlach. Twenty Years of Inflation Targeting: Lessons Learned and Future Prospects. New York: Cambridge University Press, 2010. Print.
Freedman, Charles, and Douglas Laxton. Why Inflation Targeting? International Monetary Fund, 2009. Print.
Samuelson, Paul. Economics. New York: Tata McGraw-Hill Education, 1980. Print.