IMF: More Clarity in Central Banks’ Inflation Targets Would Help

SEPTEMBER 14, 2011, 11:45 AM ET
IMF: More Clarity in Central Banks’ Inflation Targets Would Help
By Ian Talley


Amid high global food and fuel prices threatening to derail monetary-policy plans, central banks need to clearly identify and communicate their inflation targets or risk undermining their credibility in the markets, the International Monetary Fund said in a new report Wednesday.

Spiking commodity prices are complicating central bankers’ plans to spur anemic growth in advanced nations and to cool emerging economies near to overheating, all while the risk of a global recession rises. How officials should walk the fine line of policy tinkering without accidentally damaging the economy has fueled a debate central to monetary policy: the nuances of inflation targeting.

In Asia and Latin America, where a larger share of income is spent on food and fuel, central banks are grappling with whether their policy reactions to commodity prices are timely and strong enough to curb price rises without crippling growth. In Europe, the balance is between maintaining growth in Europe’s economic drivers such as Germany and fostering growth and low interest rates in peripheral countries weighed down by massive debts. In the U.S., weak growth and high unemployment has so far outweighed the risk of future explosive inflation.

The IMF reiterated calls for accommodative monetary policy in advanced economies and more aggressive action in some emerging markets.

The report was one of two chapters of the IMF’s World Economic Outlook published Wednesday. The rest of the outlook will be published next week.

Advanced countries, which have credible central banks, weak growth and low demand, “can afford to look through current commodity price shocks because all that would happen is that they would end up getting closer to their [inflation] target,” said John Simon, senior economist and lead author of the chapter.

Conversely, in areas where inflation may be above target and where there might be some overheating, missing the target can magnify inflation, “which argues for a much more active policy response,” he said.

The U.S. Federal Reserve and the European Central Bank have both come under criticism from different quarters over how they use inflation measures.

The ECB has an official headline inflation target of 2% over a two-year horizon, which generally helps to level out the volatility in food and energy prices that can warp data. Fearing the impact of inflation as stronger economies pick up, the ECB has twice raised interest rates.

IMF chief Christine Lagarde urged easy policy, however. “Monetary policy also should remain highly accommodative, as the risk of recession outweighs the risk of inflation,” she said in late August.

The U.S. Federal Reserve, meanwhile, focuses informally on a core inflation target of 2% over time, excluding energy and food prices from their calculations. The Fed has decided that inflation risks are less weighty at present than the need to encourage growth. The central bank has come under criticism from some investors and lawmakers for not adequately allowing for the risk of future inflation.

While the IMF appeared to back the Fed inflation doves, it also reinforced arguments for clarity on the inflation measures central banks use.

For example, policy credibility could suffer with harm to the economy “if the central banks’ performance continued to be evaluated based on the volatility of the headline inflation when it is targeting core inflation,” IMF staff said. Also, excluding food and fuel prices from inflation targets can also undermine credibility in the eyes of the public when households are attuned to commodity prices as a measure of the cost of living, the IMF warned.

In emerging economies where food and fuel are a higher share of the economy and the central bank lacks credibility, the IMF said underlying inflation targeting was preferred. Without the volatility of food and fuel, a central bank stands a better chance of building trust in its inflation expectations, and therefore, the effectiveness of its policy. “The higher policy credibility in turn allows the central bank to stabilize inflation with less monetary policy tightening and a smaller output loss,” IMF staff said.

The IMF declined to address the appropriate level for inflation targets when there are permanent shifts in the relative prices of commodities, a focus of the debate in advanced economies where some economists fear easy monetary policy may fuel sharper inflation as growth accelerates. “In such cases, targeting headline inflation implies a different long-term level for core inflation, and vice versa,” IMF staff said in a short notation.

“If, for some reason, annual growth of 2% in the CPI index were deemed appropriate, the central bank could communicate an equivalent target for underlying inflation,” staff noted.



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