2. 1
Contents
1. Introduction.............................................................................................................................. 2
2. How the Inflation Target is Determined and Set..........................................................................2
3. The Appropriate Level and Range.............................................................................................. 3
3.1 On the Level of Inflation......................................................................................................3
3.1.1 Normative Views...........................................................................................................3
3.1.2 Inflation Thresholds ......................................................................................................4
3.2 The Range of the Inflation Target......................................................................................... 5
4. Conclusion ............................................................................................................................... 6
5. References................................................................................................................................ 8
3. 2
1. Introduction
An increasingly stronger argument can be made in favour of inflation targeting (IT) as a
monetary policy strategy. Of the thirty-one countries that have adopted IT only three1 have
discontinued its use (Jahan, 2012). IT has the support of a wide body of literature documenting
its successes in both developed and developing countries. In emerging market economies
(EMEs) especially, these successes pertain to the framework’s curbing of high, and often
growth-restraining, inflation rates as well as IT’s contribution towards a macroeconomic
environment that is conducive to output growth. Mishkin (2004) did, however, warn that IT is
not a policy panacea for EMEs. This warning has been validated, to a great extent, by the recent
financial crisis. It has consequently become even more important to continue to deliberate best
practice with regards to the implementation of IT – particularly with respect to the appropriate
range and level of inflation targets in developing countries.
Consideration of the appropriate level and range of inflation targets in EMEs is necessary firstly
because EME economic priorities often differ from those of developed countries. Secondly,
inflation thresholds, if they exist, are likely to differ between these two groups. If there exist
significant materialisations of these types of differences, pursuing low and stable inflation as
an optimal strategy may not provide the best outcome for EMEs. The purpose of this essay is
to discuss the appropriate level and range of inflation targets in developing countries. Section
2 briefly reviews the mechanics of setting inflation targets. Section 3 then considers the views
on the appropriate level of inflation targets, discusses the empirical findings on the appropriate
level and then proceeds to discuss finding the appropriate range of the inflation target. Brief
references are also made to South Africa with regards to the level and range aspects. Section 4
concludes.
2. How the Inflation Target is Determined and Set
Before discussing what the level and range for inflation targeting should be, it is worth briefly
reviewing how these targets are set. “Inflation targets are designed based on country-specific
factors such as the degree of central bank credibility, the country’s vulnerability to shocks
and/or data availability” (Schaechter et al., 2000:7). Central banks target a particular consumer
price index and try to maintain its growth within a particular target set by the government. The
level of the target is chosen in accordance with a long run desired rate of inflation. In emerging
1 These countries areFinland,the Slovak Republic and Spain.They discontinued inflation targetingwhen each
of them adopted the Euro, and can be argued to constitute ‘special cases’.
4. 3
markets, there are cases where targets are chosen with the disinflation path to reach their long-
run inflation objective in mind (Schaechter et al., 2000:9). Most countries opt for a range in
order to ensure flexibility in responses. The choice of the target range typically depends on the
frequency and the severity of shocks and the central bank’s credibility. These processes play
an important role in determining the optimal range and level of inflation targets.
3. The Appropriate Level and Range
3.1 On the Level of Inflation
3.1.1 Normative Views
The consensus for targeting low and stable inflation stems from two observed macroeconomic
outcomes. Firstly, the consensus drew support from the inflationary episodes experienced in
the 1970s and 1980s. Secondly, there was the pre-crisis trend towards increasing degrees of
macroeconomic stability occurring alongside low inflation during what has been labelled Great
Moderation. The consensus resulted in international financial institutions like the International
Monetary Fund (IMF) integrating a target of low and stable inflation, five percent and below,
into their policy recommendations for both developed and developing countries (Muzaffar &
Junankar, 2014:604).
The view has emerged, however, that moderate inflation is not necessarily as harmful, and that
efforts to pursue this ‘one size fits all’ application could inhibit growth in developing countries.
Muzaffar & Junankar (2014) argue that Argentina was such a case, where the obsession with
low inflation led to reduced growth. This coincides with Akerlof, Dickens and Perry’s (1996)
argument that containing inflation at a level that is too low results in inefficiency and pushes
up the unemployment rate. Blanchard et al. (2010) argue that, had monetary policy allowed for
a higher level of inflation and higher interest rates, there would have been more room for
decreasing the nominal interest rate during the crisis, thus avoiding the limitations of the zero
lower bound. Masson et al. (1997) also posit that the appropriate level of inflation for EMEs is
higher than that of industrialised countries when thinking of growth.
Amato and Gerlach (2002:788) lean towards the conservative side, noting that there is no
reason to believe that a higher inflation target would necessarily be growth-promoting. In fact,
Feldstein (1999) contends that even moderate levels of inflation can adversely affect growth.
Although Amato and Gerlach (2002) find that the Samuelson-Balassa effect possibly warrants
a level of inflation one to two percent higher in EMEs than in developed countries, the authors
conclude that hard evidence for an inflation differential between these two is still lacking.
5. 4
Muzaffar and Junankar (2014:606), in turn, argue that not differentiating EMEs from
developed countries causes potential bias in estimation because of different levels of
development. Chowdhury (2006) also joins the camp against low single-digit inflation targets
in EMEs, arguing that a very low target could lead to a stabilisation trap – a condition where
inflation is low, but growth is not strong enough for sufficient poverty reduction.
3.1.2 Inflation Thresholds
“At the operational level, there is a recognition that the growth-inflation relationship depends
on the level of inflation” (Espinoza et al., 2012:100). Empirical literature finds this relationship
to be nonlinear, carrying implications for policy if inflation escalates beyond a certain point
(Muzaffar & Junankar, 2014:606; Espinoza et al., 2012:100). Theoretic literature considers the
growth-inflation relationship using inflation threshold models. If it is the case that inflation
thresholds exist, differ across countries and that the argument holds that there is a positive
growth-inflation correlation up to some point, then it would make sense to set different level
targets across countries. The question to be asked, then, is what the inflation threshold for
EMEs are, and whether it differs significantly from developed countries.
Empirical evidence shows that inflation thresholds for EMEs do tend to be higher than for
developed countries. An influential paper by Khan and Senhadji (2001) finds significant
evidence of threshold effects, and that these are substantially higher in EMEs than in developed
economies. The authors use a dataset of 140 countries from 1960 to the late nineties and
estimate inflation thresholds of 11-12 percent for EMEs and 1-3 percent for developed
countries at 1 percent significance. Muzaffar and Junankar (2014) utilise a dataset of fourteen
Asian developing countries from 1961 to 2010, and estimate the inflation threshold for these
countries at around 13 percent, allowing for variance between 7 and 14 percent. Espinoza, Leon
and Prasad (2012), in turn, use a panel estimate of 165 countries from 1960 to 2007 and find
that inflation levels in developing economies above 10% is harmful to growth while there are
no threshold effects at play in advanced economies because any level of inflation hurts growth.
The South African economy presents some interesting features given the empirical findings
mentioned. It would appear that South Africa’s inflation threshold is quite low compared to
other EMEs. Leshoro (2012) finds the threshold for South Africa to be 4 percent beyond which
inflation will hamper growth. Phiri, on the other hand, finds the threshold to be 8 percent, which
is more in line with Muzaffar and Junankar’s (2014) allowable variance for thresholds, but still
on the low side. Leshoro (2012:9) does mention that technical issues such as the time periods
6. 5
considered could be the reason for the difference. One other possibility that could exist is the
South Africa’s relatively well developed financial system could warrant a threshold on par with
developed countries, but still have the issues facing EMEs. Should the latter estimate be more
accurate, however, the 3-6 percent inflation target of the South African Reserve Bank would
need to be re-evaluated. Once again, the question should be asked as to whether a definite
threshold for inflation exists in South Africa. Since the implementation of IT in SA, inflation
has never been be below 4 percent, implying that SA has only been experiencing extensively
‘harmful’ inflation. It is unlikely that this is the case. Allowing for a higher in inflation target
in South Africa may also do more harm than good since SA’s inflation is often more attributable
to issues excessive wages for low returns to productivity and exchange rate outcomes. These
processes are likely to inhibit growth while contributing to higher inflation, making a case
against an 8 percent threshold.
3.2 The Range of the Inflation Target
It has become the norm for central banks to pursue a flexible inflation target, adhering to a
range rather than a specific point (Bernanke & Woodford, 2005:1). A range provides more
flexibility and discretion in responding to external shocks, making target breaches less likely,
allowing for more flexibility in other macroeconomic variables (Schaechter et al., 2000:10)
Naturally, the question arises as to how much flexibility the central bank should allow itself
since too narrow a target could more easily be missed while too wide a target would not inhibit
inflation volatility. In order to anchor the public’s inflation expectations and therefore reduce
volatility, most countries have opted for a band of two to three percentage points (Erceg,
2002:85).
Erceg (2002), in deriving a model for determining the optimal range of the inflation target,
argues that the range should be based on what is perceived by the monetary authorities to be
the optimal point on the monetary-policy frontier of the economy. The monetary-policy frontier
volatility trade-off between inflation and other macroeconomic variables such as
unemployment. This links the choice of range to real factors in the economy rather than just an
arbitrary choice. The range is also then interpreted probabilistically as a confidence interval for
inflation, where a point on the monetary-policy frontier implies a standard deviation consistent
with the chosen range (Erceg, 2002:88). The author shows that it is more beneficial for a small,
open economy to choose a less ambitious, and therefore wider, range than a closed economy.
This is because the small open economy would want to tolerate more inflation volatility than
volatility in certain real activities such as employment.
7. 6
South Africa classifies as a small open economy. Its monetary policy fits the description of the
3 percentage point target range which is wider than that of developed countries (Schaechter et
al, 2000:11), and also closely monitors other macroeconomic variables such as its exchange
rates and unemployment. Its responses are not strictly rigid if inflation goes out of bounds due
to concern for the volatility of other macroeconomic variables. South Africa has been relatively
successful at curbing inflation and keeping it stable, so it is unclear whether any adjustments
should be made to the width of the target even if questions are being asked about its level. It
could be argued that a greater emphasis should be put on employment by tolerating more
inflation volatility, but South Africa’s high unemployment is more than likely to stem from
labour market rigidities which are unrelated to monetary policy. Adjusting the range of the
present inflation target could most likely result in more constraints on growth and other
macroeconomic variables if narrowed, and render inflation targeting less effective if widened.
4. Conclusion
The purpose of this essay was to discuss the appropriate level and range of inflation targets in
emerging countries. When these targets are set, issues like the desired long-run inflation rate,
frequency and severity of shocks and the credibility of the central bank do play a role choosing
the level and the range of inflation targets.
Although consensus had emerged in favour of low, stable inflation and arguments have been
made that inflation tolerance should not vary across countries, more recent arguments and
empirical findings lean in the opposite direction. Evidence of a nonlinear growth-inflation
relationship and the implication of a positive growth-inflation correlation up to a certain point
led to the estimation of inflation threshold models. Most estimates considered find higher
inflation thresholds for emerging countries than for developed economies. These threshold
estimates range between 7 and 13 percent for emerging markets, and 1-3 percent for developed
economies. Thus, the arguments in favour of higher inflation tolerance and target levels in
EMEs for the sake of growth. South Africa’s threshold, though, tends to the lower side of the
spectrum. It is not agreed where the threshold actually lies, which could have policy
implications for the current target of 3-6 percent. Whether inflation thresholds exist, however,
is still not a settled cases.
Considering the range of the target, it is argued that smaller, open economies should be less
ambitious with the range of their targets and consider wider ranges relative to developed
economies. Countries should determine their range linked to the optimal point on their
8. 7
monetary-policy frontier. South Africa fits the description of a small open economy, and while
questions could be asked about the level of its inflation target, its ranged should stay the same.
In the literature it seems to be the case that there are different optimal ranges across countries
with developing countries needing higher levels with slightly larger ranges, but coming forth
with numerical propositions has to be weighed carefully.
9. 8
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