Inflation targeting – some anomalies reconsidered

Posted by Anis Chowdhury on 5 April 2011

Inflation targeting – some anomalies reconsidered


Anis Chowdhury and Iyanatul Islam[1]


The International Monetary Fund (IMF), is asking for a ‘wholesale rexamination of macroeconomic policy principles’. in the wake of the Great Recession of 2008-2009.[2] As part of this ‘rexamination’, monetary policy based on inflation targeting is a prime topic. This note reflects on, and reconsiders, some of the anomalies associated with inflation targeting.  First, the proponents of strict inflation targeting believe that inflation is caused by excess money supply.  The modern incarnation of this old conviction associated with quantity theory has been Milton Friedman’s memorandum to the Treasury and Civil service Committee of the UK House of Commons, in its 1979-80 Session where he famously proclaimed, “inflation is always and everywhere a monetary phenomenon.”


The US Federal Reserve Bank has been printing money at a faster rate than the economy's seeming ability to absorb it since the late-1990s. Yet, inflation did not accelerate. The Fed has gone on to a top gear, called quantitative easing, since the onset of the Great Recession. Instead of accelerating, the inflation rate remains well below the “desired” rate of 2-3%.  Too much money chasing too few goods has not yet translated into accelerating inflation. Japan, too, has been facing deflationary pressure despite significant easing of monetary policy since 1995.


The breakdown of the relationship between money supply and inflation may be due to a number of factors. First, as in the case of Japan, it may be due to the fact that people hold excess cash instead of spending – a situation known as “liquidity trap”. This can happen if people expect prices to fall further or they still fear losing jobs. Second, when output is much below its potential, excess spending by people to get rid of excess cash can be accommodated without raising the price. This seems to be case at the moment as most advanced economies are still reeling from the Great Recession and the unemployment rate is hovering between 9% and 10% in OECD countries.


Fiscal policy assumes a greater role in the case of a liquidity trap. If the government debt is too high, fiscal deficits can be financed by borrowing from central banks, i.e. printing money. Money-financed public spending is also a better option when the economy is at less than full employment. It does not create any upward pressure on interest rates; it may even lower the policy interest rate which is helpful for investment. This policy option has largely been ignored during the current debate.[3] This option should take some pressure off the need for severe fiscal austerity which might threaten nascent recovery.


Third, and most importantly, the breakdown of a strict relationship between money supply and consumer price inflation could be due to the availability of a large range of consumer products from cheaper production locations such as China, India, Viet Nam or Bangladesh. This, therefore, is the main reason why monetary expansion does not translate into significantly higher prices in shopping malls. Instead, it translates into significantly higher prices for capital assets, particularly real estate and equities. The people who find it easiest to borrow money these days are hedge funds and private equity firms. Through leveraged buy outs, they can easily acquire companies and, by improving their cashflow, boost their valuations. This has been the source of asset price bubbles. It is now well known that, once such bubbles burst, they can lead to major recessions. The problem of asset price bubbles seems to be a permanent feature resulting in a permanent break in the money-inflation relationship. Therefore, monetary policy makers should be watching asset prices not just consumer prices.


The second anomaly is the belief that money is neutral. That is, “in the long term monetary policy can influence nominal, but not real variables”. However, they also believe that “high inflation harms growth and the equitable distribution of income; and expectations and credibility significantly influence the effectiveness of monetary policy”.[4] These two propositions seem to be at odds with each other. If monetary policy (money) affects inflation which, in turn, affects growth, surely money is not neutral – it affects real variables as well.


The third anomaly is the belief that “central banks cannot consistently pursue and achieve multiple goals, such as low inflation and low unemployment, with only one basic instrument—the policy interest rate”.[5] There is a belief among Central Bankers that there is a “divine coincidence” (to use Olivier Blanchard’s phrase) that controlling inflation will control unemployment. This is certainly true when central banks use only one instrument. However, this is a strict application of the Tinbergen rule, which is applicable only on the assumption that there are no conflicting goals and no transaction costs.


The statement that low inflation and low unemployment cannot be achieved simultaneously itself indicates that the goals are in conflict. Additionally, it is now widely acknowledged that just as very high inflation, very low inflation can also harm growth.[6] Therefore, targeting very low inflation (usually less than 5% in developing countries and less than 3% in developed countries) may not be costless. In such circumstances, the Tinbergen rule should not preclude achieving some combination of multiple or often conflicting objectives. This would mean targeting moderate inflation and high employment (growth). This is a matter of minimising the sacrifice ratio or maximising a social welfare function in terms of unemployment and inflation.


Finally, it is also not exactly true that central banks do not have any instrument other than the policy interest rate. The fact that the IMF Article of Agreement expects simultaneous achievement of reasonable price stability  and growth and does not specify a numerical target for inflation suggests both the availability of more than one instrument and flexibility in the use of such instruments.[7] For example, while central banks can use the traditional instrument of interest rates (or such instruments as reserve requirements) assigned to keep inflation at a moderate level, specialised credit regulation can be a second instrument directed to employment creation.


Of course, specialised and directed credit programs create distortions in the financial market and are prone to rent-seeking activities. However, the cost of distortions must be weighed against the cost of market imperfections in the financial sector. Quite often it is found that in the countries that have abandoned specialised credit programs as part of financial sector reforms, there has been a massive shift of resources from the rural and small scale sectors to urban and commercial activities.[8] This had adverse effects on GDP as well as poverty.


Central banks can consider a number of options in designing specialised credit programs. In India, for example, all banks (public and private) are required to lend at least 40% of their net credit to the ‘priority sector’.  If banks fail to do so, they must lend to specific government agencies at a very low interest rate as a penalty. Studies by Banerjee and Duflo (2008)[9] found that most banks complied with the regulation and the program contributed significantly to expansion in agriculture and small scale industries.


Alternatively, the central banks can use some carrot-and-stick measures by combining Indian-type penalties with incentives such as asset-based reserve requirements, support for pooling and underwriting small loans, or utilising the discount window in support of employment-generating investments. Finally, central banks can open special discount windows to offer credit, guarantee or discount facilities to institutions that are on-lending to firms and cooperatives, engaged in employment intensive activities.


[1] Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia and Iyanatul Islam, ILO, Geneva. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or the ILO.

[2] A conference on the theme “Macro and Growth Policies in the Wake of the Crisis” took place at the IMF’s Headquarters in Washington, DC on March 7-8, 2011.  One of the key areas of focus was monetary policy. It noted “It was …thought that monetary policy could be kept largely separate from fiscal policy, and that monetary policy itself could be sub-divided into separate macroeconomic and supervisory aspects. But the crisis and the policy response have raised questions about each of these elements of the consensus”.

[3] See Wood, Richard (2001), “Deflation, debt and economic stimulus”, voxeu commentary, march 3,

[4] See, for example, Roger, Scott (2010). “Inflation Targeting Turns 20”. Finance & Development, March.

[5] Roger, op cit.

[6] See, Anwar, Sarah, Anis Chowdhury and Iyanatul Islam (2011), “Inflation targeting in developing countries revisited”, voxeu commentary, March 17,

[7] The IMF’s Article of Agreement IV states “that each member shall (i) endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances”.

[8] Professors Yunus and Mahmud, two leading experts on micro-finance, have raised concerns about commercial banks’ urban leading from rural deposits (The Daily Star, June 2, 2005, p. 1).

[9] Banerjee, Abhijit, and Esther Duflo (2008) “Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program.”