Inflation Targeting

It widely recognized that the monetary policy within a country should be primarily concerned with the pursuit of price stability. However, it is still not clear how this objective can be achieved most effectively. This debate remains unsettled, but an increasing number of countries have adopted inflation targeting as their monetary policy framework. (Dr E J van der Merwe, 2002) This topic of Inflation targeting is a subject which immediately conjures different perceptions from different people. Many feel that low inflation should be a main aim of monetary policy, while others (such as trade union activists) believe that a higher growth rate to stimulate jobs should be the main concern.

In order to understand what inflation targeting is and how it affects us, it is important to first establish what, in fact, inflation is.

Inflation can be defined as an increase in the general price level of goods and services. It is measured as the annual percent change in the prices of goods deemed necessary for life in that country. These goods are included in a "market basket" which changes infrequently, so this measure can reflect fluctuations in the price level as well as the purchasing power of the Rand.

There are two basic types of inflation, namely: cost-push and demand-pull inflation. Cost-push inflation is caused by an increase in the cost of production. Increases in the cost of labor, raw materials, equipment, and borrowing money push the cost of production up resulting in higher overall prices. Demand-pull inflation is caused by an increase in demand or in the supply of money. This increased demand allows producers to charge higher prices.

A lot can be learnt from this economic indicator. High levels of inflation indicate an unpredictable economy in which money does not hold its value for long. Workers require higher remuneration in order to cover mounting costs, and there is mass hesitancy to save. Producers in turn may raise their selling prices to cover these increases, decrease production to educe their costs (resulting in lay-offs), or fail to invest in future production.

New Zealand was the first country to implement this strategy of inflation targeting in 1990 and was soon followed by a number of other industrialized countries (Canada, the United Kingdom, Sweden, Israel, Australia and Switzerland), and by several other emerging market countries (Chile, Brazil, Korea, Thailand, and South Africa) and then also by several transition countries (Czech Republic, Poland and Hungary).

South Africa had extremely volatile inflation before the targeting framework was implemented. Our pre-inflation targeting history went as follows: During the time from 1986-1989 South Africa adopted money supply targets.

From 1990-1999 there were money supply guidelines within the framework of the "eclectic approach" where there were no explicit inflation targets per say. M3 was the key intermediate target and hitting the M3 target was more the exception than the rule. (SARB, 2005)

In February 2000 it was announced that formal inflation targeting would also be adopted in South Africa as the monetary policy framework by Minister of Finance Trevor Manuel. Before this announcement "informal inflation targeting" was already applied by the South African Reserve Bank. This decision was made in order to help bring consumer inflation, which had been in double digits for over 20 years, under control. Inflation fell from 6.9% in 1998 to less than 6.0% in 2000. (Wikimedia Foundation, 2006) The target set was to keep CPIX between 3% and 6% average per annum. This policy was initially very successful although the Rand's rapid depreciation in 2001 led to higher inflationary pressure and the target was missed during the course of 2002, with inflation coming in at an average of 9.3% for the year. Towards the end of the 1990s, the Reserve Bank moved to a more "pragmatic" inflation targeting. In this framework, developments in the monetary aggregates were still regarded as crucial elements in the inflation process, but the Bank closely monitored developments in other financial and real indicators in reaching a decision on the appropriate level of short-term interest rates. (Wikimedia Foundation, 2006)

Since September 2003, however, the CPIX inflation rate has remained extremely consistent. The average annual rates of CPIX since 2001 were: 2001 - 6.6%, 2002 - 9.3%, 2003 - 6.8%, 2004 - 4.3%, 2005 - 4.3%. (Wikimedia Foundation, 2006)

CPIX FORECAST

Success in keeping inflation at bay gave the government room to drastically bring down interest rates. in 2003 alone, interest rates were reduced by an astonishing 550 basis points. This cut in interest rates saw "consumer spending improve, the construction sector boom and the sale of new vehicles reach record levels." (Wikimedia Foundation, 2006) This resulted in much needed GDP growth. Since 1999, quarterly GDP growth has been consistently above 2% and the present business cycle upswing is the longest on record. Although economic growth has improved, the growth has been largely jobless, and quicker growth is still needed. (Wikimedia Foundation, 2006)

Inflation and Interest Rates in S.A

Why did the authorities decide to change from an informal to a formal inflation targeting policy? Four decisions can be given for this. Firstly, the informal framework formerly adopted created uncertainty among the public as to the policies being implemented by the government. This uncertainty led to all kinds of false expectations and discord by the public. (Dr E J van der Merwe, 2002) Secondly, co-ordination between monetary policy and other economic policies improves with the implementation of the inflation targeting. This is due to the structured decision making process of the framework. Thirdly, the central banks (Reserve Bank) accountability is improved along with discipline toward the monetary policy. (Dr E J van der Merwe, 2002) This is because clear targets are set which the Reserve Bank is forced to meet. Finally, due to the targets set because of the policy, expectations arise which facilitate a reduction in inflation. If these targets set are credible, they form the basis for future price and wage setting. (Dr E J van der Merwe, 2002)

Advantages of inflation targeting

Inflation targeting has numerous advantages as a strategy for monetary policy. Unlike an exchange rate peg, inflation targeting enables monetary policy to focus primarily on domestic considerations and to respond accordingly to the domestic economy. (Mishkin