Inflation target bands must be carefully designed to avoid sending confusing signals to markets

• Author: Margins of tolerance. -Target bands. -Case studies. -Conclusion.
• Pages: 37-39

Page 37

A number of industrial countries, such as the United Kingdom, have sought to achieve and maintain low inflation by adopting a monetary policy framework based on inflation targeting. Under this framework, policymakers announce that they will aim for an explicit quantitative inflation rate. Interest in inflation targeting has now begun to spread to emerging market countries, such as the Philippines and Poland, where inflation is considerably higher than the rate policymakers are aiming for over the longer term.

Margins of tolerance

IMF Policy Discussion Paper 99/8, Inflation Targeting: What Is the Meaning of the Bottom of the Band? by Eric V. Clifton of the IMF Institute, explores one aspect of designing an inflation targeting framework for emerging market economies—the significance of the lower limit of a target band when that limit greatly exceeds policymakers’ ultimate inflation goal. Given general agreement that a fixed-point target is almost certain to be missed, potentially damaging the credibility of the policy framework, the study starts with the assumption that policymakers will allow room for inflation to fall within a certain range. That is, they will build margins of tolerance for achieving the target into the design. Most countries that have adopted inflation targeting, Clifton says, have included tolerance margins that “allow a central bank to give a sense to markets of how much variability in inflation outcomes should be expected.”

It has also been found, the study reports, that trying to hit a too narrowly defined inflation target could cause interest rates to be excessively volatile. If a country sets a narrow band for inflation, more frequent changes in interest rates may be needed to keep inflation inside the band; these could destabilize financial markets even if the inflation target is met.

Once an inflation target is defined, according to Clifton, policymakers must decide what form the margins of tolerance will take: caveats, ceilings, thick points, or bands. These, he says, must then be formalized and announced to the public to ensure transparency. When policymakers set conditions under which missing a point target might be acceptable, they are said to be allowing caveats. Used alone, however, this method provides a tolerance margin only under the specific conditions the policymakers have defined. Under a second method, Clifton explains, the target is set so that inflation must fall below a certain rate, or ceiling, by a given date. This framework allows for a...