Depreciation, inflation and economic growth: The IMF query


Tuesday, August 21, 2018

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In the evening news of one of the TV stations on August 3, 2018, the International Monetary Fund (IMF) representative in Jamaica queried the country's monetary authorities for failing to achieve the inflation target of five per cent.

I became concerned (1) about the concept of inflation targeting being used and (2) the idea that Bank of Jamaica (BOJ) can use monetary policy or depreciation to achieve its inflation target goal to facilitate economic growth.

On the BOJ's inflation target, what indeed is the period? Inflation is the rate of change in prices, and inflation target is a yearly rate, so why does the BOJ repeatedly announce to the nation every month that it has failed to meet the inflation target for that period?

If inflation is 2.5 per cent in May and in June, then the average inflation for the two months is 2.5 per cent, but for the two months the inflation rate sum is five per cent, assuming away the compound effect for simplicity. This means that if the country's average inflation is 2.5 per cent per month, then for a year the country's inflation will be approximately 2.5 per cent x 12 or 30 per cent; if it is 2.5 per cent every quarter, then it will be 2.5 per cent x 4 or 10 per cent per annum. Does the annual inflation target of five per cent mean every month inflation rate in the country should be five per cent?

The other difficulty is the interpretative use of the inflation target concept. The IMF representative's query is that the monetary authorities are not doing enough to meet the five per cent inflation target to enable the country to achieve economic growth of more than two per cent (to surpass its current anaemic growth rate of more than one per cent).

The question is, how is inflation, which feeds into the cost of borrowing — the real interest rate — supposed to aid in promoting the country's anaemic economic growth? The country is not operating in a liquidity trap or zero-lower-bound, with near zero interest rate and a failing financial market, so why is the BOJ using easy monetary policy to crank up the economic growth?

Empirical evidence shows that depreciation causes inflation in the country. If the BOJ buys either treasury bills or foreign currency the net result is the same — the money supply increases to cause inflation. Is the BOJ supposed to use depreciation to drive the country to achieve its annual inflation target of five per cent? If that is the goal, then as things stand, we will end up with the currency losing its value at an exchange rate of even J$500 to US$1 without the country achieving the desired economic growth.

Historically, the country has experienced annual inflation rates of 71 per cent, 51 per cent and 35 per cent, to cite a few, yet during those times economic growth remained less than two per cent per annum.

Inflation target is a hierarchical mandate adopted by central banks to achieve a primary goal of price stability. Countries that adopt a dual mandate to achieve two conflicting goals of price stability and high employment or economic growth, such as the US, may be targeting inflation from the perspective of Taylor's rule, but they are not pursuing inflation targeting in its strict sense as is practised by New Zealand, UK, and Canada, to name a few. The BOJ's percentage points at annual inflation rate from January to June are (4.8 + 4.2 + 3.9 + 3.2 + 3.1 + 2.8) or 21.9 per cent, an average of 3.6 per cent a month.

The concept of inflation targeting aims only at stabilising prices and must not be conflated with a dual mandate which aims at achieving both price stability and economic growth. If a country adopts inflation target of five per cent, it means that its annual inflation rate cannot exceed five per cent. It does not mean that its inflation must be five per cent each year, let alone each month.

Inflation targeting is adopted to fight inflation and not to promote economic growth in the short term, although in the long run stable price environment induces economic growth. Countries that adopt inflation target cannot fire governors of their central banks when their inflation rate is two per cent, although they can fire them if the five per cent inflation target is exceeded.

Finally, it should be noted that a zero or two per cent annual inflation rate is consistent with price stability and inflation target of five per cent. In fact, the ideal goal of stable prices is achieved if the rate of change in prices is zero, despite the fact that it is not normally possible.

— Edward Ghartey is professor of economics at The University of the West Indies, Mona

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