Is there a case for formal inflation targeting in sub-saharan Africa? James Heintz and Léonce Ndikumana - PDF

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N o April 2010 Is there a case for formal inflation targeting in sub-saharan Africa? James Heintz and Léonce Ndikumana Editorial Committee Kamara, Abdul B. (Chair) Anyanwu, John C. Aly, Hassan Youssef

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N o April 2010 Is there a case for formal inflation targeting in sub-saharan Africa? James Heintz and Léonce Ndikumana Editorial Committee Kamara, Abdul B. (Chair) Anyanwu, John C. Aly, Hassan Youssef Rajhi, Taoufik Vencatachellum, Desire Coordinators Salami, Adeleke Moummi, Ahmed Copyright 2010 Africain Development Bank Angle des trois rues: Avenue du Ghana, Rue Pierre de Coubertin, Rue Hédi Nouira BP TUNIS belvédère (Tunisia) Tél: / Fax: Rights and Permissions All rights reserved. The text and data in this publication may be reproduced as long as the source is cited. Reproduction for commercial purposes is forbidden. The Working Paper Series (WPS) are producced by the Development Research Department of the African Development Bank. The WPS disseminates the findings of work in progress, preliminary research results, and development experience and lessons, to encourage the exchange of ideas and innovative thinking among researchers, development practitioners, policymakers, and donors. The findings, interpretations, and conclusions expressed in the Bank s WPS are entirely those of the author(s) and do not necessarily represent the view of the African Development Bank, its Board of Directors, or the countries they represent. Working Papers are available online at Correct citation : Heintz, James and Ndikumana, Léonce (2010), Is there a case for formal inflation targeting in sub-saharan Africa?, Working Papers Series N 108 African Development Bank, Tunis, Tunisia. AFRICAN DEVELOPMENT BANK GROUP Is there a case for formal inflation targeting in sub-saharan Africa? (1) James Heintz and Léonce Ndikumana Working Paper No. 108 April 2010 (1) James Heintz is Associate Research Professor at the Political Economy Research Institute (PERI) at the University of Massachusetts Léonce Ndikumana is the Director of Research at the African Development Bank and a member of the AERC network This paper was prepared for the Plenary Session at the Biannual Research Workshop of the African Economic Research Consortium (AERC), November 29, 2009 in Nairobi, Kenya. The authors would like to thank Machiko Nissanke for insightful comments and suggestions. Office of the Chief Economist Abstract James Heintz and Léonce Ndikumana This paper examines the question of whether inflation targeting monetary policy is an appropriate framework for sub-saharan African countries. The paper presents an overview of inflation targeting, reviews the justification for the regime, and summarizes some major critiques. Monetary policy responses to inflation depend on the source of inflationary pressures. Therefore, the determinants of inflation in African countries are investigated, using dynamic panel data, and the implications for inflation targeting are discussed. These issues are examined in greater detail for the two African countries which have formally adopted inflation targeting, South Africa and Ghana. The analysis is placed in the context of the global economic crisis. The paper concludes with a discussion of alternative approaches to monetary policies and the institutional constraints that would need to be addressed to allow central banks to play a stronger developmental role in sub-saharan African countries. 1. Introduction Inflation targeting is increasingly seen as the best practice for central bank policy in many economies around the world, including a growing number of developing countries. To date, inflation targeting has not made inroads into African economies, with only Ghana and South Africa having formally adopted this policy regime. However, as the practice of inflationtargeting spreads, it raises a number of questions for African countries. Is an inflation-targeting regime the right approach to monetary policy, if the long-run goal is to support economic development and to reduce poverty? Can inflation targeting adapt to the structural realities of African economies? What are some of the potential pitfalls to inflation targeting? Are there viable alternatives? This paper grapples with these questions and raises a number of pertinent issues that should be taken into account in choosing the right monetary policy regime for longrun growth and development in Africa. The issue of inflation targeting as a monetary policy regime has assumed even higher relevance in African countries as they attempt to respond to the impact of the global economic crisis which began to unfold in the second half of Unlike in previous crises, the majority of African countries entered this crisis from a much stronger footing in terms of macroeconomic stability thanks to efforts undertaken over the past decades to implement painful macroeconomic and trade reforms (AfDB, UNECA, and OECD 2009). These reforms have helped reduce inflation to single digits in most countries, reduced fiscal and current account deficits, and contributed to gradual improvement in the investment climate, a key factor to the resurgence in private capital inflows observed before the crisis. When the crisis hit African economies through its second round effects, African governments responded with a combination of measures to sustain domestic demand and support industrial production. Chief among these measures has been the easing of monetary policy through reduction of the policy rate, injection of liquidity in the system and intervention in the foreign exchange markets to influence the value of the national currency (see AfDB 2009a, 2009b; Kasekende, Brixiova, and Ndikumana 2010). The ability of the central banks to respond swiftly has been critical in the efforts to alleviate the impact of the crisis. Central banks responses have been guided primarily by pragmatism rather 5 than adherence to any prescribed policy regimes. Even in South Africa, where the inflation rate broke the inflation target range of 3-6 percent to reach double digits over several months, the Reserve Bank and Treasury have responded flexibly with a combination of fiscal stimulus and easing of the monetary policy stance, with an aim of supporting domestic economic activity. The crisis has clearly demonstrated both the powerful role of counter-cyclical policy and the advantages of flexibility in monetary policy in responding to exogenous shocks. This experience must inform any discussion of adequacy of monetary policy regimes and, for that matter, any other macroeconomic policy frameworks in the context of African economies. This paper is an attempt to contribute to this important and timely debate. The paper is organized as follows. In the next section, we present an overview of inflation targeting, review the justification for this approach to monetary policy, and summarize some of the major critiques. This initial review will not be restricted to sub-saharan Africa, but will draw on the existing literature on inflation targeting more broadly. Following this overview, we examine inflation dynamics in sub-saharan Africa, with particular attention to the role of exchange rates, the money supply, interest rates, and supply-side shocks. We present estimates of the determinants of inflation in African countries, using panel data. We then briefly review the experiences of the two sub-saharan African countries which have adopted formal inflation targeting Ghana and South Africa. Following this discussion the paper reflects on the current global crisis and the impact it has had on monetary policy and inflation targets among African countries. The paper concludes with a discussion of possible alternatives to inflation targeting monetary policy, whether such alternatives are viable, and the constraints which may prevent central banks from playing a stronger developmental role. 2. Inflation targeting: an overview of key issues Inflation targeting, as a formal monetary policy regime, was first introduced in New Zealand in 1990 and has since been adopted by numerous countries around the world. Formal inflation targeting is still uncommon in African countries, with only South Africa and Ghana having officially adopted the framework at the current time. Although many African countries have inflation targets, they have not implemented a policy of formal inflation targeting. Inflation 6 targeting involves a declaration of an inflation target by the central bank the target is most commonly a narrow range of inflation rates, e.g., 4-6 percent. The central bank then uses monetary tools, often a policy interest rate, in an attempt to keep inflation within the targeted range. The inflation targeting framework stresses increased accountability of the central bank; the central bank must evaluate its performance in meeting the target and publicly disclose the reasons for any deviation. In some cases, the adoption of formal inflation targeting has also involved institutional and legal changes which increase the independence of the central bank (Epstein and Yeldan, 2008). If inflation targets were strictly adhered to, inflation targeting would represent a form of rulesbased central banking, in which the scope for discretion is limited. A common justification for limiting the discretionary scope of central banking is that policy makers may, in their attempt to reach short-run objectives, increase inflation above a socially optimal level. The literature on the dynamic inconsistency of monetary policy, first advanced by Kydland and Prescott (1977), represents an influential theoretical expression of this argument: individuals rationally adapt their expectations in response to discretionary changes in monetary policy, eliminating any long-run impact on the real economy. In this framework, rules are preferable, since they eliminate the possibility that policy makers will respond erroneously to short-run incentives to boost growth or employment above a long-run equilibrium level. A crucial assumption is that individuals can distinguish monetary responses (due to central bank policy) from other economic factors (e.g., inflation due to supply-side shocks) in forming their expectations. In practice, inflation targeting is often not strictly rules-based, and has been referred to as a policy of constrained discretion or as a monetary policy framework (King, 2005; Bernanke et al., 1999). Effectively, this means that the targets represent rules that can be broken, but with a heighten degree of transparency and accountability. When inflation targeting central banks fail to meet the target, they must explain what happened. There is often a gap between the theory and the practice of inflation targeting, caused by external factors and unexpected changes in the macroeconomic environment. 7 Expectations play a central role in the motivation for inflation targeting policies. The central idea is that individual expectations will adapt to the targets announced by the central bank. The hope is that these expectations will then be incorporated into contracts, pricing practices, and collective bargaining agreements. These changes in expectations and forward-looking institutional arrangements link the inertial component of inflation (i.e., inflationary pressures derived from previous inflation rates) to the inflation target. Unlike the use of monetary tools to manage inflation, which often impose real economic costs from higher real interest rates or slower credit growth, the change in inertial inflation would not involve similar costs. Therefore, it is frequently argued that formal inflation targeting allows inflation to be controlled at lower cost than other approaches to monetary policy that focus on reducing inflation. Put another way, inflation targeting is said to reduce the sacrifice ratio the amount of output or employment which must be forgone to reduce inflation by a certain amount. Based on available evidence, it is not evident that inflation targeting significantly reduces the sacrifice ratio or improves the performance of the real economy (Ball and Sheridan, 2005; Bernanke et al., 1999; Epstein, 2008). There is some evidence that countries that have adopted inflation targeting have experienced reductions in inflation, lower volatility of inflation, and a reduced degree of exchange rate pass-through (Gonçalves and Salles, 2008; Mishkin and Schmidt-Hebbel, 2007; IMF, 2005). However, these results are sensitive to the controls used to ascertain the impact of inflation targeting and are strongest when inflation-targeting countries are compared to their own pre-targeting experience (Mishkin and Schmidt-Hebbel, 2007). Comparing the pre-targeting period with the post-targeting period may not capture the impact of inflation targeting per se, but rather a re-orientation of monetary policy towards lowering inflation (which could be achieved with or without inflation targeting). Comparisons between inflation-targeting countries and non-targeting countries are weaker and, again, depend on the control group used. Therefore, whether inflation targeting actually changes expectations in a way which reduces the cost of lowing inflation remains uncertain. 1 If inflation targeting does not have a significant 1 Bernanke et al. (1999) present evidence that inflation expectations have adjusted in some countries, but the adjustments have been gradual due to significant inertia. However, the benefits in terms of lower sacrifice ratios 8 impact on expectations, inflation targeting may not be overly distinct compared to monetary policy which simply attempts to reduce inflation, or sustain inflation at low levels. The central banks in many African countries have specific inflation targets in their policy statements, PRSPs, or national development strategies (e.g., 5 percent being common at the present time). These inflation targets differ from formal inflation targeting in that the targets are not accompanied by formal processes for holding the central bank accountable for reaching the target in an effort to influence expectations. Another justification for inflation targeting is that every economy needs a nominal anchor which can serve as the basis for making economic decisions (Bernanke et al., 1999). Without an idea of what the average price level in an economy is (and will likely be in the future), economic actors cannot accurately discern relative price movements and may make errors in allocating resources in response to changing prices. Historically, devices such as the gold standard provided this anchor. In the absence of a similar absolute standard, monetary policy must play this role, and inflation targeting represents one option for establishing a nominal anchor for a market economy. The fact that the true economic costs of inflation targeting remain uncertain raises important challenges for policy evaluation. Ideally, we would want to weigh the costs of inflation targeting against its benefits and thereby determine whether the adoption of formal inflation targeting is desirable. There is nothing intrinsically desirable about inflation. If countries in sub-saharan African countries could experience rapid growth and development with 2 percent inflation or the same rate of development with 15 percent inflation, it would be rational to choose the lower inflation rate. However, if maintaining a 2 percent rate of inflation slows the rate of economic development, then it is unclear whether keeping inflation at that level is the best option. were not evident. Ball and Sheridan (2005) present evidence suggesting that there is no evidence that inflation targeting raises economic growth. While inflation targeters may experience lower inflation, including inflationary responses to shocks (e.g., Mishkin and Schmidt-Hebbel, 2007; IMF, 2005; Gonçalves and Salles, 2008), the impact on the long-run performance of the real economy remains unclear. Mishkin and Schmidt-Hebbel (2007) present evidence that the adoption of inflation targeting may reduce an indicator of the combined volatility of output and inflation, but this does not imply that inflation targeting improves average growth performance. Gonçalves and Salles (2008) also present evidence that inflation-targeting countries have lower growth volatility relative to a selected group of non-targeters, but the sample is small (36 observations), the results will be sensitive to large outliers, and there is no clear justification for the selection of countries included in the non-targeting control group. 9 A common argument for conducting monetary policy so as to keep inflation very low (e.g., in the lower single digits) is that inflation is harmful to long-run growth. There are several reasons for this: inflation can raise transactions costs and may contribute to uncertainty about the future. 2 However, there is no consensus in the literature that maintaining rates of inflation at a typical inflation targeting level (e.g., around 5 percent) necessarily leads to faster growth. One early study of the relationship between inflation and growth across 127 countries found that growth rates declined only when inflation rates moved beyond percent and that growth increased as inflation rose up to the percent range (Bruno, 1995). Similarly, Bruno and Easterly (1998) reported that the negative relationship clearly manifests itself only when inflation exceeds 40 percent. These early estimates were based on combined data across all countries. However, the threshold at which inflation reduces growth appears to vary between developed and developing countries. Khan and Senhadji (2001) identify the threshold point at which inflation reduces economic growth at 1 to 3 percent for developed economies, but the threshold point for developing countries is between 11 and 12 percent. Pollin and Zhu (2006) find that higher inflation is associated with moderate gains in GDP growth up to percent inflation, after which growth begins to decline. The results are more robust in developing countries relative to developed economies. Some researchers have found that the threshold at which inflation reduces growth is in the single-digits (Ghosh and Phillips, 1998; Burdekin, Denzau, Keil, Sitthiyot, and Willett, 2004). 3 What can we conclude from these studies? There is broad consensus that rapid rates of inflation will have a negative impact on growth, and this turning point will most likely be reached once inflation exceeds 15 to 20 percent. Only a few studies show that reducing inflation down to the 2 The idea of menu costs, such as that advanced by Mankiw (1985), represents the kind of transactions costs associated with inflation. 3 Hodge (2006) presents evidence that, controlling for fixed investment, inflation has a negative impact on growth in South Africa. However, he uses a linear model which does not allow for threshold effects. Therefore, we cannot conclude that reducing inflation to the inflation targeting range of 3 to 6 percent will necessarily be beneficial to South Africa, holding other factors constant. Hadjimichael, et al. (1995) found a negative impact of inflation (and, surprisingly, a positive effect of the standard deviation of inflation) on growth in a cross-country study of African economies over a short time period, , and without controlling of unobserved country-specific effects (apart from broad country groupings). Again the study did not attempt to model the non-linearities in this relationship, and cannot shed light on the threshold effects discussed here. 10 level typically adopted in inflation targeting regimes will contribute to stronger growth. Other studies suggest that keeping inflation in this range actually leads to slower growth. At best, the benefits of maintaining inflation in the lower single digits are uncertain and there is a possibility it may slow the process of development. In some contexts, finding a negative relationship between inflation and growth should not be surprising. This is not because inflation causes growth to slow down, but rather because exogenous shocks to the economy (e.g., external price shocks or supply-side
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