Price stability as SBP’s primary objective

When Paul Volcker, the then chairman of the Federal Reserve, increased interest rates sharply following an increase in inflation during late 70s and early 80s, the slowdown in the economy led to somewhat dramatic protests by various actors in the economy. The Economist reports, “Framers protested outside the Fed in Washington, DC; car dealers sent coffins containing the keys of unsold cars.” However, with political support and perseverance of the Fed chairman, the inflationary spiral was broken by mid-80s.

This episode marks a much celebrated shift in how the monetary policy should be conducted. A central bank should primarily focus on stabilising inflation. While the early literature pointed to the oil shocks as the primary reason for high inflation in 70s and 80s, more recent literature has also highlighted the role of inflation expectations in driving the inflation spiral observed during this period (Benati and Goodhart, 2010). A shift in the monetary policy regime in 80s stabilised inflation expectations and, as a result, helped stabilise actual inflation.

Since then, several countries have gone ahead with adopting inflation targeting as their monetary policy regime. While the 2008 financial crisis raised questions on the adequacy of inflation targeting in advanced economy, inflation targeting has almost emerged unscathed from the crisis. The central banks have continued to communicate their policies in the context of meeting their inflation objectives. In his chapter for the Handbook of Monetary Economics, Svensson concludes, “inflation targeting has proved to be a most flexible and resilient monetary-policy regime and has succeeded in surviving a number of large shocks and disturbances, including the recent financial crisis and deep recession.”

The resilience of inflation targeting as the monetary policy regime is not just limited to advanced economies. In fact, the empirical evidence around the success of inflation targeting is stronger for developing economies than it is for developed economies (Ball et al., 2010; Batini and Laxton, 2007). This is notwithstanding the arguments that developing economies have relatively high degree of informality and that inflation in these economies is driven by cost-push shocks.

As of 2010, 15 out of 25 economies which had adopted inflation targeting were developing economies. Since 2010, more developing economies, including India, have formally adopted inflation targeting as their monetary policy regime. In a recent paper evaluating the transition to inflation targeting in India, Eichengreen et al. (2021) note, “inflation-targeting central banks were able to respond more forcefully to the Covid-19 crisis, consistent with the idea that inflation expectations were better anchored, providing more policy room for maneuver.”

Similar to the experience of developed economies, the shift towards inflation targeting in developing countries was also triggered by the failure of alternate monetary policy regimes in many of these economies. For example, the shift towards inflation targeting in South American and South East Asian economies in late 1990s and early 2000s was driven by the collapse of the fixed exchange rate regimes following a series of currency crises during 80s and 90s.

The collective experience of developing economies shows that inflation targeting has been most effective in how the central bank should conducts monetary policy in these economies. There is evidence that this has not only reduced the likelihood of a currency crisis in these economies but has also reduced the volatility in output growth. Most importantly, “there is no evidence that inflation targeting has been detrimental to growth, productivity, employment, or other measures of economic performance in either developed and developing economies” (Svensson, 2010).

The international experience spanning over several decades should address concerns expressed in Pakistan that limiting SBP’s primary objective to price stability will undermine growth. However, contrary to this, questions raised around transparency and accountability have considerable merit. The lack of an explicit inflation target or the target range undermines the objectives of an inflation targeting regime.

A monetary policy regime without an explicit target is criticised in Mishkin (1999) for “lack of transparency,” noting further, “the constant guessing game … creates unnecessary volatility in financial markets and arouses uncertainty among producers and the general public.”

But who should set the target? In practice, one can find examples where governments, central banks or both together set an inflation target. What is important is that ‘price stability’ is defined such that it reflects the preferences of the society. The last thing we want is the SBP announcing that inflation is stable, while the government plans on introducing ordinances to implement price controls. Therefore, the parliament setting the target can overcome this inconsistency between the preferences of the central bank and the preference of the society. Additionally, this will also strengthen an important democratic institution of the country.