Challenges Of Inflation Targeting Market

Different measures of inflation

Discuss about the Challenges of Inflation Targeting Market.

Ceccheti and Schoenholtz (2015) defines inflation as a phenomenon where general price level in the economy increase overtime. The rate of inflation is the rate of continuous increases in general price level affecting household, firms and government. Obtaining a stable price level is a central objective of central bank in order to achieve a stable economic growth. It is a continuous process where price level goes on increasing at a continuous phase. Inflation does not refer to the event of sudden price rise at any specific point of time. Inflation in the economy is computed by considering price movement of a certain basket of goods and services in the given year. A price index is then constructed using the prices of the taken based and compared with price index of the base year. The inflation rate is finally calculated as a percentage change in the relevant price indices (UNISA 2017).

The selected basket of goods and services differs depending on the categories of goods ad assigned weight on the goods in the basket. A number of price indices are available to compute the increases in price of the basket. Some common price indices used for the present paper are given as follows

Consumer Price Index (CPI):  The consumer price index intend to measure the cost of living in two different periods to maintain a balanced standard of living. The measured inflation rate using CPI is called headline inflation. Here, the goods and services used by the households are valued to measure the average price level of the household. The inflation targeting policy of central bank uses the measured inflation to stabilize price.

Producer Price Index (PPI):   Producer Price Index is used to trace the change in wholesale prices that is prices charged by the suppliers of the manufactured goods. As noted by UNISA 2017, PPI focuses on the prices of intermediate goods. The intermediate goods refer to the goods that are exchanged between firms. The basket includes mostly consumer goods that the retailers pay to the manufacturer. The index therefore measures the production cost.

The inflation rate computed from consumer price index is compared with the core inflation rate. Core inflation is a more sustainable measure to trace the price level movement. There are several methods of computing core inflation in the economy. The ne used by the Reserve Bank of South Africa is the method of exclusion. In this method some of the goods are removed from the selected basket of good. These goods are energy, petrol and food. For these goods price level remains generally unstable and transitory (UNISA 2017).

The nature of inflation as an indicator of conflict over income distribution

The paper discusses nature of inflation and inflation targeting in South Africa. After giving major definition related of inflation the paper analyzes the nature of inflation in describing conflict of income distribution. This then shows the importance of inflation targeting in framing monetary policy of the central bank. The issues are analyzed in context of South Africa and find the significance of exchange rate in inflation rate determination in South Africa. In this context the role of money in the inflation process, the significant role played by different sector of the economy to control inflation and major challenges that the emerging markets face in the phase of inflation targeting policy are evaluated.

The discussion of inflation needs a starting point. The inflation in an economy arises with increases in the set of goods or in a single good. Price in the market is a medium of exchange between the buyers and sellers. The price is the amount of money that needs to be exchanged at times of transaction of goods and services.The inflation therefore implies the situation where the suppliers raises price to raise their income and buyers still willing to make their purchase even ta a high price. The increase in the price level means suppliers are able to increases their income through a high price at the cost of the buyers.

The trend of inflation starts with a price hike in a single good and then gradually transforms to other goods creating inflationary pressure. The inflation in the economy is explained either supply side factors or demand factors. The cost-push inflation arises because of an increase in the production cost. The producers raise their price to recover the increased cost. Suppliers often raise the price in order to increase their profit margin. This is called profit push inflation. Increase in the demand for a good creates upward pressure on price and the resulted inflation is called demand-pull inflation. The suppliers compensates the loss incurred in times of purchasing any good that they desire to purchase by raising the price of the goods supplied by themselves.

The incidence of inflation affects all the economic agents in different ways, no matter whether they are participating in trade or not. This can be explained with a simple example.  Workers demand for an increase in their remuneration because of inflation. This raises the wage cost to the firm, which then raises the price to make higher payment to its employee.

Factors that make an economy prone to inflationary pressure

If price raises and buyers continue to purchase goods without raising the price of their own supplied goods including labor then the motion of inflation stopped. There remains inflationary motion that can be put into force. In this situation, the overall price level stops moving and stays unchanged. In the other instance, where the goods that demander purchase experiences a hike and they compensate their loss from purchasing by raising the price of the goods that they supplied then the inflation spiral is in motion. Then, there is an indication towards conflict over income distribution.

The next aspect to be discussed is identification of factors that makes an economy prone to inflationary pressure. Three factors play key role here. These are described as follows

A sustained increase in the price of goods or services regarded as essential input of in the production process or importance for maintaining living standard. In this situation, demanders may decide to absorb the small increase in price without pass on the burden in terms of raising price or wages. In order to avoid inflation, essential items such as fuels, staple food, exchange rate and wages should have stability in price.

In order to have cost-push inflation, major sectors such as firms, government and labor should be large so that they can able to protect their real income in the phase of increasing production cost by raising prices. In this case, inflation is realized because of lack of competition in goods and labor market. In this situation, business possesses enough bargaining power without concerning for losing sales volume. The labor union enjoys the bargaining power and can increase the wage without affecting level of employment and output. In case of government, it has the potential to raise taxes without fearing for any tax revolt.  This is the situation where the major sectors in the economy instead of absorbing lower profit, lower tax income and lower real wage, pass on the burden to other by hiking price. This creates inflationary pressure, which perpetuates to price level of major commodities and prevents prices to come down. This is true for firms that are major exporters. In situation where these firms are price takers in the international market and can give in high wage demand have incentives to prevent these demands (UNISA 2017).

In situation where there are highly elastic money supply, then forces of demand-pull inflation easily transmitted to an increase in demand for credit and inflationary pressure is accumulated via credit demand. In a less elastic or rigid structure of money supply firms usually do not raise price to pass their cost burden on demander because of the fear of losing market share. If firms raise price, then buyers find it difficult to finance their spending because of increasing cost.

The role of money in the inflation process

A tight monetary policy aims at reducing inflation by creation of money through raising interest rate. The idea is when there is less money and falling demand for goods then firms are left with no other option but to absorb the increasing cost and prevents the wage demand.

Inflation reflects the changing value of money. Price of goods purchased today is several times higher than that in years ago. Irrespective of kinds of goods necessary or luxury, prices are higher today than they were before. There is a positive correlation between rate of growth in the money supply and inflation rate. Inflation is defined as the continuous rise in the general price level and hence is associated with the growth money supply. There are instances of countries where inflation moves in lines with money supply. Countries such as Ukraine, Turkey and Zambia during 2000 to 2010 have experienced high inflation and high money supply. The developed countries such as United States of America, Sweden are countries that experience low inflation along with low supply of money. This validates the assertion made by Milton Friedman that inflation is a monetary phenomenon.

UNISA (2017) supports the claim made by the Friedman. It indicates the fact that a persistent increase in general price level requires an increase in total supply of money to keep the transaction volume not to shrink. It suggests inflation is a demand-pull phenomenon and accelerates with a rise in money stock. The supply side factors can also play a potential role in influencing inflation and sustain inflationary impulses (UNISA 2017).

The quantity theory of money is not applicable in the short run as that in the long run as it assumes complete flexibility of prices and wages. It indicates a change in the price level because of a change in quantity of money (Mishkin 2013). In order to continue purchase at a higher price buyers need some additional financing capacity. The financing capacity can be increased only through monetary injection that increasing supply of money by the central bank or preventing monetary leakages such as selling of financial assets, dishoarding and others. Owing to financial limit with dishoarding increasing money remains only feasible option to boost purchasing power. This implies increase in money supply is the only way to promotes inflation in the economy. During inflation central bank faces the problem of bank debt because more money is required to support the aggregate demand gives boost to the price level.

Different sector of the economy to control inflation

If credit supply does not increases with inflation then people reduces their demand which hurts the volume of sales and slows economic growth. The declining growth rate reduces output and employment and restricts further growth. The unchanged money supply in times of inflation means financial loss as same amount of goods and services are exchanged and maintained at a higher cost. This explains the rationale for allowing increasing money supply to support minimal inflation. However, the money supply is increased within limit.

The reason for accepting all sectors in the society that real income cannot grow in excess of productivity gains to come down inflation

Inflation has monetary implication in the form that those in the demand side charges a high price in times of behaving as producer to finance their additional cost of purchasing. Banks are the main source of credit expansion in terms of providing additional money supply. Therefore, supply of money needs to be increased to support inflation.

There are some major sectors in the economy that has contribution to creation of more money in the economy. These sectors are the following

1. Firms and household that involve in mortgaging to take loans from banks in order to make property purchase.
2. Government, in times of financing deficit through selling bonds and treasury bills to the central bank.
3. Household and small firms running with debt in form of bank overdraft and debt to credit card.
4. Central and commercial banks through purchasing debt paper from non bank financial institution and public.

The central bank though can directly control money supply in the economy however cannot directly control the rate of inflation.  However, there are other channels through which central bank can influence the inflation rate. One such channel is exchange rate.

In South Africa, exchange rate alone is the most significant determinant of inflation rate. The reasons for importance of exchange rate in determining the inflation rate are the following

The first reason is that a considerable portion of consumer goods in South Africa are imported from abroad. Secondly, a significant portion of domestic production coast comprise of imported raw material inputs such as machines, skilled labor, tools, fuels and other essential components. Therefore, price of domestic currency relative to its trading partners play is a vital component of the economy.

Depreciation of currency makes import costlier. Because of heavy reliance on import for both consumer and producer goods depreciation of currency that raises price of imported manufactured goods and input6s raises cost of production in the nation. The rising production cost shifted to the households in forms of raising prices pointing to cost push inflation.

For a small open economy like South Africa the sudden inflow or outflow of capital affects the balance of payment account by influencing the capital account and this affects the exchange rate. For example, fluctuation in inflation rate during recession in 2008-2009, in the middle of 2014 and important political decision in 2015 where Finance ministry considers various changes largely contributed to a decline in the value of rand. In this way, exchange rate plays a vital role in deciding the future price level.

Challenges that the emerging markets face in the phase of inflation targeting policy

In order to reduce inflation a structural solution is required. To achieve this following requirement need to be met. Stability is required in the cost of major inputs such as wage and prices of oil. In addition prices of those goods necessary for leading a standard living such as bread, maize and clothes needs to be stable. Competition should be encouraged both in the goods and factor market. The money supply should be less elastic.

As per UNISA (2017d, p.60), the central monetary authority has some counter inflationary measures to counter inflation.  The inflation in the economy can only be reduced when major sectors such as labor, business and government accepts the reduction in the real income in forms of lower wage, profit and increase in payable tax in times as compared to that in times of inflation.

Implication of inflation targeting in the framework of monetary policy and its application in South Africa

Under the inflation targeting program of monetary policy framework, the central bank first sets a target inflation rate and then uses tools of monetary policies to achieve this target. The inflation targeting framework gives transparency to the central bank’s monetary framework (SARB Inflation Targeting Framework, 2017).

Several countries adapt the inflation targeting policy with a varying level of targeted inflation. Some countries chose a range of inflation targets while others decide to stick on a particular targeted point of inflation. Some countries sort to the policy of setting inflation target in between an extreme point and a targeted range. Setting inflation target to a particular point has the flexibility of target setting. The inflation target within a range helps the nation to absorb shocks that the central authority cannot control. In 2000, South Africa made formal introduction to the policy of inflation targeting though the framework was already present informally. The announcement had made in August 1999. The policy was succeeded by a set of other policies such as discretionary monetary policy, targeting exchange rate, aggregate monetary target (SARB Inflation Targeting Framework, 2017).

• The inflation targeting policy decreases political duty. With set inflation target the pressure on the central bank is reduced as it no longer needs to take inflationary policy in the long run . this in turn reduces the likelihood of employment expansion in the short run.
• It helps general public to understand the inflation targeting and thereby reduces the uncertainty in times of discretionary monetary policy and helps to cope with interest rate, inflation. The SARB Monetary policy Committee informs public about the interest rate and corresponding inflation rate.
• It helps to regulate the monetary policy and thus increases accountability of the central bank. The transparent inflation target clears the objective of central bank to be met. Once the actual rate deviates from the targeted rate central bank needs to investigate the reason behind the deviation.

• It takes some times for the monetary policy to effectively achieve the inflation target. This time lag results in delayed signaling about the price level with revelation of set inflation target to the public considerable time lag.
• Then pre set inflation target is suspected to make the monetary policy rigid where the monetary authority is unable to deal with unforeseen circumstances.
• Too much focus on inflation when the prevailing inflation rate is beyond the target results in a restrictive monetary policy leading to high fluctuation in prices.
• A high inflation causes low growth of economies and employment- a situation similar to current economic scenario of South Africa.

The Inflation Targeting Framework of SARB in 2017, states that monetary policy is unable to influence growth and employment creation in the long term. It can only provide a stable financial environment. This helps top fulfill the necessary pre condition of economic development. Importance of expected inflation in determining inflation rate and the role of inflation expectation in inflation targeting

As mentioned by UNISA (2017) the inflation expectation plays a vital role in determining anti inflationary policy. In this regard, adaption of inflation targeting policy by the government of South Africa constitutes a clear example.

1. At first, an announcement is made in public about the numerical inflation figure or targeted inflation rate.
2. An institutional commitment is made stating inflation as the primary long term monetary policy goal and promise to achieve the announced inflation target.
3. An approach including detail information about important macro variables to taker monetary policy decision is taken.
4. There are increased means of communication to bring transparency in the monetary policy.
5. The accountability of the central bank increases to achieve the objective of inflation.

The central bank aims that public makes inflation adjustment in line with downward inflation pressure. It believes that the inflation expectation that is made today is the main driving factor for inflation rate in future. The households in the economy adjusts the inflation expectation wit their income demand. These adjustments tend to fulfill future inflation target (UNISA 2017 d, p.64). Inflation expectation thus turns out as self-fulfilling and at the same time threatens the long term policy goals of the economy. Therefore, in other countries the central bank adapts tight monetary policy using the instrument of increased interest rate without considering the adverse effect on state of economic growth.

The workers demand a high wage to compensate the loss due to price rise. UNISA 2017 finds out that price rise firms often take place in pro active manner as the firms anticipate increasing cost of production from their inflation anticipation. This encourages the firms more to raise their prices. A declining inflation target is set in times when the inflation expectation in the economy is reduced (UNISA 2017).

Therefore, it can be hoped that with a disclosure of inflation target to the public nad commitment of the central bank to achieve the target using its central power the inflation in the economy can be controlled. When public possess a downward inflation expectation then inflation target is set with a downward pressure price level.

A successful implementation of inflation targeting policy needs to fulfill some basic requirement. As most of the developing or emerging economies unable to comply with this requirement, the inflation targeting turns out to be an inappropriate policy tool for these economies (Khan 2008). The emerging markets of developing countries are more vulnerable to economic shocks a greater flexibility is required on part of these countries to resist the shocks. The example countries include Brazil, Turkey, Ukraine and others.

The mechanism for combating inflation targeting policy involves cost as stated by UNISA 2017. There are countries where such costs are so high that anti inflationary policy is opposed by most of the policymakers. Considering the high cost involved in the inflation targeting policy these countries chose to accept the high price with the hope that persistent inflation is not a permanent state and inflation will be reduced after some time and prevents the economy from experiencing a state of hyperinflation.

High interest rate have adverse effect on the economic agents highly dependents on the bank credit for financing their activities. Example includes credit needs of the household in terms of mortgaging bonds to afford their property purchase.

The tight monetary policy though intended to reduce the inflation rate adversely affected the growth rate of labor and business. The counter inflationary policy is not successful unless these agents cooperate with accepting the reduced income in form of reduced profit and wages.

A deflation which is opposite to inflation and describes a decline in the general price level increases the value of bank debt in real terms. The indebted firms and household counter the situation by restricting expenditure to repay the debt. This leads to a shrink in economic activity and decreases money supply. The result is another round of deflationary pressure on prices. This is exactly what happened during great depression in 1930s. The mechanism through which a supply shock in the form of a considerable rise in settlements of real wages (nominal wages raise more than the current inflation rate) could affect the economy of South Africa in current situation and an appropriate policy response of SARB

The study reflects that though inflation is indentified as a monetary phenomenon however it initially begins with the rise in a single commodity or a group of commodities and then gradually transmitted to the overall price level.  The initial rise in the general price level when occurs at the initiatives of suppliers then it is called supply push inflation. The supply push inflation is then divided into two categories namely cost push inflation and profit push inflation. The cost push inflation occurs when suppliers raise the prices to recover the increased cost of production. Profit push inflation on the other hand occurs when suppliers raise price simply to increase their profit margin. These two are not the only reasons of inflation. Price may rise because of an increase in demand in the economy. Prices rise in response to a high demand and termed as demand-pull inflation.

References

Cecchetti, SG & Schoenholtz, KL (2015): Money, Banking and Financial Markets. 4^th edition. McGraw-Hill Irwin.

Khan, B, 2008. Challenges of Inflation Targeting for Emerging Market Economies: The South African Case (presentation at a conference on challenges for Monetary Policymakers, South African Reserve Bank), 29-31 October.

https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/51/Brian+Kahn.pdf

Accessed on 21 October 2017.

Mishkin, B (2013): The Economics of Money, Banking, and Financial Markets. 10^th Edition. Pearson.

The South African Reserve Bank Inflation Targeting Framework (2017)

https://www.resbank.co.za/MonetaryPolicy/DecisionMaking/Pages/default.aspx

Accessed on 26 October 2017.

Kantor, Brian & Kavoli, H. 2011. Inflation and Inflation Expectations in South Africa: The observed absence of second round effects.

https://www.zaeconomist.com/wp-content/uploads/2011/04/Study-on-Inflation-and-Expectations.pdf

Accessed on 27 October 2017.

Unisa, 2017. The Basics of Inflation, Tutorial letter 105/2017, Pretoria: Unisa, pp.69 - 91