Does inflation targeting work? IMF paper casts doubt on policy of RBI, many other central banks

Findings are of relevance for RBI, which has followed inflation targeting policies since 2016 but had to write to govt in December 2022 explaining why inflation had overshot target.

The IMF logo is seen outside the headquarters building in Washington, US | Reuters file photo

New Delhi: A new paper published by the International Monetary Fund (IMF) has found that there is no definitive evidence to show that inflation targeting policies by central banks actually work in bringing down inflation.

This is of particular significance for India since the Reserve Bank of India (RBI) last month had to write to the government explaining why its policies have failed to keep inflation under control.

In a working paper titled ‘Macro Effects of Formal Adoption of Inflation Targeting’, published Monday, the authors — Surjit S. Bhalla, Karan Bhasin and Prakash Loungani — found that while early adopters of inflation targeting (IT) in the pre-2000 period all saw declines in their respective inflation rates following adoption, only half the subsequent adopters of this policy have met with success in controlling inflation.

The paper also warned that although central banks have their own reasons for pursuing an inflation targeting framework, they should be wary of the “dangers of groupthink”, and should instead critically examine the evidence of whether such a policy actually works.

Importantly, the authors also say they have found some “limited evidence” that inflation targeting leads to slower economic growth — an oft-repeated criticism of the policy.

Inflation targeting is a monetary policy adopted by central banks where they set a target for the inflation rate, make this public, and refine their policies to make sure that inflation remains at the target level. The RBI adopted a ‘flexible inflation targeting’ framework in May 2016, when the RBI Act was amended to provide a statutory basis for such a policy.

The ‘flexibility’ of the policy is due to the fact that the RBI provided a band of comfort — of 2 per cent above and below the target of 4 per cent. In other words, the RBI is okay with inflation an inflation rate between 2 and 6 per cent.

Last month, the central bank wrote to the government explaining why inflation during 2022 had been above this level for three consecutive quarters.

Role of inflation targeting unclear

“Since there is not much difference, on average, between IT and non-IT countries in mean inflation, inflation volatility, and the extent of inflation anchoring, it is not easy to sort out what role IT has played in ensuring good outcomes,” the paper said.

“Our country-by-country analysis shows that IT adoption delivers significant inflation gains in a few countries but not in the vast majority of our sample,” the paper added. “Overall, our results lead us to conclude that formal adoption of IT is neither necessary nor sufficient for attaining low inflation outcomes.”

The authors analysed inflation data for 190 countries, of which 24 were classified as advanced economies (AEs) and the remainder as emerging markets and developing economies (EMDEs), over the period 1990 to 2019.

What they found was that the median inflation rate in advanced economies has been moving downwards for the past three decades — regardless of whether they formally targeted inflation or not. For EMDEs, the median inflation rate remained high throughout the 1990s, but has since been moving down, except for a brief flare-up in the aftermath of the Global Financial Crisis of 2008.

The authors also cited previous research that shows that the decline in inflation among early adopters of inflation targeting could have been more due to a ‘regression to the mean’ than because of the policy framework itself. In other words, they found that the fall in inflation was more likely due to inflation levels coming back to their average levels after a spike than because policy interventions worked in bringing them down.

To explain this, they have quoted from a chapter by L.M. Ball and N. Sheridan from a book published in 2004, titled The Inflation-Targeting Debate, which says: “Just as short people on average have children who are taller than they are, countries with unusually high and unstable inflation tend to see these problems diminish, regardless of whether they adopt inflation targeting.”

Following their analysis, the authors of the IMF paper confirm this, saying that “‘regression to the mean’ continues to offer a powerful possible explanation for the apparent effects of IT in advanced economies and, moreover, holds with strong force for emerging market economies as well”.

Impact on growth

Economists have been divided about the impact of inflation targeting on growth. While some have said lower inflation is usually associated with higher growth, others have argued that the steps taken to lower inflation also tend to slow growth rates.

The authors of the IMF paper say their analysis has shown there is some evidence that inflation targeting policies do have a negative impact on output, although the results are not quite conclusive.

“Our evidence on the growth impacts of IT is mixed,” the paper said. “From our panel data analysis, we found little difference, on average, between IT and non-IT countries. But our country-level SCM (synthetic control method) analysis does show modest evidence that countries where the inflation declines from the adoption of IT were greater also experienced larger output declines.”

“There is thus some limited support for the concern that inflation gains come at the expense of output,” the authors added.

Central banks should be careful

The authors, in their conclusion, have included a few warnings to central banks intent on pursuing an inflation targeting framework.

“It has become commonplace for central banks and international financial institutions (IFIs) to assert the benefits of the adoption of inflation targeting,” the paper says. “We do not deny that these claims sometimes rest on a more sophisticated judgment… However, central banks and IFIs could nevertheless benefit from looking at the evidence on IT with a more critical eye, given the dangers of groupthink at these institutions as highlighted in some quarters.”

However, the authors did say that their results do not provide a “full cost-benefit analysis of inflation targeting” and that there are several possible advantages to such policies that have not been considered in this paper.

“At the same time, adherence to IT can also lead to policy mistakes if policymakers become too focussed on attaining the inflation objective to the detriment of other objectives,” they warned, adding that they would be releasing a companion paper containing “a fuller cost-benefit analysis of India’s adoption on inflation targeting”.

(Edited by Zinnia Ray Chaudhuri)