Comment: Inflation targetting

COMMENT BY CENTRALBANKNEWS

Like other inflation-targetting central banks before it, the Romanian central bank has adopted a tough stance from which it is likely to benefit. Its decision to leave its targets unchanged holds important lessons for other countries contemplating formal inflation targets.

In August last year the National Bank of Romania implemented a gradually declining inflation target along a "(dis)inflation path" of 5% for end-2006 and 4% for end-2007, with a 1% tolerance range on either side of these targets. However, inflation targetting has not gotten off to the ideal start. After years of disinflation, this week's inflation report observes that this "process came to a relative standstill" in the last quarter of 2005. The most recent forecasts see inflation overshooting the end-2006 target by around 1.6%, prompting a rethink of the 2006 target.

But, after some consideration the board decided against changing the targets. Both the 2006 and 2007 targets remain in tact for three key reasons. First, the central bank still believes the 2007 target is attainable. "Disinflation is expected to re-enter a path consistent with the attainment of the 4% inflation target (for 2007)", the report states.

Second, the central bank referred to "the need to better anchor inflation expectations". The board saw a possible revision of the 2006 inflation target as something that could "complicate the future conduct of monetary policy". Finally, the central bank expressed the need to "take prompt and firm measures" as monetary policy measures affect prices "through a time lag". The board believes inflation can be brought back within the target range in the medium term - "a time horizon during which monetary policy tools are more effective".

The Romanian central bank can take heart from the experience of other inflation targetters. Brazil and South Africa experienced particularly bumpy roads after adopting inflation targetting, with the former breaching its target in 2001 and the latter do so in 2002. Although inflation targetting certainly has its fair share of critics, the framework is broadly credited with anchoring inflation expectations and entrenching price stability in these and other emerging market economies.

For countries reducing high rates of inflating to miss their targets for brief periods is not exceptional, the important issue is that the central bank's commitment must be seen as credible. Changing the inflation target does not achieve this objective. The National Bank of Romania - and indeed other emerging market inflation targeters - are likely to gain more credibility by sticking to their guns, than they would by shifting the goal posts.