Direct Inflation Targeting: A New Monetary Policy Strategy for România

DIRECT INFLATION TARGETING

A New Monetary Policy Strategy For Romania

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. When inflation goes up, there is a decline in the purchasing power of money.

There are several variations on inflation:

Deflation is when the general level of prices is falling. This is the opposite of inflation.

Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system.

Stagflation is the combination of high unemployment and economic stagnation with inflation.

In the 1990s, the growing concern for price stability as a prerequisite for sustainable economic growth determined the central banks in numerous countries to adopt a new monetary policy strategy: direct inflation targeting.

In the “Preaccession Economic Programme” drawn up by the Government of Romania in 2001, the direct inflation targeting is mentioned as a first option for the political strategy that the National Bank of Romania takes into account for the years 2003-04, provided that the disinflation process has recorded durable gains.

The direct inflation targeting regime recognises the importance of the inflationary phenomenon in modern economies and, implicitly, the fact that ensuring price stability represents the most efficient way for the monetary policy to sustain the overall objective of long-term economic growth.

In recent years, particularly given the trend of globalization, there is increasing debate on the

role of inflation targeting as a framework for implementing monetary policy.

Inflation targeting may be defined as a framework for policy decisions in which the central bank makes an explicit commitment to conduct policy to meet a publicly announced numerical inflation target within a particular time frame.

The direct inflation targeting strategy is defined by the following features:

- non-equivocal commitment to price stability as the overriding objective of the monetary

policy, ahead of the other traditional objectives (economic growth, increase in external

competitiveness, coverage of the fiscal gaps or reduction of unemployment);

- transparency of the monetary policy strategy by communicating the monetary policy

objectives and decisions to the public;

- increase in the central bank’s accountability for attaining the inflation target;

- dependence on having in due time a whole set of information on relevant variables

concerning the four macroeconomic areas (real, monetary, fiscal and external areas).

Institutional prerequisites:

- Absolute priority for the inflation objective:

The institutional commitment towards price stability implies that monetary policy should be

given a clear mandate whereby this objective is considered fundamental and thus takes priority

over other objectives such as economic growth, external competitiveness or increase in

employment.

- Instrumental independence of the central bank

The direct inflation targeting regime requires an increased independence of the central bank in

conducting monetary policy.

- Harmonisation of monetary policy with fiscal policy

The central bank is fully independent only when the operational framework ensures that

the inflation target overrides the fiscal objectives.

- Flexible exchange rate

Another issue that may cause serious problems to the direct inflation targeting strategy is the

dollarisation phenomenon, a characteristic of many emerging markets. The flexibility of the

nominal exchange rate is a condition of the inflation targeting regime which stems from setting

the inflation target as the overriding objective.

Technical prerequisites:

Beyond the institutional prerequisites, adopting a direct inflation targeting regime implies

dealing with some technical issues :

– choosing an adequate price index (representative for the purchasing power of money and

easily understandable by the public);

– explicit setting of a quantitative target, of the accepted fluctuation band and of the time

horizon over which the target is pursued;

– building of an effective model for inflation forecasting by the central bank.

Inflation targets may help provide a clear path for the medium-term inflation outlook, reducing the size of inflationary shocks and their associated costs. Since long-term interest rates fluctuate with movements in inflation expectations, targeting a low rate of inflation would lead to more stable and lower long-term rates of interest.

The implementation of the inflation targeting regime in Romania should be analysed by considering five elements: