The efficiency of monetary policy is generally defined by its ability to bring about price and financial stability, or to mitigate cyclical economic fluctuations. Such a policy’s ability to promote long-term economic growth is usually not taken into account, as mainstream macroeconomics argues that money is neutral in the long run; thus, monetary policy cannot influence real output.
However, recent studies provide empirical evidence that monetary decisions might influence economic growth.
Inflation targeting goals
Inflation targeting is a monetary regime that is subject to the following conditions:
- The central bank announces its mid-term inflation targets.
- In its monetary policy, the central bank gives priority to price stability.
- While setting monetary policy parameters, the central bank takes into account exchange rate, monetary aggregates, and other macroeconomic indicators.
- Monetary authorities continually communicate their decisions and the reasons behind them to the public.
- Monetary authorities are responsible to the public for reaching inflation targets.
This conventional definition of inflation targeting does not mention real output among the targeted parameters. However, the effects of inflation targeting on economic growth frequently become the subject of debate. A conventional argument against inflation targeting is that it may cause high volatility of the real output or exchange rate and sustain excessive interest rates, which could have a negative impact on investment and, ultimately, economic growth.
In the first half of the 2000s, a little more than ten years after inflation targeting was first adopted (see inset), studies concluded that this monetary regime had no influence on long-term economic growth. These papers used different methods (such as difference-in-differences estimation or propensity score matching) and data from either developed or developing economies, but the results were similar: inflation targeting does not stimulate the economy.These early studies focused mainly on the period from the late 1980s until 2007. In the literature, this period is called the Great Moderation (the term was introduced by James H. Stock and Mark W. Watson in 2002), and is characterized by record low volatility of business cycle fluctuations. These conditions allowed central banks to stabilize output and inflation without a nominal peg and at fairly low cost. This is why the effect of inflation targeting could have been statistically insignificant.
More recent studies that analyze the accumulated data on the long-term effects of this monetary regime argue that inflation targeting is favorable for economic growth. Galina Hale (Federal Reserve Bank of San Francisco) and Alexey Philippov (MSU) used matching methods to evaluate the net effects of monetary policy in isolation from other factors. They compared pairs of economies where both countries had similar macroeconomic characteristics, but only one applied inflation targeting. It turned out that the adoption of inflation targeting increased developing economies’ growth rate by 0.6 p.p. Developed economies benefitted even more, gaining about 1 p.p. of growth.
Kelly Ayres (Southern Illinois University) and her co-authors estimated a dynamic model on panel data and found that the adoption of an inflation targeting regime leads to lower output in the short term (which is understandable, since switching to this regime involves restrictive policy), but its positive effects, in the long run, surpass its short-term negative influence. We achieved similar results, although we studied only developed economies: there are significant positive effects, though with a three-year lag. Recent papers reach the same conclusions. At the same time, it does not matter which regime the central bank followed prior to its shift to inflation targeting: it could have been an exchange rate peg, money supply targeting, or no obligations at all. Inflation targeting generates higher growth rates in all of the above-mentioned cases. Thus, if this regime affects long-term growth, its effects are positive. In this case, it is essential to understand the mechanism behind this impetus.
Channels of influence
The ultimate goal of inflation targeting is low and stable inflation. Thus, this regime may influence economic growth in the following way: the shift to inflation targeting decreases inflation and its volatility, while lower inflation in turn creates a favorable environment for economic growth.
The results of recent econometric studies support this theory. They prove that low inflation has, at the very least, no negative effects on economic growth. At the same time, soaring prices (surpassing a certain level) have a negative impact on growth. The above-mentioned critical rate of increase is about 3-4% for developed economies and is a little above 10% for developing ones. The Bank of Russia’s benchmark of 4% still does not seem too strict, as the studies show that the higher inflation is, the more volatile it becomes. Thus, it would be quite challenging to maintain inflation at 8-10%, as it would be unstable.
Strong price growth and volatility have adverse effects on savings and investment. The latter suffers because when the inflation rate exceeds the critical threshold, this creates great uncertainty about future relative prices. Investors do not like uncertainty. As a result, they become less motivated to invest. Moreover, soaring prices lead to increased ‘menu costs’ (costs to firms resulting from changing their prices). Considerable uncertainty pushes the risk premium up, making credit more expensive. All this together constrains accumulation of capital and, as a result, leads to slower economic growth.
At the same time, the adoption of inflation targeting should not be expected to eliminate other negative factors, aside from sustaining economic growth, as Russia’s experience shows. A rational monetary policy contributes to economic development, but it should never be the key driver. Monetary policy cannot replace real and human capital accumulation, technological progress, and a well-developed institutional environment.