QUESTION 3

Inflation targeting and the Group of Three (G3)

The G3 is comprised of the United States, Japan and the European countries using the euro (known as the Eurozone). Until relatively recently, all three members were reluctant to adopt a fully-fledged inflation targeting regime. All the central banks of the G3 have been deeply committed to price stability as a goal of monetary policy for at least the past thirty years.

In the Eurozone, the primary objective of the European Central bank is defined as the maintenance of price stability and, without prejudicing this objective, the support of general economic policies of the European Union. The general economic policies of the EU, according to Article 2 of the Treaty of the Union, are to promote the following throughout the community:

A harmonious and balanced development of economic activities

A sustainable and non-inflationary growth that respects the environment

A high degree of convergence of economic performance

A high level of employment and social protection

The raising of living standards and quality of life

Economic and social cohesion, and solidarity among member states (1992:5)

In order to achieve these objectives, the ECB follows a two-pillar monetary approach. The first pillar is provided by a reference value for the money supply M3, where prolonged or substantial deviations from this reference value signal risks to price stability over the medium term. The ECB has clearly stated that deviations from this reference value will not automatically lead to changes in interest rates, and that this rather follows a weak form of monetary targeting. The reference value of M3 is hence more of an important indicator of risk than an actual target.

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The second pillar of the ECB's monetary policy approach is a broad-based assessment of the outlook of price development, which is derived from a wide variety of economic indicators. In this sense, the ECB takes account of all the information that is relevant for future price developments. In addition, the ECB announced a price stability definition of slightly below 2%, measured as a year-on-year rate in the Harmonised Index of Consumer Prices.

In Japan, the aim of monetary policy is described as the pursuit of price stability to contribute to the sound development of the national economy. The Bank of Japan has not been very explicit on the monetary policy framework that applies to achieve this objective, probably due to the fact that since the adoption of the new Central Bank Act in April 1998, the central bank has been battling to solve persistent deflationary conditions. In coping with this problem, price stability was defined as a condition where there is no inflation or deflation, with the authorities adopting non-conventional policy measures. These measures consisted of the application of a zero interest rate policy, together with measures aimed at the quantitative easing of liquidity. The monetary base was increased by creating excess reserves, through the purchase of long-term government bonds and even riskier assets, including commercial paper, corporate bonds, equities and the bonds of non-residents. Since the recent economic slump, these kinds of measures have also been pursued by the United States and the ECB.

The Bank of Japan was reluctant to adopt inflation targeting as their monetary policy framework because they argued that, in contrast to the other countries, they would apply this framework in order to increase inflation. However, at the beginning of January 2013 the Bank of Japan officially adopted an inflation target of 2% as part of the measures to stimulate economic growth. Inflation was 0.3% in 2020, with economic growth averaging at 0.41% between 1980 and 2020. In the US, the Federal Reserve System has been tasked with carrying out monetary policy in such a way that it promotes sustainable economic expansion and reasonable price stability. However, since the beginning of the 1980s, price stability has become the dominant goal of the FRS, based on the argument that such stability is essential for the achievement of sustainable economic growth rate. In 2020, the FRS placed the employment end of its mandate above the inflation side, arguing that it will tolerate higher inflation in the interest of broad, inclusive employment gains.

Until the beginning of 2013, the monetary policy regime of the FRS was one of informal inflation targeting, in which greater attention was given to the economic performance of the economy than in fully-fledged inflation targeting countries. In January 2013, the Federal Reserve announced that it had adopted an inflation target of 2%, as measured by the personal consumption expenditure price index. This target is regarded to be consistent with its congressionally mandated goals of price stability and full employment. It did not adopt a fixed goal for employment because the level of unemployment that can be achieved without resulting in accelerated inflation is determined largely by factors other than monetary ones. The overall performance of the economy would continue to be an important factor in the determination of monetary policy. The new approach of the Federal Reserve can be described as flexible inflation targeting, which enables the central bank to conduct a stabilisation programme without departing from the longer-run goal of keeping inflation low and stable. The Federal Reserve updated its inflation target in August 2020 after years of weaker-than-expected price growth. Known as average inflation targeting, the framework seeks inflation that averages 2% over time and, therefore, allows for periods of above -2% inflation. The new policy signals the Fed will keep easy monetary conditions in place well into the US economic recovery.

Sources: Howells & Bain, 2004; Ito, 2004; Meulendyke, 1998; Wood, 2020; Winck, 2021

Why was the Bank of Japan reluctant to adopt an inflation targeting framework? (3)

It seems that in spite of the adoption of inflation targeting in recent years by the G3 countries, little emphasis has been placed on price stability by the G3 central banks. Do you agree with this (3) statement? Explain your point of view.

3.3

3.1

3.2

Many analysts have been calling for the implementation of accommodative monetary policy, which in many countries, including Japan, has not yet yielded any desired results. The same is true in South Africa; despite many years of relatively stable prices, the economy still finds itself in stagnating conditions. Do you think monetary policy easing as a tool is enough to bring about growth and development? Explain your view.

(4)