Inflation target for Ukraine
In a recent report, IMF
recommends that Ukraine switches to inflation targeting where the target range
is 3 to 5 percent per year. Is this a reasonable regime for monetary policy in
Ukraine? This blog reviews some issues related to this question.
Ukraine has had chronic problems with inflation. In the
early 1990s, inflation rate in Ukraine was in thousands of percent and this
hyperinflation damaged the economy considerably. Since then inflation subsided
but it remained relatively high and volatile (see figure below). Even in recent
history, inflation in excess of 10 percent was not unusual. While the previous
government of Viktor Yanukovych took credit for near zero inflation in 2012 and
2013, this was far more likely to be a manifestation of depressed economy and
overvalued exchange rate.
High and volatile generates serious distortions. The experience of other
transition countries suggest that inflation targeting may be effective in
solving this problem. However, there are a few challenges in implementing
inflation targeting.
First, establishing credibility is central for successful
inflation targeting. Ukraine’s economy is hit by large shocks (e.g., gas prices
set by Russia, violence in the East of Ukraine, uncertainty about the status of
Crimea) and it likely to go through high turbulence in the short and
potentially medium run. Furthermore, responding to these large shocks will
require large movements in the policy intruments such as short-term interest
rates. Can the National Bank of Ukraine control inflation in the narrow range
of 3-5%/year? Historical record is not particularly encouraging here. Hence,
the central bank should set modest goals in the short/medium run but make these
goals increasingly aggressive as it builds reputation.
Second, people and businesses in Ukraine lived through high
inflation and so inflation fears are strong. This is why the public pays
enormous attention to the movements in the nominal exchange rate as these
movements can signal inflation. By focusing on an inflation target (domestic
prices) and allowing free capital mobility, the central bank cannot control the
nominal exchange and interest rates at the same time (classic trilemma).
One may worry that the public may interpret changes in the nominal exchange
rate as signs of inflationary policies of the central bank and thus can
destabilize markets and generate panics. A possible solution could be temporary
capital controls which should be lifted as inflation expectations of people and
businesses are anchored.
Third, why do you want to have a positive inflation rate and
what numeric target should a country like Ukraine have? The standard arguments for
a positive inflation target are
- It helps to solve downward stickiness of wages (that is, workers are really averse to nominal wage cuts and so the only way to adjust wages is via inflation which gradualy reduces real wages paid to workers);
- It helps to avoid zero lower bound when all sorts of bad things can happen (e.g., monetary policy cannot be used to stabilize the economy; deflation; think of Japan in the last 10-20 years).
The main costs of positive inflation are dispersion of
prices and increased macroeconomic volatility. Hence, there is a tradeoff and
the optimal rate of inflation depends on relative strength of these forces. The
figure below is taken from Coibion et
al. (2012; ungated)
who study this question for the U.S. They find that the optimal rate for
inflation, which maximizes utility, is about 1.5%/year for the U.S. and this numeric
target is robust to a broad spectrum of alternative assumptions. Should the
optimal inflation rate be higher for a transition economy like Ukraine?
Welfare as a function of inflation target |
It seems that the answer could be that the inflation rate
should be lower. First, the labor
markets in Ukraine are fairly flexible and workers have little bargaining power
so that imposing nominal wage cuts is not impossible. Second, a higher nominal
interest rate reduces the risk of binding zero lower bound on nominal interest rate.
The equilibrium nominal interest rate r=(1/β-1)+γ+π, where β is the time
preference parameter, γ is the growth rate of productivity, and pi is the
inflation rate. Beta is usually close to one and is typically set at 0.96. γ is
fairly low in most countries (about 1 percent per year), but it can be quite
high for countries that are catching up. For Ukraine, this can be as high as 4.
Policymakers do not control β and γ and so they have to set π sufficiently
large to ensure that nominal interest rates do not hit zero. However, the need
to set a high π is reduced when g is large. If one takes the U.S. economy and
set γ to 4%/year, then the optimal inflation rate is close to zero.
The only reason why inflation could be higher is because
shocks may be very large. How large they are going to be for Ukraine is an open
question. Suppose we set γ =4%/year and vary the size of the shocks in the model
that is described and calibrated in Coibion et
al. (2012; ungated).
The figure below shows that the peak of the welfare function shifts from π=0.4%/year
to π=3.2%/year when we double the size of shocks. If we triple the size of
shocks, the optimal inflation rate is 5.7%/year. One can reduce the size of the
inflation target by imposing a more aggressive response to inflation.
Welfare as a function of inflation target for alternative sizes of shocks |
Obviously, extrapolating a U.S.-calibrate model to
Ukraine could be a stretch but these calculations are suggestive. The inflation
target of 3 to 5 percent may be reasonable given the volatility of shocks.
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