NBU and Inflation Targeting: Monetary Policy Rules for the Road Ahead
By Alex Nikolsko-Rzhevskyy (Lehigh University, USA)
On July 3, 2014, in her speech at the conference titled “Ukraine’s European Vector: Impact on Business,” the National Bank of Ukraine’s (NBU) newly appointed governor, Valeriia Gontareva (Valeriya Hontaryeva in another transcription), underscored her commitment to targeting inflation. The current end-of-year inflation rate currently anticipated nearly 19% will likely prompt an aggressive tightening of monetary policy, thereby lowering inflation to more acceptable levels with the intent to then keep it under control. A reasonable inflation target could perhaps be in the vicinity of 4%, which though exceeding the more common long-term inflation targets of 2.0-2.5% exhibit by developed economies such as the U.S. and Canada, is nevertheless in the ballpark of peer and aspiring developing countries such as Poland and Hungary. As such, what exactly should the Ukrainian public and its economy expect to happen in the middle to long run? Putting yet-unresolved structural issues aside and assuming that immediate threats, including aggressive speculative attacks on the hryvnia, are defused, let us discuss the mechanics of the process of reducing inflation and various ways to mitigate the painful transition, using past international experiences as examples.
While there are many tools available for conducting monetary policy -- including setting reserve requirements, extending discount loans to commercial banks, paying interest on reserves, as well as several less conventional methods -- the most common tool used in normal circumstances by most central banks is open market operations, which vary the supply of available reserves and thus affect their implicit price: the interbank rate. Tightening policy usually involves the aggressive sale of bonds by the central bank, which results in upward movements of short-term interest rates. Economic theory suggests that such an increase has an adverse effect on aggregate demand, sending the country into a recession in the short run, primarily by discouraging planned investment. A well-known example of such an effect is Paul Volker’s disinflation in the U.S. during 1980-1986. By conducting monetary tightening, though the Fed was able to reduce inflation from 13.5% down to 1.9%, it came at the cost of reduced production and a mid-transition rise in unemployment from 7.1% to 9.7%. Should we expect a similar outcome in Ukraine? The answer is both yes and no. While the direction of the impact will also be negative, its magnitude could actually be greater. For this, the central bank’s credibility and public’s expectations about inflation are crucial concerns.
Public disbelief in a central bank’s ability or desire to control inflation builds up inflationary pressure, which multiplies the negative effects of monetary policy tightening on GDP and exacerbates a recession. This mechanism works by bringing about upward adjustments in new long-term wage contracts, which decreases aggregate supply as the expected inflation increases. These increased expectations will hurt the economy regardless of the true NBU intentions and the sincerity of Ms. Gontareva’s desire to control inflation, as long as the public has reasons to question their motives. Unfortunately, for Ukraine, the rational public has every reason not to trust the NBU’s claims to actively combat inflation. While several factors could be involved, the most important one are corruption and (at least perceived) close ties between the NBU and the Ukrainian government.
In Ukraine, since the NBU Council members are appointed (and can be fired) by the president of Ukraine and the Verkhovna Rada, the central bank can hardly be considered to be independent. Political dependency and corruption typically result in so-called inflationary bias by causing monetary policymakers exercise discretion, lower the rates, and exploit the short-run tradeoff between inflation and employment, thus increasing the chances that their patrons are reelected. Such expansionary policy, however, eventually raises workers’ and firms’ expectations about inflation, which drives up both wages and prices and results in permanently higher inflation without any increase in output. Indeed, data show that countries with less independent central banks face higher inflation rates. In today’s Ukraine, we can expect political pressure to be especially strong given that planned monetary policy tightening is expected to further deteriorate already less-than-stellar economic conditions.
Can anything be done to convince the public that the NBU will honor its promise to bring down and control inflation, thus anchoring or even decreasing inflationary pressure, while preventing self-fulfilling prophesies from depraving the economy? Perhaps. Since it is impossible to neither completely eliminate the established culture of corruption nor easily change the Ukrainian Constitution, one option is to reduce the influence of the human factor. The belief that policymakers can be time-inconsistent emerges alongside their ability to exercise discretion. Had it instead been replaced with rules, the problem would have vanished.
What are rules? Policy rules are binding plans that specify how policy will respond (or not respond) to particular data such as unemployment and inflation. This strategy is the opposite to the current NBU strategy -- discretion, applied when policymakers make no commitment to future actions, but instead make decisions according to what they believe to be best for the situation in that moment. One of the most famous and successful rules is the Taylor rule, according to which central banks adjust their target interbank rate in response to deviations of the inflation rate from the target and output from the trend. It is crucial that the cumulative inflation response coefficient is above one so that when there is an inflation shock, the nominal interest rate goes up more than one to one with inflation, thereby raising the real interest rate. The commonly agreed size of the coefficient is 1.5, and it appears to work well for many different economies. The output gap coefficient is more controversial, but the suggested value typically falls between 0.5 and 1.0.
The chief advantage of using rules instead of discretion is the elimination of the time-inconsistency problem -- if policymakers are bound by a strict plan, then it will be difficult for them to extend political favors. Moreover, rules can decrease the probability of a policy mistake and are generally found to perform better than discretion in terms of economic outcomes. The benefits of rules should be especially pronounced in corrupt economies with less independent central banks, and Ukraine at the present time definitely falls into that category.
Of course, for rules to work, the Verkhovna Rada would have to legislate the NBU’s commitment to them, thus penalizing deviations; otherwise, using rules will not be different from exercising discretion. Rules themselves are not without drawbacks: they are rigid and might ignore useful information such as expert opinion. Hence, infrequent deviations from or changes to the optimal policy rule are warranted at times, for instance, due to structural changes in the economy. The legislation therefore needs to be flexible enough to allow the exercise of limited discretion in the time of need, while being strict enough to make the central bank honor the commitment.
A good starting point could be the U.S. Federal Reserve Accountability and Transparency Act of 2014. Among other things, this recently-proposed legislation requires the Fed to adopt a Directive Policy Rule. This rule would be chosen by the Federal Open Market Committee and would describe how the federal funds rate would respond to a change in the intermediate policy variables, presumably inflation and one or more measures of real economic activity such as the output gap, the unemployment rate, and real GDP growth. If the Fed deviated from its rule, the Chair of the Fed would be required to testify before the appropriate congressional committees as to why it is not in compliance. While it might seem that adopting similar legislation could further reduce the NBU’s independence, it would in fact it make its actions more transparent and accountable, thereby making it more difficult for interest groups to manipulate its decisions.
Notice that nothing in the proposed legislation restricts the form of the Directive Rule. Moreover, it does not even specify whether it should be a simple linear formula, such as the Taylor rule, or a set of agreed-upon instructions for how to react to a particular economic development -- the choice is completely up to bank officials. Obeying any reasonable rule would prevent the NBU from taking populist measures. And if the central bank were to deviate, it would improve transparency for the Governor to explain why.
While the NBU’s immediate goals will likely focus on speculative attacks and the ongoing war in eastern Ukraine, the Council should use this time to build up their reputation by consistently making promises and then delivering on them. This will help to establish credibility. To maintain credibility in the future, switching to a rules-based policy might be the solution.