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SAGIT – Inflation-targeting regime in Zimbabwe?

By Addmore Chakurira

THERE has been considerable debate on the course the monetary authorities have taken and are likely to take in efforts to revive the economy.

, Arial, Helvetica, sans-serif”>Questions such as whether the monetary authorities are persuing money supply targeting, exchange rate targeting or inflation targeting policies have been raised. The Reserve Bank has made it clear that it prefers home-grown policies to be enacted as opposed to adopting the commonly used policies in their entireties, that is they would blend policies to suit the country’s needs and requirements.

That said, the objective of monetary policy is price stability reflected in a low non-volatile rate of inflation. It’s generally agreed that a monetary policy is relatively inactive in an economy characterised by extensive controls and regulations in the financial, productive and international trade sectors, hence there is need to shift from a highly regulated economy to a market-based system so as to widen the scope of the monetary policy. Monetary policy influences inflation with a lag, which can be anything to 24 months.

Traditional approaches, namely influencing inflation and economic activity by controlling intermediate variables like monetary aggregates or exchange rates have their own shortcomings. As financial institutions develop money substitutes, the demand for money becomes increasingly unstable, and it’s clear that, although highly correlated in the long run, money and inflation are not sufficiently correlated in the short run.

Inflation targeting offers a number of operational advantages such as compelling policymakers to deepen reforms, enhancing transparency, and improving the fiscal stance. On that note, some advocate for a regime that targets inflation directly – which is perceived to be more transparent and hence more credible to the public since the central bank makes explicit commitment to conduct monetary policy to meet a specified numerical inflation rate target (or range) within a specified time frame.

To some extent this is the situation in Zimbabwe. The RBZ has earmarked to reduce inflation to 200% by December 2004, two-digit levels in 2005 and single digit there after. These are acting as anchors for monetary authorities, and serve as anchors for market expectations. Hence, monetary authorities made a commitment to transparency helping to reduce uncertainty while enhancing the central bank credibility and accountability. We have also seen the RBZ having a higher degree of operational independence. The RBZ has already set instruments (interest rates) at levels that will bring inflation forecasts for next year close to the targeted inflation rate. This forward-looking approach is quite commendable, given the long and variable lags between changes in the monetary instruments and their impact on the ultimate policy goal.

Due to the current high rates on inflation, it is very difficult to predict future inflation accurately, thus the likelihood of missing the targets is high, exacerbated by the degree of pass through from exchange rate changes to prices. Going forward, the monetary authorities might be inhibited since their decisions are governed primarily by the need to finance the fiscal deficit, and some form of fiscal dominance still persists. Although the RBZ might succeed in significantly lowering government’s fiscal deficit in the long run, there are still some contingent liabilities including obligations incurred by parastals or arising from quasi-fiscal deficits that threaten the consolidated public sector’s fiscal stance. This is viewed as one of the reasons why the central bank has not raised interest rates considerably in the short term.

Although the Reserve Bank appears to be on course in attaining its 200% inflation rate by December 2004, there are however problems that render inflation targeting difficult in coming years. These relate to the technical factors behind the significant lowering of the inflation rate in the current year which eventually will run their course, for example, the base on which inflation is coming from will not be as high in the coming years. It is hard to identify factors that will readily contribute towards a further dramatic reduction in the inflation rate so that future inflation rate targets are attained. Food price inflation, currently running at around 320% as at August 2004, could remain a major headache for monetary authorities during the next years because a drought would push up the inflation rate. Developments in international oil markets offer little comfort with oil prices having spiked to over US$40 per barrel. If the rally is maintained this will exert inflationary pressures in Zimbabwe. That raises the issue on whether the monetary policy should target all movements in inflation, or whether short-term fluctuations that are considered exogenous should be excluded.

Most inflation targets focus on the underlying or core inflation. This measure excludes from the Consumer Price Index (CPI) items subject to idiosyncratic price changes arising from supply shocks. Adopting a target for core inflation implies that monetary policy would accommodate only the first impact of these price increases, but not second-round effects resulting from the wage-price spiral. There seems to be a general consensus that some components of the CPI should be systematically excluded or added to the index and what new statistics might be needed to related analysis and forecasting. It should also be noted that Zimbabwe lacks sophisticated information requirements needed for inflation forecasting such as reports on leading indicators and reliable econometric models. For the inflation target to really prosper, it is important for the Central Statistics Office (CSO) to be operationally independent, while receiving adequate resources from government and interested parties through mainly funding to carry out its mandate. The funding of the CSO is the major constraint at the moment.

A move which the RBZ might make next year would be to publish quarterly reports in which the bank offers inflation forecasts based on the assumption that the current monetary policy stance persists as well as explaining discrepancies between actual and targeted inflation rates. To improve the public’s understanding of the central bank’s reasoning, these reports can also contain a description of how inflation forecasts are generated, including an assessment of upside and downside risks, as well as an indication of how the central bank would react to a relevant set of contingencies. This advance notice reduces the likelihood that the central bank’s reaction to these contingencies will be misunderstood. Explicit inflation targets, by reducing uncertainty about the future course of inflation, improve savings and investment decisions, thus enhancing overall productivity.

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