A rules-based monetary policy could be the answer for price stability

Illustration: TBS

One of the primary functions of a modern central bank is to design monetary policy that ensures price stability. In a growing, market-based economy, stable prices are crucial for overall macroeconomic and financial stability, helping to lower the risk of crises. Ideally, this stability is maintained over a full business cycle of three to five years.

An emerging consensus is that monetary policy cannot be directly deployed to promote economic growth or to generate employment over the long run. 

However, monetary policy can have some effects on real variables in the short run when prices, wages, and inflation expectations remain rigid or change slowly and verily. Whatever real changes might have taken place in response to any monetary policy actions would disappear in the long run. 

Yet, monetary policy alone or jointly with fiscal policy can be deployed to sustain economic stability in the event of any economic shocks. Monetary and fiscal policies operate on the demand side of the economy, while real output and its growth are primarily a supply-side phenomenon.

Monetary policy for price stability

The greater importance of monetary policy arises from a central bank's responsibility to control inflation and keep it at a low level on a sustained basis. Price stability is considered a public good, whereby it promotes economic growth and its stability.

High inflation generally originates from monetary mismanagement and causes major damage to the economy. When inflation remains high, the relative prices of goods and services become volatile and unpredictable. It creates a shallow financial sector that keeps the real interest rate very low or negative and makes the real exchange rate overvalued. 

The consequent financial repression slows saving, investment and economic growth, creating urgency for price stabilisation. Whether deflationary measures used to lower inflation create recessions and raise unemployment remains a question. But it is widely believed that a recession can be avoided when inflation expectations remain anchored to the inflation target under a rules-based monetary policy.

The inflation-targeting approach to monetary policy

A rules-based monetary policy, such as inflation targeting, involves determining the primary objective of monetary policy, such as price stability, and then selecting the appropriate monetary policy instrument for achieving the desired goal. 

Under inflation targeting, price stability has emerged as the primary objective of monetary policy. It represents the central bank's agreement with other stakeholders on making efforts to maintain price stability in an efficient way, without much affecting market players.

Expectations about future inflation directly affect current decisions on consumption, investment and wage demands. The stagflation episode of the 1970s influenced central banks to incorporate inflation expectations in the formulation of a rules-based monetary policy.

If inflation remains high for long, inflation expectations become floating, and it takes time to bring inflation down even under a rules-based monetary policy.

Managing inflation expectations

Managing inflation expectations is critical for keeping the inflation rate low and stable. This is not an easy task since inflation expectations vary significantly depending on the perceptions of households, businesses, professionals, and investors.

In general, when inflation remains low, citizens' perceptions do not change much, and inflation expectations hover around actual inflation. The situation changes when actual inflation reaches a high level and becomes volatile, making a central bank's anti-inflation policy measures less effective.

An increased focus on inflation expectations is required to keep inflation expectations anchored. While long-run inflation expectations remain crucial in maintaining price stability, short-term inflation expectations could be linked to the stance of monetary and fiscal measures that may affect unemployment.

While strategic communications could be an integral part of monetary policy, it needs to be consistent and credible. A central bank cannot just make a policy change without providing valid reasons and without explaining how the policy change affects stakeholders.

A sudden change in policy could be a sudden shock. Markets may then react sharply, the public could panic and the media may go overboard if policy changes are arbitrary. High inflation could have lasting effects on expectations, so it is critical to ensure that inflation does not remain elevated for too long. 

In the current environment, risk management considerations therefore call for a continued tight monetary policy stance. Despite its complexity, the process of the conduct of rules-based monetary policy should be communicated to the citizens and other stakeholders frequently, and the process should be made simple and understandable to all concerned.

Policy implications

Recent monetary-policy experiences of both developed and developing countries suggest that the success of a rules-based monetary policy depends on how inflationary expectations remain anchored to the inflation target.

When inflation persistently exceeds the inflation target, monetary policy loses credibility in controlling inflation. Inflation expectations then are believed to have become de-anchored, which lowers the effectiveness of monetary policy and keeps inflation high and unstable.

When a central bank defines a policy objective of monetary policy and introduces consistent policy measures, it signals and assures the stakeholders that inflation expectations, and hence inflation, would be contained and managed such that they would converge to the inflation target.

When the central bank's policy measures are consistent and easy to follow, they raise policy credibility, and then it becomes easier to identify the most effective monetary policy transmission mechanisms.

As households, businesses, workers, and investors sustain varied inflation expectations, the challenge is to influence varied inflation expectations to converge to the target level. Finally, personal experiences of stakeholders matter to how they form inflation expectations. 

For example, there is evidence that changes in the price of one or more essential commodities could be useful to determine inflation expectations rather than how the prices of all goods and services are being determined and whether they have increased or decreased. 

Moreover, research findings from the Reserve Bank of Australia suggest that around three-quarters of households and unions form inflation expectations by looking at past inflation rather than being purely looking forward.

There is asymmetry in the way households' inflation expectations respond to the rise in prices rather than to a reduction in prices. In general, it takes more time to bring inflation expectations down than it takes for inflation expectations to rise. It is observed that many stakeholders remain unresponsive to inflation unless inflation crosses a threshold level which may not remain constant. 

When inflation crosses the threshold level, inflation and inflation expectations reinforce each other, and hence inflation becomes persistent. When inflation expectations show signs of de-anchoring, all sections of the community start believing that the central bank has lost control over inflation, and this could create the process of a wage-price spiral depending on the strength of trade unions.

In the light of the above discussion, it is possible to draw inferences about inflation expectations on the conduct of monetary policy. Under a flexible exchange-rate system, a modern central bank such as the Bangladesh Bank can aspire to conduct monetary policy transparently and credibly to sustain low and stable inflation. This could be more effective if the Bangladesh Bank introduces a rules-based monetary policy such that inflation expectations remain anchored. 

Moreover, the rules-based monetary policy framework needs to be backed by a robust set of rules, procedures and precedents that should govern the Bangladesh Bank and its monetary policy operations transparently. Consistency, transparency and credibility are three interrelated concepts in monetary policy that the Bank should uphold to discharge with strong resolve its primary responsibility of formulating monetary policy for price stability. 

On a regular basis, Bangladesh Bank is required to explain its decisions and publish detailed statements, while key high officials are required to appear at different forums to educate market participants of the bank's policy objectives, provide forward guidance and reshape their inflation expectations when there are risks of de-anchoring of inflation expectations in the events of temporary or persistent shocks to the economy. 

Sketch: TBS

Akhand Mohammad Akhtar Hossain is a distinguished economist currently serving as the Chief Economist of Bangladesh Bank. He is also a professor of Economics at United International University.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.