News Analysis: Will BOK give up inflation targeting?
by Yoo Seungki
SEOUL, Sept. 17 (Xinhua) -- In August 2008, Bank of Korea (BOK), South Korea's central bank, raised its key policy rate by 25 basis points (bps) to 5.25 percent. The rate hike looked strange as the decision came just one month before the Lehman Brothers' collapse.
The decision by the then-BOK Governor Lee Seong-tae was understandable at that time when global crude prices skyrocketed to around 150 U.S. dollars a barrel, sending the country's consumer price inflation close to 6 percent, far above the upper end of the then-BOK's inflation target band of 2.5-3.5 percent.
Following the Lehman collapse, the South Korean central bank made a complete about-face for its monetary policy by dragging down the policy rate by a whopping 325 bps to the record-low of 2 percent during the five-month period to February 2009.
The incumbent BOK Governor Kim Choong-soo gave the answer for its 2008 puzzling decision. "In 2008, some nations under the inflation targeting regime lifted policy rates due to inflationary pressures stemming from surging oil prices," Kim told reporters at a seminar held Friday in Incheon, 40 kilometers southwest of Seoul.
The European Central Bank (ECB), which is given a single mandate of keeping inflation at a manageable level, also hiked interest rates in July 2008 when the global economy was sliding into the worst recession since the Great Depression.
Kim noted that using nominal GDP targeting as a guide for monetary policy has been at the center of talk among academics, citing Jeffrey Frankel, professor of economics at Harvard Kennedy School, who declared the death of inflation targeting.
DEATH OF INFLATION TARGETING
Frankel claimed in his column that after the global financial crisis, inflation targeting passed away as the monetary regime failed to respond to asset market bubbles. The Harvard professor said that it was neither preceded nor followed by an upsurge in inflation when the global financial crisis hit, noting the boom- bust cycle in the asset market could take place without inflation.
Since born in 1990, the inflation targeting, which tries to keep inflation at a targeted level, has been adopted in many countries across the globe, including Europe, Canada and the United Kingdom as well as South Korea. It is favored by hawks who focus solely on inflation.
The BOK belonged to the hawkish group up until late last year, but everything has changed since the revision of BOK Act granted it the other mandate to promote financial stability. "The BOK has been given a single mandate of inflation targeting, but the task of financial stability will be newly assigned to the bank. With a strong sense of duty, we will play our fresh role in preventing a systemic risk," Governor Kim said at the same seminar held a year earlier.
As Frankel mentioned, inflation targeting disclosed its vulnerability in tackling asset bubbles. Kim's comments in favor of nominal GDP targeting hinted that the central bank with dual mandates given should change its policy guide over the long run to better respond to asset market bubbles.
Kim's comments also mirrored the dilemma facing the BOK that has been recently under pressure to cut interest rates further to stimulate the economy. More accommodative monetary policy would boost aggregate demand, but the bank must have worried about the potential supply-side shocks amid a jump in oil and grain prices. The central bank froze the 7-day repo rate at 3 percent this month after the surprise rate cut in July.
The inflation targeting has made inappropriate responses to supply-side shocks as was the case for the ECB and the BOK that raised interest rates in 2008 in response to the oil price surge. Nominal GDP targeting can offset the adverse effect from inflation targeting. "Fans of nominal GDP targeting point out that it would not, like inflation targeting, have the problem of excessive tightening in response to adverse supply shocks," said Frankel.
NOMINAL GDP TARGETING
Under the nominal GDP targeting, central banks should adjust a short-term interest rate to keep nominal GDP at a targeted level. It would resolve the problem of excessive tightening from supply shocks as the regime places equal emphasis on both real GDP growth and inflation.
For example, supply-side shocks such as a surge in oil prices produce two undesirable consequences, including falling real GDP growth and rising inflation. It poses a dilemma as monetary easing to stimulate an economy would exacerbate inflation, while monetary tightening to stabilize inflation would drag down real GDP growth.
The nominal GDP targeting can solve the dilemma. Suppose that the oil price hike causes real GDP growth to fall by 1 percent and inflation to rise by 0.5 percent, interest rates can be lowered enough to lift nominal GDP growth by 0.5 percent. Thus, nominal GDP targeting would balance the conflicting effects from supply shocks.
In addition, nominal GDP targeting can boost aggregate demand. When a drop in exports arises from economic slowdown in major trading partners, central banks can lower interest rates to narrow a gap between actual real GDP and potential real GDP.
The BOK has warned that the South Korean economy will sustain a negative output gap for a considerable period of time due to the protracted eurozone fiscal crisis and the global economic slowdown. When the gap becomes larger, the bank can adjust monetary policy to reduce the gap under the nominal GDP targeting regime. The negative output gap means actual GDP growth stays below the one for potential GDP.
Martin Feldstein, an economics professor at Harvard University, said in a paper published in 1994 that nominal GDP targeting can reduce the variance of quarterly nominal GDP growth. He noted that monetary policies can be more aggressive when the GDP gap is larger, in particular producing relatively more expansionary monetary policy at a cyclical trough.
Various issues remained unresolved for the implementation of nominal GDP targeting. Central banks under the monetary regime would change interest rates if nominal GDP growth last quarter deviated from the targeted level. The lagged adjustment may result in unnecessarily protracted deviations of nominal GDP from target as changes in monetary policy take time to influence on nominal GDP.
From the time policymakers adjust a short-term interest rate, two to three quarters may pass before nominal GDP responds, according to a paper published in 1994 by Todd Clark, a vice president of the Federal Reserve Bank of Cleveland.
Even if monetary policy is adjusted in accordance with the projected future nominal GDP, concerns would remain as forecasters make errors in predicting future movement in nominal GDP. If forecast errors are large and frequent, the lagged adjustment may better stabilize nominal GDP, said Clark.
Based on simulation analysis, Clark said that he "cannot definitively determine whether the simple nominal GDP targeting rule will improve economic performance."