Nigel Clarke | Inflation - most important price in economy
It was recently announced that with 12-month inflation to June of 2.8%, the Bank of Jamaica (BOJ) missed the Government of Jamaica's (GOJ's) inflation target range of 4%-6%. The 2.8% inflation result also meant that the BOJ missed the slightly wider June 2018 inflation target of 3.5%-6.5% established under the monetary policy consultation clause of Jamaica's precautionary standby arrangement with the International Monetary Fund (IMF). This latter missed target requires the BOJ to consult with the IMF executive board.
This has caused confusion, as inflation was actually lower than the target, and conventional wisdom suggests that such an outcome is good. Others have questioned the level of the target, and some question what inflation actually measures. There has also been speculation as to what the corrective measures to raise inflation to the target range may be, and whether exchange rate depreciation features among them.
I recently gave a policy address on the GOJ's plan to modernise the BOJ, inclusive of specifying its monetary-policy mandate as the maintenance of domestic price stability, increasing central bank accountability, improving governance, recapitalising the BOJ's balance sheet, and removing the minister of finance's power to give directions on monetary policy.
As we approach this reform, and as the GOJ formally adopts inflation targeting as a policy objective, our interim accountability framework requires the Bank of Jamaica to account to the minister of finance for the missed inflation target, inclusive of corrective measures. I commit to making this correspondence (including my response) public, bringing forward some of the transparency we stand to gain from a modernised central bank.
As such, I hope that this openness with respect to official communication on corrective measures regarding a missed inflation target will also completely dispel, refute and rebut any speculation that exchange-rate depreciation is among such corrective measures.
I believe that transparency strengthens market efficiency and will not wait for passage of BOJ reform legislation for that to be incorporated into GOJ policy. (Under our modernisation proposals, the central bank accountability relationship will pivot to be with the Houses of Parliament).
Inflation a broad, average, important measure
The Statistical Institute of Jamaica (STATIN) started the Consumer Price Index (CPI) several decades ago, and in accordance with international best practices, it measures the movement in consumer prices experienced by Jamaicans.
The CPI is obtained by comparing, through time, the cost of a fixed basket of goods and services purchased by Jamaican consumers. Every month, scores of officers from STATIN visit thousands of providers of goods and services and record current prices, which are documented and used to update the CPI.
The basket of goods and services consists of approximately 500 items across the entire range of goods and services consumed by Jamaicans. Almost every regular good or service that you can imagine is included. The weighting of a particular good or service in the basket is determined by dividing the amount Jamaicans spend on that good or service by the total consumption of all Jamaicans on all goods and services.
As a result, items consumed by relatively few Jamaican households will tend to be weighted much less than items consumed by many Jamaican households. Within the category of spirits therefore, white overproof rum has a weighting that is more than 30 times the weighting of vodka and in the transportation category, bus fares have a weight that is more than 100 times that of airfares. This is so as Jamaicans spend far more on rum than on vodka and many more Jamaicans take the bus than the plane for non-business purposes.
The inflation rate is, therefore, an average measure of broad price movements and is not intended to, nor does it, represent the measure for any particular individual. Similarly, per-capita income is a useful average measure not intended to represent the income of any one individual.
However, these average measures are extremely useful and can be shown in theory and practice to have specific relationships with other variables and economic outcomes. Once expectations on what this average (i.e., the inflation rate) will be becomes firmly anchored, individual decisions of hundreds of thousands of consumers and tens of thousands of businesses will adapt and respond to inflation numbers and it will become the most important price in the economy.
How monetary policy targets inflation
One of the important relationships that I referenced above is that the inflation rate, i.e., the average measure of the movement of a broad set of prices, can be successfully targeted by monetary policy. Adjusting the levels of interest rates and liquidity conditions impacts consumer and business demand, which, in turn, leads to movement in prices. However, the time for monetary policy decisions to impact inflation can be long, for example, 12-18 months.
Lowering interest rates stimulates increased borrowing by businesses for investment and consumers for various purchases. This increases domestic demand and economic activity, which, in turn, increases economic growth, boosts job growth, and pushes prices upwards. The converse is also true. Increasing interest rates curbs borrowing, which decreases demand and dampens inflation.
Inflation target conducive to jobs and growth
Therefore, within the spectrum of 'acceptable' inflation rates, the pursuit of a higher (but still reasonably and historically low) inflation target is broadly consistent with (but does not necessarily predict) loosening of monetary policy, i.e., a lowering of interest rates, while the pursuit of a lower inflation target is more consistent with (but does not necessarily predict) the opposite, a tightening of monetary policy.
The GOJ, in setting the inflation target range some time ago, was and remains biased towards the imperatives of economic and employment growth within the reality of debt reduction. With those objectives, factors that favoured a loosening of monetary policy were properly deemed to be the priority.
In other words, an inflation target of 4%-6%, in the context of fiscal debt reduction, is more likely to lead to monetary policy that is more accommodative to economic and job growth than would be the case for a lower target (say, 3%), all other things being equal.
The 4%-6% inflation target was publicly communicated, it informed choices, and would have been explicitly referenced in, for example, public-sector wage agreements to date. It is a medium-term target and the BOJ, having missed it for June 2018, will need to 'wheel and come again' to achieve the target in a future period.
Before any reader believes that the minister of finance is giving away monetary policy direction (i.e., interest rates and liquidity, which are the purview of the central bank), let me add that the central bank's job is complicated by having to also always consider that some portion of inflation is affected by external factors, including weather conditions, which influence the movement in agricultural prices, and prices of imported commodities. Therefore, the worthiness of adjusting monetary variables of liquidity and interest rates in any particular direction can be tempered or supported by external conditions.
We continue to make substantial progress in fiscal reforms, delivering benefit to all Jamaicans. It is necessary that this is complemented by monetary reforms that increase transparency and accountability and improve market efficiency, which will assure all Jamaicans that low, stable, and predictable inflation is here to stay.
- Dr Nigel Clarke is the minister of finance and public service and member of parliament for St Andrew North Western. Email feedback to email@example.com.