Inflation targeting, as an economic policy, is an attempt to steer inflation towards a projected, or “target”, inflation rate using monetary tools such as interest rate changes (Kelikume and Evans, 2015). Under the policy, the actions of the central bank become more transparent. Investors, knowing what the central bank projects as the target inflation rate, can easily factor in possible interest rate changes in their investment sets, leading to better economic stability. Many industrialized economies, after experiencing persistent inflation rates for decades, have reduced inflation to extremely low levels recently with the aid of inflation targeting. Inflation targeting frameworks have regularly been adopted in economies suffering from chronically high inflation. Brazil and Chile, for instance, suffered inflation rate of 19 percent and 26 percent, respectively, before adoption of inflation targeting regime. A popular choice since the early 1990s, inflation targeting has gained adherence from more than twenty countries in developed and emerging-market economies. Countries have adopted inflation targeting under varying conditions, ranging from the answer to a currency crisis (e.g. United Kingdom) to a planned switch from a completely different policy regime (e.g. Canada and New Zealand). Likewise, inflation targeting has been practiced with varying verve and under diverse institutional arrangements.
Forged in 1990 in New Zealand, inflation targeting is now in use by the central banks of Canada (Bank of Canada), United Kingdom (Bank of England), Australia (Reserve Bank of Australia), Iceland (Central Bank of Iceland) South Korea (Bank of Korea), Egypt, and Brazil (Brazilian Central Bank) South Korea (Bank of Korea), and Brazil (Brazilian Central Bank) and South Africa (South African Reserve Bank), among others, and empirical evidence shows that it does what its proponents claim. Only two countries, in Sub-Saharan Africa, have officially embraced inflation targeting: Ghana and South Africa. Volatility in price and hyperinflation are huge economic challenges, able to engender financial instability and topple economies. One of the issues facing Nigeria today is the choice among two nominal anchors: exchange rate pegging or inflation targeting. Widely accepted, among central bankers and academics, is the idea that inflation targeting makes a difference with respect to its ability to mitigate the volatility of output and of inflation and to bring about a decline in the level of inflation. There is an argument that inflation targeting cannot work well in emerging markets, like Nigeria, as emerging markets are deficient of the preconditions for a proper operation of inflation targeting. The prerequisites for the success of inflation targeting consist of sound economic structure; exchange rate flexibility; central bank independence; the institutional set-up; political commitment; a great deal of transparency and accountability of the Central Bank; absence of fiscal dominance; a single, clear inflation target; a sound inflation forecasting model; virile financial markets. The absence or inadequacy of these prerequisites may pose huge challenges for emerging markets like Nigeria trying to embrace inflation targeting (Kelikume and Evans, 2015).
Besides, inflation targeting and the exchange rate flexibility have a close relationship. Exchange rate, a vital instrument in an open economy like Nigeria, plays as a transmission channel for monetary policy and simultaneously as an influencer of the real economy. Undue volatility of exchange rate can be injurious to trade and growth. Thus, responding to inflation and exchange rate variability conjointly in the policy function can lead to the risk of tradeoff or compromise between inflation and exchange rate variability. If, for example the central bank sees impending increase in inflation; to tighten the price of tradable goods, interest rates are raised. As soon as the inflation is under control, interest rates are lowered and the exchange rate depreciates. Thus the fall in inflation variability has brought about the rise in the volatility of exchange rate. Exchange rate stability is inconsistent with inflation targeting regime; inflation targeting regime certainly necessitates exchange rate flexibility.
Foreign exchange intervention policy and inflation targeting cannot coexist because there is conflict between the two policies. Flexibility in exchange rate is a prerequisite to the success of inflation targeting regime. Then again, there are contradictory views that intermediate regimes would be good for inflation targeting. In fact, the case of Chile and Israel show that exchange rate objectives is containable within an inflation targeting regime. Can inflation targeting regime work effectively in Nigeria which employs the exchange rate stability objectives? The rising number of countries embracing inflation targeting and its success are inducements for countries that employ monetary or exchange rate targeting to consider a change to inflation targeting. Thus, countries like Nigeria need to consider earnestly such a change now or in the near future, necessitating the question if Nigeria is ready for inflation targeting now, later or maybe never.
Interest and inflation rates in Nigeria have been on a double-digit value averagely over the period of 2005-2012. In recent years, inflation in Nigeria has been steadily above 10%, except 2007. As well, interest rate has been high, especially prohibitively highest in 2011 and 2012. The real exchange rate against the US dollar soars over the years. In the same vein, the consumer price index (CPI) is not left out in the steady increase. Within the same period, money and quasi money growth has reduced while Domestic credit provided by financial sector (% of GDP) has increased phenomenally. The increase in interest rates, exchange rates, relentless growth in money supply and domestic credit have all accreted, leading to persistent inflation in Nigeria. At this instant, it is crucial to project a workable nominal anchor to keep inflation in check because the present exchange rate pegging seems feckless.
Kelikume and Evans (2015) has examined inflation targeting as a possible monetary framework for Nigeria. Particularly, the study focused on the relative causality and responses between economic growth, inflation, exchange rate, interest rate, money and credit. The empirical methodology uses Granger causality and impulse response functions. As to the empirical results of the study, they showed evidence that inflation is highly sensitive to exchange rate and interest rate while economic growth is highly sensitive to exchange rate and inflation in Nigeria. Further, the causation from real exchange rate to economic growth is stronger than the causation from inflation to economic growth, meaning exchange rate determines economic growth in Nigeria more than inflation does. Therefore, inflation targeting will be less preferable to exchange rate targeting in Nigeria as a policy alternative. This unexpected finding has important implications for monetary policy conduct in Nigeria.
For Further Reading
Kelikume, I. and Evans, O. (2015). Inflation Targeting As A Possible Monetary Framework For Nigeria. In Global Conference on Business & Finance Proceedings (Vol. 10, No. 1, p. 420). Institute for Business & Finance Research.