This article first appeared in Forum, The Edge Malaysia Weekly on March 14, 2022 - March 20, 2022

All too many developing countries have been persuaded or required to prioritise inflation targeting (IT) in their monetary policy. By doing so, they have tied their own hands instead of adopting bolder economic policies for growth, jobs and sustainable development.

IT refers to monetary policy efforts to keep the inflation rate within a certain low range. Many countries — developed and developing — have adopted this policy priority following New Zealand’s 1989 lead, arbitrarily aiming to keep inflation under 2%.

Initially, developing economies adopted IT after crises to get financial support from the International Monetary Fund (IMF), for example, after the 1997/98 Asian financial crisis. From the mid-1970s, many had borrowed heavily to accelerate growth. After the US Federal Reserve raised interest rates sharply from 1980, many succumbed to debt crises.

IMF insisted on severe short-term stabilisation policies to keep inflation and debt low. The World Bank complemented it with medium-term structural adjustment policies demanding market liberalisation and other reforms.

Price stabilisation policies to keep inflation low have been an IMF priority since. But instead of accelerating growth, as promised, IT has actually slowed it. Yet, developing countries have jumped on the IT bandwagon — 25 had formally adopted IT by 2020, while most others strive to keep inflation very low.

Most believe inflation is the greatest threat to the economy and growth. Many presume inflation creates uncertainty, causing resource misallocation. All this is said to retard growth — meaning fewer jobs, less tax revenue and lasting poverty.

Higher prices hurt by reducing purchasing power, especially harming wage earners. On the contrary, price stability — implying low and steady inflation — is believed to be more conducive to ensuring growth and prosperity.

Another core IT belief is that money only temporarily affects growth, but permanently affects prices. IT advocates believe central bankers should strive mainly for price

stability — not employment or growth. They usually presumed independent central banks are better at doing so.

Many central bankers and economists dogmatically believe — without evidence — that tightly reining in inflation actually spurs growth. Acknowledging that developing countries are more prone to external and supply shocks, IMF recommended targets of up to 5% — higher than developed countries’ 2%.

Most developing countries aspiring to become emerging market economies have formally adopted IT, for example, South Africa’s 3% to 6% or India’s 2% to 6%. By setting successively lower short-term inflation targets, they believe financial markets are impressed.

But by doing so, they prevent themselves from realising their full economic potential. Striving to emulate the developed countries’ 2% target constrains both growth and structural transformation. After all, it was quite arbitrarily set for no economic reason, except the New Zealand finance minister liking the “0 to 2 by ’92” slogan!

While there is little disagreement about likely problems associated with “hyper-”, or very high, inflation, the threshold beyond which inflation becomes harmful is a moot issue on which there is no consensus.

Inflation targets are arbitrarily set, as acknowledged in an IMF paper. “[Thus,] any choice of a medium-term inflation target for these [developing] countries is bound to be arbitrary.” Economist Harry Johnson had found early IMF empirical studies of the inflation-growth relationship to be inconclusive.

Later studies did not settle the matter. For example, Michael Bruno and William Easterly at the World Bank concluded that inflation under 40% did not tend to accelerate or worsen, and “countries can manage to live with moderate —15% to 30% — inflation for long periods”.

MIT’s Rudiger Dornbusch and Stanley Fischer, later IMF deputy managing director, came to similar conclusions. They found moderate inflation of 15% to 30% did not harm growth, noting “such inflations can be reduced only at a substantial short-term cost to growth”.

A 2000 IMF paper suggested 11% inflation was optimal for developing countries; 7% inflation would have “an insignificant negative effect” on growth, while 18% inflation remained positive for growth. Yet, it recommended an IT target of 7% to 11% and “bringing inflation down to single digits and keeping it there”.

The IMF Independent Evaluation Office’s 2007 report on Sub-Saharan Africa found “mission chiefs are evenly divided on whether the Fund should tolerate higher [than 5%] inflation rates … IMF policy staff acknowledge that the empirical literature on the inflation-growth relationship is inconclusive”.

Therefore, very low inflation targets are quite arbitrary without any sound theoretical and empirical bases. But IMF and its chorus of economists have not hesitated to insist on keeping inflation very low by promoting IT for all, especially to susceptible developing country policymakers.

Very low inflation targets particularly constrain low-income countries, whose governments face modest revenue bases and limited domestic savings. So, they should borrow more from central banks to finance their development spending.

But such borrowings are prohibited by law in many developing countries — especially those that have formally embraced IT — to prove their anti-inflationary commitment. Thus, a potentially major means for central banks to be more developmental is denied by statute.

By raising interest rates to keep inflation very low, central banks reduce not only consumer spending, but also business investments. Such policies also increase both public and private debt burdens, in turn constraining spending.

Thus, overall aggregate demand remains depressed, limiting growth unless compensated by greater export demand. But higher interest rates attract capital inflows, causing exchange rates to appreciate, undermining export competitiveness.

IT policy is problematic for two major reasons. First, it demands debilitatingly low targets. Second, it denies central banks’ potential developmental role by insisting on price stability — read “containing inflation” — as its principal goal.

IMF researchers have acknowledged that “identifying the growth effects of moving from, say, 20% inflation to 5% has been challenging”.

They concluded that “pushing inflation too low — say, below 5% — may entail a loss of output … suggesting a need for caution in setting very low inflation targets in low-­income countries … In particular, inflation targets should be set so as to help avoid risks of an unintended contractionary policy stance”.

Also, San Francisco US Federal Reserve Bank research has concluded that “developing economies that adopted an inflation target did not show any substantial gains in growth in the medium term compared with those that did not adopt a target”.

Thus, developing countries prioritising IT have, often unwittingly, curtailed their own economic prospects. Falsely promoted as means to enhance growth, jobs and development, IT, in fact, constrains them — the ultimate con!

Rejecting the IT fetish does not mean doing nothing about inflation. Instead, developing countries need to better know the economic challenges they face and the efficacy of their policy tools. National economic priorities should be comprehensively addressed without subordinating all policy goals to the god of IT.

Anis Chowdhury, a former professor of economics at the University of Western Sydney, held senior United Nations positions from 2008 to 2015 in New York and Bangkok. Jomo Kwame Sundaram, a former economics professor, was United Nations assistant secretary-general for economic development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.