What is price stability as a central bank’s main objective?
Delivering price stability is the main objective of most central banks, including the NBU. Price stability is the situation in which “households and businesses need not factor in their decisions the expectations of changes in the average price level.” In other words, price stability occurs when prices rise by an amount marginal enough that it does not occur to the average person to consider future inflation when deciding to take out a loan, invest in a business, or save.
What inflation rate is considered insignificant?
In the majority of advanced countries, price stability is achieved when inflation is maintained at a level of 1% to 3%. Emerging markets have higher medium-term inflation targets, which range between 4% and 8%, as a rule.
In Ukraine, the NBU has set the medium-term inflation target (as measured by year-over-year CPI growth) at 5%.
Why not set the inflation target at 0%?
No central bank seeks to achieve zero inflation. Zero inflation makes the economy rigid and vulnerable to crises for reasons outlined below.
Near-zero inflation poses the risk of deflation, an economic phenomenon that is just as negative as high inflation.
While consumers may think that negative inflation is desirable, the advantages of deflation are illusory.
Sustained deflation makes households and businesses expect that, tomorrow, prices will be lower than today. As a result:
All of these factors reduce domestic demand and economic growth.
Why does zero inflation carry a risk of “hidden” deflation?
This is largely due to difficulties in measuring inflation accurately. A large body of research suggests that inflation figures provided by statistical agencies tend to overestimate changes in the real cost of living. Errors can be attributed to the better quality of some consumer basket goods. These goods are more expensive and are sold at a higher price, reflecting an improvement in the standard of living rather than overall price increases.
Various countries have different error ranges: between 1% and 2% in the US and around 0.5% in Canada and the UK. That is why setting the inflation target at 0% really means targeting a decrease in the real cost of living every year, however insignificant it may be.
Also, setting the inflation target at zero or close to zero makes it easy to overlook deflation, along with its repercussions.
Sticky-down prices and a highly vulnerable economy
Zero inflation makes it difficult for the economy to adjust to changes. Let’s imagine an event in which demand for goods and services falls sharply. In this situation, it would be logical for business owners to cut prices in order to spur consumption.
However, prices cannot go below production costs. And cutting production costs, especially labor costs, is not an easy thing to do.
This is largely because wages are sticky-down. Naturally enough, wage cuts produce backlash from workers and trade unions. With the purpose of preventing social unrest, labor agreements stipulate a minimum wage and redundancy payments. In some countries, these provisions are enshrined in law.
Price and wage stickiness limits the ability of the economy to adjust to deteriorating economic conditions resulting from shocks.
By contrast, moderate inflation allows business owners to reduce labor costs without staff cuts. If there are overall price increases, business owners can do that by simply freezing wages.
As we have seen, low medium-term inflation allows business owners to adjust to worsening economic conditions while keeping jobs.
Relative price fluctuations
Relative price changes in a market economy are driven by fluctuations in the supply of and demand for some goods due to both internal and external factors. An increase in the price of a commodity or a service shows that there is a need to ramp up supply. It also makes the production of those goods or services attractive for investors.
In this case, price changes do not indicate economic overheating and an imprudent monetary policy.
Although relative price changes are not regarded as a monetary event, relative price increases and decreases have an impact on other price indices, such as the consumer price index.
A zero inflation target forces central banks to tighten monetary policy if relative prices go up (due to a rise in interest rates), which has negative economic implications.
The probability of interest rates being lowered to zero by central banks
Zero or close-to-zero inflation is accompanied by very low central and commercial bank interest rates. This means that if an event (e.g. a drop in global commodity prices) triggers sustained deflation, central banks will have to cut their interest rates in order to stop deflation. However, since interest rates are already close to zero, there is no room for maneuver.
Under deflation, zero interest rates are no remedy for depressed aggregate demand, decreased output, investment, lending, and higher unemployment.
In reality, central banks have been facing this since the global financial and economic crisis of 2007–2008. As conventional monetary policy became ineffective, central banks had to resort to unconventional measures, such as negative interest rates, quantitative easing, and communicating further changes in interest rates. However, these types of unconventional measures cause other macroeconomic problems, which make them less effective.
Research provides evidence of a connection between central banks’ long-term inflation targets and the probability of interest rates being lowered to zero. Increasing the inflation target from 0% to 4% significantly reduces the probability of zero interest rates.
Why is Ukraine’s medium-term inflation target higher than that in developed countries?
High and volatile inflation in previous periods
In the past, Ukraine has experienced relatively high and volatile inflation. Studies show that “if the explicit inflation objective is adopted at a point of relatively high or volatile inflation, then the private sector might reasonably be skeptical about the likely duration of the regime, and hence its inflation expectations would only adjust gradually.”
The anchoring of inflation expectations during a disinflationary period is aided by effective central bank policies. Higher inflation targets with a wide band allow central banks to meet their announced targets, enhancing public confidence in monetary policy and making inflation expectations easier to manage.
Bringing Ukraine’s domestic prices closer to those in developed economies
The Ukrainian economy lags behind developed economies in a number of economic indicators, such as labor productivity and GDP per capita. This means that Ukraine’s large economic potential can materialize if reforms are carried out successfully.
Since Ukraine has to catch up with developed economies, it has to grow faster in terms of GDP than those economies. As a rule, faster economic growth brings prices in emerging markets to the level of prices in developed economies. This is achieved either through higher inflation or through the strengthening of the nominal exchange rate of the economy’s domestic currency. Higher inflation is often more attractive, as it brings competitive advantages in external trade and makes an open economy more resilient (by preventing balance of payments or foreign exchange crises).