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Opinions of Friday, 29 April 2005

Columnist: Ampong, Kwabena Owusu

Inflation Targeting Monetary Policy - the way forward.

The contemporary use of Inflation Targeting Monetary Policy as an instrumental regulatory mechanism by the central banks of many economies around the world is something worthy of notice. In recent times, inflation targeting monetary policy, coupled with non-artificial Central Bank independency has been a source of great success for the management and stabilization of macro-economic variables in countries like Norway, Sweden, Israel, Iceland, Denmark, New Zealand, United Kingdom, etc.

A government manages its economy through the combined actions of fiscal and monetary policies. The most notable and visible element in fiscal policymaking which is directly influenced by the state is the government?s expenditures, both recurrent and investments, whiles the nominal interest rate is used in monetary policy as a thermostatic regulator to monitor and manage the amount of ?heat? in the economy on a continuous basis.

Inflation targeting monetary policy in a simplified sense has to do with how to use adjustments to the nominal interest rate, to achieve or approach a target inflation level. In periods of economic boom, high interest rates might be needed to check inflation, while low interest rates will be needed to stimulate investments and create employment in recessions. In between these two extremes, interest rates are adjusted up or down depending on prevailing economic conditions. High interest rates will slow down the economy and cripple the private sector. Investors cannot access funds from financial institutions, thus creating low level of investments. It will also be tempting to invest available funds in high yielding bonds than in infrastructural business investments. This will reduce spending, shrink national output and bring down inflation. Low level of investments will therefore create unemployment. The central bank reacts by lowering interest rates using the sight deposit rate (inter-bank transaction rate with commercial banks also referred to as the key rate). Low interest rates stimulate the economy. Investors can access low-cost capital for investment. Employment increases, and the national output increases. Low interest rates therefore allow for borrowing and spending, but then, inflation will also pick up. As inflation picks up, companies can increase employment, since real wages decrease.

In an open economy like our own, exchange rates also have a role to play. However, exchange rates vary directly with both the GDP and inflation. A depreciation of the cedi will make Ghanaian products relatively cheaper in the global markets. This is expected to increase the demand for them, thereby increasing exports. Increase in export demand will obviously fuel domestic investments and create employment. A depreciation of the cedi both increases GDP and fuels inflation, through increased spending. The relationship between the interest rates, inflation, GDP (or more precisely the output gap), exchange rate and the interest rate differential (local-to-foreign) is not so straight forward, but they are realistically linked. These should be analysed religiously, before the central bank makes decisions on interest rates

Managing inflation and interest rates have lower and upper bounds. For the major economies in the world, inflation and interest rates are normally below 5%, whiles governments set inflation targets at 2-3%. For real economic development, inflation and interest rates should not exceed 10%. Currently, the headline inflation rate in Ghana is about 14% whiles the short-term interest rate is about 16%. It must however be noted, that this is a very significant achievement by Ghana, especially at this time when the price of crude oil is around USD $55.39 per barrel (22nd April 2005 on NYMEX). Whenever inflation and interest rates are above 10%, there will obviously be massive unemployment and the economy will suffer stunted growth and be in distress. Of course high interest rates will be expected to push inflation down and attract foreign investments, but there is a ceiling to this. Moreover, the determinants of foreign direct investments to Ghana has more to do with the perceived business risks of investing in Africa, than domestic interest rates.

The central bank, free from government interference through the Ministry of Finance, should normally be given this responsibility to manage the nominal interest rates. The government keeps control over the expenditure of public funds, since it is the government?s responsibility to create public goods and also improve the welfare of society. With an objective to ensure a flourishing life for its people, reduce unemployment, stimulate economic growth, bring down spiralling inflation, increase economic output, increase social welfare benefits, etc., the government will obviously be interested in the actions of the central bank, but not in an interfering sense. To ensure that the objectives of the central bank are in line with that of the government for a sustained economic growth, the government sets an inflation target for monetary policy.

The governor of the central bank and its board is normally appointed by government, but then there should be checks in place to ensure that they are not blindly serving in the political interest of the government, and also to protect the independency of the central bank. Such checks to limit governmental interference could be for the central bank?s governor to have a term of office longer than the constitutional term of a government. The governor position should also be non-renewable. The central bank should operate its own budget, free from the control strings of the Ministry of Finance, and create its own money, especially through the seignorage and interests from lending money to financial institutions.

Keeping the governor?s term of office to more than 4 years is also important for another reason; monetary policy normally has a time lagged effect on the economy. It takes between 4 to 6 quarters for an interest rate change to have an impact on GDP, and it also takes approximately a similar amount of time for the GDP change to subsequently affect inflation. It is therefore normally difficult to monitor the performance of central banks that use inflation targeting monetary policy within a short period of time. The other members on the board could be given a much shorter term in office, but this should not be made to coincide with the political timetable of the constitution.

Central bank independency is also very important since there can be conflicts between monetary policy and fiscal policy. A popular one, known as the output gap conflict arises when the central bank decides to increase interest rates to reduce inflationary pressures on the economy. Increasing interest rates will however shrink the output gap, and thereby create unemployment. A government approaching an election period might therefore be tempted to increase its expenditure to counter the effect of high interest rates. But increased government expenditures will rather increase inflation further, creating confusion between the short term objective of the political masters, and the long term constitutional objective of the central bank, which is to ensure a stable and growth oriented economy.

Inflation targeting monetary policy is a recent phenomenon, but countries who have opted for it have achieved great success. The base of our economy is very weak. Shocks from the relevant commodity prices in the global markets just push the economy around like a baby. Even in such a situation, much can be gained by a sound management of monetary policy in Ghana, and this is very important to fuel real economic growth. It is a stable and predictable economy with manageable interest rates and inflation, that can entice investors to invest in long term projects and create the needed employment and GDP growth to propel us out of this clutches of entrenched poverty.

It is very obvious, that monetary policy management in Ghana can be improved. The overlapping roles of the Ministry of Finance and the Bank of Ghana (Central Bank) should be corrected, and the notion that the bank of Ghana is only to monitor the operations of financial institutions should be revisited. Sometime ago, figures on the parameters of the economy from the Bank of Ghana, IEA, CEPA and Ministry of Finance were all different. This obviously indicates that there is no coherent strategy in the front line, on how to use policy to manage the fiscal and monetary aspects of the economy.

This is my recommendation:

1. The government of Ghana should set an inflation target for monetary policy.

2. The bank of Ghana should be given the sole responsibility, mandate, and the independent status to manage the monetary economy around this inflation target.

3. The bank should be non-artificially free from governmental interference in their operations.

4. This inflation target should be a very important tool and should be part of the constitution of the Bank of Ghana, and also used as an appraisal tool to judge the success of the board of the Bank of Ghana.

5. The Bank of Ghana should come up with a practical progressive and dynamic short- to medium-term strategy on how to move the current level of inflation into an interval zone around the government?s inflation target.

6. The Bank of Ghana should use the sight deposit rate as the relevant nominal interest rate to regulate monetary policy. This will be the instrument of the bank to move inflation to the target rate.

7. The Bank of Ghana should also be given the sole responsibility to set interest rates in Ghana. This decision to set interest rates should be made by the Bank?s board, after examining the economy, analysing the economic outlook and risk factors, in addition to taking into consideration exogenous economic developments, over specific time periods. Normally this would be done 4 times in a year, after which they would issue a report to the government to explain any decisions they have taken. This report should be published for everybody in Ghana to read.

With inflation targeting monetary policy, it will take less than 5 years for Ghana to create that stable and congenial macro-economic environment, hand-in-hand with real GDP growth which will be felt in the pockets of the ordinary Ghanaian (not just stability with stunted or no appreciable growth).

Kwabena Owusu Ampong
BSc Engineering, KNUST, Ghana
Master?s in International Business, NHH, Norway
Candidate for MSc in Financial Economics, BI NSM, Norway


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