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Introduction
Nominal anchor is the behavioral regulation used by Central Banks on the verge of alleviating nominal variables such as a country’s general price level. To be more precise, these mechanisms are adopted to check on either deflation or inflation in the country. The commonly used nominal anchors by the Central Banks include assets prices targets, monetary aggregate targeting, targeting the rate of exchange of currencies as well as inflation targeting. Each of these strategies comprises its own merits and demerits when used (Cole and Kocherlakota, 1998 p. 8).
This paper set out to explore various pros and cons of the three anchors commonly used by the central Banks namely monetary targeting, inflation targeting, and exchange rates targeting. The paper also addresses the need for embracing asset prices in monetary targeting as well as why their use may be a major setback.
Inflation targeting
Many countries and especially developing countries have been using this mechanism recently. Inflation targeting entails setting an inflation target by the central banks as well as the Bank giving accountability for achieving those targets. The central bank, therefore, is required to enhance its efficiency by being extremely vigilant and transparent in its operation as well as illuminating its decisions to the general public and providing inflation reports regularly (Cukierman, 1992 p. 120). Therefore, Inflation targeting consists of five fundamentals which include a commitment to ensure the stability of prices as the crucial and long-term aim of the monetary policy to attain inflation goal, making public announcements about the medium-term targets the Central bank sets to cub inflation, enhanced transparency in the strategies set out in the monetary strategies, as well as enhanced Central Bank accountability to achieve inflation objectives (Alesina, and Lawrence, 1993 p. 155).
Merits of inflation targeting
One advantage of inflation targeting is that it is easily understood by the members of the public which means transparency is enhanced. Outlining various monetary policy discussions concerning inflation goals makes it easier for Central Banks to communicate with the markets and the public easily. The benefit brought by this is that the aspect of uncertainty concerning future monetary progress is significantly eliminated. This in turn decreases volatility in the markets. In a nutshell, inflation targeting often reduces chances that Central Bank would find itself into a time discrepancy trap whereby it would only try to use expansionary monetary policy to expand output as well as employment in the short-run (Bernanke, Laubach, Mishkin, and Adam, 1999 p. 143).
Inflationary targets enhance Central Bank’s liability as well as being in line with the democratic principles. The consistent success of the inflation targeting conduct as an appraisal against a well-described inflation target could be influential in enhancing support from the Central Bank’s autonomy and as well as its policies (McCallum, 1994 p. 121).
Disadvantages of inflation targeting
These measures are very inflexible which might lead to an elevated fluctuation of output. This happens especially when the Central Bank centers so much on inflationary control. Inflationary targeting usually pays no attention to the stabilization of outputs. This brings controversies that make many economists pressure governments to use nominal income growth targets as an alternative to inflationary targeting (Svensson, 1999 p. 630). They argue that the nominal income growth target has similar characteristics as those of the inflationary target. In addition, many economists construe that it has many merits such as eliminating chances of velocity fluctuations as well as stumping time inconsistency challenges. This is the same as what happens when the central bank uses monetary targeting as well as fixed exchange rates (Bernanke and Frederic, 1997 p.103).
Inflation targeting could also be rigid at times since the Central Banks that focus on inflation targeting especially in developed economies in most cases approve more than two years’ inflation targets prospect. This at times may lead to a notion that the prospects for inflation targets are fixed. This would be construed that inflation targeting may not be flexible enough. In many cases, such economies hold the notion that there could be adjustments in the optimal monetary policy that would change the target prospect as well as the inflation path depending on the characteristics and persistency of fluctuations (Haldane, 1995 p. 182).
Monetary targeting
Monetary targeting is often used by the Central Bank on its verge of enhancing stability in the economy. Central Banks at times use monetary aggregates which include monetary base, M1, M2 as well as M3. The reason for using this is to enable them lower and stabilize inflation rates in the economies. The basic idea for this kind of target is that, whenever the velocity for money is constant, a growth target in the monetary aggregate is said to maintain nominal income at a stable path of growth which in turn enhances prices steadiness in the long –run. In such circumstances, monetary targeting as a nominal anchor brings many merits (Levin and Piger, 2004 p. 65).
Advantages of monetary targeting
One significant merit of monetary targeting is that when there are narrower monetary aggregates, the Central bank gets in a position where it can easily control those aggregates. This enhances the banks’ operations as well as lessening its monitoring strategies. The results are increased stability of prices at a national level which stimulates economies (Stephen and Jan 2001 p. 140).
Another critical advantage of monetary targeting compared to other forms of nominal anchors is that monetary aggregates are easily measured with a high degree of accuracy within a short time. This is in contrast with inflationary targeting where a longer period has to pass to check the effectiveness of the mechanism. Monetary aggregates could be a measure even over three weeks (Stanley and Norbert, 1994 p. 301).
Since the aggregate is recognized when using monetary targeting, there is high transparency of the monetary policy which encourages the markets as well as the public. This stumps out an aspect of uncertainty in the economy of a country. Such monetary aggregate usually gives light to the markets about the plans of those making policies, therefore, helping them take part in fixing the inflation outlook. This means that the pressure which would be put on Central Bank to practice expansionary monetary policy when things are worst in the economy is significantly reduced (Mishkin, 2002 p. 219).
Disadvantages of monetary targeting
One great demerit about this mechanism is that it is only effective in situations where monetary aggregates have an elevated foreseeable relationship with nominal income. However, in many countries, there have been frequent and huge changes in the velocity over a long period such that the connection between goal variables and the monetary aggregates has faced major challenges. I the same as inflation targeting as well as fixed exchange rates targeting, monetary targeting is prone to the occurrences of time inconsistency (Orphanides, 2002 p. 119).
Exchange rates targeting
The use of exchange rates targeting as a nominal anchor has been a common phenomenon reported by numerous Central Banks. The main aim of exchange rate targeting is to allow a country to enjoy a low and steady inflation rate. Various exchange rate systems are adopted in many economies on the verge of endorsing international trade competitiveness (Darrell, 2001 p. 202).
Advantages of exchange rates targeting
One of the greatest merits of exchange rate targeting is that it enhances the stability of prices for the traded goods. In addition to this, a lower rate of inflation is enhanced due to the elimination of various shocks in the markets. Exchange rate targeting is an effective strategy for the more developed countries especially when the monetary targeting is not conducive. They also significantly help the countries with emerging markets where political instability thrives. This mechanism helps stabilize the economy of such countries (Calvo and Mishkin, 2003 p. 112)
Disadvantages of exchange rates
When a Central Bank uses this exchange rate targeting, it usually loses its autonomy in setting the monetary policies in an economy, therefore the rates have to follow the monetary policy trends. This makes the central Bank incapable of responding to the fluctuation of as well as disruptions created which might hinder economic growth in an economy. In addition, exchange rates which are usually pegged on monetary policies have been known to be useful n the short-run and not in the long run. The most affected economies by this phenomenon are developing ones. They are made to pay the price by forgoing their monetary policy independence rather than controlling inflation. On the other hand, richer countries can look for another state’s currency to anchor themselves to (Froot, and Thaler, 1990 p. 180).
The central Banks may become deficient in impulsion of a competent and appropriate discretionary monetary policy especially if it practices floating exchange rates. This is more so because if the floating exchange rates decline in the international export markets, a mechanical decline in a country’s currency value prevails (Kaminsky, 1996 p. 302).
Asset prices
Asset prices are usually used as the anchor of the household price level. Asset pricing entails pricing both financial and physical assets in a tentative economic atmosphere. There arise controversies especially among scholars concerning whether central banks should or should not use asset pricing in monetary targeting.
Reasons why assets shouldn’t be used
Sometimes price stability may be connected to increased risks of financial volatility. This is usually the case especially after the repercussion of the widely corrected share prices. In some nations, appreciating assets value, as well as debt accrual, have led to stretched domestic and companies balance sheets which are susceptible to a kind of equity price rectification that has been witnessed in recent times. This makes everyone wonder whether the central bank should direct monetary policy towards maintaining price stability as well as the part it takes in combating financial insecurity (Ross, 1976 p. 349).
The use of asset prices in monetary targeting may also be unwarranted. The reason for this is that there is a lack of clarity as to whether an increase in the rates of interest would be able to stop any increase in asset prices. In addition, the essential alterations might be too large. Another reason is that central Banks should prevent occurrences of financial instabilities and a great interest rate trudge meant to avert asset prices from increasing may prompt financial instability. More often, the extreme concern of the monetary policy on the fall down of asset prices can generate moral hazard. The usual approach whereby monetary policy ignores the elevated asset prices especially when the bubble busts lessens the rate of interest thus making the bubble more likely to occur again (Lucas, 1978 p. 1434).
Another disadvantage of using asset prices is that targeting asset prices is equivalent to trying to fix prices. This creates misallocations as well as dislocations which may destabilize the markets for the assets as well as the entire economy (Schwert, 1990 p. 401).
Conclusion
Central Banks usually uses various anchors in their efforts to check on the inflationary and deflationary aspect. In practice each of nominal anchors, various advantages and disadvantages arise. Most governments in the third world usually use inflation targeting more than their development nation’s counterparts. It is more common that inflation usually affects the majority of developing countries.
Another more common mechanism that has been used for ages is exchange rate targeting. Countries using this method evaluate various aspects that could affect their currency and its competitiveness in the international markets. Monetary targeting on the other hand has been a commonly used tool by the Central Banks. Perhaps the reason for their popularity is that the aggregates are effective and can be measured over a short period.
Asset pricing is an anchor that has been the center of the debate for a long time. Some scholars advocate that central Banks should go ahead and use asset pricing in monetary targeting whereas others strongly oppose this notion.
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