The NBU Goal and Tasks For 2017: Inflation Targeting Alone Is Not Enough

The first and foremost priority of the National Bank of Ukraine (NBU) is to keep inflation low. This is stated in the law, and in the principles of the monetary policy for 2017-2020 proposed by the NBU Board, and recently approved by the NBU Council. The goal for 2017 is set at 8+-2%. Will the public accept this goal?

In this piece, I argue that the credibility of commitment to this inflation target is jeopardized thus rendering NBU’s monetary policy potentially less effective. I further propose that NBU should supplement its inflation target with clear targets on the state of the banking sector. These targets should be developed by the NBU Board and be subject to approval and monitoring of the NBU Council. I leave the discussion of the specifics of what those targets might be for another essay.

In a nutshell, my argument is as follows. The NBU has announced that it will keep inflation at 6-10% in 2017. In order for this to happen, first, the NBU should be committed to this target as its first and foremost priority and, second, the public should believe that the NBU is committed and should trust how the inflation is calculated.[1]

This may not be the case, however. In my opinion, the public understands that the NBU as well as the government also pursue other equally if not more important objectives. As a result, the public may question which objective will take precedence in case of conflict.

The public may question which objective will take precedence in case of conflict.

Take, for example, the recent nationalization of PrivatBank, Ukraine’s largest private bank that was taken over by the government on December 19, 2016. The government and the NBU are committed to keeping the bank functional and, it appears, will provide required liquidity to the bank even at the risk of increasing inflationary pressure.

Indeed, over the last two years, the NBU has simultaneously pursued two sets of objectives. First, in the monetary policy area, the Bank has abandoned the policy of maintaining a fixed exchange rate and committed to inflation targeting (see the principles of the monetary policy for 2017 and forward). In the banking sector, the Bank has run stress tests, forced the banks to disclose their ultimate owners, and imposed steep restrictions on banks dealing with related parties. Furthermore, the National Bank has removed scores of the banks that have failed to add sufficient capital, were engaged in money laundering or fraudulent activities, and nationalized a large systemic bank that was about to fail.

Under the monetary regime of inflation targeting, the central bank publicly announces desired inflation levels and uses all available tools to reach them. In case of Ukraine, the target for 2015 was 20%, for 2016 – 12%, and for 2017 it is 8% (+-2%). The National Bank did not meet the target for 2015, but met it for 2016 (please see the decision of the NBU Council).

If credible, inflation targeting has several interrelated advantages. First, it promotes the political independence of the central bank. By setting a clear and simple target, the central bank becomes accountable to the public rather than the government. The public can directly observe the level of inflation and compare it with the promises made by the central bank. In this way, the society is able to pass a judgement on the performance of the central bank without relying on experts and insiders. This is particularly helpful in Ukraine where the public distrusts government and does not have the ability to distinguish unbiased quality experts from those who are prejudiced or have vested interests [2].

Second, a clear inflation target also protects the central bank from serving short-term fiscal needs of the government that would adversely affect the economy. In simple words, the government may be under pressure to channel resources to politically important groups (for example, give funds to an industry with a strong lobby in the parliament or increase the minimum wage or pensions in order to divert some public support from opposition). These resources have to be found somewhere. A responsible way to garner these resources is through the budget process by either increasing tax revenues, additional government borrowing, or reallocation of resources from other public programs. The budget process is also subject to the public (parliamentary) approval, which reduces opportunities for corruption and favoritism. Of course, there is an alternative – to simply  have the central bank “print” money and give it to the right people or businesses (see the blog with the letter). This process is not subject to the parliamentary oversight (hence, ample opportunities for political favors and corruption) and will lead to increased inflation. But if the central bank is committed to an inflation target, it will resist “printing” money.

Third, inflation targeting is an effective way to control public expectations about inflation. Public expectations are important to an extent inflation is a self-fulfilling phenomenon: If everyone believes the prices to go up, people will demand higher salaries and will set higher prices themselves, making their expectations come true. Similarly, if everyone believes that inflation will be low, they will not demand pay increases and will not increase prices, keeping inflation at bay. Furthermore, low inflation expectations may encourage economic growth. On the other hand, if the public is skeptical and has high expectations of inflation, keeping inflation at bay will require tighter monetary policy, resulting in slower economic growth.

Public expectations are important to an extent inflation is a self-fulfilling phenomenon: If everyone believes the prices to go up, people will demand higher salaries and will set higher prices themselves, making their expectations come true.

Thus, in order for inflation targeting to work effectively, the inflation target should be the highest priority for the central bank, and the public and the government must believe it so. If the public believes otherwise, it may dismiss the regime of inflation targeting as a distraction.

Unfortunately, in Ukraine, containing inflation is only one of the pressing issues for the economy and the public. The other, equally important, is the stability of the banking system. One of the key objectives of the central bank over the last several years was dismantling banks that were engaged in money laundering or fraud. In addition, the central bank has conducted stress tests and asked the bank to add sufficient capital, removing the banks that failed to do so. Furthermore, many of the banks used to have (and some still do) constrained business models serving a limited number of clients or have a larger share of non-performing loans. Finally, the problems with the largest systemic bank PrivatBank have led to its nationalization, making state-owned banks the dominant players in the financial system. As a result, the public, the business, and the political elites may consider one of the main priorities for the National Bank of Ukraine and other regulatory institutions to be to ensure that the banking sector becomes sound, transparent and well positioned to efficiently serve Ukrainian economy. Consequently, the credibility of inflation targeting as the main priority for the central bank can be questioned by the public, diminishing it effectiveness.

Furthermore, if cleaning up the banking system is among crucial objectives of the central bank and, hopefully, the government, absence of clear and transparent targets pose the very same dangers that the regime of inflation targeting seeks to avoid. If the central bank does not commit to targets and timeline on the banking sector that are clearly understood by the general public, the performance of the central bank will be judged by the government and the professional community.[3]

Given the lack of trust by the public to media, experts, and the political elites, any judgment passed by the professionals on the performance of the central bank can and will be easily questioned by those powerful who stand to lose from removing fraudulent and insolvent banks. Furthermore, having no established targets means that the central bank does not have any external anchor for its actions. The specific actions and timing on specific banks can be worked out on the fly in joint communications with the government and powerful elites. This opens the bank to undue political influence or at least creates the perception of such influence. The public understands that and rightly becomes suspicious, providing an opportunity for the vested interests to undermine trust in and, as a result, effectiveness of the central bank.

In fact, this is exactly what has been happening in Ukraine: while most of the experts and out-of-country observers have been applauding the heroic efforts of the National Bank to take on fraud and insolvency in the banking sector, the public often perceives the bank to act in the political or, even, vested interest of the president and the government.

A possible way out of this is for the central bank to keep inflation targets but also set clear and transparent targets on the state of the banking sector. The central bank, of course, should further commit to the timeline of meeting these targets. Without this, the public will continue to suspect the central bank of being subject to political influence, rightly or wrongly, and the credibility and trust into the regulator’s will continue to be undermined by reactionary forces.