This paper summarized the advice on the institutional and operational practicalities of inflation targeting for emerging market countries that have decided to operate monetary policy under this framework. The paper also spelled out the trade-offs raised in the formulation of the inflation targeting framework for emerging market countries and described the approaches to these trade-offs used by countries that practice inflation targeting.
The information summarized in this paper suggests that emerging market countries in comparison to industrial countries seem to prefer a more formal institutional framework in support of inflation targeting. The legal frameworks of all inflation targeting countries explicitly set price or currency stability as the primary objective of the central bank and grant it instrument independence. The institutional frameworks for emerging market countries are more formal than those for industrial countries in that the former tend to modify the central bank legal framework before adopting inflation targeting, and all emerging market countries explicitly limit central bank financing of government deficits in the primary market.
The more formal institutional frameworks for inflation targeting in emerging market countries may reflect differences in their structure and history (Appendix I). They began their inflation targeting frameworks with less credibility, owing to much higher and more variable rates of inflation compared with those of the industrial countries. They have less developed financial systems, which tend to increase their exposure to financial crisis. They also have somewhat higher domestic government debt than the industrial countries, which tends to raise the potential for pressure to monetize fiscal deficits, together with much lower broad money to GDP ratios, implying that monetization of a given deficit is more inflationary. Finally, emerging market countries are more vulnerable to exchange rate crises. These characteristics of emerging market countries may accentuate the principal-agent problems inherent in central banking by making it more difficult for the public to monitor the performance and credibility of the central bank, thereby leading emerging market countries to impose more formal arrangements.
Differences in the operation and design of inflation targeting between emerging market and industrial countries are also suggested by the information summarized in this paper. Central banks in emerging market countries rely less on statistical models in the conduct of monetary policy. These central banks appear to intervene more frequently in foreign exchange markets than their counterparts in industrial countries. The design of inflation targets in emerging market countries is characterized by shorter horizons, and by inflation target bands rather than point targets. These differences may also reflect structural differences with industrial countries. Ongoing structural changes in underlying economic relationships are more prevalent in emerging market countries, which are inclined to be more vulnerable to shocks, especially volatile capital flows. Finally, policy transmission in the more open emerging market countries operates largely through the direct short-term exchange rate pass-through channel.
Most central banks in emerging market countries have taken important organizational steps to enhance their capacity to apply greater judgment and foster transparency and accountability. These steps can be particularly challenging for emerging market central banks that have traditionally operated with controls and regulations and have been reluctant to communicate their policy intentions and economic outlooks. Most have improved their governance structure by incorporating a broader range of perspectives into the monetary policy decision-making process, and by reforming their organizational structure with a view to delegating authority.
Finally, several emerging market countries during the transition to full-fledged inflation targeting have been faced with the challenge of disinflating to the long-run inflation objective. The experiences of Chile, Israel, and Poland suggest that a gradual shift from a crawling exchange rate regime to an inflation targeting framework is feasible given supportive economic and fiscal policies to manage the transition and minimize the risk of the central bank being confronted by conflicting objectives. One issue that cannot yet be resolved, however, is whether an inflation targeting framework is suitable for countries that want to disinflate from higher rates of inflation. So far, no country with a rate of inflation greater than 30 percent has begun the transition to inflation targeting.