Leiderman on inflation targeting
Inflation targeting is no longer confined largely to industrial countries but has been embraced by many emerging market and developing countries (see table, this page). But for emerging market economies, Leiderman said, implementation is more of a challenge than for industrial countries for a couple of reasons. First, emerging market economies appear more susceptible to shocks that can make attainment of the target a challenge. For instance, exchange rates in these countries are generally more volatile than in industrial countries, and an unexpected and sharp depreciation of the domestic currency can make it difficult for the central bank to meet previously announced targets.
Indeed, in a number of emerging market economies, inflation rates last year were outside the announced target range. How countries respond to this divergence between plan and outcomes, Leiderman said, may be critical in determining the eventual success of inflation targeting as a monetary regime.
Second, the success of inflation targeting—as with any monetary regime—requires that “all members of the orchestra play together.” This means that the country’s treasury and central bank have to agree on the inflation target and the policy settings that will achieve it. Pressure from the treasury to make the central bank finance a large part of the budget (through the printing of money) can undermine the success of any monetary regime. The experiences of emerging market economies suggest that the adoption of inflation targeting does not automatically insulate the central bank from such pressures. Wage-setting institutions also have to be supportive of the central bank’s inflation targets.
A testing time
Leiderman noted that inflation forecasts for a number of emerging market countries—among them Brazil, Colombia, Israel, and Mexico—were currently outside the announced target ranges. For instance, the Brazilian central bank had originally targeted inflation for 2003 of 4 percent, plus or minus 2.5 percent. But private sector expectations for inflation in 2003 are currently about 11 percent, reflecting the run-up in inflation as a result of the sharp depreciation of the peso last year and an increase in fuel prices.
How will the central banks of these countries deal with this situation? On the one hand, they must take these deviations seriously if they are to maintain the credibility of the regime. On the other hand, Leiderman said, they most likely also want to avoid being thought of as “inflation nutters”—policymakers who are oblivious to the short-term effects on output and employment of rigid adherence to inflation targets. Leiderman noted that this tension between wanting a “hard target” to gain or maintain credibility versus wanting a “soft target” to allow flexible responses to unforeseen developments in the economy had been present since the inception of inflation targeting. In the early days, hard targets were preferred, but sentiment appears to be veering toward the soft target approach.
|Pegged exchange rates||Exchange rates within||with no preannounced|
|Independently floating||within horizontal bands||crawling bands||path for exchange rate|
|Years||Inflation target||Inflation outcome|
Try a little tenderness
Leiderman reckoned that, among the emerging market economies, “more and more countries will move to the Australian model” of soft inflation targeting, under which the central bank seeks to adhere to an inflation target “on average over the course of the cycle” or “as a medium-term objective.”
This would not be a bad thing, he said. The experiences of countries that had been on inflation targeting regimes for a number of years suggested that the public cared about the central bank’s average performance over the period rather than its performance in any one year. For instance, he noted that Israel’s central bank had missed its inflation target in 9 of 11 years. But, because the deviations were small, the average performance of inflation over the whole period was pretty close to the average of the target ranges, and the inflation targeting regime had enjoyed credibility and public support (see table above).
(Since Leiderman’s seminar, the Brazilian central bank has announced that it will now target an inflation rate of 8.5 percent for 2003 and 5.5 percent for 2004. The new target for 2003 is more than double its original target but still below private sector forecasts for the year. In a letter to the finance ministry, the central bank noted that “monetary policy will be able to make inflation converge with the ceiling of the (original) goals in two years.”)
It’s mostly fiscal
While generally supporting a move by emerging market economies to an Australian model of inflation targeting, Leiderman also sounded a note of caution. There is a “danger that countries may move to the Australian model … without adopting Australia’s fiscal rectitude.” In emerging market economies, he said, “if the fiscal situation is going wrong, most other things will follow.” He noted that many observers considered the success of inflation targeting in New Zealand—which pioneered the move to inflation targeting—to be due in large part to the country’s putting its fiscal house in order at the same time. Emerging markets that move to softer inflation targeting regimes should guard against getting soft, at the same time, about achieving their fiscal targets.
In some cases, Leiderman said, the pressures on the inflation targeting regime come not from fiscal but from wage-setting institutions. Many emerging market economies turned to inflation targeting after a history of chronically high inflation; even though low inflation has generally been achieved under inflation targeting, in some countries—Leiderman suggested Mexico as an example—wage-setting institutions have not yet fully adjusted to this change. Demands for wage increases made as though the old high-inflation regime were still in place will end up imparting inertia to the inflation process and make achieving inflation targets more difficult.
The bottom line, Leiderman said, is that emerging market economies may encounter many obstacles on the path to an inflation targeting regime, but these are surmountable. Inflation targeting has worked very well for most of those that have adopted it, at a time when they needed monetary policy autonomy and flexibility to deal with severe shocks.
In emerging markets, if the fiscal situation is going wrong, most other things will follow.
Photo credits. Ali Burafi for AFP, page 17; Denio Zara, Padraic Hughes, Pedro Marquez, and Michael Spilotro for the IMF, pages 17,19,21, and 22-30; Bjarke Oersted for AFP, page 32. The photographs of the NEPAD Conference that appeared on pages 11-12 in Issue No. 1, January 20, were taken by Ibrahima Samba.