Back Matter
Author: Mr. Mark Zelmer and Ms. Andrea Schaechter
Language:
English
Keywords:
OP; central bank; inflation targeting framework; emerging market country; country
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Abstract

This report on Adopting Inflation Targeting describes the trade-offs raised in the formulation of an inflation targeting framework and states the approaches to these trade-offs used by inflation targeting countries. The inherent differences discussed in this report between the six emerging market inflation targeting countries—Brazil, Chile, the Czech Republic, Israel, Poland, and South Africa—and other emerging market countries may shed some light on the preferred starting point and conditions for inflation targeting. 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. During the transition to full-fledged inflation targeting, several emerging market countries have confronted the challenge of dis-inflating to the long-run inflation objective.

Appendix I: Economic Structure of Emerging Market Inflation Targeters

This annex compares macroeconomic indicators for emerging market countries that target inflation with those for other emerging market countries, and those for inflation targeting industrial countries. The first comparison is intended to discern any systematic differences between the emerging market countries that have adopted inflation targeting and comparable emerging market countries that use other monetary policy frameworks. The second comparison aims to identify any disparities between inflation targeting emerging market and industrial countries that could help improve understanding of the differences in inflation targeting practices discussed in this paper’s conclusion.

Emerging Market Countries: Inflation Targeters vs. Non-inflation Targeters

The six emerging market countries that target inflation (Table A1.1) are larger and more developed than are other emerging market countries. These comparisons are based on data for the developing countries in the World Economic Outlook database. Excluding large oil exporting countries and small island countries—as these two country groups generally operate in different monetary policy environments, there are a total of 118 developing countries.22 The inflation targeting countries are large—they rank in the top quintile of the 118 developing countries by total 1998 GDP in U.S. dollars (Table A1.1). These countries also rank in the top quintile by per capita GDP in U.S. dollars, indicating that they are generally more developed.

Table A1.1.

Emerging Market Countries Ranked by GDP and GDP Per Capita, 19981,2

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Source:World Economic Outlook database.

Inflation targeting countries are marked In bold. This table ranks the top 22 developing countries according to GDP and per capita GDP.

Excludes large oil exporters and small island countries.

The inflation targeting countries have better developed domestic financial systems according to standard indicators of financial market development. Since only the larger and more advanced developing countries have adopted inflation targeting, these comparisons are between the six inflation targeting countries and the 32 developing countries that are comparable in terms of GDP levels and per capita GDP (i.e., the combination of the top 22 developing countries by total GDP and top 23 developing countries by per capita GDP). The ratio of liquid liabilities to GDP is slightly higher for the inflation targeting countries on average and six percentage points greater by median relative to the comparator group (Table A1.2). The average ratio of private credit (including deposit banks and other financial institutions) for the inflation targeting countries is some 19 percentage points higher than the corresponding ratio for the other countries. Similarly, the stock market capitalization to GDP ratio is nearly twice as large for the inflation targeting emerging market countries. This relatively high level of financial sector development may help explain why all the inflation targeting emerging market countries are able to conduct monetary policy with indirect instruments and short-run interest rates as operating targets.

Table A1.2

Emerging Market Countries: Inflation Targeting and Comparator Countries

(In percent unless otherwise specified)

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Sources: World Economic Outlook database; Beck and others (1999); and IMF Israel: Selected Issues, IMF Staff Country report No. 99/40.

Argentina, Belize, Botswana, People’s Republic of China, Colombia, Croatia, Egypt, Estonia, Hungary, India, Indonesia, Lebanon, Malaysia, Mexico, Myanmar, Pakistan, Panama, Peru, Philippines, Russia, Slovak Republic, Slovenia, Thailand, Turkey, Uruguay, and Venezuela.

Differences are expressed in percentage points for the ratios given in the table.

Indicators of the external position do not show marked differences between the inflation targeting countries and the comparator emerging market countries. The average and median current account deficit during 1993–97, prior to the recent episode of turbulence in international financial markets, is slightly lower for the inflation targeting countries. In a similar vein, the external debt to GDP ratios are almost the same for the two groups of countries.

However, inflation targeting emerging market countries have higher sovereign credit ratings. As of May 2000, Moody’s assigned investment grade sovereign credit ratings to five of the six inflation targeting countries. Only nine of the 26 comparable emerging market countries enjoyed investment grade ratings.

Inflation Targeters: Emerging Market Countries vs. Industrial Countries

The inflation targeting emerging market countries began their inflation targeting frameworks with much higher and more variable rates of inflation compared to the industrial countries. The rate of consumer price inflation at the month during which the transition to inflation targeting began averaged 12.4 percent for the emerging market countries, compared to an average 3.6 percent for the industrial countries (see Table 4.3). Moreover, the standard deviation of monthly inflation during the five years prior to the adoption of inflation targeting was higher by a factor of five for the emerging market countries.

The emerging market countries that target inflation have less developed financial systems in comparison to their industrial country counterparts. The emerging market countries have much lower average and median ratios of liquid liabilities to GDP, private credit to GDP, and stock market capitalization to GDP, relative to the industrial countries (see Table A1.3, page 41). Similarly, the ratio of reserve money to GDP is much higher for the emerging market countries.

Table A1.3.

Key Financial Ratios for Inflation Targeters1

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Sources: World Economic Outlook database; Beck and others (1999); and IMF, South Africa: Selected Issue, IMF Staff Country Report No.00/42.

t denotes year of adoption of inflation targeting framework.

Gross government debt for South Africa.

Inflation targeting emerging market countries have much more open economies than their industrial country counterparts. Ratios of traded goods and services to GDP are significantly higher for the emerging market countries (Table A1.3). The emerging market countries have a slightly narrower current account deficit on average, but a much wider range.

Emerging market countries have a narrower fiscal deficit but a somewhat higher level of domestic debt than the industrial countries. The average fiscal balance to GDP ratio during the three years prior to the adoption of inflation targeting was 2.5 percentage points higher for the emerging market countries. In contrast, their domestic debt to GDP ratio was around 17 percentage points lower.

Emerging market countries are more vulnerable to currency crises and crashes relative to industrial countries. This comparison draws on the analysis of Aziz and others (2000), which covers 50 countries during 1975–97 (Table A1.4). A currency crisis occurs when an exchange rate pressure index, which is based on the exchange rate and international reserves, breaches a predefined threshold.23 A crash is a crisis where the exchange rate pressure consists mostly of devaluation. Emerging market countries comprised 60 percent of the sample, but account for 73 percent of the crises and more than 90 percent of the crashes. These results suggest that emerging market countries are much more vulnerable to an exchange rate crash than are industrial countries.

Table A1.4.

Industrial and Emerging Market Countries: Currency Crises and Crashes, 1975–97

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Source: Aziz and others (2000).

Finally, emerging market countries appear to be subject to larger real economic shocks than the industrial countries. As mentioned above, inflation is more variable for the emerging market countries. Moreover, the standard deviation of real growth during the 12 years prior to the adoption of inflation targeting was three times higher for emerging market countries compared to the industrial countries. In addition, the literature suggests that real shocks are more severe for emerging market countries. For example, Agénor and others (1999) conclude that output volatility is higher and more persistent for middle-income developing countries than for industrial countries, and that supply shocks drive business cycles in these developing countries. Kouparitsas (1996) concludes that output volatility in emerging market countries reflects the transmission of shocks originating in the industrial countries to emerging market countries through international goods and assets markets.

Appendix II: Institutional Aspects of Inflation Targeting

Table A2.1.

Institutional Aspects of Inflation Targeting in Emerging Market Countries

(As of March 2000)

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Sources: Central bank websites and publication; discussions with central banks: and Bernanke and others (1999).

Includes unspecified plus/minus range.

Table A2.2.

Institutional Aspects of Inflation Targeting in Industrial Countries1

(As of March 2000)

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Sources: Central bank websites and publications; discussions with central banks; and Bernanke and others 1999).

Inflation targeting in Finland and Spain ended in January 1999 when their exchange rate panties were irrevocably fixed with the introduction of the euro. Hence, these countries are excluded from the second panel.

Australia switched from a core measure to the CPI in 1998 when the latter was redefined by the statistical agency to exclude interest charges

Informal target.

New Zealand switched from a core measure to the CPI in 1999 when the latter was redefined by the statistical agency to exclude interest charges and section prices.

Appendix III: Country Studies

Australia

In April 1993, Australia announced an inflation target with a view to increasing the transparency and credibility of monetary policy and to condition inflation expectations. The inflation target was intended to provide a nominal anchor for monetary policy; this anchor had been missing since 1985 when the Reserve Bank of Australia (RBA) abandoned its monetary targets. Monetary policy in the 1970s and 1980s often played a supporting role to other economic policies and resulted in relatively high inflation rates (Lowe, 1997). In 1990, when the overall macroeconomic situation started to weaken, the focus of monetary policy changed. Both the RBA and the government stressed that there was an imminent need to engineer a substantial reduction in inflation from the average level of 8 percent in the 1980s (Debelle and Stevens, 1995). The shift in priorities for monetary policy was accompanied by efforts to make the RBA’s monetary operations more transparent: the RBA began to publicly explain changes in its monetary policy stance and to announce a target for the cash rate operating target (Battellino and others, 1997). The RBA adopted the inflation targeting framework after inflation had fallen to below 2 percent, thus providing a favorable environment for meeting the target.

Several aspects of Australia’s inflation targeting framework are distinct. First, Australia’s underlying inflation index comprises only about 50 percent of the consumer price index basket: all components that are volatile or seasonal, subject to administrative price setting, and sensitive to interest rate changes are excluded (RBA, 1994). Second, the RBA is the only central bank to formulate its inflation target as a “thick point” target rather than a narrow band (Debelle and Stevens, 1995). Third, the target is defined as a 2–3 percent rate of underlying inflation on average over the economic cycle. Thus, the RBA does not define a strict time frame over which it has to adjust target deviations, but it stresses the medium-term orientation of monetary policy by defining the target to be fulfilled on average over an economic cycle.

Because Australia’s inflation targeting framework is less stringent than that of most other inflation targeters, the RBA has considerable leeway in conducting its monetary policy. The high flexibility is deemed necessary by the explicit requirement that the RBA pursue its monetary policy for price stability by taking into account the short-run implications for real output and employment (RBA, 1996). This obligation has not imposed any restrictions on monetary policy, however, since inflation targeting was introduced. Over the last three years, consumer price inflation has remained at around 2 percent and underlying inflation has been less than 2 percent.

Brazil

The Central Bank of Brazil (BCB) adopted inflation targeting in June 1999 as its new monetary policy framework. The BCB found the introduction of a new policy framework necessary after Brazil was forced to abandon its crawling exchange rate peg in January 1999. The crawling exchange rate peg had provided a nominal anchor for monetary policy since mid-1994 when it was introduced as part of a stabilization process intended to stop another episode of hyperinflation. Inflation was quickly brought down to single-digit rates by end-1996 and to less than 2 percent by end-1998. The exchange rate, however, came under pressure after the Russian financial crisis in August 1998.

To restore credibility and signal the long-term orientation of monetary policy, the BCB announced in March 1999 its intention to move to an inflation targeting framework by end-June and its goal to reduce inflation to single digits by the last quarter of 1999. The BCB also tightened monetary policy by increasing interest rates. These measures, together with an IMF-supported financial package, helped to stabilize the Brazilian currency (real), reduce inflation expectations, and establish an economic environment in which the inflation targets were likely to be met (Fraga, 2000). The interim period until the formal adoption of inflation targeting in June 1999 also served as an extensive preparatory phase for the new policy framework supported by technical assistance from other inflation targeting central banks and the IMF. The BCB outlined the concrete features of the framework and prepared the publication of an inflation report, and the bank’s newly created research department started to develop inflation forecasting models and analyze the monetary transmission mechanism (Bogdanski and others, 2000).

Brazil’s inflation targeting framework encompasses the following elements. The National Monetary Council sets the inflation targets based on the proposal by the Minister of Finance. The annual targets are formulated as changes in the broad consumer price index with symmetric tolerance intervals of ±2 percent. From 2002 onwards, targets must be announced each year no later than June 30 for two years in advance. Adopting a headline index was regarded as crucial for credibility reasons, since Brazil had experienced several price index manipulations in the past (Bogdanski and others, 2000). The combination of headline inflation with relatively wide corridors in the absence of escape clauses accounts for the vulnerability of the Brazilian economy to economic shocks (Fraga, 2000).

Brazil’s inflation targeting framework also comprises a number of measures to ensure accountability and transparency, all of which are very similar to the Bank of England’s procedures. If targets are breached, the president of the BCB should issue an open letter to the Minister of Finance explaining the causes of the breaches, measures to be adopted, and the period of time that will be needed for the measures to have an effect. The decisions of the BCB’s Monetary Policy Committee, which meets every five weeks, are announced immediately after the meeting, and the minutes are published with a one-week lag. Moreover, the BCB publishes a sophisticated quarterly inflation report with details on past developments and policy decisions and an analysis of prospective inflation, including inflation forecasts presented in “fan charts.”

Brazil’s nine months experience with the inflation targeting framework is still too short to draw definite conclusions, but the framework is seen to be off to a “promising start” (Fraga, 2000). With 8.9 percent inflation at end-1999 the first inflation target was met. Short-term interest rates were lowered from 45 percent in March 1999 to 19 percent in March 2000. The exchange rate has floated with limited central bank intervention, GDP growth has slowly resumed, and the current account deficit has decreased.

Canada

In February 1991, the Bank of Canada (BoC) and the federal government jointly announced the commitment of monetary policy to inflation targeting and explicit targets for reducing inflation. During the prior decade, Canadian monetary policy had been conducted without intermediate targets or a specified path to the longer-term objective. The narrowly defined monetary aggregate (M1), which had served as a nominal anchor from 1975 to 1982, had been dropped as a target since the aggregate had become increasingly unreliable.

The inflation targets have also had an important effect on the functioning of the BoC and have provided a strong incentive for the Bank to become more forthcoming about how it would operate to achieve them (Thiessen, 1998). As a result, the BoC has taken initiatives to explain more fully its assessment of economic developments and its outlook for output and inflation. It has also clarified how it makes judgments about the actions needed to achieve the targets and how it operates in markets to implement those judgments. Perhaps most importantly, the targets have helped to improve the internal discipline of the policymaking process (Thiessen, 1998). The BoC’s commitment to the targets and the need to explain and justify any inability to meet them have resulted in a better focused internal debate on the appropriate policy actions to take, and may well have reduced the likelihood that decisions to take such actions will be postponed.

Canada’s first inflation target was set at 3 percent for the year-over-year rate of core consumer price inflation (excluding prices for food and energy and indirect taxes), to be achieved by December 1992. This target was reduced to 2.5 percent for mid-1994 and to 2 percent by the end of 1995. These targets had a band of plus and minus 1 percentage point around them. Subsequent announcements extended the 1 to 3 percent target range for inflation through to the end of 2001. The government and the central bank now plan to set the appropriate long-run target consistent with price stability before the end of 2001, rendering concrete the long-term commitment of the authorities to achieving and maintaining price stability.

At the time the targets were first announced, there was upward pressure on prices in Canada from two major shocks—the sharp rise in oil prices following the August 1990 Iraqi invasion of Kuwait and from changes in the goods and services tax. These shocks had led the BoC and the government to be concerned about a deterioration of inflation expectations and the possibility of additional upward pressure on wages and prices. By providing a clear indication of the downward path for inflation over the medium term, the key near-term aim of the targets was to help firms and households see beyond these price shocks to the underlying downward trend at which monetary policy was aiming, and to take this into account in their economic decision making.

Following the initial announcement of the targets in February 1991. inflation fell rapidly, and since 1992, inflation has resided mainly in the lower half of the target range. The speed of the decline in inflation in 1991 caught the authorities by surprise. The decrease reflected a much more severe economic downturn than either the BoC or most other forecasters had expected, owing in part to unexpectedly weak conditions outside Canada, and also to the unwinding of distortions in domestic asset prices associated with the preceding period of inflationary pressures.

There is little evidence to suggest that the 1991 announcement had a significant immediate impact on inflation expectations. Rather, the low realized trend rate of inflation since 1992 was probably the primary factor in shifting inflation expectations downwards (Thiessen, 1998). But the targets may have played a role in convincing the public and markets that the BoC would persevere in its commitment to maintain inflation at the low rates that had been achieved. In more recent years, the BoC has seen indications that the 2 percent midpoint of the target range is becoming an important anchor for current inflation expectations and for long-range corporate planning.

Chile

The abandonment of the crawling peg exchange rate regime in September 1999 can be deemed the start of full-fledged inflation targeting in Chile. This followed a long transition period from September 1990. when the Central Bank of Chile (CBC) announced its first annual inflation target for the following year. The CBC began to announce inflation targets after it obtained autonomy through the new central bank law in October 1989. Moreover, inflation, which had fallen from 30 percent in mid-1985 to about 12 percent at the beginning of 1989, started to rebound, driven by expansionary fiscal policy and increases in oil prices. The CBC’s aim in announcing inflation targets was to gradually reduce inflation by providing a focal point anchor for monetary policy that (until September 1999) was supplemental to the existing crawling exchange rate band. Fixing the exchange rate was not considered a credible alternative because of past failures, and monetary targets were deemed problematic in an environment of developing financial markets and volatile money demand (Morandé and Schmidt-Hebbel, 2000).

Inflation targets are announced annually each September for the December-to-December consumer price inflation rate (Corbo, 2000). From 2001 onwards, the target horizon is indefinite and the target is set similarly to industrial country levels (2–4 percent). This was announced in September 1999 in tandem with the abandonment of the crawling peg exchange rate regime. Target ranges were preferred for the first inflation targets, while point targets were announced after inflation Tell to single digits. Until May 1995, the operating target of the CBC was the real rate on indexed CBC paper of 90-day maturity. Since then, the CBC sets the real daily overnight interbank rate mainly through repurchase and reverse repurchase transactions (Landerretche and others, 1999).

The gradual approach to disinflation over an entire decade reflects the aim to achieve stabilization without incurring substantial output costs, which in an environment of widespread indexation was deemed particularly problematic (Landerretche and others, 1999). Inflation inertia was broken only slowly, and inflation targets and actual inflation rates were brought down in steps of one to two percentage points per year, reflecting a number of supply shocks that temporarily hiked food and energy prices (IMF, 1998a). However, those shocks were offset by the strict stance of fiscal policy—fiscal surpluses had been registered since 1988 (Landerretche and others, 1999). The stabilization efforts were challenged in the aftermath of the Asian and Russian financial crises when the peso came under speculative attack on several occasions. The CBC reacted with a combination of nonsterilized foreign exchange interventions and raised the repo rate substantially to defend the currency. Monetary policy was relaxed at end-1998 as the financial crises subsided, and the temporary recession that followed helped to push inflation down to its current level.

Czech Republic

The Czech National Bank (CNB) adopted an inflation targeting framework in December 1997, and the CNB published a comprehensive statement with details of the new strategy in April 1999. The decision to introduce inflation targeting was motivated by the desire to reduce inflation below a 10 percent threshold, around which it had fluctuated since 1994, against the background of a move to a floating exchange rate regime in May 1997 after speculative attacks prompted by the Asian financial crisis and the Czech Republic’s prospective membership of the European Union.

Prior to inflation targeting, the monetary policy framework of the CNB was built around exchange rate and monetary targets. From 1991 to February 1996, the Czech currency (koruna) was tightly pegged to a currency basket, and the CNB announced growth targets for broad money. The disinflation process was stalled by large capital inflows that limited the CNB’s ability to achieve the domestic dimension of currency stability. With the widening of the exchange rate band in February 1996, the CNB placed more emphasis on monetary targets and the bank was able to raise interest rates to respond to inflationary pressures. Rising external and fiscal imbalances and contagion effects of the Asian crisis triggered speculative attacks against the koruna, however. These were initially resisted with a sharp rise in interest rates before the move to a floating rate (Clinton, 2000). Immediately after the koruna’s flotation monetary policy was based on money growth targets, despite the uncertain and unstable relation between money growth and inflation, together with informal exchange rate targets against the deutsche mark (IMF, 1998b).

The Czech Republic’s inflation targeting framework is marked by several differences with those of other countries. First, the initiative to adopt the new framework was entirely driven by the central bank. The CNB eventually gained support by the government, which incorporated the long-term monetary strategy into the central document that defines the government’s economic policy orientation in the run-up to European Union accession (CNB, 1999c). The CNB’s intention to commit the government to the inflation target is also reflected in the time frame for target announcements, which give the government the opportunity to implement them into its state budget draft (CNB, 1999a). Second, the share of regulated prices in the Czech economy is still relatively high. Consequently, the CNB announces its inflation targets for “net inflation,” which exclude regulated prices and effects of changes in taxes. The index is calculated by the independent Czech Statistical Office to ensure the data’s integrity. Moreover, the CNB has defined a set of escape clauses that justifies deviations from the medium-term inflation target (CNB, 1999a). Third, with the adoption of inflation targeting, the CNB announced a target path for the next three years and its long-run target to be reached by 2005.

The introduction of inflation targets helped to break inflation inertia. The first two inflation targets were undershot and at end-1999 net inflation stood at 0.5 percent while consumer price inflation was somewhat higher at 2.6 percent. The reduction in inflation was brought about by the tight monetary policy stance throughout 1998 as well as the drop in oil and food prices and the compression of domestic and foreign demand. Inflation expectations fell more slowly, however, and came down considerably only at end-1998 after actual inflation had fallen. Thereafter, the CNB gradually eased monetary policy by lowering the repo rate.

Finland

Finland operated an explicit inflation targeting framework from February 1993 until the introduction of the single European currency (euro) in January 1999. It adopted inflation targeting after abandoning the peg of the Finnish currency (markka) to the European currency unit in September 1992. The motive for inflation targeting was to increase the transparency and credibility of monetary policy to create room for lowering interest rates, since Finland’s economy was in a full-scale economic and banking crisis at the beginning of the 1990s. Real GDP shrank by 3 percent a year from 1990–92 in response to falling private consumption and investment as well as the collapse of trade with the former Soviet republics. As a result, Finnish inflation was relatively low at the onset of inflation targeting (2.6 percent in 1992).

The Bank of Finland (BoF) specified its inflation target as an annual average of about 2 percent, measured by the indicator of underlying inflation. For the first target, the BoF allowed for an adjustment path of two years. Because consumer price inflation was thought to obscure underlying inflation trends, the effect of taxes, subsidies, house prices, and mortgage costs were excluded in the inflation target (Pikkarainen and Tyväinen, 1993). In contrast to oilier inflation targeting central banks, the BoF never published an inflation report and the transparency of monetary policy remained relatively low. Also, changes in its operating procedures were communicated with a lag. From December 1994 onwards the BoF conducted repurchase agreements—its main policy instrument—entirely through volume tenders to give the market clear guidance and to reduce the fluctuations in interest rates (Pikkarainen, 1996). And, the BoF gained de sure political independence relatively late, in January 1998, when the Bank of Finland Act was amended according to the requirements of the second stage of European Economic and Monetary Union.

Despite the sharp depreciation of the Finnish markka at end-1992 and the beginning of 1993, inflation was subdued below its target rate nearly from the first day of inflation targeting. The initial reduction of inflation, however, reflected the outcome of the severe depression rather than monetary policy. Inflation expectations remained above the target rate until 1995. Only when the new government announced a fiscal consolidation package and the BoF decisively tightened monetary policy, did inflation expectations fall considerably. As a consequence, the markka recovered to its level before the currency’s flotation and the strengthening of the overall economic situation.

A special feature of Finland’s inflation targeting framework was the country’s gradual move toward European integration. Finland became a member of the European Union in January 1995, joined the Exchange Rate Mechanism (ERM) of the European Monetary System with a band of ±15 percent in October 1996, and in May 1998 was chosen to be among the countries that would adopt the euro in January 1999. The move to the wide band of the ERM did not impose any constraints on the BoF’s monetary policy; although the pass-through from exchange rate movements to inflation had weakened with the markka’s flotation (Tyväinen, 1997), the BoF held the markka in a rather narrow corridor of about ±2.5 percent to the deutsche mark.

Israel

Israel began its transition toward inflation targeting in conjunction with the announcement of a crawling exchange rate band in December 1991 and can be said to have moved to a full-fledged inflation targeting framework with the widening of the exchange rate band to 28 percent in June 1997. The adoption of inflation targets in Israel took place after inflation had successfully been brought down from triple digit numbers during the mid-1980s to the 15 to 20 percent range. At the same time, however, the gradual liberalization of financial markets, and capital restrictions increasingly made it more difficult and costly to defend the currency. The Israeli currency (shekel) was devalued several times between 1986 and 1991, and after another speculative attack at end-1991 Israel switched from a peg to a crawling band with a width of ±5 percent. Inflation targets became an integral part of this new framework since they helped to define the upward slope of the crawl. Since then, the width of the exchange rate band has been increased on several occasions and the focus of monetary policy has shifted toward inflation targeting (Leiderman and Bufman, 2000).

The institutional and operational features of Israel’s inflation targeting framework evolved over time. The targets are set annually for the December-over-December change in the consumer price inflation (CPI). The CPI is the preferred price index because indexation of financial and wage contracts to CPI is still widespread (Bernanke and others, 1999). Nevertheless, the Bank of Israel (BoI) also pays close attention to different measures of underlying inflation when making its policy decisions. The first three annual inflation targets were announced jointly by the Ministry of Finance (MoF) and the BoI; thereafter, the targets were announced by the MoF in consultation with the BoI. On a few occasions, the BoI considered the targets to be lenient and publicly raised their reservations.

In the first three years, very narrow target ranges or point targets were announced to focus expectations. After the 1994 target was overshot by about 6 percentage points, the point targets were replaced by target ranges of 2 or 3 percentage points wide. An explicit medium-term orientation for monetary policy was established in 1996 when the government announced a long-term objective of bringing inflation down to the average rate of the Organization for Economic Cooperation and Development (OECD) countries by 2001. In 1999, the MoF announced two-year targets of 3–4 percent for 2000 and 2001. The BoI only recently started publishing semi-annual inflation reports (March 1998), but it refrains from making explicit quantitative inflation forecasts. The quarterly published statements of “Recent Economic Developments” are entirely backward looking. Since August 1998. the BoI governor is required to publicly explain deviations of expected inflation from the target of more than one percentage point.

Overall, Israel’s experience with inflation targeting can be broadly considered a success. Most inflation targets were met and inflation came down from 18 percent at end-1991 to about 1 percent at end-1999. Until 1998, however, the pace of disinflation was rather slow and Israel experienced three episodes of inflation pressures: in late 1994, the first half of 1996, and late 1998 (Leiderman and Bar-Or, 2000). The Bol’s decisive tightening of monetary policy in 1994 to counteract the strong target overshooting by 6 percentage points is viewed as a critical point for the overall success of the framework. In 1994, the BoI also emphasized the role of the inflation target and made clear that in case of conflicts with the exchange rate target, the former would take precedence (Bernanke and others, 1999). Ambiguity on this point before 1994 has contributed to the rise in inflation expectations (Leiderman and Bar-Or, 2000). Tight monetary policy at end-1998, which was hardly eased over the course of 1999, and the slowdown in economic activity that year brought inflation down in the last quarter of 1999 to its long-run path (Bank of Israel, 2000). Disinflation was facilitated by trend improvements in productivity, reflecting immigration and structural policies, as well as a program of fiscal consolidation.

New Zealand

New Zealand was the first country to adopt inflation targeting in December 1989 with the passage of the Reserve Bank of New Zealand Act (RBA). New Zealand’s long experience with high and variable inflation helps explain its early adoption of inflation targeting—consumer price inflation rose almost fivefold during the 15 years of generally disappointing economic performance triggered by the oil shock of 1973. A brief but temporary full in inflation to below 5 percent in the early 1980s was made possible only by distortionary wage and price freezes. Throughout the period, monetary policy faced multiple and varying objectives that were seldom clearly specified and not consistent with low inflation. In the mid-1980s, however, the government adopted the principle that all of its funding requirements would be met directly from private markets, a broad structural reform program was set in motion, and the exchange rate was floated. These policies helped bring inflation down from 17 percent to around 5 percent at the time that inflation targeting was adopted.

The institutional framework for inflation targeting includes several unusual elements. The RBA mandates “stability in the general level of prices” as the primary objective of monetary policy. Parliament chooses the objective and requires the Minister of Finance and the governor to select a specific target. The publicly announced Policy Targets Agreement (PTA) between the minister and the governor stipulates that annual changes in consumer price inflation lie between a prespecified range (subject to caveats). In the event of a breach of the target, the finance minister requests the nonexecutive directors of the Reserve Bank to make an explanation of the reasons for the breach and the actions necessary to bring inflation back within the range. While the finance minister has explicit power to remove the governor, this option has not been seriously considered even on occasions when the target has been breached.

As the inflation targeting “pioneer,” New Zealand has implemented important changes in this framework over the past decade (Bernanke and others, 1999; Sherwin, 2000). First, the inflation target range was widened to 0–3 percent in December 1996, from 0–2 percent following the election of a coalition government. The range was widened in response to the public perception that the previous range was too narrow to be credible, as well as instrument instability. Second, the parameters of the inflation target range, which were initially seen as bounded by “electric fences,” have been made more flexible in recent years. Third, the policy horizon was extended from around one year initially to one and a half years in response to the greater weight assigned to the indirect as opposed to the direct impact of the exchange rate on inflation. Fourth, operating targets and indicators have evolved in response to structural changes and the changing policy transmission channels. The attention paid to real sector inflation indicators as policy guides earlier on gave way to a focus on the trade-weighted exchange rate index and interest rates because of their relatively strong relationship with inflation. Beginning in June 1997, policy was formulated in terms of a monetary conditions index band. The subsequent pickup in interest rate volatility led to the adoption of an overnight interbank cash rate operating target in March 1999, however.

New Zealand’s experience with inflation targeting has been positive, notwithstanding the economy’s inherent vulnerability to external shocks and the lack of international experience upon which it could draw. Inflation declined to the average rate for OECD countries, from rates above the average. In addition, spreads between New Zealand bonds and U.S. bonds have narrowed considerably. This success reflects the willingness to “learn by doing,” as well as the panoply of policy changes undertaken by the national authorities.

Poland

The National Bank of Poland (NBP) announced that it would adopt inflation targeting in September 1998, but the actual start of full-fledged inflation targeting can be marked by the widening of the exchange rate band in March 1999. Inflation targeting is viewed as the most effective way to reduce inflation and pave the way for European Union membership. Monetary targeting was not considered a workable alternative because the money multiplier and money demand remain very unstable (National Bank of Poland, 1998).

Beginning in 1995, simultaneous achievement of domestic and external stability of the currency was complicated by strong capital inflows in the context of Poland’s commitment under the OECD capital code to remove all remaining capital restrictions by December 1999 (IMF, 1999a). The NBP sterilized capital inflows by selling its entire portfolio of negotiable Treasury securities and issuing NBP bills. In addition, the NBP increased the flexibility of the exchange rate. In May 1995, a crawling band was announced that followed the crawling peg that was in place since October 1991. The band was widened over time and the crawl slowed. Nevertheless, the Polish currency (zloty) experienced a cumulated real appreciation that contributed to the worsening of the current account. Also, nominal short-term interest rates remained very high and real short-term interest rates increased considerably as inflation was brought down faster than expected.

The new National Bank of Poland Act that came into effect in January 1998 defines the NBP’s primary objective as price stability and provides the NBP with instrument independence. The new constitution of the Republic of Poland prohibits central bank financing of public deficits. The NBP Act also created a new policymaking body that announced at its first meeting in February 1998 a December-to-December inflation target for 1998 of 9,5 percent or less. In September 1998, the NBP published its medium-term strategy of lowering inflation to 4 percent by 2003 (National Bank of Poland, 1998), coincident with Poland’s preparations for accession to the European Union. The annual target was set at 8.0 to 8.5 percent for 1999. When disinflationary pressures appeared to be stronger than expected, however, the NBP lowered the 1999 target to 6.6 to 7.8 percent in March 1999. At the same time, the NBP widened the exchange rate band to ±15 percent—equivalent to the exchange rate band of the Exchange Rate Mechanism (ERM) of the European Monetary System. In April 2000, Poland moved to a full float.

Poland’s short experience with inflation targeting has been somewhat mixed. It is characterized by initial reductions in inflation and inflation expectations in a difficult macroeconomic environment of widening fiscal and current account deficits. During this time, the NBP lowered the 28-day NBP bill rate from 24 percent in February 1998 to 13 percent in August 1999. From March 1999, year-over-year inflation rose from 6 percent to more than 10 percent at the beginning of 2000, however, resulting mainly from rising oil and commodity prices, the depreciation of the zloty, and fiscal imbalances. In response, the NBP raised the NBP bill rate to 17.5 percent. The resulting appreciation of the zloty. which widened the current account deficit, further complicated monetary policy.

Important challenges remain with respect to Poland’s inflation targeting framework (NBP, 1999b). First, the process of transmitting central bank signals to the economy is still distorted due to excess liquidity and the institutional structure of the banking sector. Second, deficiencies in the availability and quality of statistical data remain that make it difficult to identify inflationary pressures on a timely basis. The NBP is addressing both of these issues. Third, the expansionary stance of fiscal policy is regarded as an impediment to a further reduction in inflation.

South Africa

South Africa is the latest country to introduce a full-fledged inflation targeting framework. After a preparatory period, the Minister of Finance announced the adoption of inflation targeting in his budget speech in February 2000 (Manuel, 2000). The new policy framework is considered a formalization of the “implicit inflation targeting” or “eclectic monetary policy approach” that the South African Reserve Bank (SARB) has followed since 1997. Even though the SARB continued to announce intermediate targets for the growth of M3 until 1999, M3 no longer served as the primary indicator for policy decisions, since its relation to inflation had weakened severely due to financial liberalization and huge increases in transactions in money and capital markets (Stats, 1999). Even with frequent overshooting of the intermediate target, inflation in South Africa remained on a downward trend, notwithstanding exchange rate depreciations in 1996 and 1998. The move to an explicit inflation targeting framework occurred in times of relative economic stability and was deemed advantageous in light of the lack of coordination between the SARB and the government (Mboweni, 1999).

South Africa’s government announced its first inflation target after consultations with the SARB. The target is defined as an annual average inflation rate of 3–6 percent, measured by consumer price inflation excluding mortgage costs (CPIX) to be achieved for the year 2002. A headline inflation index is considered to be the best understood and most credible index. The target range reflects the uncertainties about the inflation process and the required discretion in monetary policy. The time horizon was chosen to account for the lags between monetary policy actions and inflation, which for South Africa are estimated to lie in the range of 18 to 24 months (Mboweni, 1999). The SARB’s operational procedures were left unchanged following the introduction of the inflation targeting framework. The SARB will continue to steer the overnight rate through daily repurchase agreements.

The formal adoption of inflation targeting followed a preparatory phase of about two years. During this lime, the SARB made important changes in its decision-making process and communication policies to increase its transparency and accountability. The SARB partly reorganized its structure, drawing on the expertise of inflation targeting central banks and the IMF. For the formulation of monetary policy, the SARB established a Monetary Policy Committee in August S999 consisting of the governor and the three deputy governors as voting members and senior SARB nonvoting members. After each MPC meeting, the monetary policy stance is publicly explained. With the creation of a Monetary Policy Forum that meets twice a year, the SARB has set the stage to better communicate its policy to its shareholders and “interested parties” (Mboweni, 2000). In addition, the SARB publishes a semiannual Monetary Policy Review to describe policy decisions in detail and to analyze potential effects on inflation. The SARB has also created a fully fledged Media Office that is concerned with external communication. To build the necessary expertise for inflation forecasting, the SARB restructured its Research Department, enhanced its computer capacity, and is enlisting the help of experts from other central banks to develop a small-scale model designed specifically for inflation forecasting purposes (Mboweni, 1999a,b).

Spain

The Bank of Spain (BoS) announced in December 1994 its intention to adopt an inflation targeting framework from January 1995 and it operated under this framework until Spain entered the European Economic and Monetary Union in January 1999. The decision to target inflation came in response to the Law on the Autonomy of the BoS as required by the 1993 Maastricht Treaty on European Union. The law defines price stability as the primary objective of monetary policy, provides the BoS with instrument independence, prohibits financing of government expenditure, and specifies measures for transparency and accountability (Gutiárrez, 1998). In addition to these institutional changes, the introduction of inflation targeting was motivated by the widening of the exchange rate band of the Exchange Rate Mechanism (ERM) of the European Monetary System to ±15 percent in August 1993, and the weakening of the link between monetary aggregates and nominal income. Since 1984, the BoS had announced annual intermediate targets for the growth of broad money (Ayuso and Escriva, 1998). After Spain entered the ERM in June 1989, the monetary targets were subordinated to the exchange rate target. When the exchange rate band ceased to be the nominal anchor for monetary policy, monetary targeting was not reactivated because money demand was seen as no longer stable (Vega, 1998). Under the inflation targeting framework, broad money growth continued to play a role as the leading indicator (Gutiárrez, 1998).

The BoS specified its first inflation target as a reduction of consumer price inflation to less than 3 percent over the course of the following three years. Defining the target in terms of CPI, rather than as an underlying inflation index, was thought to enhance the simplicity and transparency of the target. For the same reasons, the BoS refrained from defining escape clauses (Gutiárrez, 1998). The announcement of the first target was timed to coincide with a value-added tax (VAT) increase that took effect on January 1, 1995, and a strengthening of the economy. Thus, unlike most other countries, Spain adopted inflation targeting at a time when the targets would immediately be put to the test (Bernanke and others, 1999). When it became apparent that the VAT pass-through was not significant, the BoS specified the transition path to the medium-term inflation target and announced a target inflation range of 3.5 to 4 percent in 1996. The targets were then reduced to 2.5 percent for 1997 and to 2 percent for 1998.

Spain’s inflation targeting framework also comprised a range of accountability mechanisms and communication vehicles. The governor was held accountable for monetary policy by reporting regularly to the Parliament and appearing before Congress and the Senate. From March 1995, the BoS published semiannual inflation reports, which did not include any quantitative inflation forecasts, however, since their publication was regarded as of “secondary importance” and could “result in the wrong signals being sent to agents” due to the underlying uncertainty (Gutiárrez, 1998).

During its four-year period of inflation targeting, inflation in Spain fell to its lowest levels in decades. Over the first year, however, monetary policy faced several challenges. Despite the rise in central bank rates in response to inflation uncertainties, the Spanish currency (peseta) came under speculative pressure in March 1995 and was devalued (Gutiárrez, 1998). The BoS continued to tighten monetary policy until December 1995, when actual inflation reached 4.3 percent and the peseta strengthened considerably. Inflation expectations fell continuously, the peseta moved above its central parity, leading to a reduction of the repo rate, and the interest rate differential with German rates narrowed. This development was supported by a tightening of fiscal policy, undertaken to fulfill the fiscal convergence criteria of European Economic and Monetary Union (EMU) (Bernanke and others, 1999). Ultimately, Spain’s consumer price inflation fell below 2 percent and long-term interest rates fell below 4 percent, qualifying Spain to become a starting member of European Economic and Monetary Union.

Sweden

The Sveriges Riksbank (central bank) announced that it would adopt an inflation targeting framework on January 15, 1993—eight weeks after it abandoned its currency peg to the European Currency Unit (ECU). Sweden let its currency (krona) float after a sustained defense in 1992 to numerous speculative attacks on the krona through high interest rates. By September 1993, the overnight interest rate had been raised to 500 percent—an interest rate level that was untenable.

Sweden’s macroeconomic situation at the beginning of the 1990s was characterized by serious imbalances. Inflation averaged 10 percent, unemployment more than tripled from 1990 to 1992, the fiscal deficit increased sharply, and the current account deficit widened. With the widespread support of the Swedish public and government, the Riksbank adopted an inflation targeting regime as part of a stabilization package that emphasized price stability. The inflation target—defined as 2 percent consumer price inflation with a degree of tolerance of ±1 percent—was to be achieved by the beginning of 1995.

Sweden was one of the pioneer countries to adopt inflation targeting and the institutional features of its framework evolved over time. The two most prominent changes were associated with the transparency of monetary policy and central bank independence, both of which were initiated in 1997. The Riksbank published quantitative inflation forecasts for the first time in its inflation report in December 1997. Since June 1999. the Riksbank has indicated the uncertainty of inflation forecasts through “fan charts” for a horizon of 24 months. Based on these changes, the Riksbank distinguishes three phases of its inflation targeting regime (Berg, 1999): the establishment of inflation targeting (1993–95), the communication of explicit inflation forecasts (1996–97). and the introduction of distribution forecast targeting (since 1998). The Riksbank also announced at the beginning of 1999 that it will indicate in advance when deviations from the inflation target are justified due to transitory effects (Heikenstein, 1999).

The Riksbank gained de jure independence from political influence through the amendments to the Riksbank Act that came into force in January 1999. Under the new law, maintaining price stability is the primary objective of monetary policy, the Riksbank is free from government instructions, and the Executive Board was created as the new executive body of the central bank (Heikenstein and Vredin, 1998). Transparency and accountability of the Riksbank were further enhanced by publishing the minutes of Executive Board meetings with a lag of six to eight weeks, and the requirement to make a written report on monetary policy to the parliamentary standing committee at least twice a year.

The Swedish experience with inflation targeting can be judged a success. Credibility of monetary policy was quickly achieved, although the inflation targeting regime was not very transparent in the introductory phase. The Swedish experience shows that deeds and the support of the government rather than the institutional setting can help dampen inflation expectations. Steady fiscal consolidation after the adoption of inflation targeting also enhanced its credibility. Inflation was brought down to the target level within two years and remained low thereafter. The success of inflation targeting was supported by aggregate demand and supply shocks and temporary factors that put inflation on a downward trend. Inflation expectations average around 2 percent over the inflation targeting period. Although exchange rate variability has remained relatively high, the pass-through to consumer price inflation has weakened mainly because exchange rate movements are perceived to be temporary (Berg, 1999).

United Kingdom

In October 1992, the Chancellor of the Exchequer announced the adoption of inflation targeting as the Bank of England’s (BoE) new monetary policy framework after the United Kingdom had exited the Exchange Rate Mechanism (ERM) of the European Monetary System one month earlier. Inflation targeting was to provide a new nominal anchor and restore credibility. Monetary targeting was not viewed as a viable alternative since money demand instabilities had rendered the use of broad money and base money intermediate targets unsuccessful during the 1970s and 1980s.

At the onset of the new policy framework, the United Kingdom’s macroeconomic situation was characterized by contained inflation, weak domestic demand despite a slight rebound of the real economy after the 1990—91 recession, and stricter fiscal policy. The two-year episode of exchange rate targeting within the ERM had contributed to a reduction in inflation by more than six percentage points, to about 3½ percent in September 1992. Despite the sharp depreciation of the pound, the macroeconomic environment was therefore favorable to locking in the disinflation successes and achieving the first inflation target. However, inflation expectations, which had fallen to about 4 ½ percent prior to the depreciation, surged after the exchange rate crisis, to more than 6 percent (Haldane, 2000), indicating the need for a tight, clear, and transparent monetary policy.

The United Kingdom was at the forefront in establishing a formal inflation targeting framework. The BoE’s early publication of a comprehensive inflation report and the bank’s efforts to formalize its forecasting framework, including the publication of “fan charts,” were innovative. The strong efforts undertaken by the BoE in the area of inflation forecasting and its means of communication and accountability are viewed to reflect the bank’s limited control over instruments before gaining instrument independence in May 1997 (Bernanke and others, 1999). Instrument independence granted to the BoE’s newly created Monetary Policy Committee (MPC) contributed to an immediate reduction in inflation expectations, by about 0.5 percentage point (Haldane, 2000). The Bank of England Act, which came into force in June 1998, provided the statutory basis for the changes undertaken. The Act also sets out price stability as the main objective of monetary policy and assigns the Treasury the definition of price stability (Rodgers, 1998).

The United Kingdom’s inflation targeting framework is characterized by the following features. The Treasury sets inflation targets in each Budget Statement; targets are currently at 2.5 percent for retail price inflation excluding mortgage payments (RPIX). The point target is viewed as advantageous compared to the 1–4 percent target range, which was used in 1992–95 because it helps to remove any ambiguity about monetary policy, eliminates the “range bias” of inflation expectations, and makes transparent the symmetry of policy actions (Haldane, 2000). The BoE’s communications means comprise the quarterly publication of inflation reports, including inflation forecasts for two-year horizons with uncertainty ranges ("fan charts"), the announcement of MPC’s decisions immediately after the meetings, the publication of the MPC meeting minutes and votes with a two-week lag, and frequent speeches given by the MPC members to explain the BoE’s monetary policy. To enhance accountability, the Governor of the MPC is required to send an open letter to the Chancellor of the Exchequer as soon as inflation deviates by one percentage point or more from the point target. The letter must explain the reasons for the target deviations, policy measures intended to betaken, and the estimated time horizon envisaged to return to the target path (Rodgers, 1998).

The United Kingdom has not experienced target breaches since the introduction of the inflation targeting framework. The general success of inflation targeting reflects the improving fiscal position. The gaining of credibility was not always smooth, however; on a number of occasions, the government and the BoE have disagreed on the monetary policy decisions to be taken, with the BoE assessing inflationary dangers higher than the government. This raised uncertainty and affected inflation expectations, which was eliminated only when the BoE received instrument independence. Since then, inflation expectations have been near the 2.5 percent target (Haldane, 2000).

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