In recent years, emerging market countries have joined industrial countries in adopting monetary policy frameworks of formal inflation targeting. Motivated by increased demand by emerging market countries for IMF technical assistance on inflation targeting, this paper examines the institutional and operational practicalities of inflation targeting for emerging market countries adopting this regime. The paper spells out the trade-offs raised in the formulation of an inflation targeting framework and describes the approaches to these trade-offs used by inflation targeting countries.
This paper is founded on the body of knowledge formed by the years of industrial country experience with inflation targeting, as well as the more recent formulation of inflation targeting frameworks by emerging market countries. The countries identified here as practitioners of inflation targeting are those considered to have adopted most of the elements of a full-fledged inflation targeting framework (Figure 1.1).
Inflation Rate at Adoption of Inflation Targeting
Sources: Central bank websites and reports; Bernanke and others (1999); IMF, International Financial Statistics. See Table 4.1 of this report.Note: Emerging market countries are in bold.Inflation Rate at Adoption of Inflation Targeting
Sources: Central bank websites and reports; Bernanke and others (1999); IMF, International Financial Statistics. See Table 4.1 of this report.Note: Emerging market countries are in bold.Inflation Rate at Adoption of Inflation Targeting
Sources: Central bank websites and reports; Bernanke and others (1999); IMF, International Financial Statistics. See Table 4.1 of this report.Note: Emerging market countries are in bold.The experience of these countries suggests that the foundations for successful, full-fledged inflation targeting are built on the following: a strong fiscal position and entrenched macroeconomic stability; a well-developed financial system; central bank instrument independence and a mandate to achieve price stability; a reasonably well understood transmission mechanism between monetary policy actions and inflation; a sound methodology for constructing inflation forecasts; and transparency of monetary policy to build accountability and credibility. Many of these elements, especially a strong fiscal position, are needed for sound monetary policy regardless of the policy objective. In addition, these elements do not need to be in place before a country begins the transition toward full-fledged inflation targeting.
The inherent differences reported in this paper 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. The inflation targeting economies are large, relatively well developed, and have more developed domestic financial systems compared to their counterparts, suggesting that these attributes should be carefully considered by other emerging market countries thinking of adopting this regime. Moreover, experience has shown that a strong fiscal position and entrenched macroeconomic stability are equally important elements of the foundation for successful inflation targeting.
Synopsis of Inflation Targeting Frameworks
Synopsis of Inflation Targeting Frameworks
| Institutional Framework | ||
|---|---|---|
| Central bank legal framework | Instrument independence and currency or price stability is a central bank objective in all cases. Central bank financing of government deficit is limited or prohibited in all emerging market countries. | |
| Design of the inflation target Announcement of target | Announced by government or jointly by government and central bank, unless the central bank has an explicit mandate for price stability as the primary objective. | |
| Target horizon | Indefinite for countries at longer-run inflation race and annual for countries in disinflation. | |
| Price index | Consumer price index for most emerging market countries and core inflation for most industrial countries. | |
| Formal escape clauses | Only used by several countries. | |
| Point target or target range | Target range preferred by most countries given uncertainties associated with hitting targets. Point targets have been adopted in some cases to focus inflation expectations. | |
| Accountability and transparency | Press releases of policy changes, regular inflation outlook reports, active dialogue with the private sector, and in some cases, publication of inflation forecasting models. | |
| Operational Issues: Conduct of Monetary Policy | ||
| Inflation forecasting | Based on indicator variables, quantitative economic models, discussions with market participants, and, especially for emerging market countries, qualitative judgment. | |
| Policy transmission channels | Emerging market countries with higher rates of inflation have channels characterized by downward price stickiness and rapid exchange rate pass-through. | |
| Policy implementation | All countries use market-based instruments to target a short-term interest rate. Changes in official interest rates reflect deviations of inflation from the target and the output gap. | |
| Changing economic relationships | As inflation targeting framework gains credibility, linkages between inflation and the level of economic activity seem to weaken. | |
| Responding to economic and financial shocks | Responses to external shocks range from doing nothing to a mixture of foreign exchange intervention and tighter monetary policy, depending on whether shocks are expected to affect inflation expectations or the stability of the financial system. | |
| Breaches of the inflation target | Asymmetric responses to breaches of floor and ceiling during disinflation, and symmetric responses when inflation is at the long-run level; breaches do not seem to have damaged credibility. | |
| Organizational Implications for Central Banks | ||
| Internal decision making | Many central banks have incorporated a broader range of perspectives and decentralized their organizational structure to enhance judgment-based decision making. | |
| Monetary policy committees | Most central banks have formal committees. Consensus decisions are typically published while voting records are not. | |
| Central bank organization | Emerging market central banks have reorganized to improve data collection, inflation forecasting, and policy analysis. | |
| Transition Issues | ||
| Disinflation | Emerging market countries that started with higher inflation and crawling exchange rate bands disinflated over a long period to minimize output disruptions. | |
| Long-run inflation objective | Consensus of around 1–3 percent for industrial countries and somewhat higher for emerging market countries. | |
| Shifting from a fixed exchange rate regime | Slow and fast-track transitions from an exchange rate regime to full-fledged inflation targeting framework for emerging market countries. | |
Synopsis of Inflation Targeting Frameworks
| Institutional Framework | ||
|---|---|---|
| Central bank legal framework | Instrument independence and currency or price stability is a central bank objective in all cases. Central bank financing of government deficit is limited or prohibited in all emerging market countries. | |
| Design of the inflation target Announcement of target | Announced by government or jointly by government and central bank, unless the central bank has an explicit mandate for price stability as the primary objective. | |
| Target horizon | Indefinite for countries at longer-run inflation race and annual for countries in disinflation. | |
| Price index | Consumer price index for most emerging market countries and core inflation for most industrial countries. | |
| Formal escape clauses | Only used by several countries. | |
| Point target or target range | Target range preferred by most countries given uncertainties associated with hitting targets. Point targets have been adopted in some cases to focus inflation expectations. | |
| Accountability and transparency | Press releases of policy changes, regular inflation outlook reports, active dialogue with the private sector, and in some cases, publication of inflation forecasting models. | |
| Operational Issues: Conduct of Monetary Policy | ||
| Inflation forecasting | Based on indicator variables, quantitative economic models, discussions with market participants, and, especially for emerging market countries, qualitative judgment. | |
| Policy transmission channels | Emerging market countries with higher rates of inflation have channels characterized by downward price stickiness and rapid exchange rate pass-through. | |
| Policy implementation | All countries use market-based instruments to target a short-term interest rate. Changes in official interest rates reflect deviations of inflation from the target and the output gap. | |
| Changing economic relationships | As inflation targeting framework gains credibility, linkages between inflation and the level of economic activity seem to weaken. | |
| Responding to economic and financial shocks | Responses to external shocks range from doing nothing to a mixture of foreign exchange intervention and tighter monetary policy, depending on whether shocks are expected to affect inflation expectations or the stability of the financial system. | |
| Breaches of the inflation target | Asymmetric responses to breaches of floor and ceiling during disinflation, and symmetric responses when inflation is at the long-run level; breaches do not seem to have damaged credibility. | |
| Organizational Implications for Central Banks | ||
| Internal decision making | Many central banks have incorporated a broader range of perspectives and decentralized their organizational structure to enhance judgment-based decision making. | |
| Monetary policy committees | Most central banks have formal committees. Consensus decisions are typically published while voting records are not. | |
| Central bank organization | Emerging market central banks have reorganized to improve data collection, inflation forecasting, and policy analysis. | |
| Transition Issues | ||
| Disinflation | Emerging market countries that started with higher inflation and crawling exchange rate bands disinflated over a long period to minimize output disruptions. | |
| Long-run inflation objective | Consensus of around 1–3 percent for industrial countries and somewhat higher for emerging market countries. | |
| Shifting from a fixed exchange rate regime | Slow and fast-track transitions from an exchange rate regime to full-fledged inflation targeting framework for emerging market countries. | |
In contrast to industrial countries, emerging market countries tend 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. Emerging market countries usually modify the central bank legal framework before adopting inflation targeting, however, 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 their much higher and more variable rates of inflation compared to industrial countries, less developed financial systems, greater vulnerability to inflationary monetization of government debt, and greater susceptibility to exchange rate crises.
Differences in the operation and design of inflation targeting between emerging market and industrial countries are another theme of this paper. Central banks in emerging market countries rely less on statistical models in the conduct of monetary policy. They 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 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.
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 of these banks 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, during the transition to full-fledged inflation targeting, several emerging market countries have confronted 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 saddling the central bank with conflicting objectives.
