Inflation Targeting in the Context of IMF-Supported Adjustment Programs

This paper argues that the IMF's traditional monetary conditionality-a ceiling on net domestic assets of the central bank and a floor on its net international reserves-should be adapted in IMF-supported adjustment programs with countries which have a framework of explicit inflation targets for the implementation of monetary policy. This adaptation should aim at enhancing correspondence and consistency between the monetary objectives of the central bank and the targets established under the IMF-supported adjustment program, as well as between the different instruments used to achieve the policy objectives and targets. The paper reviews various general options in this regard, and, using the case of Brazil as an example, demonstrates how these options may be implemented in practice.

Abstract

This paper argues that the IMF's traditional monetary conditionality-a ceiling on net domestic assets of the central bank and a floor on its net international reserves-should be adapted in IMF-supported adjustment programs with countries which have a framework of explicit inflation targets for the implementation of monetary policy. This adaptation should aim at enhancing correspondence and consistency between the monetary objectives of the central bank and the targets established under the IMF-supported adjustment program, as well as between the different instruments used to achieve the policy objectives and targets. The paper reviews various general options in this regard, and, using the case of Brazil as an example, demonstrates how these options may be implemented in practice.

I. Introduction

Since the beginning of its implementation a few years ago, the staff of the IMF has been engaged in assessing the functioning and effectiveness of inflation targeting in IMF member countries that adopted this scheme as their monetary policy anchor. However, as inflation targets were first embraced by various industrialized economies, this involvement was restricted to the IMF’s surveillance function; i.e., it was part of the macroeconomic analysis performed during the regular annual consultations between the IMF and its member countries, and not associated with IMF lending operations.

In recent years, however, a number of emerging market economies have abandoned their fixed exchange rate regimes and moved toward a flexible exchange rate system with an explicit inflation targeting framework for monetary policy. In this context, it became increasingly likely that the IMF would face a situation in which it would be called upon to provide financial assistance—and therefore agree on a financial program—with a country that is using, or has decided to adopt, explicit inflation targets as the key component of its monetary policy framework. Indeed, shortly after adopting a floating exchange rate regime in mid-January 1999, the Brazilian authorities announced their intention to put in place a formal inflation targeting framework and, in the months that followed, the framework was implemented in the context of the ongoing IMF-supported adjustment program.

These developments posed particular analytical and practical challenges in terms of the operational procedures of the IMF in its financial relations with its member countries. The challenge resulted from the need to reconcile the inflation targeting framework with the conceptual and practical aspects of conditionality. Conditionality is the device utilized by the IMF in its financial programs, to establish safeguards that would increase the certainty that its resources are only used temporarily. This, in turn, implies the adoption of so called performance criteria, i.e., formal quantitative targets on a defined number of variables, agreed between the member country and the IMF. The evolution of these variables is subject to verification, and the fulfillment of these criteria are the condition for a disbursement to take place. In the monetary policy area, performance criteria in Fund programs have traditionally been set in terms of specific quantitative limits on the evolution of certain monetary variables. Typically, a floor is set for the level of net international reserves (NIR) and a ceiling is established on the net domestic assets (NDA) of the central bank.

At first sight, therefore, it would appear that the inflation targeting framework, by the very nature of its operating procedures, may not be compatible with the traditional monetary conditionality framework usually embodied in Fund-supported adjustment programs. This is so because the actual implementation of inflation targeting is largely based on the premise that an independent central bank can use, at its own discretion, its various policy instruments, in the proportions considered appropriate in each particular circumstance, so as to ensure the attainment of its inflation goal. This seems to clash with a scheme that sets explicit and somewhat rigorous quantitative objectives for key monetary variables.

In these circumstances, and considering that it is the prerogative of each member country to adopt a monetary policy framework of its choice, the IMF faced the question of whether and how to adapt monetary conditionality to the specific features of monetary policy under inflation targeting. In general, it was concluded that, in principle, inflation targeting could be accommodated within the traditional structure of monetary conditionality in Fund-supported adjustment programs, given that this conditionality focuses primarily on a program’s balance of payments objective. At the same time, it was also recognized that it may be desirable to modify and supplement traditional monetary conditionality by introducing features that reflect the specific functioning of the inflation targeting framework.2

The main objective of this paper is, therefore, to consider the issues that arise from the adoption of inflation targeting in the context of the conditionality embodied in Fund-supported adjustment programs, and to discuss a number of options for adapting the monetary conditionality of the programs to these particular cases. The next section briefly reviews in more detail the role of monetary conditionality in Fund-supported adjustment programs; section III discusses traditional monetary policy conditionality and consider the practical problems that may arise in the context of inflation targeting; section IV explores different options for implementing and strengthening monetary policy conditionality in the context of inflation targeting; section V shows, briefly, how monetary conditionality was adapted to inflation targeting in the context of the stand-by arrangement with Brazil; and section VI tests how some of the alternative options, particularly simple Taylor rules, would have fared during the first year of operating under the inflation targeting framework in Brazil. Finally, the paper presents some general conclusions, preliminary in nature, that are largely intended to stimulate further discussion.

II. Fund-Supported Adjustment Programs: The Role of Conditionality

In Fund-supported adjustment programs (henceforth Fund programs), conditionality refers to the linkage between the achievement of a set of policy objectives and the continuous access to IMF resources.3 The policy objectives are agreed between the IMF and the authorities of the IMF member country and, while the specific objectives vary from country to country, attaining a viable balance of payments position is the sine qua non target in every Fund program. In this sense, conditionality provides a safeguard for the IMF’s financial resources. The specification of the policy objectives and calibration of the quantitative targets, should ensure that the need for such financing is only temporary and that the borrowed funds will be repaid. Put another way, conditionality provides a yardstick for evaluating whether the policies that are being carried out are moving the country toward the achievement of the policy objectives, in particular a sustainable external balance. By doing so, conditionality also ensures the temporary use of the IMF’s resources.

The effective implementation of conditionality does not involve day-to-day monitoring of a country’s macroeconomic policies but requires a mechanism for assessing whether policies are on track for achieving their stated goals, or whether they need to be adjusted in response to unanticipated shocks, changes in economic relationships, or other new information. The monitoring mechanism in Fund programs consists of a set of explicit criteria—particularly performance criteria, but also indicative targets, and structural benchmarks—that should be met if a country wishes to make further drawings under the Fund program. These performance criteria typically refer to key macroeconomic variables— fiscal and monetary policy outcomes, including fiscal balances (e.g., overall or primary balances), indebtedness (e.g., public sector debt, public external debt, and its short-term component), and monetary variables, such as NIR and NDA4—that indicate whether macroeconomic policies are on track. Also, Fund programs may include performance criteria related to certain structural reform measures (structural benchmarks). While performance criteria permit a backward-looking assessment of policies, periodic program reviews, which are often carried out quarterly, provide for a forward-looking overall assessment of the Fund program vis-à-vis the government’s macroeconomic policy objectives.

Quantitative macroeconomic performance criteria in Fund programs do not typically rely on a specific macroeconomic model. They do, however, make use of various balance-sheet identities that link monetary and fiscal variables with the balance of payments, to ensure that the Fund program is internally consistent. In general, these performance criteria may best be thought of as signaling devices that flag a possible need for corrective action in case of deviations.

III. Monetary Conditionality—The Traditional Approach and its Implications for Inflation Targeting

Monetary policy conditionality has been at the core of Fund program conditionality. As mentioned above, it has traditionally relied on two performance criteria: a ceiling on central bank’s NDA and a floor on its NIR.5 Originally rooted in the concepts that arise from the so-called “monetary approach to the balance of payments,” this methodology has been utilized under a variety of conditions and monetary policy frameworks. Its primary focus has always been to ensure that a Fund program leads to external viability rather than tight control over inflation. In this context, performance criteria that set a floor on NIR are designed to indicate whether a Fund program is likely to achieve its external objective. On the other hand, the ceiling on NDA could be seen as an additional protection, since it seeks to ensure that the external objective is not jeopardized by excessive credit expansion or by sterilized intervention (i.e., by compensating unprogrammed NIR losses through additional credit creation). This framework is rooted in the assumption that the demand for base money matters from a macroeconomic perspective, and that it is stable and predictable.

In practice, the expected functioning of the NIR/NDA performance criteria would be as follows. An anticipated, or baseline, path for NIR is projected and a floor for NIR is set at or somewhat below the baseline. At the same time, the NDA ceiling is established at a level that, in conjunction with the projected evolution of velocity, is consistent with the NIR baseline. If a country’s actual NIR start falling toward the agreed NIR floor—maybe because of a sudden external shock—monetary policy needs to be tightened, usually through open market operations. The resulting increase in interest rates would be expected to stop further NIR losses. More generally, as long as actual NIR remain close to their baseline, the ceiling on NDA effectively limits base money expansion, thereby preventing monetary policies from putting additional pressure on the external balance and fueling inflation. Thus, the NIR/NDA mechanism sets off warning signals when NIR fall too low or when there is significant sterilization of unprogrammed sales of foreign exchange. However, the NIR/NDA framework does not prevent larger-than-programmed NIR increases from fueling monetary expansion and thus inflation. A general overview is provided in Table 1.

Table 1:

General Overview on the Functioning of the NIR/NDA Mechanism

article image

It is within this context that the appropriateness of the traditional NIR/NDA framework under an inflation targeting regime may be questioned. One may argue that, as inflation targets go hand-in-hand with floating exchange rate regimes, floors on NIR have no place or are simply irrelevant.6 However, while under inflation targeting the central bank would not be expected to use its NIR to stabilize the exchange rate per se, it may react to movements of the exchange rate to the extent that they threaten the inflation target. As most floats are not pure floats, tradeoffs between domestic objectives (i.e., inflation) and external objectives (i.e., external viability) may be unavoidable, at least conceptually. Thus, even when the exchange rate is flexible, retaining a NIR floor simply reflects the fact that one important aspect of a Fund program is to safeguard external viability.

While a NIR floor safeguards external viability independent of the monetary policy framework, retaining a NDA ceiling in the context of inflation targeting would seem somewhat more problematic. With a central bank that targets inflation and a Fund program that focuses on the quantity-based framework of NDA ceilings, there may not necessarily be any clear correspondence between the monetary objectives underlying a Fund program, and the relevant instruments to achieve the inflation targets. In addition, the communication with the markets and the public regarding the stance of monetary policy could easily become outright confusing. This is important, because inflation targeting, by its very nature, relies critically on transparency of the central bank’s policy actions. This general problem would be compounded by the fact that inflation is, in most cases, not primarily a function of NDA or its components and, therefore, it is unlikely to respond predictably or immediately to changes in NDA or base money.

Hence, a NDA ceiling could easily set off false alarms and confuse markets when there is, in fact, no need to change monetary policy from the point of view of the inflation objective. For example, one may easily conceive a situation where actual NDA exceeds the NDA ceiling, while both actual and projected inflation are still within their target. Should monetary policy be tightened in these circumstances, or should the NDA ceiling be revised upward? Since inflation is the target, an upward adjustment of the NDA ceiling seems to be the only appropriate course of action. Similarly, when actual NIR is running significantly above the NIR floor while base money is close to the projected baseline, monetary policies could only be eased to the extent that the inflation objective is not jeopardized. In general, as shown in Table 2, when inflation is the overriding objective, having a NDA ceiling may be considered somewhat superfluous or, at least, a nonbinding constraint.

Table 2:

Monetary Conditionality with NDA and Inflation Targets

article image

IV. Options for Implementing and Strengthening Monetary Conditionality Under Inflation Targeting

With an increasing number of countries abandoning fixed exchange rate regimes and moving toward formal inflation targeting, and given the inconsistencies that could potentially arise when applying traditional monetary conditionality in the case of inflation targeting, monetary conditionality needed to be modified with a view toward reflecting more closely the main parameters of decision making under inflation targeting. Ideally, under inflation targeting monetary conditionality should be geared towards the evaluation of the monetary policy stance vis-à-vis the government’s announced inflation target. However, this would require an exceedingly good understanding of the transmission channels and of the precise parameters of monetary policy.

Moreover, monetary conditionality should primarily apply to specific policy actions and policy instruments, since country authorities cannot commit to achieve a particular level of a variable over which they do not exercise some decisive degree of control. Hence, ideally, monetary conditionality should involve the parameters of a policy reaction function, i.e., the summary forward-looking rule governing the policy responses to projected deviations of inflation from the inflation target. Following this reasoning, a conditionality device that could potentially be included in Fund programs under inflation targeting could be an operational rule for reacting to actual or expected deviations from the targeted inflation path. This rule should, again ideally, be a simple but robust reaction function that relates changes in an instrument (e.g., interest rates) to deviations of inflation from its target. In practice, however, it would be difficult, if at all possible, to specify the exact timing and size of the response parameter, e.g., by how much and when should an interest rate be adjusted when projected inflation deviates from its target by a given amount. Also, while a very specific reaction function may work in one program, this may not be sufficiently general and flexible to accommodate different approaches to inflation targeting, and therefore, given the IMF’s commitment to provide equality of treatment to all its members, this could possibly entail some problems of cross-country comparability.

Despite these limitations, and while it may not be possible to specify a very precise and robust policy reaction function, it may still be useful to strengthen monetary policy conditionality by having a simple forward-looking mechanism for gauging the monetary policy stance vis-à-vis the inflation target. In this context, it could be useful to consider simple monetary policy rules, such as Taylor rules for the short-term interest rate, or a McCallum rule for the monetary base. These rules are quite flexible to encompass a range of information that is deemed relevant. A simple Taylor rule,7 for example, can be expressed as r = r* +α(Y−Y*) + β(π − π*), where r is the nominal short-term interest rate, r* is an estimated nominal equilibrium interest rate that is consistent with the target inflation rate (that is r*=r¯+π* with r¯ being the equilibrium real interest rate and π* being the relevant inflation target); Y is output and Y* is capacity output; π is inflation (either actual or projected); and α and β are coefficients, with α ≥ 0 (and typically between 0 and 0.5, depending on the degree to which the output gap figures in the central bank’s reaction function) and β > 0 (and typically between 1.5 and 2, so that the nominal short-term interest rate moves significantly in response to deviations of inflation from the inflation target). In an open economy, one could add a number of other variables in this rule, e.g., the external current account, or the foreign output gap. Also, the rule could include other variables that reflect conditions in the domestic economy such as the budgetary balance or other fiscal variables.

In fact, within this context it is also feasible to include in a Taylor rule different inflation measures, like in the following rule: r = r* +α(γ(πα−π*)+(1− γ)(πP−π*)), where πα is actual inflation and πP is projected inflation and 0<γ<l. Moreover, one could include competing inflation projections in a similar fashion. Hence, Taylor-rules are very flexible and can be specified to encompass a number of country-specific considerations.

Given that a key element in a Taylor rule is the parametric reaction to deviations between actual or projected inflation and the inflation target, an obvious weakness of such an approach is that it would not react to shocks to variables that are omitted from the rule, i.e., a Taylor rule would only show a reaction to an external shock if that shock is, in one way or another, part of the rule. Hence, while a Taylor rule is likely to be only of limited use to policymakers facing real-time decisions, it may serve as a simple and easily understood starting point for thinking about monetary policy.8 Such considerations could also be an argument for including a Taylor rule in a Fund program: as a rough check on the monetary policy stance. In practice, the exact specification of the rule would probably involve some trial and error. To reduce the likelihood of false alarms, one could consider specifying the rule somewhat cautiously. For example, one can choose r¯, the equilibrium real interest rate that underlies r*, to be slightly lower than the best available estimate based on historical data; this would add some limited flexibility for lowering interest rates.

In practical terms, the question of adapting monetary conditionality, beyond the incorporation of some Taylor-type rule, continues to turns around the question of the NIR/NDA framework. It could be said that, as of current thinking—and as discussed below in the context of the Brazilian program—the view is that NIR floors would continue to be needed to safeguard the program external objectives, but NDA ceilings may not necessarily remain the preferred choice for monetary conditionality. The ceiling on NDA could be justified because it would probably prevent large departures from inflation objectives, but it may well not provide adequate guidance to a monetary policy aimed at a more precise inflation target. The main objective of these quantitative limits in inflation target situations would be to reinforce the country’s commitment to a flexible exchange rate policy and to limit sterilized foreign exchange market intervention and base money expansion when the external position is weak.9

Another element in the adaptation of conditionality should be the enhanced role of policy reviews, particularly to include an assessment of monetary policy in the context of inflation targeting (including, but not limited to, the agreement on a reaction function, or the possible specification of a Taylor rule). The program would need to specify a quarterly inflation path consistent with the authorities inflation targets and, in the context of the review, current and projected inflation would be compared with these targets, and agreement on specific policy actions would be reached whenever the outlook suggested that inflation objectives were likely to be missed.

V. Adapting Monetary Conditionality to Inflation Targeting in Brazil

Brazil has been the first inflation targeting country with a Fund-supported adjustment program, and it took some time to tailor the program to the floating exchange rate regime with the nominal inflation anchor. In part, this reflected the need to take into account the institutional constraints that require similarity of treatment and, hence, a high degree of comparability of Fund programs across countries. Initially, the Fund program with Brazil relied on standard monetary conditionality—a NIR floor and a NDA ceiling—although it introduced some interesting innovations as well. In general, as shown in Table 3, whereas the initial program in December 1998—under the fixed exchange rate regime—relied mainly on a strict NDA ceiling for conditionality in the monetary area, the NDA ceilings were made less binding after Brazil adopted the inflation targeting framework, and were completely phased out in June 2000 with the inflation targeting framework fully established. In contrast, while the initial program included a NIR floor that was intentionally fixed at a low (or nonbinding) level to allow the Central Bank of Brazil (BCB) to use part of its actual NIR to defend the fixed exchange rate, if needed, the NIR floor became the key instrument of conditionality in the first few reviews in 1999, in an environment where uncertainty concerning the new nominal anchor was still considerably high. In July 1999, the NIR/NDA conditionality was supplemented with a general consultation mechanism on inflation targets. In November 1999, less than six months after the inflation targeting framework was adopted by the Brazilian authorities, the program incorporated a formal consultation band on inflation to supplement the floor on NIR.

Table 3.

Brazil: Overview on Monetary Policy Conditionality Under the Stand-by Arrangement, 1998–00

article image

The progressive shift away from NDA ceilings following the adoption of the inflation targeting framework reflected the need to adapt the program to the changes in the monetary policy regime. The shift also reflected the growing realization of the fact that base money did not appear to play a significant role in the monetary transmission mechanism in Brazil.10 Money demand in general, and the demand for base money in particular, seemed not very sensitive to interest rates in Brazil. Seasonalities, remonetization under the Real Plan, and the effects of tax changes have been quantitatively more important and statistically more significant determinants of base money than variables like income or the interest rate.11

The formal consultation mechanism on inflation, introduced in the November 1999 review of the Fund program, was based on the annual central inflation target and the tolerance bands announced by the Brazilian government.12 Under the program, a simple linear quarterly path was established where the central inflation target and the outer band surrounding the target declined by 0.5 percentage points each quarter.13 Also, the program established an inner consultation band of +/-1 percentage point (“inner band”) around the target path, which followed the exact same linear quarterly pattern as the target path and the outer band. Accordingly, and this was the innovation in conditionality, the Brazilian authorities would informally consult with IMF staff on the appropriate policy response if the observed 12-month rate of inflation were to go above the inner band; they would more formally consult with the IMF Executive Board on the appropriate policy response if the observed 12-month rate of IPCA (a consumer price index) inflation were to go above the outer band.

How has this mechanism worked so far? Figure 1 shows Brazil’s actual inflation performance in relation to the consultation bands. The BCB met its official inflation targets for both end-1999 and end-2000. The Fund program’s consultation mechanism on inflation was triggered in September 2000, when the 12-month rate of consumer price inflation (IPCA) reached 7.7 percent, thereby temporarily exceeding the 7.5 percent threshold requiring consultations with the Fund staff. This reflected a temporary surge in monthly inflation rates in July and August, due to unanticipated supply shocks that abated in September; core inflation had already remained relatively more subdued throughout the third quarter of 2000. In line with expectations, and facilitated by the continued firm stance of monetary policy, the rate of inflation in consumer prices declined in the fourth quarter of 2000, to match the official 6 percent target by year-end.

Figure 1.
Figure 1.

Brazil; 12-Month Rate of Consumer Price Inflation (IPCA) and Inflation Targets

Citation: IMF Working Papers 2001, 031; 10.5089/9781451845020.001.A001

VI. Actual Policies and Taylor Rules: A Simulation for Brazil

For illustrative purposes, this section explores the usefulness of some simple Taylor rules as an option for strengthening the monitoring of monetary policy stance in the context of a Fund program in a country operating under an inflation targeting framework. The basic idea is simple: if it were possible to conclude that a simple monetary policy rule tracked actual policies fairly well, then it may be possible to use the same rule to help evaluate the appropriateness of the current monetary policy stance vis-à-vis the inflation target. For this purpose, we use as an example the experience of Brazil during its first year under inflation targeting. Given the BCB’s success with inflation targeting, we ask whether a simple Taylor rule—a rule of the type that could in principle be included in a Fund program—would have provided a useful assessment of the monetary policy stance.

Figures 2 and 3 show the actual interest rate, the SELIC rate, plotted against two alternative Taylor rules, with different values for the α and β parameters. In the first alternative, α, the parameter on the output gap, equals 0.5 and the parameter on the deviation of actual inflation from target, equals 1.5. The second version is an “aggressive” Taylor rule, where only the deviation of inflation from target features in the rule (β = 2).Figure 3 differs from Figure 2 in that it includes an interest smoothing parameter ρ, which is set equal to 0.6.14 Initially, in both Figures 2 and 3 the actual twelve-month rate of inflation is used in the simple Taylor rule. The Taylor rule “bands” shown in these two figures are generated by different assumptions on the equilibrium real interest rate r¯, ranging from 10.5 percent to 12.5 percent. For the purpose of the simulations, the potential output growth rate was assumed to be 4 percent, although a lower potential growth rate (of 3 percent) resulted in only a slightly higher nominal interest rate.

Figure 2.
Figure 2.

Brazil: Taylor Rules with Current Inflation

Citation: IMF Working Papers 2001, 031; 10.5089/9781451845020.001.A001

Source: BCB and authors’ estimates.
Figure 3.
Figure 3.

Brazil: Taylor Rules with Current Inflation

Citation: IMF Working Papers 2001, 031; 10.5089/9781451845020.001.A001

Source: BCB and authors’ estimates.

In both Figures 2 and 3 we can clearly distinguish three periods. In the first period, between July 1999 and September 1999, the BCB was keeping the annual overnight interest rate (SELIC) at a higher level than what a simple Taylor rule would have suggested; this basically reflects the relatively low passthrough that had occurred in the first couple of months after the Real was left to float. When the inflation targeting framework was launched in July 1999, inflation was at a very moderate level but expected to rise. Concerned about an increasing passthrough (given the existing transmission lags), and having to establish its reputation, the BCB initially adopted a tougher policy stance than what would have been suggested by a simple Taylor rule without expectational variables.

The second period runs from October 1999 to January–February 2000, when inflation had already picked up significantly, and had reached its peak in December 2000. During that period, the BCB basically “remained put,” and, in particular did not raise the SELIC, as would have been suggested by a simple Taylor rule. The increase implied by a simple Taylor rule would have been particularly large without interest smoothing (Figure 2), whereas with interest smoothing (Figure 3), and depending on the value that is used for the equilibrium real interest rate (r¯), the suggested increase would not necessarily have needed to be large. It is clear that, although in the last quarter of 1999 inflation was higher than expected, this was perceived as transitory by the Brazilian authorities. This view was also supported by the market surveys at the time. As a result, the actual SELIC was kept somewhat below the rate that our simple Taylor rule without expectational variables would have suggested.

The third period started in February–March 2000. In this period, inflation continued on a downward trend and remained in line with the inflation target. Due to the reduction in inflation, the actual SELIC has remained within the bands of our Taylor rule, as shown in Figures 2 and 3. The actual SELIC remained basically unchanged at an annualized rate of 18.5 percent until June 2000, when a reduction by 100 basis points took place; a further reduction by 50 basis points (to an annualized rate of 17 percent) took place on July 7, 2000.

The stabilization of consumer price inflation is actually quite remarkable given the presence of various factors that could have induced a temporary increase in prices, such as the increase in wholesale prices, the increase in import prices, the increase of minimum wages and the discussion surrounding it, uncertainty about the behavior of the exchange rate in the context of more volatile international capital markets, as well uncertainty stemming from the potential fiscal costs of some pending court rulings.

This simple exercise may be interpreted in different ways, which basically depend on what the Taylor rule is intended to be used for. Simple mechanistic rules are not useful in policy making; in fact, the models used by the BCB and other central banks are much more sophisticated, although they are still considered “small-scale models.”15 At the same time, simple rules may provide a rough first evaluation of a policy stance. This is probably also one of the reasons why the U.S. Federal Reserve Bank of St. Louis, for example, has been publishing the results of simple Taylor rules and McCallum rules in its monthly economic reports.16 Simple Taylor rules may only be expected to perform satisfactorily in an environment where relatively low inflation has already been achieved, and where the overall macroeconomic environment is fairly stable (e.g., continued tight fiscal polices, and a stable exchange rate). In a more unstable or uncertain environment, other variables should probably be included to make the Taylor rule more “realistic.”

However, a more realistic Taylor rule would not necessarily involve a more complicated rule. Central banks do not only react to current levels of specific variables but also to their expected future levels—they are clearly forward looking. Since the different channels of transmission of monetary policy are known to operate with some lags, all central banks forecast the behavior of inflation in one way or another.

Accordingly, in Figures 4 and 5 we simulate again a simple Taylor rule but use market projections of inflation, as derived from the BCB’s daily survey on market expectations.17 In these examples, the Taylor rule suggests that in the second period (from October 1999 to January/February 2000), there was less of a need for the BCB to react to the pickup in inflation that occurred in the last quarter of 1999. While, initially, markets (and the BCB) may have been surprised by the inflationary outcome in the last three months of 1999, it was perceived as transitory. In early 2000 markets were expecting the Real to appreciate in nominal terms; this in turn was accompanied by expectations of a reduction of the inflation rate (or the “passthrough”). As a result, a Taylor rule that uses expected inflation seems to converge to the actual SELIC rate slightly faster than a rule that only uses the current inflation rate.

Figure 4.
Figure 4.

Brazil: Taylor Rules with Market Expectations of Inflation

Citation: IMF Working Papers 2001, 031; 10.5089/9781451845020.001.A001

Source: BCB and authors’ estimates.
Figure 5.
Figure 5.

Brazil: Taylor Rules with Market Expectations of Inflation

Citation: IMF Working Papers 2001, 031; 10.5089/9781451845020.001.A001

Source: BCB and authors’ estimates.

VII. Concluding Remarks

In Fund programs, conditionality links the achievement of a set of policy objectives to continued access to IMF resources. Conditionality provides a yardstick for evaluating whether the policies that are being carried out are moving the country toward the achievement of stated policy objectives, in particular a sustainable external balance. By doing so, conditionality also safeguards the temporary use of the IMF’s resources.

Traditionally, Fund program conditionality in the monetary area has relied on two performance criteria: a ceiling on the central bank’s NDA and a floor on its NIR. The primary focus of this approach has always been a program’s external viability, rather than inflation. The main role of the NIR floor is to indicate whether a Fund program is likely to achieve its external objective, while the ceiling on NDA seeks to ensure that this objective is not jeopardized by excessive credit expansion or by sterilized intervention, i.e., by compensating unprogrammed NIR losses through additional credit creation. The framework assumes that the demand for base money matters from a macroeconomic perspective, and that it is stable and predictable.

As argued in this paper, in Fund program countries that carry out their monetary policies on the basis of explicit inflation targets, it would seem helpful to adapt traditional monetary conditionality to take into account the specific features of inflation targeting. This would help to improve the correspondence between the monetary objectives of the central bank and the targets of the IMF-supported adjustment program, and the instruments that are used to achieve these targets and objectives. By the same token, it would also facilitate communication of central bank policies to the markets.

Clearly, as a first step, a Fund program could include, as was the case in Brazil, the government’s inflation target itself. Often, this may require specifying the target in some more detail than the official target. For example, most countries operate with annual inflation targets; however, as Fund programs are frequently monitored on a quarterly basis, additional quarterly inflation objectives may have to be added. Furthermore, there needs to be a mechanism for consultations that allows for program reviews to take place if inflation goes off-track. This, in turn, would require establishing parameters around the targeted inflation rate that would trigger such reviews. In the case of Brazil it was decided to establish consultation bands around the central target, where, depending on the size of the deviation from the target, consultations with either Fund staff or the Fund’s Executive Board would be triggered.

A potential drawback of monitoring a Fund program on the basis of inflation outcomes—for example, on the basis of the actual 12-month rate of inflation vis-à-vis the target 12-month rate of inflation—is that this is largely backward looking, i.e., the inflation outcome itself offers no guidance as to the appropriateness of the stance of monetary policies. Hence, inflation targets in the context of a Fund program work much in the same way in which they are used by the government: they are a parameter that helps to carry out an ex-post analysis of central bank policies. However, to be able to say something about the appropriateness of the current monetary policy stance, it is not enough to look at actual inflation. This raises the question whether there are additional options for further strengthening monetary conditionality under inflation targeting in the context of a Fund program.18 This could either be achieved by regular frequent consultations or by a forward-looking trigger mechanism for consultations between the country authorities and the Fund.

One option that has been explored in this paper, and on which further analysis would be desirable, is to consider simple monetary policy rules, such as Taylor rules or McCallum rules, as a potential trigger mechanism for such consultations. While simple policy rules would not be a useful device for policy making, they do provide a rough first evaluation of a policy stance. To illustrate the point, we tested various simple Taylor rules, using the experience of Brazil in its first year under inflation targeting as an example, where, after all, we know that the central bank has successfully met its inflation target. The results of the simulations suggest that simple mechanical rules may indeed provide some rough initial guidance on the appropriate level of interest rates, particularly in an environment where relatively low inflation has already been achieved, and where the overall macroeconomic environment is fairly stable (e.g., continued tight fiscal polices, and a stable exchange rate).

To strengthen Fund conditionality, and, in particular, to help monitor the stance of monetary policies vis-à-vis a government’s inflation target, Taylor rules or other rules that provide for a rough evaluation of central bank policies are an area that could usefully be explored further. In general, to be useful in a Fund program context, the rules should be kept simple, and forward looking, in the sense that they should include inflation expectations.

Bibliography

  • Banco Central do Brasil (1999–00), Relatório de Inflação, various issues since June 1999.

  • Benhabib, Jess, Stephanie Schmitt-Grohé, and Martin Uribe (2001), “The Perils of Taylor Rules,” Journal of Economic Theory, Vol. 96, No. 1/2 (January/February), pp. 40-69.

    • Search Google Scholar
    • Export Citation
  • Bogdanski, Joel, Alexandre Antonio Tombini, and Sérgio Ribeiro da Costa Werlang (2000), “Implementing Inflation Targeting in Brazil,” draft.

    • Search Google Scholar
    • Export Citation
  • Federal Reserve Bank of St. Louis (1999–00), Monthly trends (various issues).

  • Gold, Sir Joseph (1979), Conditionality, Pamphlet Series No. 31 (Washington: International Monetary Fund).

  • Goldfajn, Ilan, and Sérgio R. C. Werlang (2000), “The Pass-through from Depreciation to Inflation: A Panel Study,” draft.

  • Guitián, Manuel (1981), Fund Conditionality: Evolution of Principles and Practices. IMF Pamphlet Series No. 38 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Knight, Malcolm (1999), “IMF Conditionality under Inflation Targeting: Some Comments and Suggestions.” Paper delivered at the IMF’s Seminar on “Inflation Targeting and Fund Conditionality,” October 28, 1999.

    • Search Google Scholar
    • Export Citation
  • Kozicki, Sharon (1999), “How Useful Are Taylor Rules for Monetary Policy?Economic Review, Federal Reserve Bank of Kansas City, second quarter of 1999, pp. 5-33.

    • Search Google Scholar
    • Export Citation
  • Schwartz, Gerd (1999), “Price Developments after the Floating of the Real: The First Six MonthsBrazil—Selected Issues and Statistical Appendix, IMF Staff Country Report No.99/97 (September), pp. 7-35.

    • Search Google Scholar
    • Export Citation
  • Rabanal, Pau, and Gerd Schwartz (2001a), “Testing the Effectiveness of the Overnight Interest Rate as a Monetary Policy Instrument,” Brazil—Selected Issues and Statistical Appendix, IMF Staff Country Report, No.01/10 (January), pp.114-135.

    • Search Google Scholar
    • Export Citation
  • Rabanal, Pau, and Gerd Schwartz (2001b), “Forecasting Inflation in Brazil: How Useful are Time Series Techniques?Brazil—Selected Issues and Statistical Appendix, IMF Staff Country Report, No.01/10 (January), pp. 136-152.

    • Search Google Scholar
    • Export Citation
  • Taylor, John B. (1993), “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, No. 39, pp. 195-214.

    • Search Google Scholar
    • Export Citation

APPENDIX I

Simulation of Taylor Rules

We simulate a simple Taylor rule for Brazil during 1999-2000 to compare actual policy outcomes with rule-based policy prescriptions. Using monthly data, the rule we simulate takes the standard form, with rt=ρrt1(1ρ).[r*+αyt+β(πtπt*)] and r*=r¯+πt*, where rt is the annualized overnight interest rate (SELIC) in period t; ρ is the interest smoothing parameter with 0≤ρ≤1; yt is the output gap in period t; πt is the 12-month inflation rate in period t; πt* is the inflation target applicable to period t; r* is the equilibrium nominal interest rate; and r¯ is the equilibrium real interest rate. Parameters α and β are the parameters of the Taylor rule, were, for simplicity, we choose those suggested in Taylor’s original formulation with α equal to either 0 or 0.5, depending on whether or not output considerations can be assumed to be part of the central bank’s objective function, and β being either 2 or 1.5, accordingly.

In general, we use monthly end-of period data for the annualized overnight (SELIC) interest rate and the other variables in the model. The output gap was first estimated by fitting a linear trend on the natural logarithm of monthly GDP, as estimated by the BCB. This yielded a relatively low potential real output growth, and we consequently used values in the range of 3-4 percent as being more realistic assumptions. The value of the equilibrium real interest rate was initially assumed to be 12.0 percent, but we then used values in the 10.5 percent to 12.5 percent range to generate the Taylor rule bands.

The inflation target for each month is a linear extrapolation of the quarterly targets for December 1999 to December 2000 that are used under the program with the IMF. For the period before December 1999, when inflation was still low, we used the lower band of the target range to simulate the Taylor rule and then linearly increased it to reach 8 percent (the central target) in December 1999. Hence, for July 1999, we assume that the BCB did set its inflation target in the lower limit of its annual band for 1999 (6 percent), and that it increased this linearly to reach the inflation target of 8 percent in December 1999. However, using the December 1999 target for the period leading up to December 1999 did not change the outcomes qualitatively.

We consider four policy rules to simulate: the original Taylor rule (with α= 0.5 and β=1.5), a more aggressive rule that only targets inflation (α= 0, β= 2), and for both rules we consider the case of no interest rate smoothing (ρ = 0) and with interest rate smoothing (ρ = 0.6). Choosing ρ = 0.6 would seem to strike a balance between having a fairly high degree of interest rate smoothing and letting the effect “die out” after only a few periods.

1

Earlier versions of this paper were presented at the conferences on “One Year of Inflation Targeting,” organized by the Central Bank of Brazil in Rio de Janeiro (July 10-11, 2000), and “Ten Years of Inflation Targeting: Design, Performance, Challenges,” organized by the Central Bank of Chile in Santiago/Chile (November 30-December 1, 2000). We gratefully acknowledge the many helpful comments and suggestions received from Teresa Ter-Minassian, Marianne Schulze-Ghattas, Sandy Mackenzie, and the conference participants, as well as excellent research assistance from Stella Chan.

2

A number of internal documents were prepared and discussed within the IMF to clarify the various aspects of this approach. Some of the considerations and arguments raised in these discussions are reflected in various parts of this paper.

3

The word “conditionality” does not appear in the IMF’s Articles of Agreement and the concept evolved in stages. For a discussion of the legal aspects of the development of IMF conditionality, see Gold (1979); Guitián (1981) discusses the evolution of Fund conditionality from an economic point of view.

4

Usually, NDA are defined to equal base money minus NIR.

5

While these have been by far the most common variables used in the design of monetary conditionality, in many countries other monetary aggregates have been targeted and, in some cases, subceilings for specific types of domestic assets were also implemented.

6

Of course, some inflation targeting countries maintain (or did maintain in the past) a managed float, sometimes even with exchange rate bands. This could lead to conflicting objectives between the inflation target and the exchange rate band.

7

See Taylor (1993) for the original formulation.

8

See, for example, Kozicki (1999) for a review. Also, for a critical theoretical review of using Taylor rules as decision tools for monetary policy, see Benhabib, Schmitt-Grohé, and Uribe(2001).

9

Such safeguards seem especially relevant when the authorities view exchange market pressures as essentially short lived

10

In general, main transmission channels of monetary policy are the exchange rate, wages, asset prices, and aggregate demand. In the case of Brazil, and in light of the economic conditions that have prevailed since the inflation targeting framework was adopted in mid-1999—characterized by still fairly high real interest rates, tight fiscal policy, relatively subdued aggregate demand, and negative real wage growth—it would seem that the exchange rate was the main actual channel of transmission to inflation. This would be consistent with recent findings which suggest that the unwinding of real exchange rate misalignments in the context of a depreciation has been the most important determinant of inflation in developing economies (Goldfajn and Werlang (2000); also see Schwartz (1999) for the case of Brazil). Of course, in a floating exchange rate regime, the exchange rate itself is not a policy variable. For a discussion of the transmission mechanism of monetary policy in Brazil, also see Rabanal and Schwartz (2001a).

11

To establish NDA ceilings, the demand for base money was estimated as the sum of its two parts: currency issued and reserves on demand deposits. Currency issued was modeled as a function of a linear trend (to capture the ongoing remonetization of the economy), various seasonal dummies (e.g., for December, January, and February), and lagged dependent variables. Demand deposits were modeled as a function of seasonal dummies, dummies for tax effects (e.g., changes in the tax on financial transactions (CPMF)), and the nominal interest rate. Reserves on demand deposits were derived by applying an effective reserve rate to the projected level of demand deposits. In the short term, these projections fared quite well, but larger deviations from the econometric estimates occurred when there were shifts in seasonalities (e.g., carnival in March instead of February), or when special factors, like tax changes (e.g., in the CPMF) or the “Y2K bug” did not have the anticipated effects

12

Specifically, 8 percent at end-1999 and 6 percent at end-2000, each with a tolerance band of +/-2 percentage points (“outer band”) around the central target.

13

A linear path was chosen mainly for simplicity. Another simple option would have been to establish a path for the target 12-month inflation rate on the basis of inflation that has already happened, and then simply add to that one quarter of the year-end inflation target. For example, at the beginning of the year 2000, the target for, say, June 2000 could have been established by adding to the already known inflation outcome for July-December 1999, one half of the year-end target for 2000.

14

The interest smoothing parameter introduces some inertia into the Taylor rule by mitigating the extent to which the central bank reacts to new information. See the Appendix for further detail on the simulations that were carried out.

15

See Bogdanski, Tombini, and Werlang (2000). Also see Rabanal and Schwartz (2001b) for a review of the inflation forecasting performance of the small-scale model used by the BCB.

17

For the purpose of the Taylor rules, the expected inflation for a given month was generated by using the average expected inflation for that month, as shown in surveys carried out by the BCB in the month immediately preceding that month.

18

Fund Knight (1999) also provides suggestions on IMF conditionality in the context of inflation targeting.

Inflation Targeting in the Context of IMF-Supported Adjustment Programs
Author: Mr. Gerd Schwartz, Mr. Pau Rabanal, Mr. Mario I. Bléjer, and Mr. Alfredo Mario Leone