Inflation Pressures and Monetary Policy Options in Emerging and Developing Countries—A Cross Regional Perspective
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 3 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

This paper analyzes the monetary policy response to rising inflation in emerging and developing countries associated with the food and oil price shocks in 2007 and the first half of 2008. It reviews inflation developments in a sample of countries covering all regions and a broad range of monetary and exchange rate policy regimes; discusses the underlying causes of inflation; provides a synthesis of policy responses taken against the background of the conflicting objectives and trade-offs, the uncertainties regarding the nature of the shocks, and the additional challenges brought on by the global financial turmoil; and presents considerations for policy.

Abstract

This paper analyzes the monetary policy response to rising inflation in emerging and developing countries associated with the food and oil price shocks in 2007 and the first half of 2008. It reviews inflation developments in a sample of countries covering all regions and a broad range of monetary and exchange rate policy regimes; discusses the underlying causes of inflation; provides a synthesis of policy responses taken against the background of the conflicting objectives and trade-offs, the uncertainties regarding the nature of the shocks, and the additional challenges brought on by the global financial turmoil; and presents considerations for policy.

I. Introduction

1. The surge in food and energy prices and the subsequent increase in inflation have posed a major challenge to central banks. In particular, many emerging and developing countries have faced a substantial acceleration of inflation since early 2007, raising concerns about the credibility of monetary policy. In these countries, combating inflationary pressures has been more challenging than in advanced countries, in part reflecting a larger share of food and fuel products in the consumption basket, and also because of a preference for less flexible exchange rates and an inclination to give growth priority relative to other macroeconomic policy objectives in many cases. At the same time, many central banks lack independence and institutional capacity. Markets are also generally less well-developed, undermining monetary policy transmission.

2. The surge in food and energy prices was also the first significant test of inflation targeting (IT) regimes in emerging market countries. Most emerging market IT countries have overshot their official inflation targets while grappling with the task of finding the most appropriate policy action given the uncertainty about the nature of the shock. With the growing downside risks to economic growth and worsening conditions in the global financial markets, the sharp pick up in inflation has raised difficult questions about the inflation-growth trade-off and whether to modify some features of the IT framework. Some commentators have even questioned the very raison d’être of the IT regime and suggested its abandonment.

3. The upsurge of inflation has also highlighted the complex challenges facing policymakers in an increasingly globalized world. Coming from a recently benign inflation environment, many policymakers seem to have been caught off-guard. Central banks are facing new policy challenges, stemming from a difficult combination of global financial turmoil, economic slowdown, volatility in commodity markets, reversal of capital inflows, exchange rate depreciation, and inflation pressures. Although central bank communication has improved in recent years, the current environment is significantly more difficult and uncertain, and requires a renewed effort to credibly explain central bank actions.

4. The paper covers developments in 2007 and the first half of 2008, complementing other recent work by the Fund2 on the recent inflationary episode in emerging and developing countries. It reviews inflation developments in a sample of 50 countries covering all regions and a broad range of monetary and exchange rate policy regimes. It discusses the underlying causes of inflation and provides a synthesis of policy responses. It considers the conflicting objectives and trade-offs, the uncertainties regarding the nature of the shocks, and the additional challenges brought on by the global financial turmoil.

5. The main objectives of the paper are to: (i) bring a cross-regional perspective to the analysis of inflation developments (Section II); (ii) evaluate the impact of monetary policy responses (Section III); and (iii) present considerations that may help to inform policy advice to the Fund’s member countries (Section IV). The paper should be seen as complementary to Chapter 3 of the Fall 2008 World Economic Outlook (WEO), which also examines inflation developments in the context of the overall macro situation and implications for the monetary policy stance. It differs from the WEO in its focus on the operational aspects of monetary and exchange rate policies as they seek to deal with the present shocks.

6. The main findings of the paper are the following: Both aggregate demand pressures and surging commodity prices played a role in rising inflation in emerging and developing countries. Inflation pressures became broad-based in most countries, with second round effects following the initial shock to fuel and food prices. Most central banks tightened monetary policy with a view to constraining aggregate demand and anchoring inflation expectations, although the timing and speed of the tightening efforts varied significantly. It is early to fully gauge the impact of the policy response to date, given the need to take account of delays in monetary policy actions in many countries, possible lags in transmission, and an often accommodative monetary policy stance, with interest rate hikes falling short of the rise in inflation.

7. Looking beyond the period covered by the paper, the ongoing slowdown of the global economy will help to dampen inflation, but monetary policy-makers need to remain vigilant. Headline inflation has eased since May 2008 in some countries, reflecting the slowing of economic activity and a partial reversal of the increase in commodity prices. In many countries, however, demand pressures are still evident, the credibility of monetary policy is weak, capital outflows have led to exchange rate depreciation with a pass-through to inflation, and monetary and credit aggregates have increased sharply. Central banks will thus need to continue to credibly demonstrate their commitment to bringing inflation back to target levels.

8. In this environment, the communication strategy becomes crucial in limiting the damage to credibility. Circumstances are difficult and give rise to new communication challenges in keeping inflation expectations well anchored, and calls for greater efforts to credibly explain central bank actions while emphasizing a continuing commitment to meeting inflation objectives.

9. Supporting measures can avoid overburdening monetary policy. These include allowing the exchange rate to appreciate, where possible, maintaining a supportive fiscal policy stance, and reducing wage and price pressures through greater labor market flexibility, productivity matching wage policies, and structural reforms to boost productivity and competitiveness.

II. Cross Regional Developments in Inflation

10. Inflation pressures rose sharply since mid-2007 in emerging market and developing economies. Average headline inflation in the first six months of 2008 in these countries reached about 9 percent (y/y)—with the highest rates observed in oil exporting countries. The comparable figure for advanced countries is about 4 percent (y/y) (Figure 1). By region, Middle-Eastern countries, followed by emerging Europe, have, on average, faced stronger inflation pressures when compared to the other regions (Table 1 and Figure 2). Appendix I and Appendix Table 1 provide additional information on cross-regional inflation developments and their underlying drivers.

Figure 1.
Figure 1.

Headline Inflation by Country Group; Jan. 2003–Jun. 2008 1/

(Monthly data; year-on-year percentage change)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics.1/ Country groups follow IFS classification.
Figure 2.
Figure 2.

Headline Inflation by Geographic Region; Jan. 2003–Jun. 2008 1/

(Monthly data; year-on-year percentage change)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics.1/ Country groups follow IFS classification.
Table 1.

Sample Countries and Summary Statistics on Inflation and Monetary Policy

article image
Sources: IMF International Financial Statistics, area departments, and central bank websites.

In non-inflation targeting countries, the figures reflect the official inflation objective. † Inflation forecast from official entity. ‡ Targets core inflation.

For Euro area, where data are available, HICP excluding energy, food, alcohol and tobacco. For the other countries, the data are mostly the authorities’ published data.

For Burgalia, Estonia, Latvia, Lituania, Senegal, and Saudi Arabia, short-term market rates.

11. There is evidence that surging fuel and food prices were an important driver of higher inflation in emerging and developing countries,3 which themselves have been driven by a combination of supply and global excess demand factors. On average, headline inflation rose more sharply than core inflation (excluding fuel and food in most cases), especially in Middle Eastern countries, and there is a large gap between these two inflation indicators (Figure 3). However, the cross-sectional correlation between accumulated inflation4 and the shares of food and fuel in the CPI basket is not statistically significant (Figures 4 and 5), likely reflecting different food and fuel subsidies and the imposition of price controls in some countries (e.g., Malaysia and China).5 Different macroeconomic policy stances may also have played a role.

Figure 3.
Figure 3.

Headline and Core Inflation by Geographic Region

(As at end-June 2008 or most recent data available; In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics; and central bank websites.
Figure 4.
Figure 4.

Accumulated Inflation, July 2007–June 2008, and Share of Fuel in CPI 1/

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics, and Research Department data.1/ Includes the 25 of the “selected 50 countries” for which data for fuel share in CPI basket are available.
Figure 5.
Figure 5.

Accumulated Inflation since July 2007 and Share of Food in CPI 1/

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics, and Research Department data.1/ Includes the 25 of the “selected 50 countries” for which data for fuel share in CPI basket are available.

12. The available data also point to demand pressures as an important factor in higher inflation, in particular core inflation.6

  • Over the last few years, emerging market and developing countries grew above trend, in marked contrast to advanced countries (Figure 6). The estimated average output gap of a selected group of emerging market countries has risen, although it seems to have started to taper off recently, reflecting the recent slowdown in economic growth in many emerging market countries (Figure 7).

  • Rapid growth of credit to the private sector and capital inflows apparently contributed to buoyant demand. Figure 8 shows a positive correlation between the real growth of private sector credit and the increase in inflation.

  • Recent country reports and monetary and inflation reports of country authorities provide additional indications of demand pressures:

    • Labor markets tightened and wage pressures increased in several countries, reflecting growing supply constraints to meet aggregate demand. In some cases, wage pressures partly reflected increased emigration to advanced countries (particularly apparent in Central and Eastern Europe). Capacity constraints also became more binding in other countries (e.g., Brazil, Colombia, and Costa Rica). Supply bottlenecks for housing contributed to overheating in some Middle Eastern countries (e.g., Kuwait, and Saudi Arabia).

    • Some countries, especially oil exporters, made use of greater scope for expansionary fiscal policies (e.g., Russia, Ukraine, and Saudi Arabia). Expansionary fiscal policies also contributed to overheating pressures in Estonia and Kuwait. High commodity prices provided a positive terms of trade boost to domestic demand in the oil producing countries.

Figure 6.
Figure 6.

Indicators of Excess Demand Pressures in Emerging Market Countries

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF World Economic Outlook (WEO), and authors’ estimations.1/ Includes all countries reported in WEO. Shaded areas indicate WEO projections.2/ The output gap is estimated using HP filter for the countries where quarterly data are available. It excludes Dominican Republic, Venezuela, and Latvia.
Figure 7:
Figure 7:

Regional Developments in Output Gap, 2002Q1–2008Q2 1/

(In percent of GDP; 3 quarter moving average)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Source: Authors’ estimates.1/ Calculated using the Hodrick-Prescott filter.
Figure 8.
Figure 8.

Average Growth of Real Credit to Private Sector and Accumulated Inflation, July 2007–June 2008 1/

(Group average)

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF International Financial Statistics.1/ Includes 36 countries of “selected 50 countries” for which data are available. “Average growth” is calculated as the simple average of annual real credit growth over the past three years.

13. As a result, inflation pressures became more broad-based in most countries.

Except in China, Israel, and Malaysia, core or underlying inflation (excluding food and energy) rose along with headline inflation, suggesting second round effects. In many countries, available information also suggests that inflation expectations have increased in 2008. Econometric evidence shows that lower interest rates and domestic credit growth have been associated with higher inflation, and that second round effects may be increasing in 2007-08, compared to 2005-06 (Appendix II).

14. Differences in the severity of inflation pressures across countries appear to have been related in part to exchange rate and monetary policy arrangements.

  • The pick up in inflation was particularly marked in countries with soft exchange rate pegs (Figure 9), where monetary policy is or was geared to maintaining the exchange rate target. As a result, domestic inflation largely reflected rising international prices for goods and services. Some countries with hard pegs also experienced sharp increases in inflation (Bulgaria and the Baltic countries). The increase in inflation was slightly higher on average in countries with soft pegs to the U.S. dollar, compared with those with pegs to the euro or a currency basket.

  • IT countries with floating exchange rates experienced a smaller rise in inflation on average compared to non-IT countries (most of which target monetary aggregates or the exchange rate, Figure 10). However even here, actual inflation exceeded official targets by significant margins (Figure 11), with the IT emerging market countries facing the first real challenge to the credibility of their IT regimes.

Figure 9.
Figure 9.

Change in Inflation by Exchange Rate Regime and Monetary Policy Framework

(Group average, In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, IFS, and 2008 Annual Report on Exchange Arrangements and Exchange Restrictions.1/ Includes the selected 50 countries only.2/ Includes the pegged regimes within the selected 50 countries only.
Figure 10.
Figure 10.

Average CPI Inflation in IT and non-IT Countries; Jan. 2006–Jun. 2008 1/

(Monthly data; Year-on-year percentage change)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics.1/ Includes the selected 50 countries only.
Figure 11.
Figure 11.

IT Countries: Actual versus Targeted Inflation, June 2008

(In percent) 1/

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF, International Financial Statistics, and central banks.1/ The height of the combined bars indicates current inflation.2/ As at end-May 2008.

III. Policy Responses to Inflation Pressures

A. Policy Actions to Date

15. Faced with the rapid increase in inflation, most central banks tightened monetary policy (see Appendix III for summary information on the various policy actions). Underlying the tightening efforts were concerns that the sharp rise in food and energy prices was leading to second round effects, including wage pressures, particularly in those countries where strong demand and tighter capacity constraints had been evident. However, the extent and speed of monetary tightening differed significantly across countries:

  • Relatively few countries in the sample raised interest rates aggressively from 2007 levels (Figures 12a and 12b), including IT countries (Brazil, Romania, Serbia,7 and South Africa) and non-IT countries experiencing very high inflation (Ukraine and Vietnam), while others tightened moderately. In some cases, monetary policy was eased in 2007 to counter potential spillovers from a global economic slowdown (Dominican Republic, Indonesia, Israel, Philippines, Romania), while in others policy sought to slow short-term capital inflows (Costa Rica). Where inflation pressures were less marked (Malaysia, Thailand), interest rates were kept on hold. In a number of countries, the room to raise interest rates was limited by the pegged exchange rate regimes (Estonia, Latvia, and Lithuania, Hong Kong SAR, Kuwait, Jordan, Saudi Arabia), under which interest rates were guided by the monetary policy of the anchor country.8

  • Only a few countries started tightening as early as 2007. These include Colombia, Chile, Honduras, and Mexico, Peru; Czech Republic, Poland, and Romania; China, and Korea; and South Africa. The majority of the remaining countries started tightening during the first or second quarter of 2008, possibly suggesting that some central banks viewed higher headline inflation as temporary, reflecting an adverse supply shock, and/or underestimated demand pressures or second round effects.9

  • Some countries tightened monetary policy using other tools (in addition to or in place of higher interest rates), reflecting (to different degrees) capital inflows, weak monetary transmission, or costly sterilization. They increased reserve requirements (e.g., Bulgaria, Croatia, Russia; China, India, Vietnam; Colombia, Honduras, Peru, Uruguay; and Saudi Arabia), imposed credit controls (e.g., China, Bulgaria, Croatia), or raised reserve requirements on external liabilities to limit capital inflows (Croatia, Russia, Serbia, Ukraine; Colombia, Peru and Uruguay).10

Figure 12a.
Figure 12a.

IT Countries: Policy Rate Changes, July 2007–June 2008

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: International Financial Statistics; and central bank websites.
Figure 12b.
Figure 12b.

Non-IT Countries: Policy Rate Changes, July 2007–June 2008

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: International Financial Statistics; and central bank websites.

16. With the exception of Guatemala and Turkey, none of the IT countries revised the officially announced inflation targets in response to rising inflation (Appendix IV). Guatemala increased the mid-point and range of its official target in December 2007. Turkey, after extending the target horizon and revising the inflation forecast, raised its target over 2009-11.11 All other IT countries maintained the original targets and the associated parameters (such as target band width, the targeted index, and the target horizon), partly reflecting concerns about damaging credibility, hence possibly unmooring inflation expectations. While tightening monetary policy to limit second round effects and reiterating the commitment to price stability, most IT countries have enhanced communication, explaining the nature of the supply shock and the central bank’s policy response. A few combined higher interest rates with higher reserve requirements and other direct instruments of monetary policy (Colombia, Peru). A tight fiscal stance supported these efforts in some countries (e.g., Hungary, Poland).

17. Exchange rate policy played some role in containing inflation pressures in a number of countries, particularly where there is strong exchange rate pass-through to inflation. A negative relationship was in fact observed between the rise in inflation and nominal exchange rate appreciation since end-2006 (Figure 13).

  • In some IT countries, nominal appreciation of the domestic currency limited the pass-through of imported inflation pressures (Czech Republic, Hungary, Israel, Poland, Slovakia, Brazil, Colombia, Peru), while in some others depreciation of the currencies vis-à-vis the euro validated inflation (Romania, Turkey).

  • Some non-oil emerging market countries with managed floating or soft pegs also let their exchange rates appreciate in response to capital inflows (e.g., China, Croatia, Ukraine, Uruguay, and Egypt). However, the size of the appreciation varied widely across countries, in part because of intervention in foreign exchange markets, which in turn reflected concerns about the adverse impact of appreciation on the export sector.

  • In a number of other countries with hard or soft pegs, exchange rate policy constrained the absorption of the price shocks. The implications of the exchange rate arrangement for inflation developments would, of course, depend on many other factors, including structural characteristics of the economies in question.

Figure 13.
Figure 13.

Accumulated Inflation and Nominal Effective Exchange Rate, Dec. 2006–Jun. 2008

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Source: IMF International Financial Statistics and Information Notice System.

18. Fiscal policy by and large provided only limited support to countering inflation.12 In a few cases, fiscal policy was tightened to lessen the impact of demand pressures on inflation. In many others, fiscal policy was not supportive, owing among other things to subsidies that reduced the impact of price increases on poor segments of the populations. In several cases, the subsidies predated the pick up in inflation but were raised with the surge in global fuel and food prices.

19. Many countries also resorted to other non-monetary measures in response to rising fuel and food prices. These included lowering import tariffs; raising export taxes or imposing export quotas or bans to protect domestic supplies; reducing domestic consumption taxes on selected items; and tightening price controls (Appendix III). Some of these countries also started raising administered prices toward market levels, reflecting fiscal concerns (e.g., Indonesia and Vietnam), and some raised taxes on selected items (Czech Republic, Lithuania, Poland, Turkey).

B. How Have the Measures Worked Thus Far?

20. It is too early to gauge the ultimate impact of monetary tightening, given the lagged effect of monetary policy and the highly uncertain global economic environment. Although headline inflation pressures began to ease around May 2008 in some countries, partly reflecting a decline in commodity prices, second-round effects have prevented a quick reduction in inflation. Many of the forces underlying the surge in inflation remained in place and kept inflation high compared to its pre-shock levels, Moreover, recent policy measures will take time to have an effect. Countries with IT regimes continued to exceed the mid-points, or even upper bands, of their official targets. In many cases, markets viewed monetary policy measures as too little and too late, with the benefit of hindsight.13 With the interest rate hikes falling short of the pick up in inflation, low or negative real interest rates led to an accommodative monetary stance (Figure 14), even as exchange rates have appreciated in some cases.

Figure 14.
Figure 14.

Accumulated Inflation and Real ST Interest Rate, Jul. 2007–Jun. 2008 1/

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Source: IMF International Financial Statistics.1/ Includes 29 countries of “selected 50 countries” for which data are available. Short-term interest rates are money market or interbank market rates.

21. Inflation expectations remained elevated in most countries. Inflation expectations for 2008 (as provided in Consensus Forecasts) rose above the official targets (Figure 15). However, the size of the increase in inflation expectations varied, and was associated with the level of real interest rates: inflation expectations seem to have risen more in countries where real policy rates have declined the most.14 Inflation expectations seem to be relatively well contained in a few IT countries (e.g., Czech Republic, Hungary, Israel, Poland, Brazil, Korea, Mexico), and seem to have come down for 2009 from their 2008 levels in most IT countries, notwithstanding the continued rise in inflation beyond the targets. The latter is supported by the limited data available on inflation expectations derived from inflation-linked bonds, which suggest that inflation expectations for a selected group of IT countries (Brazil, Colombia, Korea, Mexico, Poland, South Africa, Turkey) have peaked around July-August 2008, approaching levels observed early this year.

Figure 15.
Figure 15.

Inflation Expectations for 2008 and 2009 vs. Actual and Targeted Inflation

(June 2008, In percent) 1/

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IMF International Financial Statistics, Consensus Forecast reports, and national central bank websites.

22. Inflation pressures also did not respond much to administrative measures to tighten liquidity. While controls on bank credit or reserve requirements have arguably helped slow bank lending to the private sector in a number of countries, the impact on overall credit, including from other sources (such as direct borrowing from abroad or nonbank financial institutions) has been less marked. The impact of the measures on aggregate demand and inflation is therefore ambiguous, although from a counterfactual point of view, demand and inflation pressures could perhaps have been stronger in the absence of such measures (see also Enoch and Ötker-Robe, 2007).

23. The delayed and relatively modest actions may reflect several policy dilemmas and concerns:

  • Conflicts with growth objectives. Many countries faced difficult choices between raising interest rates to fight inflation and maintaining stronger growth. These choices were made more difficult by uncertainties about the nature of the shocks. In particular, there were difficulties in judging whether the fuel and food price shocks were temporary. Some country authorities continue to believe that the inflation surge was the result of a temporary supply shock with a limited risk of second-round effects that did not warrant a monetary policy response. There are also increasing concerns about a global economic slowdown.

  • Conflict with financial stability concerns. Many countries have also been facing a difficult dilemma between raising interest rates to counter inflation and coping with the current financial crisis that is affecting both developed and emerging market economies. In some instances, central banks feared that taking aggressive action might jeopardize their limited independence, while in others there were concerns about higher interest rates exacerbating the potential impact of global liquidity conditions on their domestic financial systems. The recent deepening of the crisis has likely shifted policymakers’ focus farther away from inflation concerns, toward limiting financial instability and its implications for worsening growth prospects.

  • Conflict with exchange rate policy. Many countries have given priority to exchange rate stability. These include countries with hard or soft pegs as well as those who have been reluctant to see more rapid and extensive appreciation of the exchange rate. In particular, a number of countries with floating exchange rates have been hesitant to raise interest rates more aggressively owing to fears that such a move could lead to further exchange rate appreciation and capital inflows, fueling credit growth and higher inflation.

IV. Menu of Options for Policy Advice

24. Policymakers are facing a very challenging environment, with major domestic and external shocks. Commodity prices, although significantly off their peaks, remain high and volatile (WEO, 2008). Thus, while headline inflation may ease (as already observed in a number of countries in Europe and Asia), there is a lingering risk of second round effects. This risk is particularly great for countries where underlying inflation has been rising as a result of both the spillover of the first round effects of high commodity prices and excess aggregate demand pressures. At the same time, financial markets are experiencing a deepening crisis that is spreading from advanced countries to emerging market economies, worsening economic growth prospects but also leading to capital outflows and exchange rate depreciation that may to some extent be passed through to inflation.

25. While these concerns will overshadow policy making, central banks in a number of emerging market and developing countries need to balance these risks against those of inflation pressures. In particular, monetary policy makers will need to remain vigilant and signal a strong commitment to bringing inflation back to its pre-shock levels, particularly where excess demand pressures have been evident and the nature of the price shocks has been uncertain. Successive deviations from official inflation objectives have hurt the credibility of many emerging market central banks and require appropriate monetary policy actions to anchor inflation expectations. Where inflation expectations remain high or rise further, the extent of an eventual tightening could be greater and the adjustment more costly. It is also important that central banks be forward looking in their policy responses, taking account of projections for the next 12 to18 months, while being mindful of the relative probabilities and costs of severe but plausible outcomes.

26. To the extent that a tightening of monetary policy is needed, it should be implemented using good operational practices (see Appendix VI for more details):

  • Indirect instruments should be used to the extent possible. Mopping up or maintaining tight liquidity, where needed, should be done primarily via open market operations. If short-term capital inflows increase, sterilization should be used as required.

  • Non-remunerated reserve requirements (NRR) on bank deposits and credit controls should be used only as a last resort. NRRs are a tax on the financial system and, like credit controls, distort financial transactions and encourage disintermediation towards offshore markets or activities that are less-well regulated or supervised.15

  • Even so, it may be necessary to use NRR on a temporary basis when there are no other good options, for example when (i) the interest rate channel is weak or nonexistent given shallow financial markets, no independent monetary policy, or a high degree of financial dollarization; or (ii) when first-best monetary policy tools need to be supplemented under heavy capital inflows given the large quasi fiscal costs associated with significant sterilized intervention. To minimize side effects, central banks could accelerate their efforts to improve the monetary transmission mechanism by deepening financial markets so as to reduce the need to resort to such tools, and phase them out when inflation pressures subside.

  • Controls on capital inflows aimed at limiting the consequences of large inflows involve significant administrative costs—to control, extend, and change regulations—and their effectiveness is at best short-lived. The experiences of Thailand and Colombia in the 1990s, which imposed unremunerated reserve requirements on certain categories of inflows, provide examples of how little such controls will accomplish, especially in countries with somewhat more developed financial markets. Capital controls should, by and large, only be imposed to buy time in a balance of payments or financial crisis, and would not be helpful in the circumstances now facing most countries.16

  • Policy decisions need to be appropriately communicated. With central banks facing new communication challenges stemming from the difficult combination of rising inflation, slowing economic growth, and a deepening financial crisis in mature markets, the current environment is significantly more difficult and uncertain, and requires a renewed effort to credibly explain central bank actions. This is particularly important where central banks may need to provide additional liquidity to markets to stem market volatility while keeping inflation expectations well anchored. In doing so, they need to clearly communicate continuing commitment to price stability, while explaining how short term actions are consistent with this objective (Shimizu, 2008).

27. Supporting measures are needed to avoid overburdening monetary policy. First, even though demand pressures may be easing with the downturn in global economic activity, an appropriate fiscal policy stance could help manage aggregate demand. Second, productivity matching wage policies and curtailing backward looking indexation schemes would help to limit the contribution of wage pressures to inflation, especially in, but not limited to, those countries that have benefited from the supply shock. Third, structural reforms to boost productivity growth, enhance competitiveness, and increase labor market flexibility could add to the production capacity of the economy, helping in turn to reduce wage and price pressures in tight labor markets. Support from fiscal and incomes policies would also help avoid the risk of destabilizing exchange rate movements. The remainder of this section discusses the modalities of needed monetary policy actions.

A. Considerations for Inflation Targeting Central Banks

28. Country experiences with IT suggest that well-established policy credibility is essential in coping with unfavorable supply shocks. When expectations are well anchored, the increase in inflation from unfavorable supply shocks has relatively little effect on inflation expectations and hence minor second round effects, and policy does not have to be as restrictive as otherwise. Lack of fully established credibility would therefore call for stronger policy actions to counter inflation pressures, and the central bank would need to be prepared to be more pro-active in raising interest rates to bring about more visible reductions in inflation.17

29. The role of central bank credibility in responding to a rise in inflation can be illustrated quantitatively. Using a simple dynamic general equilibrium model calibrated to an emerging market economy faced with oil and food shocks, illustrative simulations show that low credibility associated with a delayed reaction to higher inflation can lead to inflation expectations becoming more entrenched at higher levels. The result would be an inevitable increase in interest rates that generates a larger output loss compared with an earlier reaction to rising headline inflation (see Appendix VIII, as well as Alichi and others, 2008).18

30. IT central banks then need to be especially careful to avoid losing credibility and undermining the future effectiveness of monetary policy. The following considerations may be useful in shaping their policy response:

  • Official inflation targets should not be revised upward. Such a move would undermine the credibility of a monetary policy framework in which the overriding objective is to achieve low inflation or price stability, and not to hit the targets per se. Markets could perceive central banks as being more accommodative of higher inflation and loosening monetary policy, and given the already fragile state of central bank credibility in many IT countries (as evident from the rise in inflation expectations), a further weakening of credibility could easily unanchor inflation expectations.19 A higher inflation target (or a range) will also not guarantee that real interest rates will be lower. In fact, the central bank may need to tighten even more aggressively to limit losses of monetary policy credibility, and higher nominal and real interest rates may in turn affect financial stability with perverse effects on the economy.20 21

  • Widening the target band around an unchanged mid-point target is also likely to be counterproductive. The target bands are used mostly for accountability purposes, as a trigger point for explanations when the mid-point target is missed. Widening the band may reduce the need to provide explanations and may allow the central bank to deal with the uncertainty associated with the supply shock without breaching its target. However, the implications for credibility would not be very different from those of raising the target. By widening the band, the central bank could be perceived as signaling that it is willing to tolerate a higher level of inflation. In addition to the technical difficulties in determining the “appropriate” width of the target band, the move could also validate higher inflation expectations, with the new upper limit potentially becoming the focal point for inflation expectations.

  • IT central banks could lengthen the announced period for the achievement of the longer-term target (or “target horizon”). In principle, the target horizon should match the lags in the transmission mechanism. Having a longer-term horizon can be critical at the current juncture, where IT countries are subject to shocks that can result in significant and persistent upward revisions to the official inflation forecast, and in a slower return of inflation to the medium/long-term target. Having a relatively short target horizon can be counter-productive and undermine credibility, especially if this posture fails to provide sufficient time for policy actions to affect inflation, also in view of transmission lags.22

  • Similarly, the “policy horizon” could be longer, especially following a supply shock, for countries that are disinflating when policy credibility is still low. Hit by a negative supply shock, the authorities could communicate, with well-articulated arguments, that the period over which they expect to return to the long run target inflation rate is likely to be longer.23 This approach is consistent with the view that, when the economy is hit by shocks, monetary policy should not try to bring inflation in a tight range in the short run, since doing so would result in excessive fluctuations in economic activity and might damage perceptions of the comptence and credibility of the central bank.24 Instead, “when shocks to the economy are sufficiently large, inflation may have to approach the target gradually over time and this could be longer than the two years that is usually assumed as a reasonable time horizon for monetary policy to have its intended effect on inflation” (Mishkin, 2008).

  • Inflation forecasts have a role, in this connection, in anchoring short-term expectations, by describing how the central bank sees the inflation-output trade-off and the resulting ideal path towards the medium term objective. Central banks can update and use the inflation forecast as the intermediate target and a communication tool to signal how long inflation will take to return to the long-term target. On the other hand, the medium term objective—the inflation target—sets the overall strategy and direction and should not be changed.

31. If the authorities nonetheless decide to revise the target, the following steps may help to maintain credibility and mitigate negative effects:

  • The authorities should communicate to the public that monetary policy remains firmly focused on controlling inflation in the medium-term.

  • To counter perceptions that adjusting the target signals a lack of commitment to low inflation, the central bank should adopt an ambitious plan for bringing inflation back to the revised target. In the short-term, policy may need to be tightened more aggressively to ensure that the target adjustment is not interpreted as an abandonment of the anchor objective. Brazil’s experience with revising the targets upward during 2003-04 is illustrative in this regard (Box 1).

  • If possible, the new target should also be set below long-term inflation expectations.

Brazil’s Experience with Revisions to the Inflation Target in 2002–2004

After adopting an IT framework following the 1999 currency crisis and breaching the inflation targets for two years in a row, Brazil revised the official inflation target upward. The adjustment followed the central bank’s shifting the target downwards every year. The target was revised up in January 2003 from 4 percent to 8.5 percent for 2003 and from 3.75 percent to 5.5 percent for 2004. The revision was carried out as part of an approach to guide 2003 monetary policy by an “adjusted target” that involved the partial accommodation of the inflation inertia inherited from the past, and the accommodation of first-round effects of a certain class of identifiable supply shocks (see Bevilaqua and Loyo, 2004). The new methodology served to indicate explicitly the trajectory through which inflation should be expected to return to target over the following two years; however, the targets for any year could be adjusted in the course of that year to accommodate the first-round effects of certain supply shocks.

The target revision followed a steep depreciation (44 percent in 2002) of the domestic currency, which spurred inflation from less than 8 percent in June 2002 to nearly 13 percent in December 2002. The currency depreciation was the result of a deep confidence crisis associated with the presidential campaign, notably worries about the direction of economic policy under a prospective President Luis Inacio da Silva, and was exacerbated by various external shocks.

The target revision was accompanied by substantial monetary tightening and other supportive policies which helped support the credibility of the inflation target. The BCB increased the policy rate from 18.5 percent to 25 percent during the second semester of 2002 ahead of the target revision. Rates were increased further in early 2003 to reach 26.5 percent. In February, the interest rate hike was complemented by an increase in the reserve requirements of commercial banks. In March, the rate was kept unchanged but an upward bias was announced. The new government implemented a prudent fiscal policy and gave de facto independence to the BCB.

These policies eventually paid off. Initially, expectations for 2004 inflation remained stubbornly at 8 percent. It was only when the MPC decided, at its April meeting, to maintain rates at 26.5 percent for the third month in a row, that inflation expectations started to fall, for both 2003 and 2004 horizons. The pressure on the real subsided and inflation started to decline. Starting from June, the MPC opted for a modest 50 basis point rate cut, followed by a further 150 basis point cut in July after inflation expectations had fallen to 10.4 percent for 2003 and 6.5 percent for 2004. At the end of June, the government adopted the 5.5 percent adjusted target as the official inflation target for 2004. Unlike the adjusted targets, official targets were firm, not contingent, but a ±2.5 percent margin was set around them. It was felt that it was time to return to firm targets, which were more easily understood by the general public, while maintaining the originally planned trajectory of convergence to the long-run targets. An official target of 4.5 percent for 2005 was also announced, with ±2.5 percent tolerance margins. In June and July, helped by the appreciation of the real, monthly inflation rates fell significantly. The level of activity also reached a trough in the second quarter.

Brazil’s experience suggests that it is possible to restore the credibility of the regime, even when the inflation targets are missed repeatedly and revised upward, provided that: there are legitimate reasons for the misses and the authorities accompany the target revision with an appropriate degree of monetary tightening, fiscal prudence, and measures to strengthen central bank autonomy, along with adherence to a planned trajectory of convergence to the long-run targets.

32. Central bank communications are particularly crucial in the current circumstances, especially when inflation targets have been overshot and other considerations may be affecting decision-making.

  • To limit damage to credibility, the main message to convey is that monetary policy remains focused on price stability. The central bank should also explain the reasons for tightening policy, stressing that the change in its policy stance reflects uncertainties about the duration of the shock and the associated risks, and that the size of the shock may be too large to bring inflation quickly back to its medium-term target without monetary action. The latter is particularly relevant for countries where overheating pressures and capacity constraints are contributing to rising inflation.

  • The central bank could also explicitly recognize that shocks do occur and reaffirm the medium term nature of the target. In public statements as well as in inflation reports, central banks should explain their views on: (i) the nature of the shock; (ii) the impact on inflation developments and hence why the inflation rate is deviating from the targets; (iii) policy implementation lags; (iv) a credible policy path that shows how inflation will be brought back to its longer-term target; and (v) the time horizon over which this is expected to occur.

  • The risks associated with a delayed policy response could also be reduced by frequent monitoring and communication of the various components of inflation. Frequent analyses of the effects of commodity prices on core inflation and expectations could help in assessing the extent of second round effects and the underlying pressures unrelated to the supply shock. With food and energy making up a very significant component of the CPI basket (up to 70 percent) in some countries, central banks also need to guard against the risk of underestimating core inflation (hence failing to identify second round effects), including by using various indicators of inflation and varied application of techniques to estimate core inflation.

B. Considerations for Non-Inflation Targeting Central Banks

33. Except where monetary policy is fully endogenous, monetary and exchange rate targeting central banks should signal a strong commitment to bringing back inflation to the pre-shock levels.

  • Monetary targeting central banks should keep intermediate targets unchanged.25 In addition to tightening the monetary stance, they should allow the exchange rate to appreciate gradually to compensate for imported inflation, especially in those countries that have benefited from the oil shock. If tightening monetary policy induces capital inflows, sterilized intervention may be warranted.

  • Countries with a soft exchange rate target have little room for maneuver on monetary policy and will need to rely mainly on fiscal policy to fight inflation. The central bank might raise interest rates to moderate possible demand pressures, if there is any scope to do so within the constraints of the exchange rate objective. Capital inflows triggered by higher interest rates could be absorbed with sterilized intervention, as needed, in the short-run. Capital controls may seem appealing in some cases, but are likely to be either of limited effectiveness (if modest in scope) or highly distortionary (if comprehensive).

34. When monetary policy is fully endogenous—fixed exchange rates and hard pegs under sufficient capital mobility—monetary policy options are even more constrained. Barring a change in the exchange rate arrangement, other macroeconomic policies need to be used to fight inflation.26 Changes in the exchange rate arrangement could also be contemplated where warranted, for example, if an anchor currency is no longer thought to be a suitable font of nominal stability. The transition from fixed to floating needs to be properly managed and based on certain other pre-requisites if it is to be successful (see IMF, 2004, and Ötker-Robe and Vávra, 2007, and Appendix IX for a summary).

35. Non-IT central banks should also enhance institutional capacity to boost the effectiveness of the policy response. In particular, efforts should focus on enhancing communication and transparency and the operational framework for monetary policy.

  • In view of the uncertain environment, especially with the ongoing global financial turmoil and economic slowdown, improving central bank communications is critical. Non-IT central banks should regularly explain to market participants the current dynamics of inflation, monetary policy responses, and lay out the expected possible outcomes. They should also extract information from market data, especially about inflation expectations, to help measure the impact of the current policy response and to improve the timing of policy decisions.

  • Central banks should make available to the markets on an understandable, accessible, and timely basis the rationale and the information underlying their policy decisions. Central banks should also explain how inflation developments are taken into account in their monetary policy actions. Increased transparency fosters the effectiveness of monetary policy and reinforces policy credibility. Higher credibility in turn lowers the sacrifice ratio, that is, the output cost associated with reducing inflation.27

  • Non-IT central banks should also improve the operational framework for monetary policy, where needed. This implies strengthening systemic liquidity forecasting and management with the aim of strengthening the effect of adjustments in the operational variable (e.g., a short-term policy rate) on the intermediate target, and ultimately on inflation. Central banks should rely primarily on indirect instruments of monetary policy in managing liquidity. As a supporting measure, they should foster the development of financial markets to improve monetary policy transmission and reduce the need for direct instruments.

V. Concluding Remarks and Policy Implications

36. This paper has reviewed inflation developments through mid-2008 in a sample of 50 emerging and developing countries and discussed their underlying causes, accompanying challenges, and the associated policy actions. The key conclusions are as follows:

  • Both aggregate demand pressures and surging commodity prices played a role in rising inflation in many emerging and developing countries. Growing capacity constraints and tighter labor markets also contributed to inflation pressures, with second round effects.

  • Although official inflation targets were overshot by most emerging market IT countries—the first real challenge to the credibility of the IT regimes—IT countries have in general seen inflation rise by less. Currency appreciations under the more flexible exchange rate regimes and a greater degree of central bank independence and transparency have generally been associated with lower inflation.

  • Most central banks have tightened monetary policy to constrain aggregate demand and anchor inflation expectations, though the timing and speed of the monetary policy actions varied significantly. The effect of monetary tightening has been limited at the time of the writting, given the delayed actions in many countries, lags in policy transmission, and the magnitude of the tightening.

  • Although headline inflation pressures have eased somewhat since May 2008 in some countries, in part reflecting the decline in commodity prices, inflation continues to remain high in many others. Second-round effects may prevent a quick reduction in inflation, and recent policy measures may take time to have an effect. Going forward, capital outflows and the associated exchange rate depreciation may contribute to inflation in a number of countries despite the slowdown in global growth.

  • Central banks need to signal a strong commitment to bringing inflation back over time to the pre-shock rates. Monetary policy makers will need to be vigilant, and further tightening may still be needed in some countries, particularly where demand pressures are still evident and credibility of monetary policy is weak.

  • The recent inflationary episode has shown the importance of policy credibility in limiting the risk of higher inflation becoming entrenched in inflation expectations. Absent fully-established credibility, stronger policy action is needed. Central banks need to be proactive and forward looking, acting in response to projected conditions while being mindful of the relative probabilities and costs of severe but plausible outcomes.

  • When monetary policy is fully endogenous, as under hard exchange rate pegs, other macroeconomic policies need to be used to control inflation. Changes in the exchange rate arrangement could also be contemplated if an anchor currency no longer provides adequate nominal stability.

  • IT central banks should not change inflation targets, but could extend the horizon over which inflation converges to the medium-term target. A temporarily longer horizon would help avoid adverse effects on inflation expectations and excessive fluctuations in economic activity that may in turn weaken credibility. Close monitoring of second round effects is critical to correctly calibrating and timing policy actions.

  • Communications are crucial in limiting the damage to credibility associated with overshooting (or revising) inflation targets. New communication challenges arise from the difficult combination of higher inflation, slowing economic growth, and a deepening financial crisis. These call for stepped-up efforts to explain central bank actions and renewed emphasis on a continued commitment to low inflation.

  • Direct or administrative monetary policy tools should be used only as a last resort, and only temporarily. To reduce the need for such tools, central banks should seek to improve the monetary transmission mechanism, including through financial market development. Allowing the exchange rate to appreciate, greater support from fiscal policy, and productivity matching wage policies would help mitigate wage and price pressures, while also helping avoid overburdening monetary policy.

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Appendixes

Appendix I. Cross Regional Inflation Developments28

1. Inflation pressures rose sharply since mid-2007 in emerging market and developing economies. By region, Middle-East and emerging European countries faced stronger inflation pressures than other regions, although there were significant differences in the severity of the pressures within the regions (Appendix Figure 1). While surging food and energy prices were a common driver in all regions, aggregate demand pressures also contributed to inflation pressures (Appendix Table 1). As a result, inflation pressures became more broad-based in most countries. Except in China, Israel, and Malaysia, core or underlying inflation (excluding food and energy) rose along with headline inflation, suggesting second round effects. Inflation expectations also rose.

2. In emerging and developing Europe, central banks faced rising inflation pressures since mid-2007, against the background of slowing growth and a global credit crunch. The pick up in inflation was most substantial in countries where the local currencies are either pegged (e.g., Bulgaria, Estonia, Latvia, Lithuania, Ukraine) or had depreciated vis-à-vis the euro (e.g., Serbia, Ukraine). Inflation rates were in the double digits in Bulgaria, the Baltics, Russia, Serbia, Turkey, and Ukraine, rising well above the Maastricht criteria in most new EU countries, thereby threatening the prospects for euro adoption (Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania). In countries pursuing IT regimes, actual inflation rates exceeded the upper limits of the official targets. Core inflation rose in many European countries, with indications of second round effects. There has been some slowdown in the pace of inflation since May 2008, reflecting the decline in commodity prices, as well as more sluggish economic activity.

3. In emerging Asia, similarly, inflation pressures rose, most notably since the middle of 2007, though the magnitude varied across the region: inflation in Vietnam surged to over 20 percent in the first half of 2008, and exceeded, or approached, double digits in Indonesia and Philippines, while that in Hong Kong SAR, Malaysia, and Korea was more moderate. In Indonesia, Korea, and Philippines, the official inflation targets were breached since the beginning of 2008, while inflation in Thailand remained within its target range during the first half of the year. Core inflation was also up in many of the countries in the sample, and inflation expectations increased in all. Similar slowdown were observed in the pace of inflation in emerging Asia since about May 2008, reflecting falling commodity prices.

4. In Latin America, inflation pressures also rose, albeit more modestly than in Europe, Asia, and the Middle East. Inflation pressures also varied across the region, with the largest pick-up in Chile, Guatemala, Honduras, and Dominican Republic (with double digit rates in the last three). Inflation accelerated at the fastest pace in the formally dollarized countries (El Salvador, Ecuador, and Panama, from less than 3 percent on average to more than 9 percent since end-2006) vis-à-vis countries with other monetary regimes. Among the six IT countries of the region, Chile and Guatemala showed the largest deviations from official targets, while Brazil’s inflation remained within its target. Core inflation and inflation expectations also rose. Second round effects were present in all countries.

5. In the middle-east and central Asia, inflation accelerated sharply and reached historical highs. Most Gulf oil producers had double digit rates, as well as Armenia, Egypt, Jordan, Kazakhstan, Kyrgyz Republic. In Egypt, inflation soared to almost 20 percent, the highest in almost 10 years, and in Kyrgyz Republic jumped by more than 20 percentage points since end-2006, to 24 percent.

6. In Africa, as well, inflation reached double digit levels in Botswana, Ghana, and South Africa. In South Africa, inflation surged to near five-year highs, with the official inflation target missed 12 months in a row, providing the most severe challenge to the authorities since the inception of IT. In Botswana and Ghana as well, inflation exceeded the upper band of the inflation objectives.

Appendix Figure 1.
Appendix Figure 1.

Inflation Performance in Emerging World, June 2008

(In percent)

Citation: IMF Working Papers 2009, 001; 10.5089/9781451871487.001.A001

Sources: IFS, staff calculations.
Appendix Table 1.

Fund Staff and the Authorities’ Analysis on the Nature and Drivers of Inflation

article image
Sources: IMF Country Reports, selected issues; area department desks; National central bank Inflation Reports and websites; internal memos of area departments; Economy Watch Blogs, News articles.

Second round effects are considered to be present when price increases have been more broad based that could lead to rising inflation expectations, higher wage pressures, and underlying (core) inflation.

Appendix II. Econometric Analysis of the Drivers of Inflation

7. This appendix provides a brief description of the econometric exercises carried out in the context of the paper. It analyzes the determinants of the inflationary pressures in emerging markets and developing countries, and the effectiveness of monetary policy responses. In particular, it focuses on the following questions:

  • What were the main drivers of the ongoing inflationary pressures in emerging market and developing countries? Did these pressures originate from external factors associated with the recent evolution of commodity prices, or from aggregate demand pressures?

  • Did second-round effects play any role in the observed surge in inflation? If so, are there any differences between countries with different monetary policy regimes?

  • What were the observed effects of the ongoing monetary tightening on inflation? Are there any differences between countries with different monetary policy regimes?

  • Were cross-country differences in inflation performance somewhat influenced by the institutional frameworks of monetary policy?

  • What was the estimated contribution of various factors, including monetary policy tightening, to the inflationary episode?

8. All the estimations are based on a panel dataset covering 49 emerging market and developing economies, at the monthly frequency, during Jan 2005–June 2008.29 The selection of countries reflects data availability (i.e., it includes all countries with available information), while the time coverage takes into account the span of the inflationary episode. Since the sample size has a maximum of 30 observations per country, the exercises exploit asymptotic results based on the panel dimension.

9. The baseline model has the general form:

πit=απit1+xitβ+wtγ+ηi+vit,

where πit stands for the year-on-year monthly inflation, and the sub-indexes i and t represent the panel (i.e., countries) and time dimensions, respectively. The lagged dependent variable is included in the set of regressors to account for inflation inertia. In turn, the variables in the vector xit (which may entail lags) capture factors associated with the monetary policy stance, aggregate demand pressures, and capacity constraints. These variables are considered to be either predetermined or endogenous. The variables in the vector wt capture inflationary pressures originating from world commodity prices, which are common to all countries, and are treated as strictly exogenous. The term ηi refers to country-specific time-invariant factors (or fixed effects) that we do not model explicitly, and vit is the country-specific error term, which has zero mean, and is assumed to be uncorrelated with its past and future realizations, and with the country fixed effects. Under this specification, the short-term inflationary impact of an increase in the explanatory variables included in the vector x is given by their corresponding β coefficient, while the long-term impact is given by β / (1–α). A similar treatment applies to the inflationary impact of the variables included in the vector w.

Baseline Exercises

10. A number of exploratory exercises were carried out to guide the choice of variables and their lag structure. In the selected baseline specification, the vector x of (possibly endogenous) variables includes: (i) lagged changes in the POLICY INTEREST RATE to capture inflation inertia and the monetary policy stance, and (ii) lagged CREDIT GROWTH as a proxy for aggregate demand pressures.30 In turn, the vector w of strictly exogenous variables includes FOOD INFLATION AND OIL INFLATION to capture external inflationary pressures. The definition and source of these variables is provided in Appendix Table 2. Summary statistics for these variables (not reported), show that IT countries have been able to achieve lower inflation than non-IT countries with roughly comparable increases in interest rates. Also, IT countries have been more aggressive in strengthening their frameworks of central bank governance, entailing stronger CBI and higher levels of monetary policy transparency.

11. The estimation of the selected baseline specification, using five alternative methods, is presented in Appendix Table 3. All the regressions include a set of country dummies. Time dummies are excluded to allow the assessment of the pass-through of food and energy prices to inflation (i.e., the inclusion of time dummies would preclude this analysis, as food and energy prices are common to all countries). As a robustness check, however, a parallel set of regressions were computed, including a complete set of country and time dummies, with similar results (for the coefficients of the country-specific variables). Interestingly, the coefficients associated with the time dummies in these regressions were positive and increasing over time, providing initial evidence that countries have been exposed to a common inflationary shock, particularly after the third quarter of 2006. This is consistent with hypothesis of inflation being (at least) partially driven by the rise in commodity prices.

Appendix Table 2.

List of Variables Used in the Estimations

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Appendix Table 3.

Results from the Baseline Specification

article image
Robust standard errors in brackets* significant at 5%; ** significant at 1%

12. The results indicate that the signs of the coefficients are stable across the five estimation methods and consistent with economic theory. In particular, monetary policy tightening is associated with a drop in inflation, with a lag of about one year (see below). Aggregate demand pressures and higher commodity prices are also shown to have a positive effect on inflation. In terms of magnitude, the point estimates of the coefficients and their significance levels are broadly stable across the five estimation methods. As expected, the autoregressive coefficient resulting from the Pooled OLS in column [1] is higher than the Within Groups estimate in column [2], reflecting known biases associated with the inclusion of the lagged dependent variable. Since the autoregressive coefficient in these two estimations is too close to one, the regression is computed again in column [3], after applying first differences to both sides of the equation to achieve stationarity, and using GMM to account for endogeneity. This estimation treats INFLATION, the POLICY INTEREST RATE and CREDIT GROWTH as endogenous, using their lagged levels (2 to 4 lags) as instruments.31 In turn, the estimations under column [5] and [6] further exploit information from the equations in levels, using System GMM.32

13. Overall, the specification presented in column [3] is likely to produce the more consistent point estimates. However, it precludes us from testing some of the questions posed above, as differencing the right-hand side variables removes time-invariant institutional variables associated with central bank governance that we also want to test. Therefore, we use the point estimates of specification [3] as the basis for the analysis whenever possible, and resort to the specification [5] in the tests involving variables that vary exclusively along the cross-sectional dimension.

Selected Tests

What were the main drivers of observed inflation?

14. The regression results suggest that the observed inflationary pressures have been driven by a combination of aggregate demand pressures, proxied by credit growth, and increases in food and energy prices. Using the coefficients presented in column [3] of Appendix Table 3, a one percent increase in credit growth leads to an 8.7 basis point increase in inflation on impact, and a cumulative increase of 25.4 basis points in the long-run (i.e., 8.7×1/(1–0.658)). On the other hand, the results suggest that the role of FOOD INFLATION and OIL INFLATION in the inflationary episode has not been as important as commonly believed. In particular, a 1 percent increase in oil prices translates into a 1 basis point increase in inflation on impact and a cumulative increase of 2.9 basis points in the long-run.33 The pass-through of food prices into inflation is of similar magnitude.

Appendix Table 4.

A Further Look at the Pass-Through of Food and Energy Prices

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Robust standard errors in brackets* significant at 5%; ** significant at 1%