Abstract
The Selected Issues paper examines policy challenges for inflation targeting in Hungary. It highlights that inflation targeting has been met with much initial success. A well-defined policy framework helped guide inflation expectations and provided an initial impetus toward resuming disinflation. The paper also focuses on the impact of aging on the public pension system. It describes the background underlying Hungary’s current pension system, and provides a review of some of the recent work assessing Hungary’s pension system viability.
I. Inflation Targeting in Hungary: Implementation and Policy Challenges1
A. Introduction
1. The National Bank of Hungary (NBH) adopted an inflation (IT) targeting framework in June 2001, consistent with its primary objective of achieving and maintaining price stability. This followed the widening of the exchange rate band in early May 2001 from ±2¼ percent around the central rate against the euro to ±15 percent.2 These decisions marked a significant change in Hungary’s monetary and exchange rate regime: an inflation target replaced the exchange rate as a new anchor for monetary policy.3 In a policy statement, the NBH indicated its aim of bringing inflation down to EMU-compatible levels by 2004/2005 so as to qualify for early adoption of the euro.4
2. It had become increasingly clear that a change in the monetary framework would be desirable to resume disinflation. The introduction of inflation targeting followed a period during which disinflation had stalled. Under the previous narrow exchange rate band regime, in which the central rate was adjusted according to a preannounced rate of crawl, the monetary authorities had limited leeway to tighten monetary policy, a difficulty frequently accentuated by strong capital inflows that kept the forint at the strong edge of the band. The NBH had to conduct sterilized intervention at times, and the risk of fueling additional inflows prevented the active use of interest rate hikes to tackle inflation. By 2000, it was evident disinflation had stalled: average inflation in that year—at 9.8 percent—barely budged from the 10 percent recorded for 1999. The new framework helped avoid the risk that inflation would settle in at 10 percent or more, which could have raised the costs of achieving lower inflation and complicated the approach to EU membership and adoption of the euro.
3. Inflation targeting has met with much initial success. It created a well-defined policy framework (see Box 1), which helped guide inflation expectations (Figure 1) and provided an initial impetus towards resuming disinflation. Coupled with the band widening, the authorities increased the room for maneuver for monetary policy to fight inflation. Monetary conditions were, in fact, tightened: the forint appreciated by some 10 percentage points against the euro since the band widening and, with inflation expectations coming down, real short-term interest rates increased. So far, tradable goods price inflation has moderated some 2 percentage points on the heels of the appreciation of the exchange rate. Year-on-year consumer price inflation declined steadily from 10.8 percent in May 2001 to 5.9 percent in March 2002, also reflecting declining food and fuel prices, and lower inflation in services.
Hungary: Reuter’s Poll of Year-on-Year CPI Inflation Forecasts for end-December 2002
Citation: IMF Staff Country Reports 2002, 109; 10.5089/9781451817867.002.A001
Sources: NBH and Reuters.Hungary: Reuter’s Poll of Year-on-Year CPI Inflation Forecasts for end-December 2002
Citation: IMF Staff Country Reports 2002, 109; 10.5089/9781451817867.002.A001
Sources: NBH and Reuters.Hungary: Reuter’s Poll of Year-on-Year CPI Inflation Forecasts for end-December 2002
Citation: IMF Staff Country Reports 2002, 109; 10.5089/9781451817867.002.A001
Sources: NBH and Reuters.The Inflation Targeting Framework of the National Bank of Hungary (NBH)
Inflation targeting helped create a transparent and well-defined policy framework, with the following key characteristics:1
An objective of satisfying the Maastricht criteria on inflation by 2004/2005, with intermediate inflation targets of 4.5 percent for end-2002 and 3.5 percent for end-2003.
Inflation targets formulated as the 12-month rise in the CPI at end-December. The decision to use headline instead of core inflation reflected the goal of keeping the framework transparent and simple. A tolerance band of ±1 percent around the central targets allows for unexpected shocks to inflation.
Using the NBH’s benchmark interest rate as the primary instrument to attain the inflation goal. Among the various channels of monetary policy transmission, the exchange rate is viewed as the most powerful and fastest one. Reflecting lags in the transmission mechanism, the NBH works with a target horizon (i.e., the period over which the NBH commits to trying to achieve the targeted inflation rate) of 1 to 1½ years.
Preparing and publishing detailed quarterly inflation forecasts six quarters ahead, as part of the NBH’s Quarterly Inflation Report. This report also provides an analysis of inflation developments, discusses inflation projections and risks, and describes considerations underlying monetary policy decisions.
A Monetary Council that decides on changes in monetary policy. Its policy actions are aimed at addressing divergences between the forecast of inflation and the inflation target.
4. Notwithstanding these successes, the new framework is confronted with challenges. First, a great deal of uncertainty remains about the monetary policy transmission mechanism—particularly through the interest rate channel, but also via the pass-through from the exchange rate to inflation (the subject of Section B below), Second, tensions may arise from operating an inflation targeting framework in the context of an exchange rate band (discussed in Section C). Finally, minimizing the real costs of achieving lower inflation is a key objective and challenge (discussed in Section D). In each of these sections, the aim of this paper is to draw out some ortant considerations. These were relevant parts of the discussions for the 2002 Article IV consultation.5
B. Monetary Policy Transmission Mechanism
5. In an open economy, monetary policy actions are transmitted in various ways. Briefly, through the interest rate channel, an increase in interest rates can reduce inflation by reducing aggregate demand, and by influencing inflation expectations, which in turn affect the wage and price-setting mechanism. Through the credit channel, two effects are generally distinguished: the impact of a tighter monetary policy on the supply of loans by banks (the lending channel) and, the impact on the liquidity of borrowers (the balance sheet channel). The direct exchange rate channel entails the pass-through of exchange rate changes (an appreciation in the case of a tighter monetary policy) on to tradable goods prices, as well as indirect effects on the prices of domestically produced goods via the price of imported intermediate inputs.6
6. The impact of changes in monetary policy through the interest rate and credit channels is constrained by the structure of the economy. While determining the efficiency of monetary transmission is not an easy task, there is some evidence for Euro area countries that interest rate effects are sizable (Guiso et al. (1999)) (Table 1). And for a number of these countries, the interest rate channel is a dominant channel in the transmission mechanism (Angeloni (2002); Mojon and Peersman (2001); and, van Els et al. (2001)). While the interest rate and credit channels may become more influential over time in Hungary, these effects are likely to be moderate now for three main reasons. First, the direct impact of interest rate changes on domestic demand can be expected to be relatively weak because of limited financial deepening (for example, the ratio of broad money to GDP is low at about 50 percent of GDP). Second, bank intermediation is low in Hungary. The ratio of bank loans to GDP is 25 percent compared with the EU average of 91 percent, reflecting fairly low leverage of the household sector.7 An additional factor is that a large share of Hungarian enterprises relies on external borrowing, including intercompany loans (corporate external debt is close to 20 percent of GDP). Third, taking into account the balance sheet channel, the impact of rising interest rates on firms’ and households’ balance sheet positions should be modest, in light of the relatively low debt ratios in Hungary.8
Hungary: Effects of Interest Rate Changes on CPI
(In Percent)
Domestic short-term interest rates increase by one standard deviation (Mojon and Peersman (2001)).
Permanent 100 basis point interest rate increase.
Hungary: Effects of Interest Rate Changes on CPI
(In Percent)
| Euro Area | Country with Lowest Response | Country with Highest Response | ||||
|---|---|---|---|---|---|---|
| After 1 Year | After 3 Years | After 1 Year | After 3 Years | After 1 Year | After 3 Years | |
| VAR simulation1 | 0.00 | -0.07 | 0.00 | 0.00 | -0.24 | -0.36 |
| Structural model2 | -0.13 | -0.13 | 0.00 | -0.11 | -0.79 | -0.78 |
Domestic short-term interest rates increase by one standard deviation (Mojon and Peersman (2001)).
Permanent 100 basis point interest rate increase.
Hungary: Effects of Interest Rate Changes on CPI
(In Percent)
| Euro Area | Country with Lowest Response | Country with Highest Response | ||||
|---|---|---|---|---|---|---|
| After 1 Year | After 3 Years | After 1 Year | After 3 Years | After 1 Year | After 3 Years | |
| VAR simulation1 | 0.00 | -0.07 | 0.00 | 0.00 | -0.24 | -0.36 |
| Structural model2 | -0.13 | -0.13 | 0.00 | -0.11 | -0.79 | -0.78 |
Domestic short-term interest rates increase by one standard deviation (Mojon and Peersman (2001)).
Permanent 100 basis point interest rate increase.
7. The exchange rate is the dominant channel for monetary policy transmission, but the NBH’s ability to influence the exchange rate is limited. Benczur et al. (2002) highlight the importance of the direct exchange rate channel in the disinflation process in Hungary. An appreciating nominal exchange rate is not only the central, but also the fastest channel of monetary policy transmission in this regard.9 However, the main instrument of the NBH to influence the exchange rate is limited to its policy interest rate,10 and many other factors, which cannot be foreseen and involve expectations in financial markets over a range of domestic and external variables, also play a critical role. Moreover, the exchange rate can be volatile (Figure 2).
Hungary: Policy Interest Rate and the Forint 2001–2002
Citation: IMF Staff Country Reports 2002, 109; 10.5089/9781451817867.002.A001
Sources: NBH and staff estimates.Hungary: Policy Interest Rate and the Forint 2001–2002
Citation: IMF Staff Country Reports 2002, 109; 10.5089/9781451817867.002.A001
Sources: NBH and staff estimates.Hungary: Policy Interest Rate and the Forint 2001–2002
Citation: IMF Staff Country Reports 2002, 109; 10.5089/9781451817867.002.A001
Sources: NBH and staff estimates.8. There is also a good deal of uncertainty about the size and timing of exchange rate pass-through. At this early stage of the new monetary policy regime, too short a time series prevents new econometric estimates of the pass-through. Research by the NBH on the pass-through coefficient using historical data prior to the band widening (Darvas (2001)) estimates a long-run pass-through of 40 percent for Hungary, but shows the relationship was unstable.11 Evidence from relevant cross-country studies would seem to suggest that estimates of the pass-through to the overall CPI could fall in the range of 20 to 50 percent after 4 quarters (Box 2).
Selected Recent Empirical Estimates of the Exchange Rate Pass-Through
There is extensive research on the exchange rate pass-through in the literature, with a significant number of studies analyzing the pass-through to import and export prices, and mostly for industrial countries. The following recent studies estimate the exchange rate pass-through directly to consumer prices, and focus on emerging markets and/or inflation targeters:
Gagnon and Ihrig (2002) estimate a long-run rate of pass-through of 0.22 for a selected group of inflation targeters, using cross-country data for industrial countries between 1971 and 2000. Their results suggest that, on average, a one percent change in the nominal effective exchange rate causes consumer prices (CPI) to rise by approximately a quarter of a percent in die long-run.
Mihaljek and Klau (2001) estimate pass-through coefficients for a group of emerging market economies, using various sample periods between 1981 and 2001. Their estimates, based on nominal bilateral exchange rates, vary greatly from 0.08 in the Phillipines to 0.54 in Hungary (estimated for the period 1993 through 2000), and 0.56 in Turkey. These estimates are for the impact of contemporaneous exchange rate changes and up to two-quarter lags, with strong evidence of structural breaks for most countries.
Choudhri arid Hakura (2001) work with cross-section data for a group of 71 developing and developed countries from 1971 to 2001. They report pass-through estimates for Hungary of 0.18, 0.31 and 0.48 with 1, 2, and 4 lags (quarters) respectively, using nominal trade-weighted effective exchange rates.
9. A number of factors would tend to lessen the exchange pass-through in Hungary.12 First is the exchange rate regime itself. Under the new regime, with greater exchange rate flexibility, a change in the exchange rate is less likely to be regarded as permanent as then under the previous regime. And transitory changes in the exchange rate would be expected to have less effect on prices. Second, and related to the first, is the degree of exchange rate variability. There is some evidence in the literature that higher exchange rate volatility leads to a lower pass-through (Gagnon and Ihrig (2001)), including by clouding agents’ assessments of how temporary (or permanent) changes in the exchange rate are.13 Third, lower inflation has been associated with a lower pass-through (Taylor (2000)). This is because a low inflation environment itself may change price-setting behavior (Bank of Canada’s Monetary Policy Report): “when inflation is low, and the central bank’s commitment to keeping it low is highly credible, firms are less inclined to quickly pass higher costs on to consumers in the form of higher prices.” Choudhri and Hakura (2001) find evidence of strong association between the pass-through and the average inflation rate across a large group of countries and periods.14
10. In practice, the NBH has taken a pragmatic and flexible approach in dealing with the exchange rate pass-through in its central projection for inflation. In the absence of a firm historical relationship, and based on international experience, the NBH initially assumed that a permanent change in the forint’s exchange rate would lead to a 50 percent pass-through to the price level of tradable goods over the course of one year, and 75 percent over two years, translating roughly into a 20 percent pass-through to the CPI over two years.15 Since the band widening, however, the actual pass-through of the exchange rate appreciation on to tradable goods prices seems to have been slower than expected earlier16—possibly reflecting the first two factors discussed in the preceding paragraph. In its February 2002 inflation report, the NBH revised downward its working assumption for the pass-through to 37.5 percent and 60 percent over the course of one and two years, respectively—or about 15 percent for headline inflation over two years. This falls below the range of estimates in Box 2, possibly reflecting the desire by the NBH to use conservative assumptions, in addition to the recognition that the extent of the pass-through may have diminished.
C. Inflation Targeting and the Exchange Rate Band
11. The NBH’s move toward greater exchange rate flexibility, in the form of a wider exchange rate band, has several advantages. Besides allowing the NBH to move closer to EMU requirements and signalling the importance it still attaches to the exchange rate, it gave more leeway to respond to demand pressures, and provided a buffer to cope with potentially volatile capital flows—following the full liberalization of the capital account. In addition, greater exchange rate flexibility raised the exchange rate risk premium and eliminated the perceived exchange rate “guarantee” to domestic borrowers, discouraging unhedged borrowing by residents.
12. Under the new exchange rate regime, a nominal anchor was called for. While the exchange rate remains the main channel of disinflation in the new monetary policy framework, the exchange rate band, by design, is too wide to have the exchange rate effectively guide expectations. In focusing directly on the primary goal of disinflation, the explicit inflation target provides a transparent nominal anchor to guide monetary policy and expectations.17
13. The IT framework subordinates the exchange rate path to inflation targets. The viability of the wide band will depend, therefore, on adopting inflation targets and supporting policies that are consistent with the band itself. It is not unusual for central banks to adopt a flexible approach to IT in which there is a positive weight on variables other than inflation (such as output, the current account, or exchange rate variability) in the central bank’s objective function (Svensson (1998)). However, as pointed out in Mishkin (2001), if the central bank is also determined to respond to certain exchange rate movements or keep the exchange rate within certain bounds (consistent with the “fear of floating” identified by Calvo and Reinhart (2000)), meeting the inflation targets could be put at risk.18 So far, the width of the exchange rate band in Hungary seems to have been sufficient to mitigate such problems, as the forint has moved freely within the band. And the NBH has made clear its orientation of monetary policy towards achieving the inflation targets.
14. In practice, conflicts may arise between inflation targeting and the exchange rate band. Balassa-Samuelson effects need to be considered. Perhaps reflecting the scope for higher productivity in services in the transition context, these effects may be fairly small. However, there is also evidence that these effects may be large, so this is another area of uncertainty.19 Another example is the situation in which higher interest rates are needed to contain inflation, but may attract capital inflows, putting upward pressure on the exchange rate, and threatening the exchange rate band. If the prospective current account deficit were within safe limits, and fiscal consolidation adequate, a revaluation of the central parity would be an option. While not yet in ERM2 officially—which cannot take place until after joining the EU—the authorities are mimicking this regime. Thus, it is worth noting that revaluation of the central parity does not restart the clock on the two years needed in ERM2 before adopting the euro. However, resulting pressures from higher interest rates would be particularly problematic if external competitiveness were a concern. In this case, fiscal tightening would help keep monetary tightening as modest as possible, and avoid too strong an appreciation of the forint. Box 3 describes the experience of two present euro area members that had inflation targets coexist with ERM style bands, and highlights the important role of fiscal policy.
D. Reducing the Costs of Disinflation—The Role of Inflation Targeting
15. There is ample literature to highlight the potential output costs of disinflation.20 Buiter (2001) discusses a number of policy frameworks in open economies and their impact on the costs of disinflation and concludes that “the benefits from eliminating moderate inflation cannot be enjoyed without incurring the pain of increased unemployment and lost production.” Structural features of the economy—e.g., the share of the tradables sector and the degree of wage flexibility—have traditionally played a prominent role in determining the magnitude of the sacrifice ratio (ratio of the loss of output to disinflation) (Mankiw (2001), and Taylor (1998)). Not surprisingly, attempts to obtain meaningful estimates of the sacrifice ratio across a number of countries, going back to Ball (1994), yield a wide range of estimates, but support the view that “disinflations are almost always costly.”21
16. The NBH has undertaken some work on assessing the potential costs of disinflation in Hungary. A recent NBH working paper by Benczur et al. (2002) calculates sacrifice ratios for Hungary in the range of 0.8 to 1.8, simulating an open economy model of the type found in Svensson (1998) and Batini and Haldane (1999).22 They note that a sacrifice ratio of this size is similar to the one implied by macro econometric model estimates in another NBH working paper by Jakab and Kovács (2002). Not surprising, the simulations in Benczur et al. are very sensitive to assumptions on inflation persistence: higher persistence, and therefore less forward looking behavior in forming inflation expectations, could increase the cost of disinflation and imply sacrifice ratios well outside the range reported here.
Selected Country Experiences with Inflation Targeting and ERM2-style Exchange Rate Bands
Of the countries that adopted formal inflation targeting prior to joining the EMU, Finland and Spain pursued inflation targets along with exchange rate bands. In both countries, decisive fiscal action helped underpin disinflation and contributed to avoiding conflicts between the inflation and exchange rate targets.
Spain announced in December 1994 its intention to adopt an inflation targeting framework from January 1995, and it operated under this framework until joining EMU in January 1999. Spain had been a member of the ERM since 1989, and the introduction of the IT took place shortly after the widening of the ERM band to ±15 percent in August 1993. At the time of the regime change, monetary policy faced new challenges, with the Spanish currency (peseta) coming under speculative pressure in March 1995, and it was devalued. But against the background of a continued tightening of monetary policy, the peseta strengthened, and inflation expectations fell. The Bank of Spain managed to reduce inflation from 4.7 percent to under 2 percent in the three years following adoption of the IT. The considerable width of ERM bands gave the authorities leeway in pursuing inflation targets subject to the exchange rate band. Disinflation was underpinned by supporting monetary policies and decisive and strong fiscal consolidation.
Finland adopted an explicit inflation targeting framework from February 1993 until the introduction of the single European currency (euro) in January 1999. It adopted inflation targeting after abandoning the peg of the Finnish currency (markka) to the European currency unit (ECU) in September 1992. Between January 1995 and October 1996, it adopted a ±3 percent fluctuation band against the ECU, and subsequently joined the exchange rate mechanism of the European Monetary System (ERM), allowing the markka to fluctuate within a ±15 percent band. The move to the wide band of the ERM did not affect the BoF’s monetary policy stance: although the pass-through from exchange rate movements to inflation had weakened with the markka’s floatation (Tyvainen, 1997), the Bank of Finland held the markka in a rather narrow corridor of about ±2.5 percent to the deutsche mark. A key factor that contributed to avoiding conflicts between the inflation and exchange rate targets was the significant, gradual and steady fiscal consolidation throughout the period.
17. Policy frameworks can play a role in reducing the costs of disinflation, invariably a goal of policy makers. In introducing the new inflation targeting framework, the NBH noted that “for the purpose of reducing the cost of disinflation, the Central Bank had devised a gradual but ambitious program of disinflation of several year’s duration.” As noted in Buiter (2002) policy frameworks that reduce inflation persistence can help reduce costs of disinflation. This can be achieved by inducing a more forward-looking behavior in the economy or by improving the response of prices and wages to changes in relative prices. The latter can be achieved either through changes in the price- and wage-setting mechanism, or by improving the credibility of disinflationary policies.23
18. The IT framework may help reduce the costs of disinflation in Hungary in a number of ways.
By making inflation expectations more forward-looking—hence weakening the weight of past inflation. Based on a sample of inflation targeters and non-inflation targeters, Corbo et al. (2001) found that inflation persistence declined strongly among targeters during the 1990s, suggesting that inflation targets strengthened forward-looking expectations of inflation. Corbo also found that inflation forecast errors, based on country VAR models for emerging market economies, fell consistently with adoption of inflation targeting, toward the low levels prevalent in non-inflation targeting industrial countries.
By focusing monetary policy more clearly on inflation. The framework may improve the NBH focus on price stability, as well as the NBH’s response to inflation shocks. By being particularly visible and easily monitored, the targets provide a readily understood and transparent nominal anchor for monetary policy—and help to establish the necessary credibility to make the formation of expectations forward looking.
By acting as a commitment device. To the extent that the formal framework is binding on the monetary authorities, inflation targeting can increase the accountability of the central bank, helping avoid time-inconsistency problems. In this context, the new framework and the choice of the ERM2 style exchange rate band provides a strong signal of the authorities’ intention to seek early EU membership and adoption of the euro. The existence of a clearly established end-point serves to reinforce the role of inflation targets in anchoring the policy framework, helping lend credibility to the NBH’s ambitious program of disinflation.
19. The effectiveness of the framework (in reducing the cost of disinflation) hinges on the NBH’s ability to shift market expectations in the direction of its inflation targets. As argued in Yetman (2001), with the objective of monetary policy clearly stated, the distance between expected inflation and the actual target is closely linked to the credibility of policies. In this regard, the NBH should be able to build upon its initial success, but the following considerations will be at play:
Strengthening the credibility of the inflation targeting framework will take time and depend on the NBH’s success in meeting disinflation objectives. At the same time, the NBH’s ability to achieve lower inflation will, ultimately, depend on how quickly expectations about future inflation become more firmly anchored on the target. The less-than-perfect monetary policy transmission mechanisms—as highlighted in section B of this paper—would seem to add to the NBH’s challenges.
Ensuring that supportive policies are in place will be key, so that the NBH can give priority to inflation. As discussed in section C of this paper, a prudent and supportive fiscal policy is essential, including by keeping the external current account deficit within safe limits.
Keeping the monetary policy framework transparent, and building on it, could help improve the response of prices to NBH adjustments in policies. By doing so, agents may be increasingly able to infer the objective of monetary policy from observing changes in the NBH’s instrument, rather than from economic outcomes. The quality of the NBH’s Quarterly Report on Inflation should facilitate the task at hand by helping communicate to the public the forward looking nature of monetary policy.24
E. Concluding Remarks
20. The adoption of the inflation-targeting regime is a welcome development. It has met with much initial success, and provides an appropriate framework for monetary policy anchored firmly on disinflation. Various aspects of the monetary policy transmission mechanism pose challenges for the NBH, calling for prudent assumptions in the conduct of monetary policy in light of the benefits of strengthening policy credibility. Successfully implementing the IT framework can play a significant role in helping to reduce the costs of disinflation in Hungary, especially when supported by a high level of transparency and adequate support from fiscal policy.
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Prepared by Paulo Drummond.
Thus the new band resembles ERM2, the transition regime toward adopting the euro. For details of ERM2, see “Monetary and Exchange Rate Regimes in the Central European Economies”, on the Road to EU Accession and Monetary Union,” SM/01/209 (September 5, 2001)
All foreign exchange restrictions were lifted on June 5, 2001, making the forint fully convertible, and a new Central Bank Act was approved by Parliament on June 19, 2001, defining the primary objective of the NBH as the achievement and maintenance of price stability. A new president of the NBH took office in February 2002.
NBH’s “Statement on The System of Monetary Policy” (June 12, 2001).
For an extensive review of issues in the design and implementation of inflation targeting, see Carare et al. (forthcoming), Mishkin (2001), Schaechter et al. (2000), Bernanke et al. (1999).
For a detailed discussion of these channels, useful references are: Bernanke and Gertler (1995); Bondt (1998); Meltzer (1995); Mishkin (1995), Svensson (1998), and Taylor (1995).
The speed at which credit responds to changes in the interest rate also depends on the maturity structure of banks’; loan portfolios. A relatively high share of medium- and long-term loan contracts and fixed interest rates are likely to cushion the impact of any policy interest rate hike (Bondt (1998, 1999))—but these characteristics do not apply strongly to Hungary.
The impact of a tightening of monetary policy that causes firms’ balance sheets to deteriorate (by reducing their cash flow) also depends on the size of short-term or floating-rate debt exposure in their balance sheets. While the availability of data on debt exposure of firms is limited, banks’; balance sheets indicate that the percentage share of forint assets with repricing periods of up to 90 days was about 80 percent in 2001 (NBH’s Financial Stability Report, November 2001, p. 34).
NBH’s “Quarterly Report on Inflation,” August 2001, p. 35.
While foreign exchange interventions cannot be ruled out, the NBH has refrained from intervening since the band widening, and it has signaled that it would resort to intervention only in emergency situations.
The study, which used time-varying coefficients, is based on inflation in non-food, non-energy, and non-administered prices and is therefore not strictly comparable with the assumed pass-through in the NBH’s inflation report.
These factors abstract from measurement problems that arise when estimating the exchange rate pass-through. One such measurement problem could occur if Balassa-Samuelson (B-S) effects were not adequately controlled for, so that the impact of an exchange rate appreciation, for example, would be masked to a degree by higher B-S induced inflation.
Engel (2001) explores the hypothesis that low pass-through of exchange rates might imply high exchange-rate volatility in equilibrium, explaining the exchange rate “disconnect” from the rest of the economy.
Other factors affecting the pass-through deal with the business cycle and the structure of the economy, including import shares and competitive structure (Fisher (1989)).
Based on the NBH’s review of the experiences of the Czech Republic and Greece. Tradable goods account for about 25 percent of the CPI basket.
The ratio of the cumulative fall in the price of tradables to the cumulative exchange rate appreciation, using the month prior to the exchange rate band widening as the base was about 25 percent. Of course, this calculation abstracts from changes in tradables prices due to factors other than changes in the exchange rate, and it is only based on the first ten months since the band widening.
As pointed out by Abel (2001), and consistent with section B above, while the IT framework provides a nominal anchor, there is a need for “considerable caution concerning the smooth functioning of the transmission mechanism.”
Mishkin (2000) suggested that emerging market economies should “adopt a transparent policy of smoothing short-run exchange rate fluctuations that helps mitigate potentially destabilizing effects of abrupt exchange rate changes, while making it clear to the public that they will allow exchange rates to reach their market-determined level over longer horizons.”
For more discussion, see Doyle et al. (2001), which supports that the B-S effects may lie in the range of 1–3 percent per year.
While this section focuses on the output costs of disinflation, which are temporary, bear in mind that the welfare gains from reducing inflation are permanent.
Ball (1994) estimated output costs, based on the difference between the actual level of output and what output would have been without disinflation, for 19 countries. He identified 65 episodes where “trend inflation fell substantially, with an overall average sacrifice ratio of 0.8. However, the ratios vary widely across countries from –0.8 percent (and therefore sometimes negative, implying no cost) to 4 percent.
The calculation is based on a number of parametric assumptions, including a growth rate of potential output of about 4.5 to 5 percent, and inflation persistence coefficients of 0.6 and 0.7.
Following Blinder (1999), “a central bank is credible if people believe it will do what it says.”
Clearly, a number of other detailed but important technical and institutional issues play a role in how effective the IT framework can be. While analyses of all these issues is beyond the scope of this paper, it is important to stress that the NBH has chosen a simple and transparent system that seems to have most, if not all, the desirable institutional features of a successful inflation targeting framework.
