Abstract
This Selected Issues paper examines the potential costs of faster disinflation in Russia, drawing on the experience of European transition countries. The paper analyzes this experience, discusses factors contributing to the persistence of moderate inflation, and quantifies the disinflation costs in these countries. It compares the Russian economy with the sample countries. The paper concludes that a relatively rapid reduction of core inflation from above 10 percent in 2002 to less than 5 percent in 2004 would be beneficial for the Russian economy.
IV. The Choice of a Nominal Anchor: Is Russia Ready for Inflation Targeting?1
A. Introduction
1. This paper examines the conduct of monetary policy by the Central Bank of Russia (CBR) since 1999 and assesses whether and how the policy framework could be modified to keep inflation on a downward path. Since the August 1998 crisis, the authorities have been successful in steadily reducing inflation while accumulating large balance of payments surpluses generated by high world energy prices. This was made possible by the large budget surpluses which helped partially sterilize the considerable foreign exchange inflows, and a strong recovery in money demand in the aftermath of the crisis. The CBR may find it difficult to continue to rely on these factors in the period ahead if the relaxation of fiscal policy continues, the pace of money demand growth moderates, and the recent decline in net private capital outflows continues. Given the need to bring inflation further down,2 the existing monetary framework would need to be modified to deal with these challenges.
2. The main conclusions are as follows:
The authorities should consider adopting a nominal anchor. However, the traditional anchors have several drawbacks which would make them unsuitable for Russia.
The authorities should consider moving to a full-fledged inflation targeting regime as this would give precedence to the inflation objective over other priorities. This would help anchor inflationary expectations, reduce the scope for discretionary policy changes, and help achieve a faster pace of disinflation.
Many of the pre-conditions for inflation targeting either already exist in Russia, or can be established without much difficulty, including mechanisms to ensure a supportive fiscal policy. However, the development of effective tools to conduct monetary policy as well as the development of the financial sector may require some time, and therefore, delay the possible introduction of inflation targeting.
Nevertheless, the CBR should consider beginning the process of transition to such a regime by placing greater emphasis on its inflation reduction objective. Key to this process is the authorities’ willingness to make greater use of the interest rate tool and to allow more flexibility in the exchange rate regime.
B. Monetary Policy in Russia Since 1999
3. In principle, the CBR conducts monetary policy on the basis of a reserve money targeting framework. It specifies intermediate targets in terms of an annual rate of growth of ruble broad money that would be consistent with the inflation objective. Given a multiplier with no clear trend (Figure 4.1), the operational targets are set in terms of reserve money, and operational procedures are based on net international reserves and net domestic assets of the monetary authority.
Money Multiplier
(Seasonally Adjusted)
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Money Multiplier
(Seasonally Adjusted)
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Money Multiplier
(Seasonally Adjusted)
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
4. However, in practice, the CBR pursues multiple objectives. According to the CBR Law and subsequent amendments, the CBR’s monetary operations are to be geared toward meeting the twin objectives of price stability as well as ruble stability. Moreover, since 1999 monetary policy has been guided by several considerations—reducing inflation, slowing the pace of real ruble appreciation in the face of strong balance of payments inflows to preserve growth, and accumulating sufficient foreign exchange reserves to service extern al liabilities. Having built up a sizeable reserve cover ($48 billion, 6.3 months of imports at end-2002), the focus of monetary policy shifted to inflation reduction and limiting the real appreciation of the ruble in recent years. The CBR acknowledges that in the coming years monetary policy goals would also include the establishment of stable and “reasonable” short-term interest rates to discourage speculative capital inflows and to establish confidence in the banking sector regarding the availability of ruble liquidity when needed.
Money Demand
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Money Demand
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Money Demand
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
5. Limiting the pace of real appreciation has been of paramount importance to the CBR. It has sought to accomplish this objective by engineering a gradual nominal depreciation of the ruble through largely unsterilized net CBR purchases in the foreign exchange market (Figure 4.3). Given an estimated inflation path, the nominal exchange rate followed a path consistent with the targeted real appreciation of the ruble. Inflationary pressures generated by this policy have been limited because the liquidity injections by the CBR have, to some extent, been absorbed by a faster-than-expected growth in money demand and a build up in government balances in the central bank as a result of successive years of budgetary surpluses (Table 4.1). Nevertheless, M2 grew even faster and resulted in inflation exceeding targeted levels (Table 4.2), although the extent of overshooting in 2002 was minimal.3
Exchange Rate and Gross Reserves
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Exchange Rate and Gross Reserves
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Exchange Rate and Gross Reserves
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Percentage Change Relative to Beginning Year Base Money
Percentage Change Relative to Beginning Year Base Money
| Dec 99 | Dec 001 | Dec 01 | Dec 02 | ||
|---|---|---|---|---|---|
| Base money | 54 | 60 | 38 | 30 | |
| NIR | 61 | 165 | 69 | 69 | |
| NDA | -7 | -105 | -31 | -39 | |
| Net credit to general government | 14 | -57 | -12 | -3 | |
| Net credit to banks | -10 | -25 | 0 | -10 | |
| Other items net | -10 | -22 | -19 | -26 | |
Percentage Change Relative to Beginning Year Base Money
| Dec 99 | Dec 001 | Dec 01 | Dec 02 | ||
|---|---|---|---|---|---|
| Base money | 54 | 60 | 38 | 30 | |
| NIR | 61 | 165 | 69 | 69 | |
| NDA | -7 | -105 | -31 | -39 | |
| Net credit to general government | 14 | -57 | -12 | -3 | |
| Net credit to banks | -10 | -25 | 0 | -10 | |
| Other items net | -10 | -22 | -19 | -26 | |
Russian Federation: The CBR’s Targets Versus Outcomes 1/
(In Percent)
The CBR’s “Basic Guidelines of State Integrated Monetary Policy” for relevant years.
Russian Federation: The CBR’s Targets Versus Outcomes 1/
(In Percent)
| Inflation (e.o.p.) | Annual Ruble Broad Money Growth | |||
|---|---|---|---|---|
| Target | Outcome | Target | Outcome | |
| 1999 | 20-30 | 37 | 18-26 | 57 |
| 2000 | 18 | 20 | 21-25 | 62 |
| 2001 | 12-14 | 19 | 27-34 | 40 |
| 2002 | 12-14 | 15 | 24-28 | 32 |
The CBR’s “Basic Guidelines of State Integrated Monetary Policy” for relevant years.
Russian Federation: The CBR’s Targets Versus Outcomes 1/
(In Percent)
| Inflation (e.o.p.) | Annual Ruble Broad Money Growth | |||
|---|---|---|---|---|
| Target | Outcome | Target | Outcome | |
| 1999 | 20-30 | 37 | 18-26 | 57 |
| 2000 | 18 | 20 | 21-25 | 62 |
| 2001 | 12-14 | 19 | 27-34 | 40 |
| 2002 | 12-14 | 15 | 24-28 | 32 |
The CBR’s “Basic Guidelines of State Integrated Monetary Policy” for relevant years.
Monetary Policy Instruments in Russia Since 1999
During 1999-2002, the CBR has had access to a number of instruments for conducting monetary policy, although only a few are actually used. The lack of a single policy instrument (interest rate) has hampered the signaling and implementation of monetary policy, which has been further undermined by the CBR’s intervention at various points on the yield curve.
Until late 2002, the CBR’s liquidity draining instruments comprised:
Deposit facility (SF), used at the commercial hanks’ initiative at rates fixed by the CBR for various maturities (overnight to 3 months).1
Foreign exchange swaps (MO), mainly used to manage ruble liquidity.
Other instruments which are seldom used include: (i) outright government security sales (MO), whose use is limited by the small size of the CBR’s portfolio of tradable government securities; (ii) CBR debt instruments sales (OBRs) (MO), whose sale is constrained by legal requirements for issuance and unfavorable tax treatment; (iii) foreign exchange outright sales (MO), which are used only to smooth volatility in the foreign exchange market; and, (iv) modified repo (MO), for which there is little demand, involving a sale of government securities at an artificially high price with the issuance of an irrevocable offer to purchase those securities again at some date in the future at a given (even higher) price.2
In November 2002, biweekly deposit auctions of a 1-week maturity were introduced as the CBR’s main intervention tool in times of excess ruble liquidity. All maturities beyond 1 week for the standing deposit facility were eliminated, with a 3 percent rate set for the maturities between overnight and 1 week. “Revised modified” (reverse) repos were introduced with a 1 month maturity with biweekly auctions.
Until late 2002, the CBR’s liquidity providing instrument comprised:
Purchase of foreign exchange, which is frequently used but for exchange rate management rather than ruble liquidity management purposes.
Intraday and (automatic) overnight credits if intraday credit is not repaid (SF), which is used in relation to payment system. Overnight credits are collatcrized and carry a penal interest rate.
Other, rarely used, instruments comprise: (i) Lombard credit (SF), (ii) Lombard auctions (MO) in principle conducted weekly for up to 10-day finance at a fixed rate, and monthly for 90-day finance; (iii) collateralized refinance credit (SF), to stimulate lending to the real economy, as the required collateral is linked to real economy e.g., trade bills; (iv) Foreign exchange swaps (MO), used occasionally by some 10 banks mainly at certain times of the month e.g., when tax payments are due.
In September 2002, a standing overnight foreign exchange swap facility was introduced to overcome the segmentation of the ruble money market and to diversify the collateral base. Standard repo operations with 1-7 day maturities were also introduced, primarily to develop a repo market for future purposes and to support securities market development.
The recent changes are welcome and there is evidence that intra-month volatility in the ruble money market has declined following the introduction of the new instruments, especially foreign exchange swaps to inject overnight ruble liquidity during the last 10 days of a month when ruble liquidity customarily tightens due to tax payments and prudential regulations. Despite the improvement, however, the ruble money market remains segmented and thin, resulting in volatile overnight rates. Moreover, while the deposit auction is supposed to be the main instrument to influence the ruble money market, foreign exchange operations (especially outright purchases) remain frequent, often sending conflicting signals about the stance of monetary policy. This is further complicated by the fact that the CBR continues to over-determine the yield curve by fixing the interest rates for the entire short end (overnight to 1 month).
1/ SF stands for standing facilities, MO for market operation instruments.2/ The artificially high price allows the CBR to not have to recognize a book loss on its balance sheet (since the securities currently held are valued well above market prices).6. In the event of a conflict between the two objectives, the CBR’s exchange rate objective has taken precedence over its inflation objective, especially in recent years. To this end, the CBR has, on occasions, opted not to deploy its existing monetary policy instruments (Box 4.1) to mop up excess liquidity, preferring to accept the inflationary consequences instead. Most notably, although the CBR limited (or partly reversed) its foreign exchange market interventions in anticipation of the end-year budgetary spending surges during 2000-02, it chose not to sterilize the excess liquidity more aggressively through a proactive increase in its deposit facility rates (Figure 4.4).4 5 Moreover, the CBR’s revealed preference has been for limiting the real appreciation of the ruble through a nominal depreciation of the ruble in combination with a higher than targeted inflation. Public statements by high ranking CBR officials would seem to bear out these conclusions. For instance, the CBR has recently indicated that a nominal exchange rate appreciation could be considered only over short periods of time but not over a longer period such as a few months or a year. The monetary policy framework practiced by the Russians can thus be characterized as “inflation targeting lite” (Stone, 2002) as the CBR has used an inflation target to define its monetary policy framework but has not been able to subordinate other objectives to the inflation target.
Money and Deposit Facility Rates
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Money and Deposit Facility Rates
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
Money and Deposit Facility Rates
Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A004
7. While the monetary policy framework of the CBR has slowed the real appreciation of the ruble and successfully reduced inflation, the pace of disinflation has been slower than targeted by the authorities. Some part of the deviation may be explained by the increase in administered prices whose weight in the CPI basket is not public knowledge.6 While these adjustments have been economically necessary, the timing and amount of adjustment have been difficult to predict, and it is difficult to estimate the inflationary impact of such adjustments. Other exogenous factors have also had an inflationary impact—for example, staff estimates indicate that a 1 percent increase in world oil prices would translate into a 0.1 percentage point increase in inflation. Nevertheless, inflationary pressures generated by the nominal exchange rate depreciation engineered by the CBR have contributed importantly to the breaching of the authorities’ inflation target.7
C. An Appropriate Nominal Anchor for Russia over the Longer Term
8. The monetary policy framework that has prevailed has a built-in inflationary bias and is not sustainable over the longer term. The circumstances which have so far enabled the CBR to simultaneously lower inflation while checking real appreciation in the face of strong balance of payments flows (see paragraph 5) are unlikely to persist over the medium-term; GDP can be expected to grow at a more sedate pace if much needed structural reforms to boost the non-energy sector are not undertaken; oil prices may fall from their current high levels; and the cost of structural reforms—once implemented—could raise the level of budgetary expenditures. Furthermore, the robust growth of money demand after the 1998 crisis is unlikely to continue at the same pace, as key contributing factors—the reduction of non-payments and barter, and the return of macroeconomic and political stability—are unlikely to play as large a role in the future, and, as just noted, high rates of growth are unlikely to materialize in the absence of key structural reforms. Weaker budget surpluses and money demand growth would constrain the CBR’s ability to manage monetary and exchange rate policy in a manner which would keep inflation on a downward path while limiting the pace of real appreciation. Monetary and exchange rate policy would be further complicated if the current trend of considerable capital inflows were to continue and strengthen, as this would likely make the usual monetary policy instruments less effective in stemming pressures on the exchange rate.8 Looking ahead, therefore, the CBR should consider how best to modify the existing monetary framework to deliver low and steadily declining inflation rates under the changing circumstances.
9. Under these changing circumstances, a steady pace of disinflation would be facilitated by the adoption of inflation reduction as the primary objective of monetary policy and the selection of a nominal anchor to guide inflationary expectations.9 The choice of inflation as the CBR’s primary objective would help influence inflationary expectations by signaling to the market that the CBR gives priority to reducing inflation in the event of conflict between its exchange rate and inflation objectives. Moreover, since inflationary expectations are likely quite entrenched after 5-6 years of double digit inflation and a slow pace of disinflation, the explicit choice of a suitable and credible nominal anchor could also help realign expectations, not least by signaling a change in current policy.
10. More generally, the extent to which the different regimes are successful in achieving price stability depends critically on their ability to reduce discretionary policymaking. Policy makers may often have the incentive to pursue time-inconsistent policies—expansionary policies with the aim of producing higher growth and employment in the short-run at the expense of higher inflation but not higher growth or employment in the long run. By acting as a constraint on domestic policy, a nominal anchor would help weaken the time-inconsistency problem so that in the long run, price stability is more likely to be achieved.
11. The conventional forms of nominal anchor—money and exchange rate—have important drawbacks in the Russian context.
Exchange rate pegging would have the advantage of linking the Russian inflation rate and expectations to that of the anchor country.10 It would provide an automatic rule for conducting monetary policy which helps reduce the time-inconsistency problem; and, it is simple, clear and easily understood by the public. Nevertheless, such a strategy would be risky because of Russia’s high dependence on natural resources and susceptibility to large terms of trade shocks; the structural and price rigidities in the system which would limit the economy’s ability to adjust to large shocks; and the possible absence of supporting (especially fiscal) policies in the future which could lead to large, disruptive corrections. It will remove the signal that the foreign exchange market provides about the stance of monetary policy on a daily basis. Finally, under such a regime, it is difficult to establish the accountability of the central bank unless its balance sheet and actions are fully transparent.
Monetary targeting would allow the CBR to adjust its monetary policy to cope with domestic considerations. Like an exchange rate target, it provides immediate signals to the public and markets about the stance of monetary policy and helps influence expectations. Monetary targets also promote almost immediate accountability for monetary policy and so help constrain the policymaker in making time-inconsistent decisions. However, these advantages can only be reaped provided there is a strong and stable relationship between the monetary aggregate and inflation. Given the difficulty in predicting the extent of the remonetization process, projecting money demand in Russia is subject to great uncertainty and, therefore, monetary targeting would be problematic.11
12. Many countries have recently adopted inflation targeting as their monetary policy regime, given the increasingly complex the relationship between monetary aggregates and inflation. While inflation targeting shares some of the drawbacks of both exchange rate pegging and monetary targeting, it has several important advantages. Unlike exchange rate targeting, it allows the policy maker to focus on domestic considerations and to respond to shocks to the domestic economy. Unlike monetary targeting, it envisages a reduced role for intermediate targets such as money growth because the monetary policy strategy can no longer rely on a stable money-inflation relationship. Indeed, an inflation target allows the monetary authority to use all available information to determine the best course for monetary policy. Inflation targeting is readily understood by the public and is thus highly transparent and allows for greater accountability of the central bank. Finally, by focusing the political debate on what the central bank can do in the long run (control inflation) versus what it cannot do (raise growth),12 it reduces political pressure on the central bank to pursue inflationary monetary policy.
13. The Russian authorities may want to consider moving to a full-fledged inflation targeting regime over the medium term, with the CBR gearing its monetary policy actions toward an explicit inflation target. An inflation targeting regime would help shift public attention toward low and stable inflation and guide expectations downwards. Given the difficulty of predicting money demand, it would be superior to monetary targeting and would enhance the accountability and discipline of monetary and fiscal policies as the CBR and the government gear their policies to achieve the targeted inflation rate to which they are both committed (see paragraph 17, Section D). In light of Russia’s dependence on oil exports, inflation targeting would also be superior to exchange rate pegging because it would allow the CBR to focus on shocks to the domestic economy in the event of a terms of trade shock. While inflation targeting has a potential drawback in that it could exacerbate the impact of a terms of trade shocks on growth, this impact can be moderated by a careful choice of the inflation target (see paragraph 20) and the adoption of a fiscal rule (and/or an oil stabilization fund) to support the inflation target13 Moreover it would allow the central bank to respond to short-term deviations without threatening its long-term credibility, and finally, it would motivate institutional reform of the central bank (Section D).
14. While conditions are not appropriate for an immediate move to inflation targeting, a credible commitment to an inflation targeting may bring forward some of the benefits of a single nominal anchor. Moreover, public discussion of the benefits of a single anchor can help motivate the fiscal and structural reforms needed to establish credibility. Finally, a period of transition may be needed to lay the institutional groundwork for the new regime (Table 4.3).
Transition to Full-Fledged Inflation Targeting
Transition to Full-Fledged Inflation Targeting
| Beginning of Transition to Inflation Targeting | Adoption of Full-Fledged Inflation Targeting | |
|---|---|---|
| Brazil | June 1999 | June 1999 |
| Chile | September 1990 | September 1999 |
| Czech Republic | December 1997 | December 1997 |
| Israel | December 1991 | June 1997 |
| Poland | October 1998 | March 1999 |
| South Africa | August 1999 | February 2000 |
Transition to Full-Fledged Inflation Targeting
| Beginning of Transition to Inflation Targeting | Adoption of Full-Fledged Inflation Targeting | |
|---|---|---|
| Brazil | June 1999 | June 1999 |
| Chile | September 1990 | September 1999 |
| Czech Republic | December 1997 | December 1997 |
| Israel | December 1991 | June 1997 |
| Poland | October 1998 | March 1999 |
| South Africa | August 1999 | February 2000 |
D. Pre-Conditions for Inflation Targeting in Russia
15. International experience has shown that several initial conditions would need to be in place in Russia in order to support an inflation targeting framework.14 These are:
Inflation as the primary objective of monetary policy
16. It would desirable to amend the Central Bank Law to ensure that price stability is the primary objective of monetary policy. This would ensure that the CBR has the necessary legal basis to allow the inflation target to take precedence over other objectives. The CBR could still intervene in the foreign exchange market; indeed all inflation targeting central banks explicitly allow for such an option. However, to reinforce its commitment to the inflation target, the CBR would need to publicly commit to limiting interventions in the foreign exchange market to smoothing the effect of temporary fluctuations and attaining the inflation objective.15 Concerns about competitiveness, growth and external position would be best achieved through fiscal or structural policies.
17. The CBR would need to have the necessary political support to give priority to the inflation objective over other objectives. Besides making it a legal requirement for the CBR to place precedence on reducing inflation, another way to ensure the necessary political buy-in would be to involve the government in setting the inflation target. This would strengthen the credibility of the inflation targeting framework by committing the government to operate fiscal policy—including wage policy—in a manner that would support the achievement of the inflation objective. Moreover, it would give the government the incentive to coordinate the amount and timing of administered price increases.16
Instrument independence
18. The CBR Law grants the CBR sufficient discretion in attaining its monetary policy objective (instrument independence). However, this law has recently been amended to establish a National Banking Council (NBC) comprising representatives from the government, parliament and presidency with the power to approve those aspects of the CBR’s budget which relate to personnel, capital investment and other administrative expenditures. The NBC is also empowered to pronounce on the CBR’s monetary policy operations and it remains to be seen whether this hinders the CBR’s ability to conduct monetary policy.
19. There may be a need for the government to regularize its financial relations with the CBR in order to enhance the CBR’s ability to undertake sterilization operations on a large scale. While its income position has strengthened17 with the accumulation of foreign assets and through the restructuring of part of its portfolio of government bonds to market-interest rate terms, a reliable assessment of the CBR’s capital position is complicated by valuation issues. These involve both its holdings of government securities that do not pay market interest rates and of precious metals, both of which, consistent with Russian Accounting Standards, are valued at acquisition costs. To ensure that the CBR’s financial position does not pose a constraint on its ability to conduct monetary policy, it may be necessary for the government to restructure a sufficient portion of its outstanding liabilities to the CBR.18
Public accountability
20. To establish credibility, the CBR must be held publicly accountable and consistently match word to deed. It is important to achieve a relatively high degree of transparency and accountability, given the long and variable lags between policy actions and inflation outcomes. To this end, the public should be provided with periodic reports to be able to monitor the CBR’s performance on an ongoing basis, despite the difficulties posed by policy transmission lags. Efforts in the following areas should help improve public accountability:
The inflation target—the numerical targets, the underlying price index, the underpinning assumptions and the time horizon for its achievement—should be made explicit and public. Inflation forecasts should be published and updated regularly.
The CBR should target the headline CPI as this measure of inflation is more likely to be understood by the Russian public and is therefore more likely to influence inflation expectations. As in most countries, a target range (rather than a point target) could be specified as it would allow the CBR some flexibility in responding to shocks, with the width of the target adjusted if large shocks are anticipated. Such a mechanism would be superior to the use of “escape clauses” (predefined conditions under which deviations from targets would be tolerated) to enhance the CBR’s credibility.
The public should have a clear understanding of the principal monetary policy operations that are executed to achieve the inflation target. The signal being conveyed by the CBR should be readily discerned by the public, and therefore, the CBR’s recent efforts to improve the signaling content of its monetary policy instruments (see Box 1) is a step in the right direction.
The CBR should disclose information about the monetary policy framework in a timely manner to help ensure that the public has enough information to assess its policy performance. While there has been considerable progress in improving transparency of monetary and financial policies, the content and timeliness of disclosures could be further improved through greater disclosure of the financial relationship between the CBR and its various subsidiaries; use of a broader set of disclosure channels; improving the content and timeliness of disclosure; and fuller explanation of the reasons underlying changes in monetary policy, especially the CBR’s transactions with precious metals.19 The intention of preparing and publishing financial accounts on the basis of the International Accounting Standards would, if implemented, be a considerable improvement.
An ex-post assessment of the performance of monetary policy would enhance public accountability (e.g., by publishing the minutes of the quarterly discussions of the NBC on the implementation of monetary policy).
21. The CBR should build expertise in external relations and economic research to achieve greater transparency. It is important that the information disclosed is timely, consistent, and readily understood by the target audience. Moreover, a clearer understanding of the analytical underpinnings of the inflation process would enable the CBR to better explain its monetary policy stance to the market.
Macroeconomic pre-conditions
22. From the macroeconomic point of view, Russia seems well placed to move toward an inflation targeting regime relatively soon:
Some institutional arrangements are already in place to ensure the absence of fiscal dominance in Russia. The CBR Law stipulates that fiscal deficits cannot be monetized by the CBR, and, following the 1998 crisis Russia has successfully brought its fiscal house in order, running surpluses since 2000. Additional measures may be need to ensure that fiscal policy continues to be supportive of the authorities’ real exchange rate and inflation objectives in the period ahead. A joint government-CBR commitment to the inflation target would enlist the necessary fiscal support (see paragraph 17). In addition, it will be critical to support the inflation targeting framework through a fiscal rule (and/or an oil stabilization fund) that would insulate the budget from political pressures to raise spending when oil revenue are high.
Russia’s external position is sufficiently stable to enable monetary policy to focus on achieving the inflation target over time without being sidetracked by developments in the foreign exchange market. While the external position has not been a major factor in determining the appropriate timing for adopting inflation targeting in other countries, typically most emerging market countries have moved to inflation targeting after several years of external stability (the exceptions being Brazil and Turkey).
Ideally Russia should adopt an inflation targeting framework after it has succeeded in lowering inflation to single digits. International experience shows that most countries adopted full fledged inflation targeting when inflation was on the decline—as is the case in Russia—and when inflation had fallen below the 10 percent mark.20 At the outset of full-fledged inflation targeting, inflation should be low enough to ensure a reasonable degree of monetary control. Countries that adopted inflation targeting with higher rates of inflation and crawling exchange rate regimes disinflated over long periods to limit disruptions to the real economy (e.g., Chile, Israel, and Poland).
Monetary policy tools
23. The CBR would need to further enhance the effectiveness of its monetary policy instruments in order to be able to steer inflation toward the target. Recent IMF technical assistance recommended the following measures be taken:
The existing monetary instruments should be redesigned to improve policy implementation and efficiency and the CBR has recently taken several important steps in this area (Box 4.1). In particular, a short-term deposit auction interest rate was introduced as the CBR’s policy intervention open market operation interest rate. International experience indicates that every full-fledged inflation targeting central bank uses a short-term interest rate as its operating tool, ranging in maturity from overnight to three-months.21 Moreover, virtually all inflation targeting central banks employ market-based indirect instruments of monetary policy (open market operations and repurchase transactions) involving domestic or foreign securities.
Adoption of a formal liquidity forecast procedure to enhance liquidity management and make monetary policy decision-making more forward looking. In order to improve its ability to forecast the market’s liquidity needs, in November 2002, the CBR formalized existing procedures for pooling together all requisite information within the CBR in order to provide estimates of the market’s liquidity needs to the Monetary Policy Committee on a daily basis. Plans for improving inter-agency cooperation in this area are also underway. However, problems arising as a result of uncertainties regarding government transactions remain to be addressed.
The reform of the payment systems would benefit monetary operations. Despite substantial improvements over the past ten years, the system remains fragmented and inefficient, and thereby impedes the development of the CBR’s monetary and market operations. Recognizing this, the CBR is in the process of assessing progress in implementing the recommendations of the concept paper adopted in 1997 with a view to formally amending the paper.
24. The CBR should further improve and seek to better understand the effectiveness of the transmission mechanism of monetary policy,22 The stronger the transmission links, and the better they are understood, the more effective will changes in monetary instruments be in attaining the inflation target. One of the principal challenges faced by inflation targeting central banks, especially for emerging market countries, is the uncertainty in the transmission of monetary policy to inflation. In Russia, as in other emerging market countries with higher inflation rates, the transmission channels are characterized by downward price stickiness and rapid pass-through from the exchange rate to inflation.23
25. A weil functioning financial system which can respond to the CBR’s monetary policy decisions appropriately, is key. Thus, reforms to rebuild confidence in the banking system and improve competition in the financial system will also help improve the effectiveness of monetary policy.24
The CBR should ensure that the financial system is stable before moving to full-fledged inflation targeting. A stable financial sector would enable monetary policy to pursue the inflation target and not be sidetracked by concerns about the health of the financial sector. Financial system stability has preceded the adoption of inflation targeting by emerging market countries as large bailouts of financial institutions through the provision of central bank liquidity could generate inflation pressures.
Well-functioning financial markets facilitate the formulation of monetary policy and also improve the effectiveness of monetary policy operations. The CBR will need to be able to conduct these transactions in large sizes to implement monetary policy efficiently, manage its balance sheets and the country’s foreign exchange reserves, and, when required, supply credit to financial institutions in its role as lender of last resort.
Inflation forecasting
26. The CBR should further develop its ability to make inflation forecasts using a broad range of available information on the inflationary outlook. This will enable the CBR to adjust the stance of monetary policy whenever there is evidence that future inflation might differ persistently from the target path, and improve its credibility in the eyes of financial market participants and the public. Thus, the CBR should further broaden the information base on which it undertakes monetary policy decisions;25 develop the necessary expertise for modeling and forecasting purposes, develop “hands-on” experience in working with forward-looking models of inflation, gathering qualitative information on economic conditions, and assessing judgmentally the outlook for inflation and the appropriate policy response in an inflation targeting framework. In addition, the CBR should collect as much information as possible from discussions with private sector officials and financial market participants. These discussions should seek to obtain information on the state of the economy and the implications for future inflation and may also provide additional insight into private-sector inflation expectations. These discussions could be particularly useful in Russia, where economic relationships are changing rapidly, and financial markets are less developed.
E. Transition Period
27. Many of the above pre-conditions for moving to full fledged inflation targeting already prevail in Russia, or can be established without undue delay. Macroeconomic pre-conditions are broadly appropriate and are unlikely to prove a major constraint to the adoption of full fledged inflation targeting if fiscal policy were to be based on an appropriate fiscal rule. The necessary changes in the legal and institutional set up can be made relatively quickly. There has been considerable progress in improving transparency and public accountability in monetary policy operations and further progress can be easily accomplished. The new CBR management has been active in explaining the stance and objectives of its monetary policy operations to market participants. In recent years, the CBR has begun work on improving its analytical understanding of the inflation process; this work should be accelerated and its focus extended to better understand the monetary transmission mechanism.
28. The speed with which the CBR can adopt full fledged inflation targeting would depend on how quickly it can improve the effectiveness of monetary policy and develop the financial sector. In both these areas the CBR has recently taken several important initiatives. However, the reform agenda is vast, especially that relating to financial sector reform.
29. While a full-fledged inflation targeting regime cannot be immediately adopted, the CBR can already begin the process of transition to such a regime by placing greater emphasis on its inflation reduction objective. Key to this process would be to allow for greater flexibility in the exchange rate regime. In doing so, the CBR should bear in mind that transition countries with open capital markets tend to attract large capital flows and have limited domestic monetary independence (Lipschitz et al., 2002). This makes the economy more vulnerable, especially if the perceived risk premia of investing in the country is unrelated to domestic market developments. In such a situation, fiscal policy becomes the most important tool of stabilization policy even though the exchange rate regime can have a significant influence on market perceptions and behavior, with sufficient variations in the exchange rate providing a significant deterrent to foreign exchange exposure. Other policy tools are institutional in nature—greater transparency can help market participants to make better informed decisions about risk premia; the pace and sequencing of capital account liberalization should be geared toward longer-term flows and should take into account the stability and resilience of the financial markets; and, finally, the prudential and regulatory regime should be sufficiently well developed to be able to properly assess risks.
Institutional Details Associated with Inflation Targeting-A Cross-Country Comparison
But in exceptional circumstances the Minister of Finance can issue a formal directive to the central bank Governor.
Subject to a requirement that monetary actions be taken with regard to financial system soundness.
Institutional Details Associated with Inflation Targeting-A Cross-Country Comparison
| 1 | Primary objective of monetary policy in central bank law | Price stability: Poland, New Zealand, Norway | Other objectives: Chile (currency), Israel (multiple), Canada (multiple), Australia (multiple) | |
| 2 | Target set by | Jointly by government and central bank: New Zealand, Australia, South Africa, Canada | Central bank: Chile, Poland | Government: Norway |
| 3 | CPI targeted | Total CPI: Australia (excluding interest charges), New-Zealand (excluding interest charges and section prices), Chile, Poland | Underlying CPI: Canada, Sooth Africa, Norway | |
| 4 | Escape clause | Yes: Canada, New Zealand, Chile, Poland | No: Australia, South Africa, Norway | |
| 5 | Specification of target | Target range: Australia, New Zealand, Canada, Chile, Poland, South Africa | Point target: Norway | |
| 6 | Instrument independence | Exists: Chile, Israel, Poland, South Africa, Australia, Canada 1/, New Zealand 2/, Norway | Does not exist: | |
| 7 | Exchange rate regime | Floating: Chile, New Zealand, Australia, Poland, South Africa, Norway (managed float) | Other: | |
| 8 | Inflation rate when full-fledged inflation targeting adopted | Below 18 percent: South Africa (5.2), Australia (1.7), Canada (4.4) 3/, New Zealand (4.9) 31, Norway | Above 10 percent: Chile (26), Poland (11.7). Israel (19) | |
| 9 | Horizon | More than one year: Norway (24 months). New Zealand (18-24 months), Canada (18-24 months), Australia (on average over the economic cycle), Chile (more than 1 year from 2001 onwards | Annual targets: Poland, South Africa, Israel | |
But in exceptional circumstances the Minister of Finance can issue a formal directive to the central bank Governor.
Subject to a requirement that monetary actions be taken with regard to financial system soundness.
Institutional Details Associated with Inflation Targeting-A Cross-Country Comparison
| 1 | Primary objective of monetary policy in central bank law | Price stability: Poland, New Zealand, Norway | Other objectives: Chile (currency), Israel (multiple), Canada (multiple), Australia (multiple) | |
| 2 | Target set by | Jointly by government and central bank: New Zealand, Australia, South Africa, Canada | Central bank: Chile, Poland | Government: Norway |
| 3 | CPI targeted | Total CPI: Australia (excluding interest charges), New-Zealand (excluding interest charges and section prices), Chile, Poland | Underlying CPI: Canada, Sooth Africa, Norway | |
| 4 | Escape clause | Yes: Canada, New Zealand, Chile, Poland | No: Australia, South Africa, Norway | |
| 5 | Specification of target | Target range: Australia, New Zealand, Canada, Chile, Poland, South Africa | Point target: Norway | |
| 6 | Instrument independence | Exists: Chile, Israel, Poland, South Africa, Australia, Canada 1/, New Zealand 2/, Norway | Does not exist: | |
| 7 | Exchange rate regime | Floating: Chile, New Zealand, Australia, Poland, South Africa, Norway (managed float) | Other: | |
| 8 | Inflation rate when full-fledged inflation targeting adopted | Below 18 percent: South Africa (5.2), Australia (1.7), Canada (4.4) 3/, New Zealand (4.9) 31, Norway | Above 10 percent: Chile (26), Poland (11.7). Israel (19) | |
| 9 | Horizon | More than one year: Norway (24 months). New Zealand (18-24 months), Canada (18-24 months), Australia (on average over the economic cycle), Chile (more than 1 year from 2001 onwards | Annual targets: Poland, South Africa, Israel | |
But in exceptional circumstances the Minister of Finance can issue a formal directive to the central bank Governor.
Subject to a requirement that monetary actions be taken with regard to financial system soundness.
References
Amato, Jeffrey and S. Gerlach, 2001, “Inflation Targeting in Emerging Market and Transition Economies: Lessons After A Decade” (Centre for Economic Policy Research Discussion Paper Series, No. 3074)
Banerji, Angana, 2002a, “Money Demand”, IMF Country Report No. 02/75 Russian Federation: Selected Issues and Statistical Appendix, April
Banerji, Angana, 2002b, “Banking Sector Reform”, IMF Country Report No. 02/75 Russian Federation: Selected Issues and Statistical Appendix, April, and FSSA.
Berge, Claes, 2000, “Inflation Forecast Targeting: The Swedish Experience” in Bléjer et al., “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”
Bléjer, Ize and A. Leone, 2000, “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”,
Clinton,K., 2001, “On Commodity-Sensitive Currencies and Inflation Targeting”, (Bank of Canada Working Paper 2001-3)
Debelle Guy, 2000, “Inflation Targeting and Output Stabilization in Australia” in Bléjer et al., “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”
International Monetary Fund, 2001, “Establishing the Preconditions for Inflation Targeting”, (Monetary and Exchange Affairs Department Operational Paper)
International Monetary Fund, 2000, “Practical Issues in the Adoption of Inflation Targeting by Emerging Market Countries” (SM/00/199)
Mourmouras,A., 2002, “Poland’s Inflation Targeting Performance: A Peer Group Perspective”, IMF Country Report No. 02/128, Republic of Poland: Selected Issues and Statistical Appendix, June
International Monetary Fund Resident Office in Russia, 2002, “Russia: Trends in Net Private Capital Flows”
Kongsamut,P., 2001, “Philippines: Preparations for Inflation Targeting” (IMF Working Paper WP/01/99)
Lipschitz,L., et al., 2002, “Capital Flows to Transition Economies: The Dilemma for Stabilization Policy” (IMF Working Paper WP/02/11)
Longworth,D, 2000, “The Canadian Monetary Transmission Mechanism and Inflation Projections” in Bléjer et al., “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”
Masson,P., et al., 1997, “The Scope for Inflation Targeting in Developing Countries” (IMF Working Paper WP/97/130)
Morandé Felipe and Klaus Schmidt-Hebbel, 2000, “Monetary Policy and Inflation Targeting in Chile” in Bléjer et al., “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”
Mishkin,F.S., 1999, “International experiences with different monetary policy regimes,” Book of Monetary Economics, 43, 579–605
Leiderman Leonardo and Gil Bufman, 2000, “Inflation Targeting Under a Crawling Band Exchange Rate Regime: Lessons from Israel” in Bléjer et al., “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”
Research Department, Central Bank of Brazil, 2000, “Issues in the Adoption of an Inflation Targeting Framework in Brazil” in Bléjer et al., “Inflation targeting in practice: Strategic and Operational Issues and Application to Emerging Market Economies”
Soikkeli,J., 2002, “The inflation Targeting Framework in Norway” (IMF Working Paper WP/02/184)
Stone,M., 2002, “Inflation Targeting Lite” (IMF Working Paper WP/02/102)
Prepared by Angaria Banerji (EU2).
See Chapter I.
Money and inflation targets have also been breached due to technical factors. First, an assessment of the strength of money demand has been complicated by the considerable uncertainty and frequent data revisions in estimated GDP growth and the structural break in an estimated money demand equation as a result of the 1998 crisis. Thus, to some extent, the higher than targeted money growth mainly reflects a stronger growth in money demand than originally anticipated. Second, due to a lack of coordination with the government, the CBR has been unable to take into account the effect of administered price adjustments when setting its inflation target. Third, liquidity management has been complicated by the inadequate coordination between the CBR and MOF regarding the timing and amount of budgetary spending which have been characterized by large surges at year-end. Finally, the lack of effective instruments of monetary policy (due, inter alia, to possible balance sheet constraints which have likely eased in recent years) have limited the CBR’s ability to effectively sterilize liquidity injections.
Deposit facility rates (1 and 2 week rates) were last increased in January, 2002; however, the increases were modest and the rates continued to remain negative in real terms.
In this context it must be noted that the CBR’s ability to sterilize large amounts of liquidity injections might, to some extent, be limited by its balance sheet constraints, although these constraints have likely eased in recent years.
In addition to headline inflation, from January 2003, Goskorostat has also started publishing estimates of core inflation on a monthly basis. The excluded items account for 17 percent of the total CPI basket.
Staff analysis (Chapter II) show that in Russia the nominal exchange rate pass-through to inflation varies between 0.5-0.7 percentage points for a 1 percent change in the nominal exchange rate and is transmitted within 2-3 quarters. The immediate impact of a depreciation of the nominal exchange rate on inflation is fast (transmitted within one quarter) and relatively high (roughly 0.3 percentage points).
IMF Resident Representative’s Office, Moscow (2002). Also available via the Internet: http://ww.imf.org/extemal/countrv/rus/rr/2Q02/pdf/111402.pdf
Chapter I explains why a faster pace of disinflation would be desirable.
An extreme form of this could be establishing a currency board.
Concerns about real GDP growth are usually reflected in the determination of the pace of disinflation.
Several resource-based countries (such as Norway, New Zealand, Canada, Chile and Australia) have adopted inflation targeting to anchor monetary policy. These regimes have allowed deviations from the targeted inflation in response to temporary supply sbocks (e.g., food and energy prices), indirect tax changes, and imputed rental costs.
In recent years, such interventions among inflation targeting countries have been practiced mainly by emerging market countries with thinly-traded currencies and greater susceptibility to disturbances emanating from the foreign exchange market.
There are a number of issues related to the inflation target itself where the role of the government would be very important (see paragraph 20).
The CBR’S profit increased from Rub 1.2 bn in 1999 to Rub 9 bn in 2002.
In February 2003, part of the government paper in the CBR’s securities’ portfolio was restructured into Rub 30 billion of marketable securities.
See Financial System Stability Assessment (2003).
See SM/00/199.
A few countries, which are on their way to inflation targeting, used or still use a quantity guide (e.g., Peru) but they plan to move to a short-term interest rate-operating guide in the future.
Emerging market countries, however, tend to rely less on statistical models due to data shortfalls and ongoing structural changes (SWOO/199).
See Chapter II.
Even if they have successfully developed models, emerging market central banks must often rely on more qualitative information since these economies are typically subject to more uncertainties than those of industrial countries.
