A new study by three economists in the Monetary Operations Division of the IMF’s Monetary and Exchange Affairs Department highlights practical suggestions on inflation targeting that could be particularly useful for emerging market countries. The paper, forthcoming in the IMF Occasional Papers series, taps the years of experience industrial countries have had with inflation targeting, as well as the more recent formulation of inflation targeting frameworks by emerging market countries.

Abstract

A new study by three economists in the Monetary Operations Division of the IMF’s Monetary and Exchange Affairs Department highlights practical suggestions on inflation targeting that could be particularly useful for emerging market countries. The paper, forthcoming in the IMF Occasional Papers series, taps the years of experience industrial countries have had with inflation targeting, as well as the more recent formulation of inflation targeting frameworks by emerging market countries.

In recent years, emerging market countries have joined industrial countries in adopting formal inflation targeting monetary policy frameworks. (See related stories, IMF Survey, February 7, page 37, and April 3, page 103.) Brazil, Chile, the Czech Republic, Israel, Poland, and South Africa have adopted inflation targeting, while other countries, such as Mexico and Thailand, are in the process of doing so.

The experiences of the countries examined suggest that the foundation for successful, full-fledged inflation targeting consists of a strong fiscal position and entrenched macroeconomic stability; a well-developed financial system; central bank instrument independence and a mandate to achieve price stability; a reasonably well-understood transmission mechanism between monetary policy actions and their effects on inflation; a sound methodology for constructing inflation forecasts; and transparency of monetary policy to build accountability and credibility. Many of these elements, especially a strong fiscal position, are needed for sound monetary policy, regardless of the policy objective. In addition, these elements do not need to be in place before a country begins the transition toward full-fledged inflation targeting.

Framework

Under inflation targeting, the legal framework for central banks defines the objectives of monetary policy and provides the central bank with the scope to meet them. Countries usually modify their legal frameworks before adopting inflation targeting. All inflation targeting central banks have effective instrument independence—that is, they are free to choose how they will set their instruments, such as interest rates, to achieve their goal. All countries that adopt inflation targeting specify price or currency stability as a central bank objective—most, but not all, adopt it as the principal objective—reflecting the trade-off between the credibility gains from more formal legislative safeguards versus the effort required to obtain the political support needed to change the governing legislation. All emerging market countries limit central bank financing of the government.

Typically, the government alone, or jointly with its central bank, announces the inflation targets. In countries where price stability is the primary legal objective of monetary policy, central banks tend to announce the inflation targets unilaterally. The length of the target horizon has, in practice, reflected whether inflation is at or above the long-run objective. When inflation is above its long-run objective, targets are set annually to reduce uncertainty and provide flexibility; annual targets permit policymakers to take advantage of unexpected opportunities to disinflate. Long—in some cases, indefinite—target horizons are the norm when inflation is at the desired long-run level, because extended horizons are better able to accommodate lags in the transmission of policy and short-run output stabilization objectives.

The inflation target price index covers all or a large subset of consumer goods (consumer price index (CPI)). Industrial countries generally use a measure of core CPI inflation because it is influenced less by the most volatile prices and interest rates than total CPI inflation, which emerging market countries typically use because it is widely understood and therefore more credible.

In setting the target, most countries opt for a range, or band, rather than a specific point. An inflation target band provides the central bank with flexibility in responding to shocks. Some countries, however, prefer a point target, again because it is more widely understood. Transparent monetary policy and clear accountability mechanisms are indispensable to the inflation targeting framework. Strong accountability is essential because instrument independence gives central banks significant discretion in conducting policy, but at the same time lags in the transmission of monetary policy make it difficult for the public to monitor policy on an ongoing basis. As a result, central banks have increased their accountability by regularly publishing press releases and inflation outlook reports—and, in some cases, inflation forecasting models—and by communicating with the private sector and the media.

Transition issues

Whether emerging market countries have shifted gradually or rapidly to full-fledged inflation targeting has depended largely on the degree of nominal rigidities built into the economy, such as price indexation resulting from histories of high inflation. At the beginning of the transition, the authorities announce either the intention to adopt inflation targeting or the inflation target itself. Most countries adopted inflation targeting when inflation was on the decline. In all countries, inflation had fallen below 10 percent at the time they adopted a full-fledged inflation targeting framework (see chart, this page).

The emerging market countries that began the transition with higher inflation and crawling exchange rate bands took the slow-track approach to full inflation targeting to minimize disruptions to employment and output. They gradually widened the exchange rate band and placed increasing weight on the inflation objective, owing to widespread indexation of prices and wages.

Emerging market countries often introduce full-fledged inflation targeting only after attaining a strong fiscal position, stabilizing their financial system–which is especially important for emerging market countries–and reducing their vulnerability to currency crashes. These conditions help limit the risk that the framework might be confronted by multiple objectives in its early days when credibility is fragile.

Photo Credits: Denio Zara and Padraic Hughes for the IMF, pages 337, 339, 341, 343, and 344; Eriko Sugita, Reuters, page 337; and United Nations, page 352.

Operational issues

The operation of monetary policy under inflation targeting is similar for emerging market countries and industrial countries. All inflation targeters need to use good judgment in deciding how to act on the information they have. However, the emerging market countries that have adopted inflation targeting tend to rely less on statistical models for operating monetary policy than their industrial country counterparts. There are also important structural differences between emerging market countries that use inflation targeting and other emerging market countries: the inflation targeters rank in the top 20 percent of developing countries by total GDP and per capita GDP, and they have more developed domestic financial systems.

In emerging market countries that target inflation, policy transmission channels are rapid, weighted toward the exchange rate, and subject to considerable uncertainties. In countries with higher inflation, the channels seem to be characterized by downward price stickiness and rapid pass-through from the exchange rate to inflation until the inflation targeting framework becomes credible. Policy channels can be rendered less effective by corporate and bank balance sheet problems.

Monetary policy in all inflation targeting countries relies on market-based instruments and short-term interest rates. In emerging market countries that target inflation, the use of market-based instruments reflects their relatively well-developed financial markets. In industrial and emerging market countries alike, the setting of official interest rates generally reflects deviations of inflation from the target, the output gap, and other variables.

How a country responds to breaches of inflation targets largely depends on whether inflation is at or above the long-run target. When the inflation target is at the long-run rate, policy responses to breaches of the floor and the ceiling of the target range tend to be symmetric in order to limit output variability. Countries that are trying to reduce inflation, in contrast, have accepted inflation that is below the target and have taken advantage of such unexpected disinflationary outcomes to announce lower targets. Transparency and preemptive policy responses seem to have limited the damage to credibility from breaches of the target ceiling.

A06ufig01

Inflation at time of full-fledged inflation targeting

annual CPI inflation rate (percent)

Citation: IMF Survey 0029, 020; 10.5089/9781451926651.023.A006

Note: Emerging market countries are in bold

Inflation targeting central banks strive to limit the effects of large exchange rate movements on inflation expectations and on the domestic financial system. The generally successful responses of inflation targeting central banks to the Asian crisis in 1997 and the Russian crisis in 1998 ranged from doing nothing to combining foreign exchange intervention and higher official interest rates, depending on whether the shocks were perceived to raise inflation expectations or potentially destabilize the domestic financial system. It is a difficult challenge for countries to reverse, in timely fashion, actions they took in response to financial disturbances. The experiences of several countries in the wake of the Asian and Russian crises suggest that inflation may undershoot if the policy response is not reversed promptly.

The background papers for the high-level seminar “Implementing Inflation Targets,” held in Washington in March 2000, are available on the IMF website: http://www.imf.org/external/pubs/ft/seminar/2000/targets/index.htm).

IMF Survey: Volume 29, Issue 20
Author: International Monetary Fund. External Relations Dept.