Inflation Targeting in Emerging Economies

Inflation targeting has recently become a popular monetary policy framework in emerging economies. While institutional set-ups were largely in place in advanced countries during the adoption of inflation targeting, the more recent adoption and implementation of such policies in emerging economies have been more nuanced. This article briefly summarizes recent research in this area, highlighting the key contributions to conceptual and practical issues.

The collapse of the Bretton Woods system, the sharp increase in worldwide inflation in the 1970s, and a series of supply shocks led to a search for alternative monetary frameworks. Although many countries experimented with monetary targeting during the 1980s, the results proved to be unsatisfactory (Goodfriend, 2007). There was a need for a better framework to anchor expectations, especially in countries with a history of high inflation. An explicit commitment to a quantitative inflation objective was proposed as a way to bring about and sustain low and stable inflation. Starting with New Zealand and Canada, an increasing number of advanced countries adopted inflation targeting as their monetary framework. Several emerging economies followed suit in the late 1990s (Freedman and Laxton, 2009a). However, for emerging economies, implementation of inflation targeting posed challenges that are different from those in advanced economies.

Key among them are building institutional capacity and overcoming a multitude of policy challenges.

While institutional capacity was largely in place in many developed countries, more work was necessary in emerging economies before inflation targeting could be adopted. An early debate focused on the set of preconditions necessary for successful adoption of inflation targeting. Although initially it was thought that a long and demanding list of strict preconditions should be met, this was later qualified with the successful adoption of inflation targeting in a number of emerging economies (IMF, 2006). Using survey and econometric evidence, Batini and Laxton (2007) show that no inflation targeter—not even industrial economies—had the strict preconditions in place before adopting inflation targeting. The key to successful adoption is the authorities' commitment to the price stability objective and the ability to bring institutional change required to achieve the objective.

In order to prepare the institutional structure for inflation targeting, a number of choices have to be made. These include the choice of the target index and its level; the medium-term targets in the case of disinflation; the long-term definition of price stability; necessary institutional arrangements to establish and enhance transparency; and development of a communications strategy. Heenan, Peters, and Roger (2006) and Freedman and Laxton (2009b) discuss the trade-offs between various organizational choices and provide a cross-country perspective. Inflation targeters use a short-term policy interest rate to provide an anchor for inflation and inflation expectations. In many emerging economies the shift towards a reliance on money market operations has been gradual and, at times, fraught with difficulty. Laurens (2005) proposes a stylized sequencing of reforms that enables countries to tailor the introduction of money market operations to their particular circumstances. An organizational structure within the central bank is essential to support policy decisions in inflation targeting. (Laxton, Rose, and Scott, 2009; Canales and others, 2006).

On the policy front, two areas have proven to be particularly challenging: managing the role of the exchange rate, and conducting policy with limited credibility. While exchange rates historically played a key role in monetary policy in many emerging economies, in inflation targeting, the exchange rate typically floats freely. The switch to more flexible and, ultimately, floating exchange rates has not been easy. Institutional and operational requirements, as well as the need to change public perception of the role of the exchange rate, have required a better understanding of the transition to inflation targeting.

Duttagupta, Fernandez, and Karacadag (2004) describe the operational aspects of a move to a more flexible exchange rate and identify the following successful ingredients for floating: developing a deep and liquid foreign exchange market; formulating intervention policies consistent with the new regime; establishing an alternative nominal anchor in the context of a new monetary policy framework and developing supportive markets; and building a capacity to manage exchange rate risks. In a follow-up study, Ötker-Robe and Vavra (2007) analyze the concrete steps taken by a group of countries that transitioned to greater exchange rate flexibility, with a view to identifying pros and cons of alternative strategies. Many of these countries eventually adopted inflation targeting—some of them soon after they floated their currencies, others more gradually.

Stone and others (2009) further build on these themes using a more macroeconomic view that specifically focuses on the role of the exchange rate in inflation targeting in emerging economies. A key challenge for monetary policymakers at the earlier stages of inflation targeting, or during the transition to it, is whether and how to take the exchange rate into account. Based on case studies and simulations, the paper demonstrates that under certain circumstances there could be a limited role for the exchange rate in inflation-targeting frameworks, but even in these rare cases, too much emphasis on the exchange rate is likely to be harmful. Model simulations distinguish between a financially robust economy and a financially vulnerable emerging market economy. The shocks hitting these two types of economies include demand shocks, cost-push shocks, and risk premium shocks. The results suggest that while inflation targeting performs the best in handling demand and cost-push shocks, dampening of exchange rate changes could be useful in handling risk premium shocks; the results are especially pronounced for the financially vulnerable economy. Responding to the level of the exchange rate, however, performs poorly.

Another challenge on the policy front is implementation of inflation targeting with limited credibility. In countries with good inflation performance, expectations are well anchored, giving policymakers more room to respond to supply and demand shocks compared to counties with limited credibility. This problem became central in 2007 due to food and oil rice shocks. Inflation rates in most developing countries rose significantly above targets in emerging economy inflation targeters. In a comprehensive cross-country study, Habermeier and others (2009) document the shocks that contributed to rising inflation provide policy options for a range of countries, and underline the importance of communications efforts to keep inflation expectations well anchored.

Alichi and others (2009) take a theoretical approach, focusing on the relationship between the level of credibility and the optimal monetary policy. A key feature of their model is the endogenous policy credibility process, by which monetary policy can gain or lose credibility over time. Demand shocks are easy to handle, but adverse supply shocks present the most difficult problems for inflation, particularly if inflation expectations are not well anchored. In the early part of the disinflation path, the central bank has to be prepared to raise interest rates to a level that dampens demand and brings about visible reductions in inflation. Any hesitation, out of excessive concern for limiting short-run output losses, damages credibility, delays the achievement of the low-inflation goal, and results in more prolonged output losses. Battini and Tereanu (2009) use a small, open-economy DSGE model to design the monetary policy response to a protracted supply shock.

The global financial crisis has raised questions about central banks' primary focus on price stability. There is now a debate on what weight central banks should give to financial stability, and whether and how the current consensus on the conduct of monetary policy should be altered (Svensson, 2009; and White, 2006). Carney (2009) highlights several challenges that policymakers will face in the new financial environment. Examples of changes include higher capital requirements for systematically important banks, or procyclical capital requirements. These will change the channels through which monetary policy impacts the economy, even if the monetary policy framework remains intact. Clearly, more research on the linkages between macroeconomic and financial factors is needed. IMF (2009) provides econometric and simulation evidence that suggests policymakers should react more strongly to signs of increasing macrofinancial risks. How to achieve this operationally is another avenue for future research (Evens and others, 2000).