Ugandan women count money during microfinance meeting. Uganda stabilized short-term interest rates and adopted inflation targeting despite low levels of financial development (photo: Macduff Everton/National Geographic Creative/Corbis).
MONETARY POLICY
There has been significant progress made toward the liberalization and deepening of financial markets over the past twenty years. But according to the IMF, greater central bank independence, reduced fiscal dominance, and increased exposure to global capital markets have put pressure on an increasing number of lower income countries to modernize their policy frameworks.
Sound principles of monetary policy still apply
The study by IMF staff, Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries, aims to provide guidance to this group of countries, and uses the same set of principles that characterize effective monetary policy frameworks in countries with scope for independent monetary policy. “These principles encapsulate the key characteristics of any sound forward-looking monetary policy framework,” the authors say, adding countries should consider how best they can follow them to support their reform agendas.
The principles that characterize effective monetary policy frameworks by central banks, according to the report, include:
• a clear mandate and operational independence to pursue its goals;
• price stability as the primary objective of monetary policy over the medium term;
• a medium-term inflation objective that guides monetary policy actions and communications;
• macroeconomic and financial stability considerations when determining policy;
• clear and effective operational framework aligned with market conditions and policy stance;
• transparent forward-looking policy strategy; and
• clear communications, which enhances the overall effectiveness of monetary policy.
While these principles are consistent with an inflation-targeting framework, the paper emphasizes that these frameworks are not the only way to implement them. “For one thing, the meaning of the term ‘inflation targeting’ varies and has evolved over time. The principles stated in the paper stress the primacy of a medium-term inflation objective, but do not require an unduly narrow focus on inflation at the expense of considering the impact on the real economy and the financial system,” the study says.
Price stability a critical first step in reform agenda
The report also emphasizes the importance of price stability as a primary objective in a country’s reform agenda—as it moves to an interest-rate based operating framework and greater exchange rate flexibility. The development of analytical tools for policy making and techniques for effective communication are also critical to help anchor inflation expectations, the paper says.
There is substantial difference in how countries have managed to modernize the framework for monetary policy, and the report draws lessons from the experiences of a number of countries in a background paper. In particular, while there is not a specific set of preconditions that countries need to meet, critical first steps include a commitment to the primacy of price stability, and the ability of the central bank to pursue that goal. ”Many of the challenges come from the coexistence of multiple and often inconsistent targets and objectives,” the study says. The authors also suggest countries move forward on as many fronts as possible, as progress can be self-reinforcing, and so those reforms that can have a catalytic role should be conducted early in the modernization process.
Another important goal in the modernization process, according to the study, is to increase control over short-term interest rates, by establishing appropriate central bank monetary instruments (which typically combine standing facilities, open market operations, and reserves requirement). While the move toward interest-rate based frameworks can be swift, the report says, the end point should be a framework where policy is signaled with a “policy rate” that anchors interest rates in the financial system.
Enhancing analytical capacity should also be part of the modernization process, the report says. Improving the central bank’s capacity to interpret data helps produce coherent medium-term forecasts and analysis, and provides policy recommendations consistent with current and expected state of the economy and the policy objectives. This requires the development of quantitative frameworks for monetary policy analysis and forecasting, including the development of a quarterly projection model.
The IMF study concludes by offering its continued support to low- and lower-middle income countries in their process of strengthening and modernizing their frameworks through policy advice on institutional issues, both in surveillance and program contexts, as well as technical assistance and training.
