| I. Executive Summary
In recent years, emerging market countries have joined industrial countries
in adopting monetary policy frameworks of formal inflation targeting.
Motivated by increased demand by emerging market countries for IMF technical
assistance on inflation targeting, this paper examines the institutional
and operational practicalities of inflation targeting for emerging market
countries adopting this regime. The paper spells out the trade-offs raised
in the formulation of an inflation targeting framework and describes the
approaches to these trade-offs used by inflation targeting countries.
This paper is founded on the body of knowledge formed by the years
of industrial country experience with inflation targeting, as well as
the more recent formulation of inflation targeting frameworks by emerging
market countries. The countries identified here as practitioners of inflation
targeting are those considered to have adopted most of the elements of
a full-fledged inflation targeting framework (Figure 1.1).
Figure 1.1. Inflation Rate at
Adoption of Inflation Targeting
 |
Sources: Central bank websites
and reports; Bernanke and others (1999); IMF, International
Financial Statistics. See Table 4.1 of this report.
Note: Emerging market countries
are in bold.
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The experience of these countries suggests that the foundations for
successful, full-fledged inflation targeting are built on the following:
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 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.
The inherent differences reported in this paper between the six emerging
market inflation targeting
countries—Brazil, Chile, the Czech Republic, Israel, Poland, and
South Africa—and other emerging market countries may shed some
light on the preferred starting point and conditions for inflation targeting.
The inflation targeting economies are large, relatively well developed,
and have more developed domestic financial systems compared to their
counterparts, suggesting that these attributes should be carefully considered
by other emerging market countries thinking of adopting this regime.
Moreover, experience has shown that a strong fiscal position and entrenched
macroeconomic stability are equally important elements of the foundation
for successful inflation targeting.
Table 1.1. Synopsis of Inflation Targeting
Frameworks
|
|
Institutional
Framework |
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|
Central bank legal framework |
|
|
Instrument independence and currency
or price stability is a central bank objective in all
cases. Central bank financing of government deficit
is limited or prohibited in all emerging market countries. |
| Design of the inflation target |
|
|
Announcement of target |
|
|
Announced by government or jointly by
government and central bank, unless the central bank
has an explicit mandate for price stability as the primary
objective. |
|
|
Target horizon |
|
|
Indefinite for countries at longer-run
inflation rate and annual for countries in disinflation. |
|
|
Price index |
|
|
Consumer price index for most emerging
market countries and core inflation for |
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|
|
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most industrial countries. |
|
|
Formal escape clauses |
|
|
Only used by several countries. |
|
|
Point target or target range |
|
|
Target range preferred by most countries
given uncertainties associated with hitting targets.
Point targets have been adopted in some cases to focus
inflation expectations. |
|
Accountability and transparency |
|
|
Press releases of policy changes, regular
inflation outlook reports, active dialogue with the
private sector, and in some cases, publication of inflation
forecasting models. |
|
|
Operational
Issues: Conduct of Monetary Policy |
|
|
Inflation forecasting |
|
|
Based on indicator variables, quantitative
economic models, discussions with market participants,
and, especially for emerging market countries, qualitative
judgment. |
|
Policy transmission channels |
|
|
Emerging market countries with higher
rates of inflation have channels characterized by downward
price stickiness and rapid exchange rate pass-through. |
|
Policy implementation |
|
|
All countries use market-based instruments
to target a short-term interest rate. Changes in official
interest rates reflect deviations of inflation from
the target and the output gap. |
|
Changing economic relationships |
|
|
As inflation targeting framework gains
credibility, linkages between inflation and the level
of economic activity seem to weaken. |
|
Responding to economic and
financial shocks |
|
Responses to external shocks range from
doing nothing to a mixture of foreign exchange intervention
and tighter monetary policy, depending on whether shocks
are expected to affect inflation expectations or the
stability of the financial |
|
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system. |
|
Breaches of the inflation target |
|
|
Asymmetric responses to breaches of floor
and ceiling during disinflation, and symmetric responses
when inflation is at the long-run level; breaches do
not seem to have damaged credibility. |
|
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|
Organizational
Implications for Central Banks |
|
|
Internal decision making |
|
|
Many central banks have incorporated
a broader range of perspectives and decentralized their
organizational structure to enhance judgment-based decision
making. |
|
Monetary policy committees |
|
|
Most central banks have formal committees.
Consensus decisions are typically published while voting
records are not. |
|
Central bank organization |
|
|
Emerging market central banks have reorganized
to improve data collection, inflation forecasting, and
policy analysis. |
|
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Transition Issues |
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|
Disinflation |
|
|
Emerging market countries that started
with higher inflation and crawling exchange rate bands
disinflated over a long period to minimize output disruptions. |
|
Long-run inflation objective |
|
|
Consensus of around 13 percent
for industrial countries and somewhat higher for emerging
market countries. |
|
Shifting from a fixed exchange
rate regime |
|
|
Slow and fast-track transitions from
an exchange rate regime to full-fledged inflation targeting
framework for emerging market countries. |
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In contrast to industrial countries, emerging market countries tend
to prefer a more formal institutional framework in support of inflation
targeting. The legal frameworks of all inflation targeting countries
explicitly set price or currency stability as the primary objective
of the central bank and grant it instrument independence. Emerging market
countries usually modify the central bank legal framework before adopting
inflation targeting, however, and all emerging market countries explicitly
limit central bank financing of government deficits in the primary market.
The more formal institutional frameworks for inflation targeting in
emerging market countries may reflect their much higher and more variable
rates of inflation compared to industrial countries, less developed
financial systems, greater vulnerability to inflationary monetization
of government debt, and greater susceptibility to exchange rate crises.
Differences in the operation and design of inflation targeting between
emerging market and industrial countries are another theme of this paper.
Central banks in emerging market countries rely less on statistical
models in the conduct of monetary policy. They appear to intervene more
frequently in foreign exchange markets than their counterparts in industrial
countries. The design of inflation targets in emerging market countries
is characterized by shorter horizons, and by target bands rather than
point targets. These differences may also reflect structural differences
with industrial countries. Ongoing structural changes in underlying
economic relationships are more prevalent in emerging market countries,
which are inclined to be more vulnerable to shocks, especially volatile
capital flows.
Most central banks in emerging market countries have taken important
organizational steps to enhance their capacity to apply greater judgment
and foster transparency and accountability. These steps can be particularly
challenging for emerging market central banks that have traditionally
operated with controls and regulations and have been reluctant to communicate
their policy intentions and economic outlooks. Most of these banks have
improved their governance structure by incorporating a broader range
of perspectives into the monetary policy decision-making process, and
by reforming their organizational structure with a view to delegating
authority.
Finally, during the transition to full-fledged inflation targeting,
several emerging market countries have confronted the challenge of disinflating
to the long-run inflation objective. The experiences of Chile, Israel,
and Poland suggest that a gradual shift from a crawling exchange rate
regime to an inflation targeting framework is feasible given supportive
economic and fiscal policies to manage the transition and minimize the
risk of saddling the central bank with conflicting objectives.
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