High-Level Seminar: Implementing Inflation Targets -- Closing Remarks by Mr. Eduardo Aninat
March 21, 2000Closing Remarks by Mr. Eduardo Aninat
Deputy Managing Director of the International Monetary Fund
Washington, DC, March 21, 2000
I am very honored to present the closing remarks at this high-level seminar on Implementing Inflation Targets. The issues addressed in the past two days were of great interest, particularly for developing and transition countries that are either still reducing inflation or consolidating their gains on that front. The attendance of so many representatives from the central banks of these countries is particularly encouraging. I would like to congratulate the speakers, discussants, and chairpersons for their contributions, and the IMF Institute for organizing this event.
Let me begin my brief address by noting the considerable consensus that has emerged among academics and policymakers that medium-term price stability is the appropriate ultimate goal of monetary policy. This consensus reflects two findings: first, that high rates of inflation (and its high variability) distort the decisionmaking of private agents, ultimately leading to slower economic growth and a worsening income distribution, with their attendant social costs; and second, that by lowering inflation, monetary policy contributes to sustainable economic growth by preventing high inflation from distorting investment, savings, and production decisions.
Encouragingly, the past 15 years have witnessed the return of conditions of relatively greater price stability, not only in the industrial world, but also in developing regions that had long been plagued by chronic inflation at two- to three-digit levels.
How has this been achieved? The general trend toward lower inflation has occurred while central banks have been granted much greater independence than in the past in choosing the monetary policy framework to achieve price stability. Although strategies have differed across countries, depending on economic conditions and traditions, successful approaches have traditionally shared a common feature: they have provided a transparent standard for the assessment of policy—an announced intermediate target. Commitment to this intermediate target, traditionally, an exchange rate or monetary target, is intended to make the commitment to price stability credible.
However, a number of OECD countries, first New Zealand followed by Canada, Israel, the United Kingdom, Australia, Finland, Spain, and Sweden, have found their experience with exchange rate or monetary targets either unsustainable or unsatisfactory. As a result, in the early 1990s, they adopted inflation targeting as a strategy for conducting monetary policy. This approach involves the public announcement of numerical targets for inflation and an institutional commitment by the monetary authorities to achieve these targets, without explicit reference to any intermediate target.
The successful implementation of inflation targeting by some of these countries persuaded a number of developing countries to adopt a similar strategy to tame inflation, enhance credibility, and anchor expectations. In Latin America, Chile, Brazil, Colombia, and Mexico, and in other parts of the world, the Czech Republic, Poland, South Africa, and since last month, Thailand, have all started to conduct monetary policy through a more-or-less formal process of inflation targeting.
In this seminar, you pointed to several desirable features of the inflation targeting strategy. One important feature is that the strategy, although not strictly a "rule," imposes limits on "discretion." In actuality, inflation targeting is a framework for conducting monetary policy under constrained discretion, as has been described in the literature. Thus the strategy provides a sensible and workable compromise to the old "rules versus discretion" debate. Unlike rigid rules, such as monetary or explicit exchange rate targets, inflation targeting allows for some flexibility in responding to unforeseen real and external shocks. But, similar to "rules," the forward-looking approach of inflation targeting forces central banks to avoid policies perceived to be inconsistent with attaining the announced inflation target.
As your discussions emphasized, the other advantage of inflation targets is improved transparency and public communication. Because the central bank's intentions are clearly stated, the public is able to understand and monitor central bank actions. This improves the transparency of monetary policy, making communication with the public more effective, while providing increased discipline and accountability for central bank activities.
What is the record of inflation targeting in industrial countries? So far, it appears promising. But here, I must insert a word of caution. Inflation targeting has not been tested yet over a full business cycle. In fact, the recent increase in oil prices is probably one of the biggest challenges for inflation targeting to date. Even so, the general focus on price stability seems to have contributed to a remarkable convergence of inflation rates among industrial countries. Of course, this trend has been aided by the generally benign international economic environment in recent years, and the process of international integration. We do not know whether these developments will continue to ensure, by themselves, a continued low-inflation trend. Thus, low inflation has to remain the responsibility of monetary policy, and central banks will have to remain on their guard.
How does inflation targeting apply to developing countries? While the primary objective of central banks in industrial countries is to keep inflation low, central banks in many developing countries are still concerned with bringing inflation down to internationally more acceptable levels. As we heard in this seminar, a growing number of developing countries are looking into the possibility of adopting the inflation targeting strategy for this purpose. Here, too, the record is encouraging. It appears that countries that have adopted inflation targeting so far have succeeded in reaching their inflation targets.
Chile is a good example. As finance minister from 1994 to 1999, I witnessed one of the early attempts—perhaps the first, among developing countries—to adopt the inflation targeting strategy. Following the successful stabilization of the economy in the second half of the 1980s, Chile decided to abandon monetary targeting in the early 1990s because of concerns about the suitability of that strategy in the context of fast-developing financial markets and volatile demand for money. In view of the two failed experiences with exchange rate anchors in 1959-62 and in 1979-1982, the remaining choice of a nominal anchor was an inflation target.
I must mention that the Chilean case is unique because inflation targeting was adopted when inflation was still running at an annual rate of close to 20 percent. However, a key feature of the Chilean approach was its gradual and flexible implementation, which contributed to reducing inflation without incurring substantial output costs. In fact, it incurred no output costs until 1998. In 1999, the fallout of the Asian crisis resulted in the first (mild) recession since 1982-83. The bottom line is that after almost 10 years of experience with inflation targeting, Chile's real growth rate has averaged about 6.5 percent, with an annual inflation rate of just 2.3 percent (December to December 1998-99).
So, how can inflation targeting benefit developing countries? Let me mention four ways:
But policymakers must also recognize that developing countries have specific problems that can make inflation targeting more challenging to implement than in industrial countries. There are several reasons. First, many developing countries still have relatively high rates of inflation (say, 25 percent or more); and at such high rates, accurate prediction of future inflation is difficult. Consequently, setting targets might actually damage the credibility of the central bank. Second, widespread explicit or even implicit indexation mechanisms in these countries may result in considerable inflation inertia.
Third, one of the prerequisites for inflation targeting is commitment to adopting no other nominal target. However, for developing countries with a sizable share of assets and liabilities denominated in foreign currencies, the exchange rate movements that may be needed to adhere to the inflation target could pose a problem.
Fourth, other prerequisites for inflation targeting are central bank independence and absence of fiscal dominance. But in many developing countries, central bank independence is more a statutory than a de facto situation, and some fiscal dominance still persists. Under these circumstances, central banks might hesitate to raise interest rates for fiscal reasons (fiscal sustainability considerations, for example), although they would be required to do so to contain inflation. Even so, independence must not imply an absence of coordination. Prudent coordination of fiscal, monetary, and exchange rate policies can clearly enhance credibility.
On the operational side, let me cite two challenges for developing countries. First, adapting central bank analytical work to an inflation targeting framework requires substantial investment in human capital and institution building. It also requires the development of appropriate monetary instruments and market operations and a clear understanding of the underlying monetary policy transmission mechanism.
Second, improving the transparency and accountability of central bank activities to the public is at the heart of inflation targeting. Consequently, inflation targeting should conform to the criteria stated in the recently issued Code of Good Practices on Transparency in Monetary and Financial Policies.
Turning to the IMF, What does inflation targeting imply for conditionality? More and more countries are adopting some form of inflation targeting. This means that the IMF will have to decide whether this monetary framework calls for any modification in the way Fund conditionality and program monitoring currently operate. The issue is that Fund conditionality, by imposing a floor on net international reserves and a ceiling on net domestic assets, could in some circumstances generate inconsistencies with inflation targeting and thus confusion about a country's monetary policy priorities. The Executive Board and the staff of the Fund are currently studying this issue, but the view so far is that the traditional structure of conditionality is consistent with inflation targeting. Indeed, the Fund has already approved a program with Brazil, albeit with some modifications to traditional conditionality prompted by the authorities' inflation targeting regime. In particular, the program includes (in addition to a floor on net international reserves and a ceiling for the central bank's net domestic assets) a "consultation band" for the 12-month rate of the broadest available consumer price index.
On balance, the inflation-targeting approach appears to be very promising for developing countries. It offers a number of operational advantages, and it compels policymakers to deepen reforms, enhance transparency, improve the fiscal stance, and eventually converge to international level of inflation. As the experience of inflation targeting in industrialized countries indicates, to attain these objectives, central banks must keep the public informed about their policies and performance. By issuing periodic consumer-type publications, like the Inflation Reports, the central bank makes its intentions known in a way that improves private sector planning and enhances public understanding of what the central bank can and cannot achieve. It also helps clarify the responsibilities of the central bank, and of other executive branches of the government.
Finally, it is important to keep in mind that the inflation targeting strategy is not a panacea. It is a useful framework for conducting monetary policy because of the transparency it provides on the link between monetary policy actions and the pursuit of the inflation target. But maintaining sound macro fundamentals remains the necessary condition for preserving price stability under any monetary framework. This is essentially my core message today.
I would like to thank all the participants of the seminar for their useful contributions, and hope that the insights that you have gained will be fruitful in your future work.
Thank you for this time of reflections.