Remarks by Murilo Portugal, Deputy Managing Director of the International Monetary Fund, At a High-level Regional Seminar on Inflation TargetingRabat, Morocco
April 4, 2007
As Prepared for Delivery
Distinguished Ladies and Gentlemen:
"I am delighted to participate in this High-Level Regional Seminar on Inflation Targeting co-organized by Bank Al Maghreb and the IMF. Let me begin by thanking the Moroccan authorities for hosting this important conference here in Rabat.
"I would like to give a special welcome to our guests from Algeria, Egypt, Jordan, Lebanon, Libya, Mauritania, and Tunisia, whose presence here confirms the importance of inflation targeting to our membership in this region of the world. My thanks also to our eminent speakers from Brazil, the Czech Republic, Mexico, and the Bank for International Settlements, who have kindly agreed to share their experiences and views on adopting and implementing inflation targeting with the other participants.
"Over the next three days, the IMF will also be running a workshop on inflation forecasting issues for central bank experts of the countries of the region, an initiative I believe will offer an appropriate way to promote technical cooperation and share hands-on experience among experts.
"In my remarks today I would like to touch on four main issues. The first concerns the broadening interest in inflation targeting as a monetary policy strategy in emerging market and developing countries. Second, I will comment on macroeconomic performance under inflation targeting in emerging market and developing economies over the past decade. Third, I will suggest some lessons that we might draw for other countries—including for the Maghreb and Middle East—regarding inflation targeting requirements. Lastly, I will speak a little about the IMF's role in assisting countries develop their inflation targeting frameworks.
The spread of inflation targeting"Ever since New Zealand started inflation targeting in 1990 through to the late 1990s, the practice was restricted to a handful of industrial countries. But over the past decade, more and more emerging market and developing countries have based their monetary policy on direct inflation targeting, and today the picture is quite different.
"Of the 24 countries now pursuing direct inflation targeting, 16 are emerging market and developing economies. In our discussions with IMF members, it is also apparent that many more emerging market and developing countries would seriously like to follow suite within the next 10 years. So why is inflation targeting becoming increasingly popular? I would point to four main factors:
• First, the increasing international integration of goods and financial markets has been a common factor behind monetary policy regime changes, as many countries have decided that a flexible exchange rate framework is better suited to cushioning domestic economic performance from external disturbances than fixed exchange rates. However, replacing a peg with a flexible exchange rate regime requires identifying benchmarks for monetary policy to establish a clear nominal anchor. Inflation targeting can play this role.
• Second, innovations in financial products and financial market behavior, including those associated with capital account liberalization, and development of modern financial systems and markets, inevitably affect the relationships between financial activity and the real economy. In such circumstances, money and credit aggregates may well become less reliable or useful as intermediate monetary targets for achieving inflation and growth objectives.
• Third, there has been fairly broad acceptance world-wide that high inflation is bad for both growth and equitable distribution of income; that putting and keeping fiscal policy on a sustainable track is important and beneficial for achieving low inflation; and that central bank autonomy and transparent accountability helps to build policy credibility, resulting in better outcomes for inflation and growth performance.
• Lastly, the inflation targeting experience of industrial countries is widely considered as a successful model to adapt. Inflation targeting is seen as providing policy credibility and flexibility, resulting in better inflation and growth performances in these countries, together with increased resilience to shocks.
"Although the adoption of inflation targeting by industrial countries has generally been regarded as a success, its adoption in emerging market and developing countries has been more controversial. Debate has focused on three main questions. The first is whether inflation targeting works as well or better than alternative monetary policy frameworks in non-industrial economies. A particular concern is whether achieving better inflation performance is likely to come at the cost of poorer growth performance. The second question is what pre-conditions need to be met, and whether these are likely to be too demanding for most emerging market and developing countries. The third question is whether emerging market and developing countries can sustain inflation targeting if a less benign global macroeconomic environment were to lead to substantially increased financial market volatility, compared with what has been experienced in recent years.
"These questions have been debated, sometimes passionately, for nearly a decade, in academic circles, between central banks, and inside the IMF. Now though, we can draw on the experiences of countries like Brazil, the Czech Republic, Korea, Mexico, and South Africa to start answering these questions.
The experience of emerging market and developing economies
"A growing number of studies—including the IMF's World Economic Outlook published last September—suggest that inflation targeting in emerging market and developing countries has been associated with better macroeconomic performance than under alternative monetary policy frameworks in otherwise similar economies over the same period.
" Most emerging market and developing countries—whether they targeted inflation or not—performed much better in terms of growth and inflation since 2000 than during the 1990s. But the evidence also shows that those that adopted inflation targeting tended to see bigger improvements than others, both in terms of inflation and growth performance.
"It is still not certain to what extent better macroeconomic performance in inflation targeting countries can be credited solely to the change in the monetary policy regime. This is because in most countries targeting inflation, the change in the monetary framework has been part of a much more wide-ranging set of structural and policy reforms, including substantial fiscal consolidation. These may have been more profound than in non-targeting countries. It is, therefore, difficult to attribute better economic performance to monetary policy alone.
"Overall, these findings are generally favorable to inflation targeting. They do not guarantee that it will work well in every emerging market or developing country. But they do suggest that the growing interest in inflation targeting is warranted, and that it is important to consider inflation targeting within the broader context of institutional and policy reforms.
"The favorable overall experience with inflation targeting in these countries does not mean that there have not been problems. Let me highlight two particular issues that have been problematic in several countries:
• First, a perennial issue in any open economy, including an inflation targeter, is the role of the exchange rate. For a number of inflation targeters, it has proven to be quite difficult to accept the subordination of exchange rate and competitiveness concerns to the inflation objective. In Chile, Hungary, and Romania for example, markets have tested the central bank's commitment to the inflation target as opposed to an exchange rate objective. Eventually, however, the private sector and policy makers need to accept that international cost competitiveness is more fundamentally an issue of productivity—that is, using labor and capital efficiently to keep costs down. A weak exchange rate may be able to boost competitiveness temporarily, essentially by cutting wages and profits, but it does not address the underlying issue of the need to raise productivity. It is no different in industrial countries.
• Second, inflation targeting countries are not immune to disruptive shifts in investor sentiment and the consequences for exchange markets and, ultimately, growth and inflation performance. As with other frameworks, turbulence has been triggered by a variety of causes. In many episodes of turbulence, the trigger has been a fairly general shift in investor sentiment either toward or against emerging markets. In some cases, however, domestic factors can play a role. For example, Brazil and the Philippines have experienced episodes of turbulence in which political developments and related concerns over future fiscal policy appear to have played a key role. Last year, Iceland also experienced some exchange market pressure, reflecting concerns over the large current account imbalance and banking sector vulnerabilities associated with rapid credit growth.
"In no case, however, has the turbulence led to a breakdown of the policy framework, as can occur when an exchange rate peg becomes unsustainable. Indeed, such episodes, however painful at the time, can also strengthen policy credibility if the central bank keeps its focus on the inflation objective. Nonetheless, inflation targeting frameworks in many emerging market and developing economies are yet to be tested by a more volatile and trying global macroeconomic and financial market environment.
Issues in inflation targeting in emerging market and developing economies
"So what lessons can countries considering the move to inflation targeting draw from the experiences of emerging market and developing nations that are inflation targeters? The institutional and technical requirements for successful inflation targeting would probably spring to mind first. This has been a particularly contentious issue, with some arguing that a long list of pre-conditions need to be met before starting inflation targeting. Others suggest, in the spirit of the popular Nike sports shoe manufacturer mantra just do[ing] it!
"The experience of emerging market countries and, indeed, the industrialized nations that have adopted inflation targeting suggests that we need to think a little bit differently about preconditions for inflation targeting. The more basic issue is what conditions need to be met to conduct an independent monetary policy rather than an exchange rate peg. The basic requirements appear to be the following:
• First, the central bank needs to have the autonomy—and associated accountability—required to pursue a clear mandate, with the policy objectives supported by the government. In this context, I should emphasize that government support—in the sense of agreement on objectives—is very important for the credibility of policy in financial markets. Government support is also essential in a more active sense. In particular, fiscal discipline can contribute significantly to the achievement of the inflation objectives.
• Second, the central bank needs to have effective instruments for influencing domestic spending and savings behavior. In all countries that have adopted inflation targeting to date, central banks implement monetary policy primarily through short-term money markets, in order to influence retail interest rates. This in turn requires functioning financial markets, as well as a reasonably stable financial system. In this context, I might note the relevance of the increased emphasis that Maghreb countries are placing on strengthening financial systems. This was reflected in the Conference on Financial Sector Reform and Financial Integration in Maghreb Countries, held last December in Rabat.
• Third, because monetary policy acts with lags, it is important for policymakers to be able to anticipate the macroeconomic consequences of their actions so that the objectives can be reached. Fundamentally, this requires that the central bank has adequate economic and financial data, a reasonable understanding of how monetary policy affects inflation, as well as appropriate analytical and forecasting capabilities.
"I want to emphasize that these requirements apply to virtually any meaningful independent monetary policy, not just inflation targeting. The experience of emerging market inflation targeters suggests that if these conditions are largely met, then it is not a big step to establish a workable inflation targeting framework. In most emerging market countries, it has now become standard practice to modify central bank legislation to set a clear goal of price stability, and to strengthen central bank autonomy. In addition, most inflation targeting central banks have had to strengthen their analytical and forecasting capabilities substantially. They have also had to increase transparency greatly, and develop comprehensive public communications. And finally, of course, they have had to establish an explicit inflation target.
"Although one can debate what constitutes a minimum required standard for each of the different elements I have referred to, there is little doubt that the further along a country is in developing these elements prior to adopting inflation targeting, the more credibility the policy framework will have, and the better its macroeconomic performance is likely to be.
"I would like to refer briefly in more detail to the case I know more closely, which is that of Brazil, where many of these issues emerged. Brazil adopted inflation targeting in 1999 in the wake of a sharp devaluation and the floating of the exchange rate. There were concerns that the preconditions for inflation targeting were not present, especially that there was fiscal dominance. There were also concerns that the transmission channels of monetary policy were partially blocked, due to a too low private credit to GDP ratio (initially 27% and now 34%), a perverse wealth effect resulting from a too large share of public debt indexed to the short term interest rate, and the presence of indexation in utility rates and other prices governed by contracts, which represent 30% of the consumer price index chosen to measure the inflation target.
"The Central Bank conducted regular surveys of inflation expectation of about 100 professional forecasters, mostly in the financial sector, which were compiled and a summary of consensus forecasts was published weekly. In order to strengthen incentives, the Central Bank also publishes the ranking of the best short and medium term forecasters.
"Brazil also had a vulnerable external position, which made it quite exposed to shocks. In fact, inflation targeting in Brazil was marked by three episodes of sharp exchange rate devaluation in 1999, 2001 and in 2002. As a result of these shocks, the authorities had to use twice, in 2003 and 2005, an adjusted operational target that was higher than the inflation target mid point. But while doing so, the Central Bank indicated that it would respond asymmetrically to further shocks, reacting to shocks that would threaten to increase the upward deviation of inflation from the operational target, but taking advantage of favorable shocks to bring inflation closer to the original mid-point target.
"The concerns about fiscal dominance proved exaggerated, as fiscal policy was adjusted, as well as those about weak transmission channels. The new inflation targeting regime marked a major improvement in monetary policy transparency and was instrumental in anchoring inflation expectations. There are signs that inflation uncertainty has declined, that dispersion of inflation expectations across the survey respondents may have diminished, and that inflation targets are playing a bigger role as anchors of inflation expectations. There is evidence that the risk premium implicit in long-term interest rates has declined. In sum, the overall results of inflation targeting in Brazil have been positive.
The IMF and inflation targeting
"I wish to conclude by talking about where and how the IMF can assist countries in preparing to adopt inflation targeting. The IMF has several avenues for helping member countries develop inflation targeting frameworks. This could either be in advance of adoption, or in strengthening implementation. The Fund's regular Article IV consultations may assist member countries in drawing road maps toward inflation targeting. Similarly, Fund programs may also include and support development of an inflation targeting framework. Bilateral technical cooperation missions are also used to assist countries with designing and developing various elements of inflation targeting frameworks. To date, at least 14 countries have benefited from such missions and much of the assistance has focused on modeling and forecasting issues. In some cases, the IMF has also arranged for resident advisors to work with central bank staff member in developing their capacity to implement inflation targeting.
"Missions in other more traditional areas of IMF expertise like debt management, foreign exchange operations and statistics, also contribute to strengthening inflation targeting capacity.
"The IMF also conducts focused workshops on various aspects of inflation targeting, including, especially, modeling and forecasting. These workshops, like this one here in Rabat, bring together practitioners from a group of central banks to work with a team of leading edge experts.
"Finally, the IMF runs training courses on inflation targeting issues, both in Washington and at regional training centers. These include the Joint Vienna Institute, the Singapore Training Institute, and the Brazil Training Center. Such courses are in strong demand, and we are working to give greater attention to inflation targeting issues in some of our standard courses on monetary policy.
"Let me conclude by stressing that the Maghreb and the Middle-East countries that are represented here could reap the benefits of inflation targeting if they meet the requirements that I highlighted. Strengthening financial institutions and modernizing relevant legislations are an important part of the adjustments that need to be made. A number of countries like Egypt, Morocco and Tunisia are contemplating the adoption of inflation targeting and paving the way for the introduction of such a framework in the medium-term. In this context, I would like also to reiterate the IMF's commitment to assist countries in this important endeavor through bilateral and regional technical cooperation, and through our annual consultation with each country. The Fund would encourage and facilitate the sharing of experiences between countries that have adopted inflation targeting and those that are planning to move toward such a framework.
"I look forward to listening to your views and engaging in productive discussions. I also wish every success to the proceedings of tomorrow's workshop."