## c3 - Introduction

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---

### Overview
- Inflation in emerging market and developing economies (hereafter, emerging markets) has, on average, been remarkably low and stable in recent years.
- Following large commodity price swings, inflation in most emerging markets has been quick to stabilize, allowing central banks to cut interest rates to fight recessions.
- As monetary policy gradually normalizes in advanced economies, the ability of emerging markets to fend off inflationary pressures is being tested.
- Chapter objective: examine whether improved inflation performance is sustainable or reflects potentially temporary global factors.

### Main empirical questions and sample
- Main questions:
  - Was the recent benign inflation behavior widespread among emerging markets?
  - What was driving inflation during this episode?
  - Have gains in inflation been well rooted through better domestic policies, or can they be expected to wane as global conditions shift?
- Sample and data notes:
  - Core analysis largely based on 19 emerging markets: Argentina, Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, and Turkey.
  - The 19 sample countries constitute 80 percent of the GDP of all emerging market and developing economies.
  - Headline consumer price inflation statistics available for 90 emerging market and developing economies; detailed econometric analysis focuses on the 19-country sample.
  - Weighted averages use weights of nominal GDP, expressed in US dollar terms, for 2010–12.

### Key findings (breadth, determinants, expectations)
- Breadth of gains:
  - Improved inflation performance since the mid-2000s was broad based, though not uniform; some emerging markets continue to find it challenging to keep inflation low.
- Dominant determinants:
  - Longer-term inflation expectations have been the main factor determining inflation, compared with the considerably smaller role of external conditions.
  - This suggests domestic, not global, factors were the main contributors to recent gains in inflation performance.
- Inflation expectations and policy implications:
  - Anchoring of inflation expectations improved significantly over the past two decades, with the bulk of gains in the 2000s.
  - Considerable heterogeneity remains: longer-term inflation expectations in several countries are still relatively volatile.
  - Better-anchored expectations reduce inflation persistence and limit pass-through of currency depreciations to domestic prices, allowing monetary policy to focus more on smoothing output fluctuations and improving resilience to adverse external shocks.

### Extent of improvements in inflation outcomes
- Regional convergence:
  - Headline consumer prices across Asia, Latin America, and Europe/Middle East/Africa converged to lower inflation rates by the mid-2000s.
  - Dispersion of inflation rates (distance between the 10th and 90th percentiles) declined substantially by the mid-2000s and has remained relatively stable since then.
- Double-digit inflation:
  - Share of emerging market and developing economies with inflation rates exceeding 10 percent declined dramatically from the mid-1990s until the early 2000s and stayed relatively stable thereafter.
  - Nonetheless, 15 percent of emerging market and developing economies have had a headline inflation rate of 10 percent or more, on average, from 2004 to the first quarter of 2018.
- Alternative price measures:
  - Core consumer prices (excluding food and energy) declined until the mid-2000s and have remained low and stable since then.
  - Producer price inflation fell drastically during the 1990s and has remained at relatively low levels since.
  - GDP deflators show a similar pattern.
- Inflation variability and persistence:
  - Inflation variability has been stable or declining in emerging markets since 2004.
  - Decline in inflation variability is not driven by exchange rate behavior; no clear evidence of a decline in exchange rate variability since the late 1990s.
  - Inflation persistence declined gradually during the sample period.
  - Since 2004, the volatility of inflation for a large share (but not all) of the country sample has been comparable to that in advanced economies; persistence remains somewhat above advanced-economy levels.

### Determinants of inflation and empirical strategy
- Primary question: during 2004–first quarter of 2018, what drove inflation—external price pressures or changes in longer-term inflation expectations?
- Two-stage empirical approach:
  1. Estimate a Phillips curve (hybrid New Keynesian Phillips curve variant) including:
     - Domestic and foreign output gaps;
     - Three-year-ahead inflation forecasts (proxy for longer-term inflation expectations);
     - A measure of external price developments;
     - Inflation persistence and country fixed effects.
     - Baseline estimated for panel of sample emerging markets using core inflation and quarterly data from the first quarter of 2004 to the first quarter of 2018.
  2. Decompose actual inflation during 2004–18 into contributions from the estimated explanatory factors (degree of economic slack, inflation expectations, external factors).
- Robustness:
  - Main findings unchanged for specifications using headline consumer price inflation.
  - Results robust to excluding the global financial crisis period or focusing on the postcrisis period.

### Headline CPI findings and model performance
- Key quantitative contributions and explanatory power:
  - Contribution of longer-term inflation expectations to inflation: 0.5 percentage point (overall).
  - Contribution of external prices: −0.05 percentage point annually (average).
  - Decline in overall deviation of inflation from target during 2004–14: 0.7 percentage point.
  - Model explains on average: 55 percent of deviations.
  - Inflation expectations explain on average: 20 percent of variation (country-average).
  - Cross-country range of share attributable to inflation expectations: 2 percent to 35 percent.
  - External price movements explain on average: 8 percent of inflation deviations.
  - Estimated contribution of foreign factors to inflation variability: 5–15 percent.
  - Unexplained portion of inflation variability: 45 percent.
  - Difference in contribution of expectations between less- and more-anchored groups: 0.4 percentage point annually.
  - Rank correlations across anchoring measures: range from 0.56 to 0.87.
- Heterogeneity:
  - Changes in longer-term inflation expectations had a sizable inflationary impact for only about half of the economies.
  - External price developments exerted downward pressure on domestic prices for three-fourths of the economies, though magnitude is small.
  - When split by anchoring, the less-anchored group shows larger contributions from longer-term expectations.

### Anchoring of inflation expectations: measurement and trends
- Operational definition: anchored longer-horizon expectations are centered around the explicit or implicit target, do not react to transitory fluctuations in actual inflation or short-term expectations, and exhibit low dispersion across forecast respondents.
- Four survey-based metrics (professional forecasters; definitions in Online Annex 3.3):
  - A summary measure of absolute deviations in inflation forecasts from a target.
  - A summary measure of the variability of inflation forecasts over time.
  - The dispersion of inflation forecasts across individual forecasters.
  - The sensitivity of inflation forecasts to surprises about current inflation.
- Trends and cross-country variation:
  - Inflation expectations in emerging markets have become increasingly anchored over the past two decades, with most gains in the early 2000s; subsequent gains were more muted.
  - Toward the end of the sample period, some countries show evidence of worsening anchoring, but this is not consistent across the four metrics.
  - Substantial cross-country variation: economies in the bottom quartile have average readings between three and seven times larger than those in the top quartile.
  - On average, anchoring in emerging markets remains substantially weaker than in advanced economies.
  - The position of economies in the anchoring ranking has changed little over time, indicating slow changes in the extent of anchoring.

### Representative anchoring metrics (reported values)
- Deviation of Long-Term Forecasts from Target: 8.37
- Variability of Long-Term Forecasts: 5.99
- Dispersion of Long-Term Forecasts: 4.41
- Sensitivity of Long-Term Forecasts to Inflation Surprises: (figure label present)

### Cross-country correlates and regressions (selected reported relations)
- Years in IT and CB Transparency Index:
  - y = 0.93 – 0.05x; R2 = 0.36 (t-stat = –2.97)
  - y = 0.94 – 0.04x; R2 = 0.09 (t-stat = –1.23)
- EMBIG and CDS Spread (deviation from global, bps):
  - y = 0.99 + 0.002x; R2 = 0.10 (t-stat = 1.32)
  - y = 1.42 + 0.004x; R2 = 0.25 (t-stat = 2.14)

### Model insights and taper tantrum evidence
- Model (New Keynesian) counterfactuals:
  - More-credible central bank: better-anchored three-year-ahead expectations, faster return of inflation to long-run level after shock, smaller exchange rate pass-through, lower inflation persistence, smaller required increase in policy rate, smaller cumulative decline in output, and smaller increase in expected real interest rate.
- Taper tantrum (May 2013 = 1) event analysis:
  - Exchange rate: currency depreciates on impact in both groups; initial depreciation somewhat smaller in less-anchored group; after two months depreciation equalizes.
  - Consumer prices: less-anchored economies experienced a very persistent and statistically significant increase in the price level; more-anchored economies broadly no consumer price impact; differences statistically significant at all horizons.
  - Exchange rate pass-through:
    - Reduced-form estimate after six months: less-anchored = 11 percent; taper tantrum event exercise = 14 percent.
    - More-anchored: reduced-form = 1 percent; event exercise = 5 percent.
  - Growth and policy rate: less-anchored countries experienced a significant fall in expected output growth but did not pursue looser monetary policies; no significant difference in policy rate response across groups at any horizon.
  - Confidence: cumulative impulse responses use 90 percent confidence intervals with Driscoll-Kraay standard errors.
- Countercyclical monetary policy and anchoring:
  - Simple correlation (2004:Q1–2018:Q1) between detrended policy rate and output gap: monetary policy in both groups, on average, reacted countercyclically; countercyclical response stronger in more-anchored group.
  - Formal Taylor-type estimation: output gap coefficient smaller for less-anchored countries; coefficient on NEER larger for less-anchored countries; in two specifications difference in output gap coefficients statistically different from zero.

### Limitations and caveats
- Phillips curve estimates can be affected by endogeneity; robustness exercises suggest potential biases are relatively small.
- Decomposition results subject to sizable uncertainty given 45 percent of inflation variability remains unexplained.
- Labeling contributions as domestic versus global warrants caution because inflation expectations can be affected by both domestic and global factors; alternative specifications and purged-expectations tests produce similar baseline results, but biases in either direction are possible.

### Policy implications and recommendations
- Consolidate and, where necessary, further improve the anchoring of inflation expectations as advanced economies normalize monetary policy.
- Fiscal policy:
  - Fiscal sustainability is a necessary precondition for a credible nominal anchor.
  - Continued commitment to improving long-term sustainability of fiscal frameworks is critical, including by adopting fiscal rules and preserving and rebuilding fiscal buffers where necessary.
  - Note: public debt has increased in emerging markets over the past decade and is projected to increase further in many of the largest economies over the next five years.
- Monetary policy and central bank credibility:
  - A credible and independent central bank that communicates intentions in a transparent and timely manner is essential to reduce variability of longer-term inflation expectations.
  - Improve credibility of central banks by consolidating and enhancing independence.
  - Improve timeliness, clarity, transparency, and openness in communications.
  - Anchor inflation expectations through consistent, transparent policy frameworks even when economic conditions are favorable—anchoring takes time.
  - In countries with relatively low credibility of monetary frameworks, emphasize clear communication of the reasons for policy actions taken in response to global developments.
- Communication and predictability best practices (Box 3.2):
  - Disclose internal decision metrics (for example, vote tallies and board arguments).
  - Concentrate public communications on medium-term outlooks.
  - Synchronize policy decisions with comprehensive explanatory reports.
  - Revise policy statements to provide richer macroeconomic context and rationale for policy actions.
- Interaction of policies:
  - Sound fiscal institutions are a precondition for credible monetary policy; interaction of inflation targeting and fiscal rules has a beneficial effect on fiscal balances and inflation.

### Comparative evidence across broader country groups
- Wider group: comparison includes 71 emerging market and developing economies separated into 33 other emerging markets and 38 low-income developing countries (LIDCs).
- Representative statistics (post-2004):
  - Average inflation: sample group = 5 percent; other emerging markets = 7 percent; LIDCs = 8 percent.
  - Share of countries with double-digit inflation fell from 50–70 percent in 1995 to less than 15 percent at the end of the sample period.
  - Inflation volatility declined after 2004 but remains higher in the other two country groups than in the sample countries.
- Explanatory factors for higher inflation in other groups:
  - Greater comovement of inflation with commodity price inflation.
  - In LIDCs, higher food shares in consumption linked to higher inflation.
  - Lower central bank transparency and weaker monetary policy frameworks associated with greater sensitivity of inflation to external shocks and higher exchange rate pass-through.
- Central bank transparency and predictability:
  - Central bank transparency index (range 0 to 15) improved more slowly in the other two country groups and remains significantly below sample-group levels.
  - Predictability of policy rate actions remains below that of advanced-economy inflation-targeting central banks; poor predictability is significantly related to weaker anchoring of medium-term (two-years-ahead) inflation expectations.

### Conclusions (summary)
- Sample and period: analysis covers 19 emerging markets during 2004–18.
- Broad-based gains in inflation performance are present across alternative price measures and geographic regions, and in both inflation levels and inflation variability.
- Heterogeneity and remaining challenges:
  - Some emerging markets continued to face double-digit inflation during the period.
  - Main driver of deviations of inflation from target is fluctuations in longer-term inflation expectations; global factors played a more limited role.
  - Extent of expectations anchoring has improved but remains subpar in many emerging markets relative to better-performing peers and advanced economies.
- Implications of global financial conditions normalization:
  - If tightening global financial conditions leads to currency depreciations in emerging markets, some adjustment in relative prices and a temporary increase in inflation rates is to be expected.
  - Well-anchored expectations mean price stability would not be jeopardized; they attenuate the inflationary impact of adverse external shocks and reduce the monetary policy dilemma between stabilizing output and inflation.
  - Subpar anchoring can constrain central bank responses and make emerging markets more vulnerable to adverse external shocks.

*International Monetary Fund | October 2018 — Chapter 3, "Challenges for Monetary Policy in Emerging Markets as Global Financial Conditions Normalize"*

### Introduction

### c3 - Introduction

### Overview
- Inflation in emerging market and developing economies (hereafter, emerging markets) has, on average, been remarkably low and stable in recent years.
- Following large commodity price swings, inflation in most emerging markets has been quick to stabilize, allowing central banks to cut interest rates to fight recessions.
- As monetary policy gradually normalizes in advanced economies, the ability of emerging markets to fend off inflationary pressures is being tested.

### Competing explanations for improved inflation performance
- Optimistic view:
  - Substantial supportive changes in institutional and policy frameworks (for example, adoption of inflation targeting after the late-1990s Asian crisis).
  - Price stability endured despite sharp swings in commodity prices, the global financial crisis, and periods of sustained US dollar appreciation.
  - Policy changes combined with real-world success suggest gains are well rooted.
- Pessimistic view:
  - China’s integration into world trade and broader globalization created a disinflationary environment benefiting emerging markets.
  - Historically benign external financial conditions after the global financial crisis—low US government bond yields and compressed spreads in emerging markets—limited crisis events and inflation surges.
- Chapter objective: examine whether improved inflation performance is sustainable or reflects potentially temporary global factors.

### Main empirical questions addressed
- Was the recent benign inflation behavior widespread among emerging markets?
- What was driving inflation during this episode?
- Have gains in inflation been well rooted through better domestic policies, or can they be expected to wane as global conditions shift?

### Sample and data notes
- Core analysis largely based on 19 emerging markets: Argentina, Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, and Turkey.
- The 19 sample countries constitute 80 percent of the GDP of all emerging market and developing economies.
- Headline consumer price inflation statistics are available for a comprehensive set of 90 emerging market and developing economies; detailed statistics and econometric analysis focus on the narrower sample of 19 emerging markets.
- Weighted averages are constructed using weights of nominal GDP, expressed in US dollar terms, for 2010–12.

### Key findings
- Breadth of gains:
  - The improved inflation performance since the mid-2000s was indeed broad based, though not uniform; some emerging markets continue to find it challenging to keep inflation low.
- Dominant determinants:
  - Longer-term inflation expectations have been the main factor determining inflation, compared with the considerably smaller role of external conditions.
  - This suggests domestic, not global, factors were the main contributors to recent gains in inflation performance.
- Inflation expectations and policy implications:
  - The anchoring of inflation expectations has improved significantly over the past two decades, with the bulk of gains in the 2000s.
  - Considerable heterogeneity remains: longer-term inflation expectations in several countries are still relatively volatile.
  - Better-anchored inflation expectations reduce inflation persistence and limit pass-through of currency depreciations to domestic prices.
  - Such stability allows monetary policy to focus more on smoothing output fluctuations and improving resilience to adverse external shocks.

### Extent of improvements in inflation outcomes
- Regional convergence:
  - Headline consumer prices across Asia, Latin America, and Europe/Middle East/Africa converged to lower inflation rates by the mid-2000s.
  - The dispersion of inflation rates (distance between the 10th and 90th percentiles) declined substantially by the mid-2000s and has remained relatively stable since then.
- Double-digit inflation:
  - The share of emerging market and developing economies with inflation rates exceeding 10 percent declined dramatically from the mid-1990s until the early 2000s and stayed relatively stable thereafter.
  - Nonetheless, 15 percent of emerging market and developing economies have had a headline inflation rate of 10 percent or more, on average, from 2004 to the first quarter of 2018.
- Alternative price measures:
  - Core consumer prices (excluding food and energy) declined until the mid-2000s and have remained low and stable since then.
  - Producer price inflation fell drastically during the 1990s and has remained at relatively low levels since.
  - GDP deflators show a similar pattern.
- Inflation variability and persistence:
  - Inflation variability has been stable or declining in emerging markets since 2004.
  - The decline in inflation variability is not driven by exchange rate behavior; there is no clear evidence of a decline in exchange rate variability since the late 1990s.
  - Inflation persistence also declined gradually during the sample period.
  - Since 2004, the volatility of inflation for a large share (but not all) of the country sample has been comparable to that in advanced economies; persistence remains somewhat above advanced-economy levels.

### Determinants of inflation and empirical strategy
- Primary question: during 2004–first quarter of 2018, what drove inflation—external price pressures or changes in longer-term inflation expectations?
- Two-stage empirical approach:
  1. Estimate a Phillips curve (hybrid New Keynesian Phillips curve variant) including:
     - Domestic and foreign output gaps;
     - Three-year-ahead inflation forecasts (proxy for longer-term inflation expectations);
     - A measure of external price developments;
     - Inflation persistence and country fixed effects.
     - Baseline estimated for panel of sample emerging markets using core inflation and quarterly data from the first quarter of 2004 to the first quarter of 2018.
  2. Decompose actual inflation during 2004–18 into contributions from the estimated explanatory factors (degree of economic slack, inflation expectations, external factors).
- Robustness:
  - Main findings are unchanged for specifications using headline consumer price inflation.
  - Results are robust to excluding the global financial crisis period or focusing on the postcrisis period.

### Policy implications and recommendations
- Consolidate and, where necessary, further improve the anchoring of inflation expectations as advanced economies normalize monetary policy.
- Policies linked to anchoring inflation expectations:
  - Fiscal sustainability is a necessary precondition for a credible nominal anchor.
  - A credible and independent central bank that communicates intentions in a transparent and timely manner is essential to reduce variability of longer-term inflation expectations.
- Even emerging markets with better-anchored expectations need to maintain commitment to inflation targets as global monetary normalization proceeds.

*International Monetary Fund | October 2018 — Chapter 3 Introduction*

### 1. Headline Consumer Price Index Inflation

### 1. Headline Consumer Price Index Inflation

### Key findings on drivers of inflation in emerging markets
- Changes in longer-term inflation expectations have been the key driver of the level of inflation in emerging markets; the overall contribution of longer-term inflation expectations is reported as 0.5 percentage point (annual average over the sample period).
- External price developments exerted a deflationary influence, with an average magnitude of −0.05 percentage point annually over the sample period.
- Output gaps (domestic and foreign) contributed to higher inflation during the 2004–07 boom and depressed inflation during the 2008–09 bust.
- The overall deviation of inflation from target declined gradually during 2004–14 by 0.7 percentage point.

### Model explanatory power and heterogeneity
- The model explains, on average, 55 percent of the deviations of inflation from target.
- Inflation expectations are the largest contributing explanatory factor for four-fifths of the sample countries, explaining, on average, 20 percent of the variation in inflation.
- Cross-country heterogeneity in the share attributable to inflation expectations ranges from 2 percent to 35 percent.
- External price movements, on average, explain 8 percent of inflation deviations.
- The foreign output gap contribution is described as negligible in all decomposition results.
- Despite the model’s explanatory power, 45 percent of the variability in inflation remains unexplained.

### Country-level patterns
- Changes in longer-term inflation expectations had a sizable inflationary impact for only about half of the economies in the sample.
- External price developments exerted downward pressure on domestic prices for three-fourths of the economies in the sample, although the magnitude is small.
- When economies are split into two groups by how well-anchored expectations were during 2004–18, the contribution of changes in longer-term inflation expectations to actual inflation is larger for the less-anchored group by 0.4 percentage point annually on average.

### Common/global vs domestic contributions
- Interpreting fluctuations in inflation expectations and domestic output gaps as domestic factors, and external price pressure and foreign output gaps as global factors, foreign factors explain 5–15 percent of inflation variability during 2004–18.
- Time fixed effects (a common component across emerging markets) capture the commodity-induced inflation surge during 2008 but otherwise make a small economic contribution to inflation deviations from target.
- The residual common component provides a negligible average contribution to inflation during the post–global financial crisis period.

### Limitations noted by the authors
- Phillips curve estimates can be affected by endogeneity issues; robustness exercises suggest potential biases are relatively small.
- Decomposition results are subject to sizable uncertainty given that 45 percent of inflation variability remains unexplained.
- Labeling of contributions as domestic versus global warrants caution because inflation expectations can be affected by both domestic and global factors; alternative specifications and purged-expectations tests produce similar baseline results, but biases in either direction are possible.

### Summary numerical highlights (preserved exactly)
- Contribution of longer-term inflation expectations to inflation: 0.5 percentage point (overall).
- Contribution of external prices: −0.05 percentage point annually (average).
- Decline in overall deviation of inflation from target during 2004–14: 0.7 percentage point.
- Model explains on average: 55 percent of deviations.
- Inflation expectations explain on average: 20 percent of variation (country-average).
- Cross-country range of share attributable to inflation expectations: 2 percent to 35 percent.
- External price movements explain on average: 8 percent of inflation deviations.
- Estimated contribution of foreign factors to inflation variability: 5–15 percent.
- Unexplained portion of inflation variability: 45 percent.
- Difference in contribution of expectations between less- and more-anchored groups: 0.4 percentage point annually.
- Rank correlations across anchoring measures: range from 0.56 to 0.87.

---

### Anchoring of inflation expectations: measurement and evolution
- Operational definition: In economies with anchored expectations, longer-horizon expectations should be centered around the explicit or implicit target and not react to transitory fluctuations in actual inflation or short-term expectations; dispersion of individual longer-term forecasts should be low.
- Four complementary survey-based metrics constructed from professional forecasters (detailed definitions in Online Annex 3.3):
  - A summary measure of absolute deviations in inflation forecasts from a target.
  - A summary measure of the variability of inflation forecasts over time.
  - The dispersion of inflation forecasts across individual forecasters.
  - The sensitivity of inflation forecasts to surprises about current inflation.
- In all four measures, lower readings denote better anchoring.

### Trends and cross-country variation in anchoring
- Inflation expectations in emerging markets have become increasingly anchored over the past two decades, with most gains occurring in the early 2000s; subsequent gains were more muted.
- Toward the end of the sample period, some countries show evidence of worsening anchoring, but this is not consistent across the four metrics.
- Substantial cross-country variation: economies in the bottom quartile (least anchored) have average readings between three and seven times larger than those in the top quartile (most anchored).
- On average, anchoring in emerging markets remains substantially weaker than in advanced economies.
- The position of economies in the anchoring ranking has changed little over time, indicating slow changes in the extent of anchoring.

### Role of policy frameworks
- The credibility of the monetary strategy is central to anchoring; credibility depends on public beliefs that the monetary authority will not deviate from its plan or subordinate it to other considerations (for example, restoring fiscal solvency).
- Empirical evidence and literature confirm that adopting an inflation target and transparent public communication of monetary policy help anchor inflation expectations in emerging and advanced economies.
- The data analyzed confirm the importance of inflation targeting and transparency in the sample of emerging markets covered.

*Source: IMF staff calculations, Chapter 3, "Challenges for Monetary Policy in Emerging Markets as Global Financial Conditions Normalize," World Economic Outlook, October 2018.*

### Annex 3.1 for data sources and country coverage. The figures show the average

### Annex 3.1 for data sources and country coverage. The figures show the average

### Data and measures
- The figures show the average value for each anchoring measure over 2004–17.
- Values marked with (*) have been truncated at 2.
- The measures on the degree of anchoring of inflation expectations are defined in Online Annex 3.3.
- In all panels, lower values denote more-anchored inflation expectations.
- Data labels use International Organization for Standardization (ISO) country codes.
- EMBIG spreads and CDS spreads are the residuals from a regression on time fixed effects.
- For the CB transparency index, higher values indicate higher degree of transparency.
- Argentina is excluded from the figures as an outlier; its inclusion would further strengthen the depicted relationships.

### Cross-country heterogeneity and correlates of anchoring
- The extent of anchoring of inflation expectations varies markedly across emerging markets and remains substantially weaker than in advanced economies on average.
- The cross-country variation in the degree of anchoring is related to:
  - Years in IT regime (age of inflation-targeting regime).
  - Central bank transparency (as measured by Dincer and Eichengreen 2014).
- Sound and sustainable fiscal policy is essential for the credibility of monetary policy; if public debt is perceived to be unsustainable, higher inflation will be expected through the expectation of “fiscal dominance.”
- The cross-country variation in the degree of anchoring is positively related to the market perception about the sustainability of public debt (Figure 3.11, panel 2).

### Representative anchoring metrics (labels and reported numeric values as displayed)
- 1. Deviation of Long-Term Forecasts from Target: 8.37
- 2. Variability of Long-Term Forecasts: 5.99
- 3. Dispersion of Long-Term Forecasts: 4.41
- 4. Sensitivity of Long-Term Forecasts to Inflation Surprises: (figure label present)

### Statistical relationships shown (Figure 3.11 regressions and fit statistics)
- 1. Years in IT and CB Transparency Index
  - y = 0.93 – 0.05x
  - R2 = 0.36 (t-stat = –2.97)
  - y = 0.94 – 0.04x
  - R2 = 0.09 (t-stat = –1.23)
- 2. EMBIG and CDS Spread (deviation from global, bps)
  - y = 0.99 + 0.002x
  - R2 = 0.10 (t-stat = 1.32)
  - y = 1.42 + 0.004x
  - R2 = 0.25 (t-stat = 2.14)

### Implications of anchoring for monetary policy — model insights
- A New Keynesian monetary model (sudden-stop shock modeled as a temporary surge in the country risk premium) is used to illustrate how anchoring affects responses to external shocks.
- Model findings:
  - Regardless of credibility, external shock induces sharp nominal currency depreciation that boosts actual inflation.
  - In the economy with a more credible central bank:
    - Longer-term inflation expectations are better anchored.
    - Inflation more quickly returns to its long-run level once shock dissipates.
    - Smaller exchange rate pass-through to consumer prices and lower inflation persistence.
    - Monetary policy rate need not increase by as much and can return to neutral sooner, leading to a smaller cumulative decline in output.
  - The expected real interest rate also increases by less in the country with a more credible central bank.
- Figure 3.12 axis/time labels indicate quarters with shock at time = 1; panels included for:
  - 1. Three-Year–ahead Inflation Expectations
  - 2. Headline Consumer Price Index
  - 3. Policy Rate
  - 4. Output (Cumulative Change)

### Taper tantrum empirical evidence (summer of 2013)
- Event analysis uses the taper tantrum (May 2013 = 1) to compare responses across more-anchored and less-anchored emerging markets.
- Estimation method: local projection framework controlling for lags of dependent variable; robustness and details in Online Annex 3.5.
- Key empirical findings:
  - Exchange rate:
    - Currency depreciates on impact in both groups.
    - Initial depreciation somewhat smaller in the less-anchored group (possible “fear of floating”); after two months depreciation equalizes across groups.
  - Consumer prices:
    - Less-anchored economies: very persistent and statistically significant increase in the price level.
    - More-anchored economies: broadly no consumer price impact.
    - Differences between groups statistically significant at all horizons.
  - Exchange rate pass-through:
    - Pass-through substantially larger in less-anchored countries.
    - Reduced-form estimate: pass-through for less-anchored countries after six months = 11 percent; taper tantrum event exercise estimate = 14 percent.
    - For more-anchored countries, magnitudes = 1 percent (reduced-form) and 5 percent (event exercise).
  - Growth and policy rate:
    - Less-anchored countries experienced a significant fall in expected output growth but did not pursue looser monetary policies; no significant difference in policy rate response across groups at any horizon.
- Figures and confidence:
  - Cumulative impulse responses use 90 percent confidence intervals with Driscoll-Kraay standard errors.
  - Solid squares (unfilled circles) denote differences statistically significant (not statistically significant) at 90 percent confidence.

### Countercyclical monetary policy and anchoring
- Simple correlation (2004:Q1–2018:Q1) between detrended policy rate and output gap:
  - Monetary policy in both groups, on average, reacted countercyclically.
  - Countercyclical response was stronger in the more-anchored group.
- Formal estimation of monetary policy reaction function (Taylor-type specification with inertia, inflation rate, output gap, change in nominal effective exchange rate) allows coefficients to differ across more- and less-anchored groups (details in Online Annex 3.6).
- Identification strategies to focus on adverse external shocks:
  - Regressions restricted to 2011–15 (period of slowdown in net capital inflows).
  - Domestic output gap instrumented with shocks to global risk premium (VIX).
- Results:
  - The output gap coefficient is smaller for less-anchored countries than for more-anchored ones across specifications.
  - In two specifications the difference between the two output gap coefficients is statistically different from zero (Figure 3.16).
  - The coefficient on the nominal effective exchange rate is larger for less-anchored countries.
  - Interpretation: monetary policy in less-anchored countries faces a starker trade-off and is relatively less able to act countercyclically when confronted with adverse external shocks.

### Summary points
- Economies with better-anchored inflation expectations were more resilient to the taper tantrum episode in the summer of 2013: they experienced a smaller increase in inflation and could keep monetary policy relatively more accommodative.
- Model simulations and empirical evidence both indicate that higher credibility and better anchoring reduce exchange rate pass-through, lower inflation persistence, and increase the ability of monetary policy to respond to output downturns without exacerbating inflation expectations.
- The cross-country degree of anchoring is linked to monetary framework maturity (years in IT), central bank transparency, and market perceptions of fiscal sustainability.

*International Monetary Fund | October 2018*

### conclusions.

### conclusions.

### Key findings on inflation performance and expectations anchoring
- Sample and period: analysis covers 19 emerging markets during 2004–18.
- Broad-based gains: for the average sample emerging market, gains in inflation performance are broad based—present across alternative price measures and geographic regions, and in both inflation levels and inflation variability.
- Heterogeneity and remaining challenges:
  - Some emerging markets continued to face double-digit inflation during the period under study.
  - The main driver of deviations of inflation from target is fluctuations in longer-term inflation expectations, while the role of global factors is more limited.
  - The extent of expectations anchoring has improved but remains subpar in many emerging markets relative to better-performing peers and relative to advanced economies.
- Empirical model results:
  - Model estimates suggest that monetary policy reacts more to output fluctuations and less to exchange rate developments in countries with better-anchored inflation expectations.
  - In less-anchored countries, monetary policy not only responds less to output gap fluctuations, but it also responds more to fluctuations in the nominal effective exchange rate (NEER).
  - More-anchored inflation expectations reduce inflation persistence and limit the pass-through of currency depreciations to domestic prices, allowing monetary policy to focus more on reducing output fluctuations.

### Implications of global financial conditions normalization
- If tightening global financial conditions leads to currency depreciations in emerging markets, some adjustment in relative prices and a temporary increase in inflation rates is to be expected.
- Well-anchored expectations mean price stability would not be jeopardized; they attenuate the inflationary impact of adverse external shocks and reduce the monetary policy dilemma between stabilizing output and inflation.
- Subpar anchoring of longer-term inflation expectations can constrain central bank monetary policy responses and make emerging markets more vulnerable to adverse external shocks, such as normalization of monetary policy in the United States and other advanced economies.

### Policy implications and recommendations
- Domestic policy frameworks matter: fiscal and monetary policy frameworks can significantly affect output and inflation responses to adverse external shocks through their impact on anchoring of inflation expectations.
- Fiscal policy actions:
  - Continued commitment to improving the long-term sustainability of fiscal frameworks is critical, including by adopting fiscal rules and preserving and rebuilding fiscal buffers where necessary.
  - Note: public debt has increased in emerging markets over the past decade and is projected to increase further in many of the largest economies over the next five years.
- Monetary policy and central bank credibility:
  - Improve credibility of central banks by consolidating and enhancing independence.
  - Improve timeliness, clarity, transparency, and openness in communications.
  - Anchor inflation expectations through consistent, transparent policy frameworks even when economic conditions are favorable—anchoring takes time.
  - In countries with relatively low credibility of monetary frameworks, emphasize clear communication of the reasons for policy actions taken in response to global developments.
- Interaction of policies:
  - Sound fiscal institutions are a precondition for credible monetary policy; interaction of inflation targeting and fiscal rules has a beneficial effect on fiscal balances and inflation.

### Comparative evidence across wider groups of economies
- Wider group: comparison includes a broader set of 71 emerging market and developing economies separated into 33 other emerging markets and 38 low-income developing countries (LIDCs).
- Representativeness: the 19-sample economies are among the largest emerging markets and are representative of the broader set along dimensions including GDP per capita, financial development, growth, and trade openness; the sample has, on average, more flexible exchange rates.
- Inflation levels and volatility (post-2004):
  - Average inflation: sample group = 5 percent; other emerging markets = 7 percent; LIDCs = 8 percent.
  - Share of countries with double-digit inflation fell from 50–70 percent in 1995 to less than 15 percent at the end of the sample period.
  - Inflation volatility declined after 2004 but remains higher in the other two country groups than in the sample countries.
- Explanatory factors for higher inflation in other groups:
  - Greater comovement of inflation with commodity price inflation, indicating stronger exposure to commodity price fluctuations.
  - In LIDCs, higher food shares in consumption are linked to higher inflation.
  - Lower central bank transparency and weaker monetary policy frameworks are associated with greater sensitivity of inflation to external shocks and higher exchange rate pass-through.
- Central bank transparency and predictability:
  - Central bank transparency (an index ranging from 0 to 15) improved more slowly in the other two country groups and remains significantly below sample-group levels.
  - Predictability of policy rate actions remains below that of advanced-economy inflation-targeting central banks; poor predictability is significantly related to weaker anchoring of medium-term (two-years-ahead) inflation expectations.
  - Best practices to improve predictability include announcing a clear objective and frequent, regular publication of statements, minutes, and reports that explain policy decisions and the outlook.

*Source: IMF staff calculations and analysis presented in the chapter conclusions.*

### Box 3.2. Clarity of Central Bank Communications and the Extent of Anchoring of Inflation

### Box 3.2. Clarity of Central Bank Communications and the Extent of Anchoring of Inflation Expectations

### Summary findings on communication, predictability, and anchoring
- Improvements in central bank transparency over the past decade have brought the level of transparency in emerging market and developing economies much closer to the levels observed in advanced economies (Dincer and Eichengreen 2014).
- The Central Bank of Chile added information to policy statements released after meetings, such as the vote tally and the main arguments given by the members of the board.
- Several countries, including Chile, Colombia, and Mexico, implemented reforms to increase clarity of communications:
  - Streamlined communication events to focus on medium-term developments.
  - Reduced the frequency of monetary policy meetings, aligning them with the release of the monetary policy report.
  - Revamped the content of policy statements to give a richer account of the macroeconomic context and explain why certain policy actions were taken.

### Empirical relationships illustrated (figures and indices)
- Figure 3.2.2 and related discussion report a relationship between monetary policy predictability and the anchoring of inflation expectations:
  - Axis/variables referenced include "Frequency of monetary policy surprises, 2010–18 (percent of total decisions)" with scale 0 to 30 and "Absolute deviation of two-year-ahead inflation expectations from central bank target, 2010–17" with horizontal scale 0.0, 0.2, 0.4, 0.6, 0.8, 1.0, 1.2.
  - Reported fit statistic: R 2 = 0.485.
- Figure 3.2.3 relates central bank communication measures to monetary policy predictability:
  - Communication measures include a central bank transparency index and the Flesch reading ease index (RE).
  - Two reported fit statistics: R 2 = 0.4935 and R 2 = 0.2856.
- The sample for the readability analysis includes 21 inflation-targeting economies.
- The Flesch reading ease (RE) index is defined and used for central bank press releases in English:
  - RE = 0.33[206.835 – (1.015 × ASL) – (84.6 × ASW)], in which ASL = average sentence length and ASW = average number of syllables per word.

### Policy-relevant implications
- Greater transparency and clearer, more readable communication by central banks are associated with improved predictability of monetary policy decisions and better anchoring of inflation expectations.
- Specific communication reforms that appear feasible and have been implemented by some countries:
  - Disclose internal decision metrics (for example, vote tallies and board arguments).
  - Concentrate public communications on medium-term outlooks.
  - Synchronize policy decisions with comprehensive explanatory reports.
  - Revise policy statements to provide richer macroeconomic context and rationale for policy actions.

*Sources: Bloomberg Finance L.P.; Consensus Economics; Dincer and Eichengreen (2014); and IMF staff calculations.*

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_Source: https://www.imf.org/-/media/files/publications/weo/2018/october/english/c3.pdf_