## _wp0901 ## Source details **Canonical URL:** [_wp0901](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0901.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0901.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0901.pdf.json) --- ### Overview and context - Sample: 50 countries covering all regions and a broad range of monetary and exchange rate policy regimes; focus on developments in 2007 and first half of 2008. - Main contextual challenges: - Surge in food and energy prices producing a substantial acceleration of inflation since early 2007. - Larger share of food and fuel in consumption baskets in many emerging and developing countries. - Preference for less flexible exchange rates and an inclination to give growth priority over price stability in some countries. - Limited central bank independence and institutional capacity in many cases, and less-developed markets undermining monetary policy transmission. - Analytical objectives: - Cross-regional perspective on inflation developments (Section II). - Evaluate impact of monetary policy responses (Section III). - Provide considerations to inform policy advice to members (Section IV). - Complement Chapter 3 of the Fall 2008 WEO with operational focus. ### Core findings on drivers and dynamics of inflation - Both aggregate demand pressures and surging commodity prices contributed to rising inflation in emerging and developing countries. - Inflation pressures became broad-based in most countries with second-round effects following initial fuel and food shocks. - Most central banks tightened monetary policy to constrain aggregate demand and anchor inflation expectations; timing and speed varied significantly. - Reasons to be cautious in gauging policy impact: - Delays in monetary policy actions in many countries. - Possible lags in transmission. - Interest rate hikes often fell short of the rise in inflation, yielding an often accommodative stance. ### Key statistics and patterns (preserve source numbers) - Average headline inflation in the first six months of 2008 in emerging and developing countries: about 9 percent (y/y). - Comparable average for advanced countries: about 4 percent (y/y). - Fuel and food items together account for about 40 percent of CPI baskets in the emerging and developing countries in the sample. - Accumulated inflation defined as percent change in CPI between July 2007 and April 2008 for most countries; specific alternative end-dates used for selected countries. - Regression summaries (cross-sectional correlations): - Fuel share (Figure 4): regression line y = -0.5256x + 10.268; R2 = 0.0393; p-value = 0.3635. - Food share (Figure 5): regression line y = 2.0614x + 17.672; R2 = 0.0991; p-value = 0.0939. ### Demand pressures and other contributors - Emerging market and developing countries grew above trend; estimated average output gap rose then started to taper off (referenced Figures 6–7). - Rapid growth of credit to the private sector and capital inflows contributed to buoyant demand; positive correlation shown between real growth of private sector credit and increase in inflation. - Currency depreciation and one-off administrative measures also contributed in a number of countries (country examples cited). - Empirical correlations and key reported regressions: - Figure 8 (Average growth of real credit to private sector vs. Accumulated Inflation since July 2007): y = 3.7371x - 8.1317; R^2 = 0.293; p-value = 0.00099. (36 countries) - Figure 13 (Accumulated Inflation since Dec 2006 vs. Change in nominal effective exchange rate): y = -0.8826x + 11.575; R^2 = 0.1665; p-value = 0.0122. - Figure 14 (Accumulated inflation since 2007 vs. Real short-term interest rates): y = -2.1495x + 10.634; R^2 = 0.5629; p-value = 0.000023. ### Breadth, second-round effects, and expectations - Except in China, Israel, and Malaysia, core (underlying) inflation rose with headline inflation, indicating second-round effects. - Available information suggests inflation expectations increased in 2008. - Econometric evidence indicates lower interest rates and domestic credit growth associated with higher inflation; second-round effects increased in 2007–08 versus 2005–06. ### Monetary policy responses and instruments used - Most central banks tightened policy; extent and speed varied: - Relatively aggressive rate hikes: Brazil, Romania, Serbia, South Africa, Ukraine, Vietnam (examples). - Some eased policy in 2007 to counter slowdown or slow capital inflows: Dominican Republic, Indonesia, Israel, Philippines, Romania, Costa Rica (examples). - Countries with pegged regimes had limited room to raise interest rates (examples: Estonia, Latvia, Lithuania, Hong Kong SAR, Kuwait, Jordan, Saudi Arabia). - Non-rate monetary tools used: - Increased reserve requirements (examples: Bulgaria, Croatia, Russia; China, India, Vietnam; Colombia, Honduras, Peru, Uruguay; Saudi Arabia). - Credit controls (examples: China, Bulgaria, Croatia). - Raised reserve requirements on external liabilities to limit inflows (examples: Croatia, Russia, Serbia, Ukraine; Colombia, Peru, Uruguay). - Timing: - A few countries tightened in 2007 (e.g., Colombia, Chile, Honduras, Mexico, Peru; Czech Republic, Poland, Romania; China, Korea; South Africa). - Majority began tightening in first or second quarter of 2008. - Inflation-targeting (IT) regimes: - With exceptions (Guatemala, Turkey), IT countries did not revise official targets; many enhanced communication and kept targets to protect credibility. - Some combined higher interest rates with higher reserve requirements or direct instruments (examples: Colombia, Peru). - Tight fiscal stances supported efforts in some countries (examples: Hungary, Poland). ### Fiscal and administrative measures - Fiscal policy generally provided limited support to counter inflation; some tightened fiscal policy in a few cases. - Subsidies and price controls reduced impact on poor segments; some subsidies predated the pickup but were increased with the surge in prices. - Other measures: lowering import tariffs; raising export taxes or imposing quotas/bans; reducing domestic consumption taxes on selected items; tightening price controls. - Some countries raised administered prices toward market levels (examples: Indonesia, Vietnam) and raised taxes on selected items (examples: Czech Republic, Lithuania, Poland, Turkey). ### Effectiveness and outcomes to date (as of mid-2008) - Too early to gauge ultimate impact of tightening given lags and uncertain global environment. - Headline inflation pressures began to ease around May 2008 in some countries partly due to commodity price declines; second-round effects prevented quick reductions. - Markets often viewed policy measures as "too little and too late." - Low or negative real interest rates in many cases led to an accommodative monetary stance. - Inflation expectations (Consensus Forecasts) for 2008 rose above official targets; expectations rose more where real policy rates declined the most. - Inflation-linked bond data for selected IT countries (Brazil, Colombia, Korea, Mexico, Poland, South Africa, Turkey) suggest expectations peaked around July-August 2008. ### Econometric baseline, variables, and sample - Panel dataset: 49 emerging market and developing economies; monthly, Jan 2005–June 2008. - Baseline model: π_it = α π_{i,t-1} + β x_{it} + γ w_t + η_i + v_it. - π_it: year-on-year monthly inflation. - x_it: lagged POLICY INTEREST RATE and lagged CREDIT GROWTH. - w_t: FOOD INFLATION and OIL INFLATION (treated as strictly exogenous). - Short-term impact = β; long-term impact = β /(1–α). - Variables include Food Inflation (IFS Series 76 EX DZF), Oil Inflation (IFS Series 76 AADZF), Share of Food in CPI, Share of Fuel in CPI, Policy Interest Rate, Inflation (IFS), Core Inflation (GDS), Credit Growth (IFS Series 22D), and governance/transparency indices. ### Selected estimation results (preserve reported coefficients and formats) - Baseline estimation (Appendix Table 3) — selected coefficients: - Lagged inflation (L. Inflation): 0.971 [0.016]** (col [1]); 0.928 [0.025]** (col [2]); 0.658 [0.099]** (col [3]); 0.967 [0.029]** (col [4]). - L11D. Policy Interest Rate: -0.143 [0.080] (col [1]); -0.163 [0.076]* (col [2]); -0.217 [0.081]* (col [3]); -0.183 [0.079]* (col [4]); -0.174 [0.080]* (col [5]). - L11. Credit growth: 0.008 [0.002]** (col [1]); 0.010 [0.005] (col [2]); 0.087 [0.029]** (col [3]); 0.024 [0.008]** (col [4]); 0.016 [0.006]** (col [5]). - Food Inflation: 0.013 [0.003]** (col [1]); 0.015 [0.004]** (col [2]); 0.014 [0.009] (col [3]); 0.009 [0.004]* (col [4]); 0.009 [0.004]* (col [5]). - Oil Inflation: 0.005 [0.002]** (col [1]); 0.006 [0.002]** (col [2]); 0.010 [0.003]** (col [3]); 0.006 [0.002]** (col [4]); 0.005 [0.002]** (col [5]). - Observations: 12,421 (cols [1],[2],[4],[5]); 11,93 (col [3]); Number of Country ID: 49. - Robust standard errors in brackets; * significant at 5%; ** significant at 1%. - Weighted pass-through (Appendix Table 4) — selected coefficients: - L. Inflation: 0.967 [0.021]** (col [1]); 0.915 [0.028]** (col [2]); 0.676 [0.117]** (col [3]); 0.954 [0.027]** (col [4]). - L11. Credit growth: 0.013 [0.004]** (col [1]); 0.011 [0.006] (col [2]); 0.093 [0.035]* (col [3]); 0.033 [0.016]* (col [4]). - Weighted Food Inflation: 0.037 [0.015]* (col [1]); 0.079 [0.020]** (col [2]); 0.043 [0.036] (col [3]). - Weighted Oil Inflation: 0.039 [0.012]** (col [1]); 0.028 [0.018] (col [2]); 0.099 [0.055] (col [3]). - Observations: 769; Number of Country ID: 31; R-squared reported 0.94 (col [1]) and 0.88 (col [2]). ### Quantitative magnitudes and interpretations from estimations - Monetary policy tightening associated with a drop in inflation with a lag of about one year (negative L11D. Policy Interest Rate). - Demand pressures: credit growth positive and significant. - Using Difference GMM (col [3]) point estimates: a one percent increase in credit growth → 8.7 basis point increase in inflation on impact; cumulative increase of 25.4 basis points in the long-run (8.7 × 1/(1–0.658)). - Commodity pass-through: - Using col [3] estimates: a 1 percent increase in oil prices → 1 basis point increase in inflation on impact; cumulative increase of 2.9 basis points in long-run. Food pass-through similar magnitude. - Overall: food and oil relatively less important than internal demand pressures in this episode. - Robustness: five estimation methods produced stable signs and broadly stable magnitudes; Difference GMM favored for consistency; System GMM used when including time-invariant institutional variables. Sargan and Arellano-Bond diagnostics reported supportive. ### Additional exercises: pass-through, second-round effects, and governance - Share of food and energy in CPI added as regressors: coefficients "were not found to be statistically significant." - Weighting food and oil inflation by CPI shares: coefficients positive and larger but not statistically significant. - Conclusion: "pass-through of world commodity prices into headline inflation has been relatively mild," possibly due to subsidies and price controls. - Second-round effects (Appendix Table 5) — selected coefficients: - L.Core Inflation 0.332 [0.191]*. - Core Inflation 2007-08 0.848 [0.388]**. - Inflation Targeters*Core Inflation 2007-08 -0.958 [0.578]*. - Observations 715; Number of Country ID 27. - Monetary tightening magnitude and timing (Appendix Table 6 highlights): - Baseline statement: "A one percentage point increase in the policy interest rate leads to an estimated 21.7 basis point drop in inflation on impact, and a long-run effect of 63.5 basis points." - Response lag: "a lag of about 4 to 5 quarters"; coefficients negative and statistically significant around the 10th–14th lags support choice of 11 lags in preferred specification. - Institutional measures (Appendix Table 7) — selected coefficients: - Change in CBI Index -0.382 [0.224]* and -0.554 [0.257]**. - Change in Transparency Index -0.246 [0.106]** and -0.320 [0.132]**. - L11D.Policy Rate * Governance Indicator -2.964 [1.358]** ; 2.126 [1.112]* ; 2.871 [1.034]***. - Findings: stronger central bank reform (CBI, transparency) associated with lower inflation and more effective monetary policy; interaction results suggest decreasing marginal benefits associated with transparency. ### Back-of-the-envelope decomposition (Jun-07 to Jun-08, Appendix Table 8) - Entire Sample: - Inflation: Jun-07 5.1 ; Jun-08 9.7 ; Difference 4.6. - Policy Interest Rate: Jun-07 7.4 ; Jun-08 8.6 ; Difference 1.2 [Estimated Contribution to Inflation 1/ [-0.2 -0.3]]. - Credit Growth: Jun-07 28.6 ; Jun-08 25.5 ; Difference -3.1 [Estimated Contribution to Inflation 1/ [0.5 2.5]]. - Food Inflation: Jun-07 7.6 ; Jun-08 4.5 ; Difference -3.1 [Estimated Contribution to Inflation 1/ [0.4 0.6]]. - Oil Inflation: Jun-07 -0.19 ; Jun-08 2.9 ; Difference 3.0 [Estimated Contribution to Inflation 1/ [0.5 0.9]]. - IT versus Non-IT (selected summary): - IT: Inflation Jun-07 4.0 ; Jun-08 7.4 ; Difference 3.5. - Other regimes: Inflation Jun-07 5.9 ; Jun-08 13.5 ; Difference 7.6. - Food and oil jointly explain between 1.0–1.5 percentage points of aggregate increase; aggregate demand pressures (credit growth) explain between 0.5–2.5 percentage points. - Ongoing monetary tightening explains about 0.2–0.3 percentage points drop so far; effects stronger among IT countries. ### Policy dilemmas and menu of policy advice (Section IV highlights) - Key dilemmas: - Trade-off between fighting inflation and supporting growth amid uncertainty about shock persistence. - Financial stability concerns amid a global financial crisis complicate aggressive rate hikes. - Exchange rate policy conflicts where pegs limit monetary maneuverability or where appreciation from tightening could be undesirable. - Recommended posture: - Central banks should remain vigilant and signal strong commitment to bringing inflation back to pre-shock levels where excess demand evident and credibility weak. - Be forward looking, accounting for projections for the next "12 to18 months" while weighing costs of severe plausible outcomes. - Operational guidance (Appendix VI summaries): - Use indirect instruments (open market operations) primarily to mop up or maintain tight liquidity. - Sterilization when short-term capital inflows increase. - Non-remunerated reserve requirements (NRR) and credit controls only as last resort and temporarily when first-best tools unavailable. - Phase out NRRs as inflation pressures subside; deepen financial markets to improve monetary transmission. - Controls on capital inflows: significant administrative costs and short-lived effectiveness; generally only to buy time in balance of payments or financial crisis. ### Communication, credibility, and institutional guidance - Communications priorities: - Main message: monetary policy remains focused on price stability. - Explain nature of shock, impact on inflation, policy lags, credible policy path back to longer-term target, and expected time horizon. - Frequent monitoring and communication of inflation components; analyze commodity effects on core inflation and expectations. - Note: food and energy can make up "up to 70 percent" of the CPI basket in some countries. - IT-specific guidance: - Do not revise official inflation targets upward (risks undermining credibility). - Widening target band is likely counterproductive. - Consider lengthening the announced "target horizon" to match transmission lags. - Use inflation forecasts to anchor short-term expectations; medium-term objective should remain unchanged. - If revising target, communicate continued focus on medium-term control and adopt an ambitious plan to bring inflation back to revised target, accompanied by tightening and supportive fiscal policy (Brazil example detailed). - Non-IT central banks: - Signal strong commitment to bringing inflation back to pre-shock levels, keep intermediate targets unchanged, tighten stance where feasible, and allow exchange rate to appreciate gradually when appropriate. - Strengthen communication, transparency, operational framework, liquidity forecasting, and financial market development. ### Liquidity management and use of instruments (Appendix and Table examples) - Prefer market-based instruments (open market operations) to develop money and debt markets and improve interest rate channel. - NRR and credit controls: distortive, to be used only as last resort; when used, phase out and consider remunerating reserves to limit side effects. - Operational aspects: averaging over maintenance periods, timely accounting, and deep active money markets facilitate effective liquidity management. - Examples of recent reserve requirement adjustments (selected): - Bulgaria: raised from 8 to 12 percent in September 2007. - China: raised from 11.5 percent end-2006 to 17.5 percent in June 2008. - Brazil: reserve requirements on leasing company repo operations introduced Jan 2008; gradual increases planned to 25 percent by Jan 2009. - Saudi Arabia: reserve requirement raised from 7 percent in Nov 2007 to 12 percent in Apr 2008. ### Capital flow controls: design, experience, and recent uses (Appendix VII) - Rationale: preserve monetary autonomy under fixed/heavily managed exchange rates; protect monetary and financial stability. - Historical designs: taxes, unremunerated reserve requirements (URR), minimum stay requirements, regulatory measures (examples: Brazil, Chile, Colombia, Malaysia, Thailand). - Effectiveness: mixed; some success in reducing short-term inflows but not total net inflows except in Malaysia and Thailand; controls subject to circumvention and administrative costs. - Recent uses: Chilean-type controls in Croatia; URR introduced in Thailand and Colombia in 2006–08 to curb appreciation from portfolio inflows. ### Illustrative simulations for oil price shocks (Appendix VIII) — model and key conclusions - Assumed 18-month price changes: - world price of oil increases by 240 percent (total); - food increases by 60 percent; - world inflation up by 2 percentage points over same period. - Two scenarios: (i) temporary level shock (prices revert over next 18 months); (ii) permanent level shock (prices stay higher forever). - Model: New Keynesian DSGE calibrated to an emerging market importer of oil and food; features include oil as input and consumption good, two production sectors, imperfectly competitive retail sectors, imperfectly competitive labor market, and central bank under peg or IT; risk premium depends on net foreign liabilities. - Calibration choices and behavioral targets: - Share of oil (energy) in imports for consumption scaled to almost 20 percent; overall share of oil consumption about 13 percent. - Transition parameter: 1 percent exchange rate appreciation equivalent to 5 percentage point increase in interest rate. - Historical calibration: peg regimes saw inflation increase ~6 percentage points; IT regimes saw ~3 percentage points. - Simulated interest rate hikes in IT regimes vary from 100–600 basis points; under a peg interest rate rises ~200 basis points from risk premium effects. - Main simulation outcomes: - Under both temporary and permanent shocks: inflation rise higher and output fall smaller under a peg compared with IT. - Greater interest rate response under IT dampens inflation but causes larger output/employment losses. - Reacting to headline inflation under IT is more effective at containing inflation but induces larger output loss than reacting only to core inflation. - Imperfect credibility worsens inflation and output outcomes; temporarily raising the inflation target yields no substantial benefit. - Under peg, parity revaluation contains inflation faster but lowers output; devaluation raises inflation more and lowers output decline. - Policy mistakes when uncertainty about shock duration exist: delayed recognition of permanence is costly for inflation; overly quick tightening can exacerbate stagflation if shock temporary. ### Exchange rate flexibility, exits from pegs, and institutional prerequisites (Appendix IX) - Drivers for greater flexibility: more monetary autonomy to respond to external shocks and volatile capital flows. - Obstacles: concerns about credibility loss, adverse effects on external balances, exchange rate pass-through in weak institutional settings, currency mismatches, and timing choice. - Four "ingredients" for smoother exit to floating regimes: - (i) deep and liquid FX market; - (ii) systems to review and manage exchange rate risks; - (iii) coherent intervention policies consistent with new regime; - (iv) appropriate alternative nominal anchor in new monetary framework. - Lessons from country experiences: - Gradual transitions allow capacity building; premature flexibility can be damaging; supportive fiscal policy and strong financial system reduce risks. - No unique sequencing; common early elements include laying groundwork for alternative monetary framework, establishing FX markets, and building FX risk-management systems. - Transparent communication and credible, consistent policies are crucial. *Source: _wp0901 - IMF Working Paper (excerpted content)._ ### 1. Sample Countries and Summary Statistics on Inflation and Monetary Policy ......................6 ### 1. Sample Countries and Summary Statistics on Inflation and Monetary Policy ### Overview and context - The paper reviews inflation developments in a sample of 50 countries covering all regions and a broad range of monetary and exchange rate policy regimes, focusing on developments in 2007 and the first half of 2008. - Key contextual challenges faced by central banks: - Surge in food and energy prices producing a substantial acceleration of inflation since early 2007. - Larger share of food and fuel in consumption baskets in many emerging and developing countries. - Preference for less flexible exchange rates and an inclination to give growth priority over price stability in some countries. - Limited central bank independence and institutional capacity in many cases, and less-developed markets undermining monetary policy transmission. - The episode was the first significant test of inflation targeting (IT) regimes in emerging market countries; most emerging market IT countries overshot official inflation targets. ### Main analytical objectives - Bring a cross-regional perspective to inflation developments (Section II). - Evaluate the impact of monetary policy responses (Section III). - Present considerations to inform policy advice to the Fund’s member countries (Section IV). - Complement Chapter 3 of the Fall 2008 World Economic Outlook (WEO) with a focus on operational aspects of monetary and exchange rate policies. ### Core findings on drivers and dynamics of inflation - Both aggregate demand pressures and surging commodity prices played a role in rising inflation in emerging and developing countries. - Inflation pressures became broad-based in most countries, with second-round effects following the initial shock to fuel and food prices. - Most central banks tightened monetary policy to constrain aggregate demand and anchor inflation expectations, but timing and speed varied significantly. - It is early to fully gauge the impact of policy responses given: - Delays in monetary policy actions in many countries. - Possible lags in transmission. - An often accommodative monetary policy stance, with interest rate hikes falling short of the rise in inflation. ### Key statistics and empirical patterns (preserve numeric values as in source) - Average headline inflation in the first six months of 2008 in emerging and developing countries reached about 9 percent (y/y). - Comparable average for advanced countries is about 4 percent (y/y). - Fuel and food items together account for about 40 percent of CPI baskets in the emerging and developing countries in the sample. - Accumulated inflation is defined as the percent change in CPI between July 2007 and April 2008 for most countries, with specific alternative end-dates for Cameroon (Jan 2008), Kuwait (Dec 2007), Nigeria, South Africa, Singapore, China, India, Malaysia, Ukraine, Russia, Romania (March 2008), and other publication-lag exceptions noted. - Figure-based evidence: - Headline inflation rose more sharply than core inflation (excluding fuel and food in most cases), especially in Middle Eastern countries, producing a large gap between headline and core inflation. - Cross-sectional correlation between accumulated inflation and the shares of food and fuel in the CPI basket is not statistically significant: - For fuel share (Figure 4): regression line y = -0.5256x + 10.268; R2 = 0.0393; p-value = 0.3635. - For food share (Figure 5): regression line y = 2.0614x + 17.672; R2 = 0.0991; p-value = 0.0939. ### Interpretation of the food/fuel share correlations - Lack of strong statistical correlation between accumulated inflation and food/fuel shares likely reflects: - Different food and fuel subsidies and the imposition of price controls in some countries (examples cited in the source: Malaysia and China). - Different macroeconomic policy stances across countries. ### Policy implications and recommendations highlighted - Monetary policy needs to remain vigilant even as the global slowdown helps dampen inflation; central banks must credibly demonstrate commitment to bringing inflation back to target levels. - Communication strategy is crucial to limit damage to credibility: - Greater efforts are required to credibly explain central bank actions and keep inflation expectations well anchored. - Supporting measures to avoid overburdening monetary policy include: - Allowing the exchange rate to appreciate, where possible. - Maintaining a supportive fiscal policy stance. - Reducing wage and price pressures through greater labor market flexibility, productivity-matching wage policies, and structural reforms to boost productivity and competitiveness. ### Appendices and further analysis (as presented in source) - The paper includes appendixes with cross-regional inflation developments (Appendix I), econometric estimates of drivers of inflation (Appendix II), policy responses and country examples (Appendixes III–V), recommendations to foster monetary policy effectiveness (Appendix VI), use of controls on capital inflows (Appendix VII), and illustrative simulations and exchange rate flexibility discussions (Appendixes VIII–IX). - Appendix II provides econometric estimates referenced in the main text; Appendix Table 1 provides additional information on cross-regional inflation developments and their underlying drivers. *Source: _wp0901 - 1. Sample Countries and Summary Statistics on Inflation and Monetary Policy; canonical PDF: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0901.pdf* ### 12. The available data also point to demand pressures as an important factor in ### _wp0901 - 12. The available data also point to demand pressures as an important factor in ### Demand pressures and inflation drivers - Over the last few years, emerging market and developing countries grew above trend, in marked contrast to advanced countries (referenced Figure 6). - The estimated average output gap of a selected group of emerging market countries has risen, though it seems to have started to taper off recently, reflecting a slowdown in many emerging market countries (referenced Figure 7). - Rapid growth of credit to the private sector and capital inflows apparently contributed to buoyant demand; Figure 8 shows a positive correlation between the real growth of private sector credit and the increase in inflation. - Currency depreciation and one-off administrative measures also contributed to price pressures in a number of countries (examples given: Romania, Serbia, Turkey, Ghana, South Africa, Korea, Kazakhstan; administrative price and VAT increases in Czech Republic, Estonia, Latvia, Botswana, Indonesia, Singapore, Egypt). EU-required regulated price adjustments and indirect tax rises also contributed in Europe. ### Empirical correlations and indicators (selected reported statistics) - Figure 8 regression (Average growth of real credit to private sector vs. Accumulated Inflation since July 2007): y = 3.7371x - 8.1317; R^2 = 0.293; p-value = 0.00099. Figure 8 includes 36 countries of "selected 50 countries" for which data are available. "Average growth" is the simple average of annual real credit growth over the past three years. - Figure 13 regression (Accumulated Inflation since Dec 2006 vs. Change in nominal effective exchange rate): y = -0.8826x + 11.575; R^2 = 0.1665; p-value = 0.0122. - Figure 14 regression (Accumulated inflation since 2007 vs. Real short-term interest rates): y = -2.1495x + 10.634; R^2 = 0.5629; p-value = 0.000023. - Output gap estimation: calculated using the Hodrick-Prescott filter for countries with quarterly data (excludes Dominican Republic, Venezuela, and Latvia in that estimation note). ### Breadth of inflationary developments and second-round effects - Inflation pressures became more broad-based in most countries. - Except in China, Israel, and Malaysia, core or underlying inflation (excluding food and energy) rose along with headline inflation, suggesting second-round effects. - Available information suggests inflation expectations increased in 2008. - Econometric evidence indicates that lower interest rates and domestic credit growth have been associated with higher inflation, and that second-round effects may be increasing in 2007-08 compared to 2005-06. ### Role of exchange rate and monetary policy frameworks - The pick up in inflation was particularly marked in countries with soft exchange rate pegs; domestic inflation reflected rising international prices when monetary policy was geared to maintaining the exchange rate target (referenced Figure 9). - Some hard-peg countries also experienced sharp increases in inflation (examples: Bulgaria and the Baltic countries). - The increase in inflation was slightly higher on average in countries with soft pegs to the U.S. dollar compared with pegs to the euro or a currency basket. - Inflation-targeting (IT) countries with floating exchange rates experienced a smaller rise in inflation on average compared with non-IT countries; however, actual inflation exceeded official targets by significant margins in many IT emerging market countries. - A negative relationship was observed between the rise in inflation and nominal exchange rate appreciation since end-2006 (referenced Figure 13). In some IT countries nominal appreciation limited imported inflation pass-through (examples: Czech Republic, Hungary, Israel, Poland, Slovakia, Brazil, Colombia, Peru); in others depreciation validated inflation (examples: Romania, Turkey). - Some non-oil emerging market countries with managed floating or soft pegs let their exchange rates appreciate in response to capital inflows (examples: China, Croatia, Ukraine, Uruguay, Egypt), though the size of appreciation varied due to interventions concerned about export competitiveness. ### Policy responses taken - Most central banks tightened monetary policy in response to rapid inflation increases (see Appendix III referenced for summary of policy actions). - The extent and speed of tightening varied considerably: - Relatively few countries raised interest rates aggressively from 2007 levels (examples listed: Brazil, Romania, Serbia, South Africa, Ukraine, Vietnam); others tightened moderately. - Some countries eased policy in 2007 to counter potential global slowdown spillovers (examples: Dominican Republic, Indonesia, Israel, Philippines, Romania); others eased to slow short-term capital inflows (Costa Rica). - In countries with pegged exchange rate regimes, room to raise interest rates was limited (examples: Estonia, Latvia, Lithuania, Hong Kong SAR, Kuwait, Jordan, Saudi Arabia), since interest rates were guided by the anchor country. - A number of countries used non-rate monetary tools: - Increased reserve requirements (examples: Bulgaria, Croatia, Russia; China, India, Vietnam; Colombia, Honduras, Peru, Uruguay; Saudi Arabia). - Imposed credit controls (examples: China, Bulgaria, Croatia). - Raised reserve requirements on external liabilities to limit capital inflows (examples: Croatia, Russia, Serbia, Ukraine; Colombia, Peru, Uruguay). - Timing of tightening: - Only a few countries started tightening in 2007 (examples: Colombia, Chile, Honduras, Mexico, Peru; Czech Republic, Poland, Romania; China, Korea; South Africa). - The majority of remaining countries began tightening during the first or second quarter of 2008. - Inflation-targeting regime responses: - With the exception of Guatemala and Turkey, none of the IT countries revised officially announced inflation targets in response to rising inflation. Guatemala increased the mid-point and range of its official target in December 2007. Turkey extended the target horizon, revised the inflation forecast, and raised its target over 2009-11. - Most IT countries maintained original target parameters to avoid damaging credibility; some enhanced communication to explain supply shocks and policy responses. - Some combined higher interest rates with higher reserve requirements or other direct instruments (examples: Colombia, Peru). - Tight fiscal stances supported efforts in some countries (examples: Hungary, Poland). - Fiscal policy and administrative measures: - Fiscal policy by and large provided limited support to countering inflation; in a few cases fiscal policy was tightened to lessen demand pressures on inflation. - Subsidies in many countries reduced the impact of price increases on poor segments; in several cases subsidies predated the pickup in inflation but were raised with the surge in global fuel and food prices. - Other non-monetary measures included lowering import tariffs; raising export taxes or imposing export quotas or bans; reducing domestic consumption taxes on selected items; tightening price controls (Appendix III referenced). - Some countries started raising administered prices toward market levels (examples: Indonesia, Vietnam) and some raised taxes on selected items (examples: Czech Republic, Lithuania, Poland, Turkey). ### Effectiveness and outcomes to date - It is too early to gauge the ultimate impact of monetary tightening given lags and an uncertain global environment. - Headline inflation pressures began to ease around May 2008 in some countries, partly reflecting a decline in commodity prices, but second-round effects prevented a quick reduction in inflation. - Many forces underlying the surge in inflation remained in place; recent policy measures will take time to have an effect. - Markets often viewed monetary policy measures as too little and too late, with the benefit of hindsight. - With interest rate hikes falling short of the pick up in inflation, low or negative real interest rates led to an accommodative monetary stance in many cases (referenced Figure 14). - Inflation expectations: - Inflation expectations for 2008 (Consensus Forecasts) rose above official targets (referenced Figure 15). - The size of the increase in expectations varied and was associated with the level of real interest rates: expectations rose more where real policy rates declined the most. - Inflation expectations appear relatively well contained in some IT countries (examples: Czech Republic, Hungary, Israel, Poland, Brazil, Korea, Mexico). - Data from inflation-linked bonds for a selected group of IT countries (Brazil, Colombia, Korea, Mexico, Poland, South Africa, Turkey) suggest inflation expectations peaked around July-August 2008, approaching levels observed earlier in the year. - Administrative liquidity-tightening measures: - Controls on bank credit or higher reserve requirements helped slow bank lending to the private sector in a number of countries, but the impact on overall credit including nonbank and external borrowing has been less marked. - The impact of such measures on aggregate demand and inflation is ambiguous; from a counterfactual perspective, demand and inflation pressures could perhaps have been stronger absent these measures. *Source: _wp0901 - 12. The available data also point to demand pressures as an important factor in (PDF chapter/section).* ### 23. The delayed and relatively modest actions may reflect several policy dilemmas ### 23. The delayed and relatively modest actions may reflect several policy dilemmas ### Policy dilemmas and concerns - Conflicts with growth objectives: - Difficult choice between raising interest rates to fight inflation and maintaining stronger growth. - Uncertainties about the nature of shocks, particularly whether fuel and food price shocks were temporary. - Some authorities believed the inflation surge was a temporary supply shock with limited risk of second-round effects and did not warrant a monetary policy response. - Increasing concerns about a global economic slowdown. - Conflict with financial stability concerns: - Dilemma between raising interest rates to counter inflation and coping with the current financial crisis affecting developed and emerging market economies. - Central banks feared aggressive action might jeopardize limited independence in some instances. - Concerns that higher interest rates could exacerbate the impact of global liquidity conditions on domestic financial systems. - Deepening of the crisis likely shifted policymakers’ focus away from inflation toward limiting financial instability and its implications for worsening growth prospects. - Conflict with exchange rate policy: - Priority given to exchange rate stability by countries with hard or soft pegs and by those reluctant to see more rapid appreciation. - Some floating-rate countries were hesitant to raise interest rates aggressively due to fears of further exchange rate appreciation and capital inflows, fueling credit growth and higher inflation. ### IV. MENU OF OPTIONS FOR POLICY ADVICE — context and risks - Policymakers face major domestic and external shocks. - Commodity prices remain high and volatile (WEO, 2008), though significantly off their peaks. - Headline inflation may ease in some countries, but a lingering risk of second round effects exists. - Risk particularly great where underlying inflation has risen due to spillover of first-round effects of high commodity prices and excess aggregate demand pressures. - Financial markets are experiencing a deepening crisis spreading from advanced to emerging market economies, worsening growth prospects and leading to capital outflows and exchange rate depreciation that may pass through to inflation. ### Monetary policy posture and vigilance - Central banks in emerging market and developing countries need to balance financial crisis risks against inflation pressures. - Monetary policy makers should: - Remain vigilant and signal a strong commitment to bringing inflation back to its pre-shock levels, particularly where excess demand pressures have been evident and the nature of price shocks is uncertain. - Recognize that successive deviations from official inflation objectives have hurt credibility and require appropriate monetary policy actions to anchor inflation expectations. - Be forward looking, taking account of projections for the next 12 to18 months, while weighing relative probabilities and costs of severe but plausible outcomes. ### Operational guidance for tightening monetary policy (see Appendix VI) - Use indirect instruments to the extent possible: - Mopping up or maintaining tight liquidity should be done primarily via open market operations. - If short-term capital inflows increase, sterilization should be used as required. - Non-remunerated reserve requirements (NRR) and credit controls: - Should be used only as a last resort: NRRs are a tax on the financial system and, like credit controls, distort financial transactions and encourage dis-intermediation towards offshore markets or less-well regulated/supervised activities. - May be necessary temporarily when no other good options exist, for example when (i) the interest rate channel is weak or non-existent given shallow financial markets, no independent monetary policy, or a high degree of financial dollarization; or (ii) when first-best monetary policy tools need to be supplemented under heavy capital inflows given the large quasi fiscal costs associated with significant sterilized intervention. - To minimize side effects, central banks could accelerate efforts to improve monetary transmission by deepening financial markets and phase out NRRs when inflation pressures subside. - Controls on capital inflows: - Involve significant administrative costs and have at best short-lived effectiveness. - Experiences of Thailand and Colombia in the 1990s (imposing unremunerated reserve requirements on certain inflows) illustrate limited accomplishments, especially in countries with somewhat developed financial markets. - Capital controls should, by and large, only be imposed to buy time in a balance of payments or financial crisis and would not be helpful in the circumstances facing most countries. ### Communication and credibility - Policy decisions need appropriate communication: - Central banks face new communication challenges from rising inflation, slowing growth, and a deepening financial crisis. - Renewed effort required to credibly explain central bank actions, especially when providing additional liquidity to stem market volatility while keeping inflation expectations anchored. - Need to clearly communicate continuing commitment to price stability and explain how short-term actions are consistent with this objective (Shimizu, 2008). ### Supporting measures to avoid overburdening monetary policy - Fiscal policy: - An appropriate fiscal stance could help manage aggregate demand even if demand pressures ease with a global downturn. - Wage and incomes policies: - Productivity-matching wage policies and curtailing backward-looking indexation schemes would help limit wage contributions to inflation. - Structural reforms: - Reforms to boost productivity growth, enhance competitiveness, and increase labor market flexibility could expand production capacity and reduce wage and price pressures in tight labor markets. - Fiscal and incomes policy support would help avoid destabilizing exchange rate movements. ### A. Considerations for Inflation Targeting (IT) central banks - Policy credibility is essential when coping with unfavorable supply shocks: - When expectations are well anchored, increases in inflation from supply shocks have relatively little effect on inflation expectations and minor second-round effects; policy need not be as restrictive. - Lack of fully established credibility calls for stronger policy actions to counter inflation pressures; central banks may need to be more pro-active in raising interest rates to bring visible reductions in inflation. - Quantitative illustration: - Simple dynamic general equilibrium model calibrated to an emerging market economy facing oil and food shocks shows low credibility with delayed reaction can entrench higher inflation expectations and necessitate an eventual larger interest rate increase that generates a larger output loss compared with earlier reaction (see Appendix VIII; Alichi and others, 2008). - Uncertainty about duration and nature of shocks means risk of tightening excessively: quick interest rate response may exacerbate stagflation if shock is temporary; delayed reaction could be costly in higher inflation and expectations if shock is permanent. ### Specific guidance for IT central banks - Official inflation targets should not be revised upward: - Raising targets would undermine credibility of a framework focused on low inflation or price stability. - Markets could perceive accommodation of higher inflation and loosening of policy; fragile credibility could lead to unanchored inflation expectations. - A higher inflation target will not guarantee lower real interest rates; central bank may need to tighten more aggressively eventually, potentially raising nominal and real interest rates and affecting financial stability adversely. - Widening the target band around an unchanged mid-point is likely counterproductive: - Target bands serve accountability and trigger explanations; widening may be perceived as tolerating higher inflation and validate higher inflation expectations. - Technical difficulty in determining appropriate width; new upper limit could become focal point for expectations. - Lengthen the announced period for achievement of the longer-term target ("target horizon"): - Target horizon should match transmission lags. - A longer horizon can be critical when shocks cause significant and persistent upward revisions to official inflation forecasts and slower return of inflation to medium/long-term target. - Short horizons can be counter-productive and undermine credibility if policy cannot affect inflation within that time. - Extend the "policy horizon" after a supply shock: - For countries disinflating with low policy credibility, authorities could communicate a longer period to return to the long-run target, with well-articulated arguments. - This approach recognizes that monetary policy should not try to keep inflation tightly ranged in the short run when shocks are large, to avoid excessive output fluctuations and damage to perceptions of central bank competence and credibility. - When shocks are sufficiently large, inflation may have to approach the target gradually over time, possibly longer than the two years usually assumed. - Use inflation forecasts to anchor short-term expectations: - Forecasts describe the inflation-output trade-off and ideal path toward the medium-term objective. - Central banks can use updated inflation forecasts as intermediate targets and communication tools to signal how long inflation will take to return to the long-term target. - The medium-term objective—the inflation target—sets overall strategy and should not be changed. ### Steps if authorities decide to revise the inflation target - Communicate that monetary policy remains firmly focused on controlling inflation in the medium-term. - Adopt an ambitious plan for bringing inflation back to the revised target: - In the short-term, policy may need to be tightened more aggressively to ensure the target adjustment is not interpreted as abandonment of the anchor. - Brazil’s experience with revising targets upward during 2003–04 is illustrative (Box 1). - If possible, set the new target below long-term inflation expectations. ### Box 1. Brazil’s Experience with Revisions to the Inflation Target in 2002–2004 — key facts and timeline - Context: - After adopting an IT framework following the 1999 currency crisis and breaching inflation targets for two years, Brazil revised the official inflation target upward. - Targets revised in January 2003 from 4 percent to 8.5 percent for 2003 and from 3.75 percent to 5.5 percent for 2004. - The adjustment guided 2003 monetary policy by an “adjusted target” accommodating inflation inertia and first-round effects of identifiable supply shocks; the trajectory to return to target over the following two years was explicitly indicated. - Triggering events: - Target revision followed a steep depreciation of the domestic currency of 44 percent in 2002, which spurred inflation from less than 8 percent in June 2002 to nearly 13 percent in December 2002. - Depreciation resulted from a confidence crisis associated with the presidential campaign and was exacerbated by external shocks. - Accompanying policies: - Substantial monetary tightening and supportive policies accompanied the target revision. - The BCB increased the policy rate from 18.5 percent to 25 percent during the second semester of 2002 ahead of the revision; rates were increased further in early 2003 to reach 26.5 percent. - In February, reserve requirements of commercial banks were increased; in March rates were kept unchanged but an upward bias was announced. - The new government implemented a prudent fiscal policy and gave de facto independence to the BCB. - Outcomes: - Initially, expectations for 2004 inflation remained at 8 percent. After the MPC maintained rates at 26.5 percent for three months, inflation expectations started to fall for 2003 and 2004. - Starting from June, the MPC opted for a modest 50 basis point rate cut, followed by a further 150 basis point cut in July after inflation expectations had fallen to 10.4 percent for 2003 and 6.5 percent for 2004. - At the end of June, the government adopted the 5.5 percent adjusted target as the official inflation target for 2004. Official targets were firm, not contingent, with a ±2.5 percent margin. - An official target of 4.5 percent for 2005 was announced, with ±2.5 percent tolerance margins. - In June and July, monthly inflation rates fell significantly, helped by appreciation of the real; the level of activity reached a trough in the second quarter. - Lessons: - It is possible to restore credibility even when inflation targets are missed and revised upward, provided: - There are legitimate reasons for the misses. - Authorities accompany target revision with appropriate monetary tightening, fiscal prudence, and measures to strengthen central bank autonomy. - Adherence to a planned trajectory of convergence to long-run targets is maintained. *Source: IMF Working Paper chapter titled "23. The delayed and relatively modest actions may reflect several policy dilemmas" (extracted content).* ### 32. Central bank communications are particularly crucial in the current ### _wp0901 - 32. Central bank communications are particularly crucial in the current ### Central bank communications when inflation targets are overshot - Main message: monetary policy remains focused on price stability. - Explanations to convey when tightening policy: - the change in policy stance reflects uncertainties about the duration of the shock and the associated risks; - the size of the shock may be too large to bring inflation quickly back to its medium-term target without monetary action; - this is particularly relevant where overheating pressures and capacity constraints are contributing to rising inflation. - Recommended public communications (statements and inflation reports) should explain: - (i) the nature of the shock; - (ii) the impact on inflation developments and hence why the inflation rate is deviating from the targets; - (iii) policy implementation lags; - (iv) a credible policy path that shows how inflation will be brought back to its longer-term target; and - (v) the time horizon over which this is expected to occur. - Reduce risks of delayed policy response by: - frequent monitoring and communication of the various components of inflation; - frequent analyses of the effects of commodity prices on core inflation and expectations to assess second round effects and underlying pressures unrelated to the supply shock; - guarding against underestimating core inflation, including by using various indicators of inflation and varied application of techniques to estimate core inflation. - Note: food and energy can make up a very significant component of the CPI basket (up to 70 percent) in some countries. ### Considerations for non-inflation-targeting (Non-IT) central banks - Monetary and exchange rate targeting central banks should signal strong commitment to bringing inflation back to pre-shock levels, except where monetary policy is fully endogenous. - For monetary targeting central banks: - keep intermediate targets unchanged; - tighten the monetary stance and allow the exchange rate to appreciate gradually to compensate for imported inflation, especially in countries that have benefited from the oil shock; - if tightening induces capital inflows, sterilized intervention may be warranted. - For countries with a soft exchange rate target: - limited room for maneuver on monetary policy; rely mainly on fiscal policy to fight inflation; - the central bank might raise interest rates to moderate possible demand pressures if there is scope within exchange rate constraints. - Capital inflows triggered by higher interest rates: - could be absorbed with sterilized intervention in the short-run; - capital controls may be of limited effectiveness (if modest) or highly distortionary (if comprehensive). - When monetary policy is fully endogenous (fixed exchange rates and hard pegs under sufficient capital mobility): - monetary policy options are highly constrained; - other macroeconomic policies need to be used to fight inflation; - changes in the exchange rate arrangement could be contemplated if the anchor currency is no longer suitable; - the transition from fixed to floating needs to be properly managed and based on certain pre-requisites. - Institutional capacity enhancements for Non-IT central banks: - improve communication and transparency: regularly explain inflation dynamics, monetary policy responses, and expected possible outcomes; extract information from market data (especially about inflation expectations) to measure policy impact and improve policy timing; - make rationale and information underlying policy decisions available in an understandable, accessible, and timely basis; explain how inflation developments are taken into account in actions — increased transparency fosters effectiveness and reinforces credibility, which lowers the sacrifice ratio (the output cost associated with reducing inflation); - improve the operational framework: strengthen systemic liquidity forecasting and management to enhance the effect of adjustments in the operational variable (e.g., a short-term policy rate) on the intermediate target and ultimately on inflation; - rely primarily on indirect instruments of monetary policy in managing liquidity and foster financial market development to improve monetary policy transmission and reduce the need for direct instruments. ### Concluding remarks and policy implications (key conclusions from review through mid-2008) - Causes and dynamics: - both aggregate demand pressures and surging commodity prices played a role in rising inflation in many emerging and developing countries; - growing capacity constraints and tighter labor markets also contributed, with second round effects. - Inflation targeting (IT) versus others: - official inflation targets were overshot by most emerging market IT countries; - IT countries have in general seen inflation rise by less; - currency appreciations under more flexible exchange rate regimes and greater central bank independence and transparency have generally been associated with lower inflation. - Monetary policy responses: - most central banks have tightened monetary policy to constrain aggregate demand and anchor inflation expectations, though timing and speed varied significantly; - the effect of monetary tightening has been limited at the time of the writing, given delayed actions, lags in policy transmission, and the magnitude of the tightening. - Recent developments and risks: - headline inflation pressures have eased somewhat since May 2008 in some countries, partly reflecting the decline in commodity prices, but inflation remains high in many others; - second-round effects may prevent a quick reduction in inflation, and recent policy measures may take time to have an effect; - capital outflows and associated exchange rate depreciation may contribute to inflation in a number of countries despite the slowdown in global growth. - Policy guidance: - central banks need to signal a strong commitment to bringing inflation back over time to pre-shock rates; - monetary policy makers must be vigilant; further tightening may still be needed in some countries, particularly where demand pressures are evident and credibility is weak; - absent fully-established credibility, stronger policy action is needed; - central banks should be proactive and forward looking, acting in response to projected conditions while weighing relative probabilities and costs of severe but plausible outcomes. - Special cases and instruments: - when monetary policy is fully endogenous (hard pegs), other macroeconomic policies must control inflation; changes in exchange rate arrangements could be contemplated if anchor currency fails to provide nominal stability; - IT central banks should not change inflation targets but could extend the horizon over which inflation converges to the medium-term target to avoid adverse effects on expectations and excessive fluctuations in economic activity; - close monitoring of second round effects is critical to calibrating and timing policy actions; - communications are crucial to limit damage to credibility when targets are overshot or revised, especially given higher inflation, slowing growth, and a deepening financial crisis; - direct or administrative monetary policy tools should be used only as a last resort and only temporarily; - to reduce need for direct tools, improve monetary transmission (including through financial market development), allow the exchange rate to appreciate, secure greater fiscal support, and adopt productivity-matching wage policies to mitigate wage and price pressures. - Summary of empirical/contextual points: - food and energy can constitute up to 70 percent of the CPI basket in some countries; - some countries experienced double-digit inflation (examples cited in regional discussion include Bulgaria, the Baltics, Russia, Serbia, Turkey, and Ukraine); - in many emerging and developing Europe countries inflation exceeded Maastricht criteria and official targets; core inflation rose in many European countries, with indications of second round effects; - some slowdown in inflation pace since May 2008 reflected declining commodity prices and more sluggish activity. *Source: IMF working paper content provided in the supplied PDF excerpt.* ### 3. In emerging Asia, similarly, inflation pressures rose, most notably since the middle ### _wp0901 - 3. In emerging Asia, similarly, inflation pressures rose, most notably since the middle ### Regional inflation developments (selected facts) - Emerging Asia: - Inflation in Vietnam surged to over 20 percent in the first half of 2008. - Inflation exceeded, or approached, double digits in Indonesia and Philippines. - Inflation in Hong Kong SAR, Malaysia, and Korea was more moderate. - In Indonesia, Korea, and Philippines, the official inflation targets were breached since the beginning of 2008. - Inflation in Thailand remained within its target range during the first half of the year. - Core inflation rose in many sample countries; inflation expectations increased in all. - Pace of inflation slowed in emerging Asia since about May 2008, reflecting falling commodity prices. - Latin America: - Inflation pressures rose more modestly than in Europe, Asia, and the Middle East. - Largest pick-up in Chile, Guatemala, Honduras, and Dominican Republic (double digit rates in the last three). - Formally dollarized countries (El Salvador, Ecuador, and Panama) saw inflation move from less than 3 percent on average to more than 9 percent since end-2006. - Among six IT countries, Chile and Guatemala showed largest deviations from targets; Brazil’s inflation remained within target. - Core inflation and inflation expectations rose; second round effects present in all countries. - Middle East and Central Asia: - Inflation accelerated sharply and reached historical highs. - Most Gulf oil producers had double digit rates, as well as Armenia, Egypt, Jordan, Kazakhstan, Kyrgyz Republic. - Egypt: inflation soared to almost 20 percent, highest in almost 10 years. - Kyrgyz Republic: inflation jumped by more than 20 percentage points since end-2006, to 24 percent. - Africa: - Double digit inflation in Botswana, Ghana, and South Africa. - South Africa: inflation surged to near five-year highs; official target missed 12 months in a row. - In Botswana and Ghana, inflation exceeded the upper band of inflation objectives. ### Econometric analysis — data, specification, and scope - Sample and period: - Panel dataset covering 49 emerging market and developing economies. - Monthly frequency, Jan 2005–June 2008. - Maximum of 30 observations per country; asymptotic results exploited based on panel dimension. - Country list explicitly includes: Armenia, Botswana, Brazil, Bulgaria, Cameroon, Chile, China, Colombia, Costa Rica, Croatia, Czech Republic, Dominican Republic, Egypt, Estonia, Ghana, Guatemala, Honduras, Hong Kong SAR, Hungary, India, Indonesia, Israel, Jordan, Kazakhstan, Korea, Kuwait, Kyrgyz Republic, Latvia, Lithuania, Mexico, Mozambique, Nigeria, Peru, Philippines, Poland, Romania, Russia, Saudi Arabia, Senegal, Serbia, Republic of, Singapore, Slovak Republic, South Africa, Thailand, Turkey, Uganda, Ukraine, Uruguay, and Vietnam. - Baseline model (as specified): - General form: π_it = α π_{i,t-1} + β x_{it} + γ w_t + η_i + v_it (notation in source). - π_it is year-on-year monthly inflation. - x_it includes lagged POLICY INTEREST RATE and lagged CREDIT GROWTH. - w_t includes FOOD INFLATION and OIL INFLATION (treated as strictly exogenous). - Short-term impact = β; long-term impact = β /(1–α). - Variables (from Appendix Table 2): - Food Inflation: Percent, yearly change in index of food prices (2000=100), IFS Series 76 EX DZF. - Oil Inflation: Percent, yearly change in index of average crude prices (2000=100), IFS Series 76 AADZF. - Share of Food in CPI: Percent, latest observation, central bank websites and staff estimates. - Share of Fuel in CPI: Percent, latest observation, central bank websites and staff estimates. - Policy Interest Rate: Percent, the policy interest rate, central bank websites. - Inflation: Percent, CPI Inflation, IFS and central bank websites. - Core Inflation: Percent, Core CPI Inflation, GDS and central bank websites. - Credit Growth: Percent, growth of credit to the private, IFS Series 22D. - Turnover, CBI Index, CBT Index: governance/transparency measures (sources listed in Appendix Table 2). ### Baseline estimation results (Appendix Table 3 — selected coefficients) - Column [1] Pooled OLS; Column [2] Within Groups; Column [3] Difference GMM; Column [4] System GMM; Column [5] System GMM Dependent: Diff. in Inflation - Lagged inflation (L. Inflation): - 0.971 [0.016]** (col [1]) - 0.928 [0.025]** (col [2]) - 0.658 [0.099]** (col [3]) - 0.967 [0.029]** (col [4]) - L11D. Policy Interest Rate: - -0.143 [0.080] (col [1]) - -0.163 [0.076]* (col [2]) - -0.217 [0.081]* (col [3]) - -0.183 [0.079]* (col [4]) - -0.174 [0.080]* (col [5]) - L11. Credit growth: - 0.008 [0.002]** (col [1]) - 0.010 [0.005] (col [2]) - 0.087 [0.029]** (col [3]) - 0.024 [0.008]** (col [4]) - 0.016 [0.006]** (col [5]) - Food Inflation: - 0.013 [0.003]** (col [1]) - 0.015 [0.004]** (col [2]) - 0.014 [0.009] (col [3]) - 0.009 [0.004]* (col [4]) - 0.009 [0.004]* (col [5]) - Oil Inflation: - 0.005 [0.002]** (col [1]) - 0.006 [0.002]** (col [2]) - 0.010 [0.003]** (col [3]) - 0.006 [0.002]** (col [4]) - 0.005 [0.002]** (col [5]) - Observations and sample identifiers: - Observations: 12,421 (columns [1], [2], [4], [5]); 11,93 (col [3] listed as 11,93 in table formatting) - Number of Country ID: 49 - Robust standard errors in brackets; * significant at 5%; ** significant at 1%. ### Additional pass-through results (Appendix Table 4 — weighted measures) - Lagged inflation (L. Inflation): - 0.967 [0.021]** (col [1]) - 0.915 [0.028]** (col [2]) - 0.676 [0.117]** (col [3]) - 0.954 [0.027]** (col [4]) - L11D. Policy Interest Rate: - -0.250 [0.134] (col [1]) - -0.211 [0.097]* (col [2]) - -0.247 [0.132] (col [3]) - -0.188 [0.103] (col [4]) - -0.173 [0.102] (col [5]) - L11. Credit growth: - 0.013 [0.004]** (col [1]) - 0.011 [0.006] (col [2]) - 0.093 [0.035]* (col [3]) - 0.033 [0.016]* (col [4]) - 0.019 [0.010] (col [5]) - Weighted Food Inflation: - 0.037 [0.015]* (col [1]) - 0.079 [0.020]** (col [2]) - 0.043 [0.036] (col [3]) - 0.045 [0.024] (col [4]) - 0.042 [0.019]* (col [5]) - Weighted Oil Inflation: - 0.039 [0.012]** (col [1]) - 0.028 [0.018] (col [2]) - 0.099 [0.055] (col [3]) - 0.040 [0.033] (col [4]) - 0.028 [0.025] (col [5]) - Observations: 769; Number of Country ID: 31; R-squared reported 0.94 (col [1]) and 0.88 (col [2]). ### Selected econometric conclusions and quantitative magnitudes - Monetary policy tightening: - Associated with a drop in inflation with a lag of about one year (negative coefficients on L11D. Policy Interest Rate across estimations). - Aggregate demand pressures: - Credit growth has a positive and statistically significant effect on inflation. - Using column [3] (Difference GMM) point estimates: a one percent increase in credit growth leads to an 8.7 basis point increase in inflation on impact, and a cumulative increase of 25.4 basis points in the long-run (8.7 × 1/(1–0.658)). - Commodity price pass-through: - Using column [3] estimates: a 1 percent increase in oil prices translates into a 1 basis point increase in inflation on impact and a cumulative increase of 2.9 basis points in the long-run. - Pass-through of food prices into inflation is of similar magnitude. - Overall, food and oil prices were found to be relatively less important than internal demand pressures in this episode (source language: “relatively less important than internal demand pressures”). - Robustness and diagnostics: - Five estimation methods produced stable coefficient signs and broadly stable magnitudes. - Difference GMM (column [3]) favored for consistency; System GMM (columns [4], [5]) used when including time-invariant institutional variables. - Sargan tests: p-values do not reject null (instruments valid). - Arellano-Bond tests: presence of first-order autocorrelation in differenced residuals, but cannot reject null of no second-order autocorrelation (supporting parameter consistency). ### Policy-relevant implications (from analysis) - Monetary policy: - Tightening of policy interest rates is effective in lowering inflation with roughly a one-year lag (negative L11D. Policy Interest Rate coefficients). - Demand management: - Containing credit growth can mitigate inflationary pressures: quantified impact in column [3] (0.087 on impact, 25.4 basis points long-run). - External versus internal drivers: - While food and oil inflation contributed positively to headline inflation, internal demand pressures (credit growth) played a larger quantitative role in the observed inflationary episode. - Institutional frameworks: - IT countries achieved lower inflation with roughly comparable increases in interest rates; IT countries exhibited stronger central bank governance (stronger CBI and higher transparency) according to summary statistics in the analysis. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0901.pdf* ### 15. Two additional exercises were conducted to further study the pass-through of ### _wp0901 - 15. Two additional exercises were conducted to further study the pass-through of ### Pass-through of food and energy prices into headline inflation - Adding the share of food and energy in the CPI as regressors produced coefficients that "were not found to be statistically significant", indicating no evidence that countries with larger CPI shares of food and energy "have not seen higher average inflation during the period studied." - Weighting food and oil inflation by their CPI shares produced target coefficients that were "positive and larger than those obtained in the baseline regression but not statistically significant." - Overall conclusion: "the pass-through of world commodity prices into headline inflation has been relatively mild," possibly due to compensatory measures such as government subsidies or price controls. ### Second-round effects (feedback from core to headline inflation) - Replacing lagged inflation with lagged core inflation (treated as endogenous) indicates the presence of feedback effects from core inflation to headline inflation. - Appendix Table 5 key coefficients (as reported): - L.Core Inflation 0.332 [0.191]* - Core Inflation 2005-07 0.330 [0.197]* - Core Inflation 2007-08 0.848 [0.388]** [0.938] [0.556]* - Inflation Targeters*Core Inflation 2005-07 0.172 [0.439] - Inflation Targeters*Core Inflation 2007-08 -0.958 [0.578]* - Observations 715; Number of Country ID 27 - Evidence that feedback (second-round) effects have been increasing over time; some evidence these effects are "somewhat lower among IT countries." ### Effects of monetary tightening on inflation; speed of transmission - Baseline regression finding: "A one percentage point increase in the policy interest rate leads to an estimated 21.7 basis point drop in inflation on impact, and a long-run effect of 63.5 basis points." - Response of inflation has "a lag of about 4 to 5 quarters." - Appendix Table 6 highlights (selected reported coefficients and statistics): - L. Inflation 0.518 [0.129]*** and 0.658 [0.099]*** - L5D. Policy Interest Rate 0.187 [0.193] and 0.047 [0.094] - L6D. Policy Interest Rate 0.127 [0.212] and -0.060 [0.100] - L7D. Policy Interest Rate 0.305 [0.270] and -0.035 [0.087] - L8D. Policy Interest Rate 0.268 [0.252] and -0.008 [0.083] - L9D. Policy Interest Rate 0.368 [0.302] and -0.032 [0.071] - L10D. Policy Interest Rate -0.180 [0.323] and -0.234 [0.093]** - L11D. Policy Interest Rate -0.488 [0.431] and -0.217 [0.081]** ; additional columns: -0.348 [0.109]*** and -0.174 [0.080]** - L12D. Policy Interest Rate -1.354 [0.980] and -0.336 [0.296] - L13D. Policy Interest Rate -0.964 [1.117] and -0.233 [0.274] - L14D. Policy Interest Rate -1.797 [1.184] and -0.453 [0.239]* - L11. Credit growth 0.133 [0.046]*** ; 0.087 [0.029]*** ; 0.021 [0.007]*** ; 0.016 [0.006]*** - Food Inflation 0.023 [0.011]** ; 0.014 [0.009] ; 0.006 [0.005] ; 0.009 [0.004]** - Oil Inflation 0.009 [0.004]** ; 0.010 [0.003]*** ; 0.004 [0.002]* ; 0.005 [0.002]*** - Observations vary by specification (e.g., 1043, 1193, 1090, 1242); Number of Country ID 47 or 49 - Interpretation: coefficients negative around the 10th–14th lags and statistically significant around the 4th quarter support the choice of 11 lags in the preferred specification; "effects on inflation of the monetary tightening initiated in the third quarter of 2007 have not yet fully materialized." ### Role of central bank institutional frameworks - Three measures of central bank governance used (Crowe and Meade (2007) dataset): - CENTRAL BANK INDEPENDENCE (CBI) index (Cukierman, Webb, and Neyapti (1992) methodology) - CENTRAL BANK TRANSPARENCY index (Blinder et al. (2001) methodology) - TURNOVER rate of central bank governors (measure of effective CBI) - Changes in these indicators (two observations per country allow computing changes) were added one at a time to avoid multicollinearity; results support priors. - Appendix Table 7 selected coefficients: - Change in CBI Index -0.382 [0.224]* and -0.554 [0.257]** - Change in Transparency Index -0.246 [0.106]** and -0.320 [0.132]** - Change in Turnover 0.237 [0.440] and 0.560 [0.533] - L11D.Policy Rate * Governance Indicator -2.964 [1.358]** ; 2.126 [1.112]* ; 2.871 [1.034]*** - Observations by column: 668, 398, 614, 668, 398, 614; Number of Country ID 26, 14, 24, 26, 14, 24 - Findings: - "Countries that have more strongly pursued central bank reform have been able to attain lower inflation rates." - Improvements in CBI and transparency are associated with "a more effective monetary policy." - Interaction results imply decreasing marginal benefits associated with monetary policy transparency (positive coefficient on POLICY INTEREST RATE * TRANSPARENCY INDEX). ### Back-of-the-envelope decomposition: contribution of selected factors to observed inflation (June 2007–June 2008) - Sample averages and baseline coefficients used to estimate contributions; results reported in Appendix Table 8 (columns [4] and [5] show estimated contributions and alternative estimates for IT vs non-IT). - Key aggregate numbers (Entire Sample, Jun-07 to Jun-08): - Inflation: Jun-07 5.1 ; Jun-08 9.7 ; Difference 4.6 - Policy Interest Rate: Jun-07 7.4 ; Jun-08 8.6 ; Difference 1.2 [Estimated Contribution to Inflation 1/ [-0.2 -0.3]] - Credit Growth: Jun-07 28.6 ; Jun-08 25.5 ; Difference -3.1 [Estimated Contribution to Inflation 1/ [0.5 2.5]] - Food Inflation: Jun-07 7.6 ; Jun-08 4.5 ; Difference -3.1 [Estimated Contribution to Inflation 1/ [0.4 0.6]] - Oil Inflation: Jun-07 -0.19 ; Jun-08 2.9 ; Difference 3.0 [Estimated Contribution to Inflation 1/ [0.5 0.9]] - Inflation Targeters (IT) versus Other Monetary Regimes (Non-IT) (selected reported numbers): - IT: Inflation Jun-07 4.0 ; Jun-08 7.4 ; Difference 3.5 - Policy Interest Rate difference 1.2 with contributions [-0.2 -0.3] and [-0.5 -0.5] (column [5] alternative) - Credit Growth difference -12.0 with contributions [0.4 1.9] and [-0.2 0.2] - Food Inflation contribution [0.4 0.6] and [0.5 0.7] - Oil Inflation contribution [0.5 0.9] and [0.2 0.5] - Other Monetary Regimes: Inflation Jun-07 5.9 ; Jun-08 13.5 ; Difference 7.6 - Policy Interest Rate difference 1.2 with contributions [-0.2 -0.3] and [-0.1 -0.1] - Credit Growth difference -3.7 with contributions [0.5 2.9] and [0.5 3.5] - Food Inflation contribution [0.4 0.6] and [0.2 0.5] - Oil Inflation contribution [0.5 0.9] and [0.5 1.1] - Interpretations from these calculations: - IT countries experienced a smaller rise in inflation (3.5 percent) than non-IT countries (7.6 percent) between June 2007 and June 2008. - Food and oil jointly explain between 1.0–1.5 percentage points of the aggregate increase (reported text). - Aggregate demand pressures (proxied by credit growth) explain between 0.5–2.5 percentage points (reported text). - "The ongoing monetary policy tightening is only beginning to dent inflation, and could explain a drop of about 0.2–0.3 percentage points." - Effects of monetary tightening on inflation appear stronger among IT countries. ### Concluding empirical findings and policy implications (selected) - The episode was driven by a combination of external (commodity-price) and internal (domestic demand, credit growth) factors. - Commodity-price-related common inflationary shock "has since abated." - Internal demand pressures (bank credit growth) "have played an important role" and may abate with global growth slowdown. - Countries tightening monetary policy more aggressively are attaining lower inflation rates; effects come with a lag of about 4 quarters, so recent tightening is "only beginning to dent inflation." - Between June 2007–June 2008, average increase in policy rates for IT and non-IT countries was "around 1.2 percentage points"; however, real interest rates became negative among non-IT countries, implying "Further monetary tightening appears to be necessary." - Second-round effects (lagged core → headline) "have been increasing over time, doubling in 2007–08 relative to 2005–06"; increase somewhat lower for IT countries, differences not statistically significant. - Countries that implemented stronger central bank reforms in the 1990s—improving central bank independence and transparency—"have been able to attain lower inflation rates," driven by "increased effectiveness in the workings of monetary policy transmission." *Source: Excerpt from _wp0901 (Appendix Tables and text provided).* ### APPENDIX IV. EMERGING IT COUNTRIES: POLICY RESPONSES TO DATE ### APPENDIX IV. EMERGING IT COUNTRIES: POLICY RESPONSES TO DATE ### Inflation pressures and the test of IT regimes - Countries implementing IT regimes experienced significant inflation pressures since mid-2007. - Most IT countries overshot their official inflation targets. - Many IT countries faced unprecedented policy challenges in responding to these inflation pressures. ### Target adjustments: general pattern and notable exceptions - None of the countries with IT regimes revised the officially announced inflation targets in response to rising inflation, except Guatemala and Turkey (as of end-August 2008). - Authorities generally kept official targets and their parameters unchanged to avoid damage to credibility and the risk of unanchoring inflation expectations. - Country-specific notes: - Hungary: Resisted upward adjustment despite strong government pressure, citing potential negative effects on market sentiment, Hungary’s reputation regarding its euro accession plans, and on the Bank’s policy credibility. - South Africa (SARB): Rejected calls for upward adjustment of its official target or features, and rejected invoking the “explanation clause” because it would not relieve responsibility for explaining deviations. - Turkey: In June 2008, revised upward the official target for 2009-2011 after extending the target horizon and revising the inflation forecast. Authorities argued that better alignment of rising inflation forecasts with targets could reduce future overshooting and market confusion. The new targets were described as ceilings rather than point targets and intended to indicate tolerance for first round effects. - Guatemala: In December 2007, adjusted upward both the mid-point and the target range of its official target by 50 basis points, reflecting a higher inflation forecast in the context of the monetary program for 2008. ### Monetary and macroprudential responses where targets were not adjusted - Countries that did not modify official targets used a range of policy tools to cope with rising inflation: - Majority tightened policy rates to anchor expectations, limit second-round effects, reiterate commitment to price stability, and maintain the IT regime (Czech Republic, Hungary, Israel, Poland, Romania; Indonesia, Philippines; Brazil, Chile, Colombia, Mexico, Peru; South Africa). - Some central banks emphasized that the time to return to target could differ depending on circumstances and the state of the economy. - In some countries, nominal or real exchange rate appreciation helped limit pass-through of imported inflation pressures (Czech Republic, Hungary, Israel, Poland, Slovakia, Brazil, Colombia, Peru). - A few countries combined higher interest rates with prudential measures (Romania) or higher reserve requirements and other direct instruments of monetary policy (Colombia, Peru). - A tight fiscal stance provided support in some cases (Hungary, Poland). ### Appendix Table 9: Country-by-country policy responses (as of August 2008) - Latin America - Brazil - Target overshot: No - Target adjusted: No - Actions: - Raised key policy rate (175 bp since Apr 2008) - Imposed reserve requirement on leasing companies - Exchange rate appreciated - Chile* - Target overshot: Yes - Overshooting since: Aug 2007 - Target adjusted: No - Actions: - Raised key policy rate (275 bp since Jul 2007) - Colombia* - Target overshot: Yes - Overshooting since: Early 2007 - Target adjusted: No - Actions: - Raised key policy rate (250 bp since Jan 2007) - Raised reserve requirements - Imposed reserve requirements on foreign liabilities - Let exchange rate appreciate - Guatemala* - Target overshot: Yes - Overshooting since: n.a - Target adjusted: Yes - Actions: - Raised key policy rate (200 bp since Apr 2007) - Revised the target from 5 ±1% to 5.5 ±1.5% in 2008 and to 5.5 ±1% (2009) in December 2007 - Mexico* - Target overshot: Yes - Overshooting since: Early 2007 - Target adjusted: No - Actions: - Raised key policy rate (100 bp since Apr 2007) - Peru* - Target overshot: Yes - Overshooting since: Fall 2007 - Target adjusted: No - Actions: - Raised key policy rate (150 bp since Jul 2007) - Raised reserve requirement and imposed capital control - Let exchange rate appreciate - Europe - Czech Republic* - Target overshot: Yes - Overshooting since: Fall 2007 - Target adjusted: No - Actions: - Raised key policy rate (125 bp from Jan 2007) - Let exchange rate appreciate - Lowered the key rate 25 bp on August 7, 2008 given strong koruna appreciation and downside inflation risks - Hungary - Target overshot: Yes - Overshooting since: Fall 2006 - Target adjusted: No - Actions: - Raised key policy rate (100 bp since Mar 2008) - Abandoned the band (Feb 2008) and let the forint float - Tight fiscal policy - Israel - Target overshot: Yes - Overshooting since: End 2007 - Target adjusted: No - Actions: - Raised key policy rate (75 bp since May 2008) - Let exchange rate appreciate - Poland* - Target overshot: Yes - Overshooting since: End 2007 - Target adjusted: No - Actions: - Raised key policy rate (200 bp since Apr 2007) - Let exchange rate appreciate - Tight fiscal policy - Romania* - Target overshot: Yes - Overshooting since: Fall 2007 - Target adjusted: No - Actions: - Raised key policy rate (325 bp since Oct 2007) - Prudential measures for credit - Serbia - Target overshot: Yes - Overshooting since: Early 2008 - Target adjusted: No - Actions: - Raised interest rates (575 bp since end-2007) - Maintained the core inflation target, reaffirming its 2008 target and setting a declining path for 2009-10 - Slovak Republic - Target overshot: Yes - Overshooting since: Mid 2007 - Target adjusted: No - Actions: - Revalued the exchange rate (May 2008) - Turkey - Target overshot: Yes - Overshooting since: Fall 2007 - Target adjusted: Yes - Actions: - Raised key policy rate (150 bp since Apr 2008) - Revised the target from 4% to 7.5%, 6.5%, 5.5% in 2009, 2010, 2011 - Asia - Indonesia - Target overshot: Yes - Overshooting since: Early 2008 - Target adjusted: No - Actions: - Raised key policy rate (100 bp since May 2008) - Korea* - Target overshot: Yes - Overshooting since: Late 2007 - Target adjusted: No - Actions: - Raised key policy rate (75 bp since Jun 2007) - Philippines - Target overshot: Yes - Overshooting since: Early 2008 - Target adjusted: No - Actions: - Raised key policy rate (100 bp since end-2007) - Thailand - Target overshot: No - Overshooting since: Mid 2008 - Target adjusted: No - Actions: - Raised key policy rate (25 bp since July 2008) - Africa - South Africa* - Target overshot: Yes - Overshooting since: Early 2007 - Target adjusted: No - Actions: - Raised key policy rate (450 bp since June 2006) - Reiterated commitment to price stability and IT regime - Rejected calls for revising the target, to invoke “explanation clause”, and alternative definitions of the target basket - Note: * Indicates that the country had a relatively early monetary policy response to persistent inflation pressures. ### Turkey: revision to the inflation target and market reactions (summary of Appendix V) - CBT adopted IT in January 2006; inflation targets met for four years in a row before being missed following shocks. - Inflation accelerated in late 2007, reaching 10.7 percent in June 2008, significantly higher than the 4 percent medium-term target. - CBT two-step response to food and energy shocks: - April 2008: Kept 4 percent medium-term target, emphasized forecasts in short-term, revised forecasts substantially upward, extended policy horizon to 3 years with disinflation path up to 2011:Q1. Forecasts assumed a measured tightening in first half 2008 and constant rates thereafter; provided two alternative scenarios about food and energy prices. MPC increased policy rates by 50 basis in the May, June and July meetings. - June 3, 2008: Announced upward revision to inflation targets to 7.5, 6.5, 5.5 percent for 2009, 2010, and 2011 respectively. The medium-term objective of 4 percent was not mentioned at the time of the revision. Revised targets described as ceilings, indicating tolerance for first round effects and implying an asymmetric response to shocks (respond strongly to inflation pressures but not necessarily to disinflationary ones). - Market reaction: - Following the decision to revise the target, the Turkish lira and stock prices fell, and yields on lira-denominated bonds rose (by as much as 26 basis points to a 14-month high of 20.28 percent). - Although CBT tightened policy subsequently, inflation expectations deteriorated and long term bond yields remained elevated. CBT expectations surveys showed that both inflation expectations and their standard deviation increased, indicating more uncertainty. ### Recommendations to foster the effectiveness of monetary policy (from Appendix VI) - Central banks need to ensure monetary policy can effectively counter rising inflation by: - Tightening monetary policy where warranted. - Improving implementation of monetary policy. - Strengthening operational underpinnings of monetary policy execution. - Expanding transparency and communication. - Monetary policy formulation and implementation should be consistent with the policy regime in place: - Central banks should make monetary policy goals explicit and identify clearly the intermediate target and corresponding operational target used in their reaction function. - Inconsistent or unpredictable central bank reactions increase market volatility and uncertainty and can cause market expectations about inflation to drift from targets. - Improvements in operational underpinnings of implementation: - Effective liquidity management and forecasting are needed to transmit monetary policy shocks to aggregate demand and prices. - In countries with deep money markets, a key policy rate should be used as an operational target to influence short-term interest rates and the yield curve (examples of such interest rates are the selic rate in Brazil, the monetary policy rate in Chile, and the policy interest rate in Thailand). - In countries with shallow money markets and monetary-targeting regimes, central banks can rely on monetary aggregates as operational variables. - In exchange rate peg regimes, central banks can still manage liquidity; the central bank’s interest rate should be linked to the policy rate in the anchor country, and maintaining interest rates at this level requires proper liquidity management and well-developed money markets. - A deep, active money market facilitates effective liquidity management by financial institutions and government cash management. *Source: _wp0901 - APPENDIX IV. EMERGING IT COUNTRIES: POLICY RESPONSES TO DATE* ### 35. For effective liquidity management, central banks should primarily use market ### For effective liquidity management, central banks should primarily use market based instruments of monetary policy ### Liquidity management instruments and their effects - Open market operations: - Encourage the development of money—and debt—markets. - Boost the functioning of the interest rate channel of the transmission mechanism of monetary policy. - Non-remunerated reserve requirements (NRR) and credit controls: - Should only be used as a last resort despite benefits for central bank balance sheets. - Distort financial transactions and discourage intermediation away from domestic banking system towards offshore markets or activities that are less well regulated and supervised. - Increasing NRR is less efficient than open market operations because central banks would not be able to calculate accurately the likely impact on interest rates—not only how much but also how fast. - Credit controls impair liquidity management and blur the informational content of interest rates, thereby undermining the transmission mechanism of monetary policy. - Temporary uses of NRR: - May be necessary when there are no other good options, for example when: - (i) the interest rate channel is weak or nonexistent given shallow financial markets, a high degree of financial dollarization, or no independent monetary policy; or - (ii) when first-best monetary instruments need to be supplemented under heavy capital inflows given their high quasi fiscal costs. - Operational aspects to buffer reserve supply instability: - Averaging over the maintenance period and lags in the accounting framework (calculation period ends before the maintenance period begins) buffer the impact of any instability in the supply of reserves on interbank interest rates and help banks plan their reserve holding pattern. - Minimizing negative side effects of NRR: - (i) phase NRR out as inflationary pressures subside; - (ii) remunerate reserve requirements, subject to the position of the central bank balance sheet. - Central banks should accelerate efforts to improve the functioning of the monetary transmission mechanism by deepening financial markets to reduce the need to resort to such tools. ### Communication, transparency, and inflation management - Importance: - An effective communication strategy and transparency are crucial to enhancing the effectiveness of monetary policy in a more uncertain environment. - Transparency and communication apply across monetary policy regimes and are even more important when central bank credibility is at an early stage of development. - Objectives of enhanced transparency and communication: - Explain policy objectives and mandate, and behave and communicate accordingly. - Explain how policy reacts to economic developments, the strategy guiding decisions, the likely impact of decisions on inflation and expected inflation, the assessment of inflation pressures and principal risks to the outlook, and intentions for policy rates. - Policy making bodies should meet on a regular basis, with outcomes communicated to the public (e.g., through press releases). - Benefits: - Facilitates monetary policy predictability and contributes to reducing inflation. - Anchors long-run inflation expectations, helps private agents understand the central bank’s reaction function, and influences interest rate expectations and economic decisions. - Predictability helps dampen macroeconomic fluctuations, including those of interest rates and exchange rates, and moderates output cost from tightening. - Current communication priorities (at the present juncture): - Explain the nature of the pickup in inflation, the central bank policy response, and expected inflation developments. - Reaffirm commitment to fighting inflation and: - Explain how the rise in food and energy prices is fueling inflation, and why central banks are missing their inflation targets; elucidate the information provided by both headline and core inflation and how they are affected by the supply shock; provide a credible explanation of short-run overshooting and the path back to targets. - Stress the need to tighten monetary policy, where warranted, to limit chances of a broader impact on the general level of prices despite possible short-term output cost; consider channels of transmission and how policy operates. - Emphasize the forward-looking nature of monetary policy and the lagged impact on demand and prices of goods and services; in countries with strong central bank professional skills, markets would benefit from a reliable medium-term path of inflation. ### Appendix Table 11 — Selected countries: recent adjustments to reserve requirements (2007–2008) - Bulgaria: - Raised reserve requirements from 8 to 12 percent in September 2007. - Russia: - Raised reserve requirements in July 1 2008: compulsory reserve requirements for commercial banks from 4.5 percent to 5 percent for retail deposits in roubles; from 5 percent to 7 percent for banks' liabilities to non-resident banks, and to 5.5 percent for other bank liabilities. - Ukraine: - Imposed new reserve requirements on banks’ foreign borrowing in late 2007. - Saudi Arabia: - Reserve requirement raised from 7 percent in November 2007 to 12 percent in April 2008. - Brazil: - On January 2008, introduced reserve requirements on repo operations made by leasing companies; reserve requirement increasing gradually—5 percent every other month starting in May 2008 until reaching 25 percent by January 2009. - Colombia: - Introduced differentiated marginal reserve requirements on sight and saving deposits (27 percent) and on certificate of deposits (5 percent) in mid-2007. In June 2008, marginal reserve requirements were eliminated but reserve requirements were raised from 8.3 to 11.5 percent on sight and saving deposits and from 2.5 to 6 percent on certificates of deposits. - Honduras: - Introduced compulsory—and remunerated—investments at the central bank equivalent to 4 percent of total liabilities in domestic currency (February 2007), with up to 2 percent accumulated using bonds from the public sector energy enterprise up to May 2008. Since February 2008, compulsory investments increased to 9 percent, to be met up to 5 percent with government securities. - Reserve requirements for financial institutions providing at least 80 percent of their credit in domestic currency to support “productive” activities were reduced gradually from 12 percent in February 2008 to 7 percent in June 2008. - Financial institutions providing at least 70 percent of credit in foreign currency to support “productive” activities were reduced gradually from 24 percent in February 2008 to 14 percent in June 2008. - Nicaragua: - In October 2007, reduced legal ratio of reserve requirements from 19.25 to 16.25. - Uruguay: - In April 2008, imposed a 100 percent reserve requirement on government deposits at the central bank and, in May 2008, required nonresident financial institutions to maintain 35 percent of their deposits at the central bank. - China: - The People’s Bank of China raised reserve requirements from 11.5 percent at the end of 2006 to 17.5 percent in June 2008 in several steps. - Vietnam: - The State Bank of Vietnam raised compulsory reserve requirements from 5 percent to 10 percent in June 2007 and from 10 percent to 11 percent in February 2008. ### Use of controls on capital inflows (Appendix VII) - Rationale for capital controls when exchange rate is fixed or heavily managed: - Preserve monetary policy autonomy and reduce pressures on the exchange rate. - Protect monetary and financial stability in the face of persistent capital flows, especially concerns about (i) inflationary consequences of large inflows, or (ii) inadequate assessment of risks by banks or the corporate sector in a heavily managed exchange rate environment that encourages unhedged foreign currency positions. - Historical use and objectives: - A number of countries imposed controls on capital inflows in response to increasing size and volatility of inflows in the 1990s (e.g., Brazil, Chile, Colombia, Malaysia, Thailand). - Sterilization operations were typically the first policy response but entailed costs and could attract further inflows by keeping interest rates high. - Controls were used to reduce reliance on sterilization and preserve monetary policy autonomy while stabilizing the exchange rate. - Prudential motivations included altering the maturity composition of inflows toward less volatile flows and reducing their overall volume; short-term flows posed potential adverse effects on macroeconomic and financial stability. - Design variations and country examples: - Brazil (1993–97): explicit tax on certain foreign exchange transactions and foreign loans, plus administrative controls (prohibitions or minimum maturity requirements); tax rates raised or differentiated by maturity as markets adopted derivatives strategies to circumvent controls. - Chile (1991–98): combined market-based controls (indirect taxation via an unremunerated reserve requirement (URR)) with direct measures (minimum stay requirement for direct and portfolio investment) and regulatory measures (minimum rating requirement for domestic corporations borrowing abroad and extensive reporting requirements on banks). - Colombia (1993–98): URR on external borrowing with maturity less than 18 months (including certain trade credits), later adjusted with higher rates for shorter maturities and broader coverage. - Malaysia (1994): administrative prohibitions (nonresident purchases of money market securities and nontrade-related swap transactions) and regulatory measures (asymmetric limits on bank external liability positions for nontrade purposes, reserve requirements on foreign banks’ ringgit funds). - Thailand (1995–97): indirect, market-based measures (asymmetric open position limits, detailed information requirements, and reserve requirements on nonresident bank accounts and baht borrowing, finance company promissory notes, and banks’ offshore short-term borrowing). - Effectiveness and lessons: - Mixed effectiveness: some initial success in creating a wedge between domestic and foreign interest rates and reducing exchange rate pressures, but none achieved both objectives consistently. - Controls were not effective in reducing total net inflows except in Malaysia and Thailand, but helped reduce short-term inflows. - Sterilization operations often continued with associated costs (Brazil and Chile). - For controls to be effective, coverage should be comprehensive and implementation forceful; significant administrative costs incurred in extending, amending, and monitoring compliance. - Controls can lose effectiveness over time as markets exploit loopholes; sophisticated financial markets reduce circumvention costs. - Difficult to distinguish controls’ role from accompanying policies (e.g., strengthening prudential regulations, greater exchange rate flexibility). - Recent uses: - Croatia introduced a Chilean-type control in 1998 (deposit requirement at the central bank for short-term foreign credits) and an unremunerated marginal reserve requirement on bank borrowing in 2005 to limit rapid expansion of bank credit funded by borrowing from abroad. - Thailand and Colombia introduced URR in 2006–08 to curb currency appreciation caused by strong portfolio inflows. *Source: _wp0901 - 35. For effective liquidity management, central banks should primarily use market* ### 47. The effects of these newer measures have been mixed. In Croatia, the MRR has led ### APPENDIX VIII. ILLUSTRATIVE SIMULATIONS FOR POLICY RESPONSES TO OIL PRICE SHOCKS ### Shocks - Assumed changes in prices over 18 months: - world price of oil (energy) increases by a total of 240 percent; - food increases by 60 percent; - world inflation goes up by 2 percentage points over the same period. - Two shock scenarios: - (i) temporary level shock: prices come back to previous levels (over another 18 months); - (ii) permanent level shock: prices stay unchanged forever at a higher level. - Movements in world oil prices are unexpected; agents rationally expect the oil price next period to equal the current period price. - Note: the food price shock is subsumed under the oil shock by increasing the share of oil in consumption to reflect both oil and food consumption. ### The model - New Keynesian DSGE model calibrated to an emerging market economy importing oil and food, with features: - oil is an input into domestic production and enters consumption directly; - two production sectors: home goods (produced from labor, fixed capital stock, and imported oil and intermediates) and export goods; - consumption is the only domestic final expenditure item; - two monopolistically competitive retail sectors: one for home goods, one for oil (to consumers and firms); - imperfectly competitive labor market; - central bank either keeps the exchange rate fixed (peg) or targets inflation by changing the interest rate (IT); - model closed using a risk premium that depends on net foreign liabilities (NFL) and stock of capital. ### Calibration - Production is intensive in labor and non-energy imports; export industry is the most important income-generating sector. - Share of retail profits in GDP is high, reflecting low degree of retail competition. - Share of oil (energy) in imports for consumption scaled up to almost 20 percent to account for a price-adjusted food content. - Overall share of oil consumption (production plus final consumption) in GDP is about 13 percent (versus observed share about 9 percent) to reflect food content adjustment. - Steady state net export and foreign asset position chosen very close to zero. - Transition parameters calibrated so that exchange rate appreciation by 1 percent is equivalent in its impact on inflation to a 5 percentage point increase in the interest rate. - Calibration reflects observed behavior of inflation in response to oil and food price shocks since end-2006: - peg regimes saw inflation rates increase by about 6 percentage points; - IT regimes saw inflation rates rise by around 3 percentage points. - In simulations, interest rate hike in IT regimes varies from 100-600 basis points. - Under a peg, the interest rate rises by about 200 basis points (resulting from rise in risk premium after current account deterioration). ### Policy experiments and shock transmission - Shock transmission channels: - production side: higher prices for oil, food, and non-energy imports → negative technology change → higher marginal cost, lower demand for labor and capital, and lower imports; - capital is fixed, so returns to capital bear adjustment burden; - labor market adjustment shared between employment and real wages depending on wage flexibility; - consumers face higher inflation and perceived income reduction (terms of trade deterioration) → consumption falls and substitution toward domestic goods; - production falls from declining demand and supply; inflation rises from domestic and imported components. - Permanent higher oil prices (unless temporary) have permanent real effects: worse terms of trade, lower consumption, production, and wages; long-term levels of inflation and interest rates not affected, long-term nominal exchange rate depends on shock length and policy response. - Policy experiments analyzed: - propagation under IT vs peg; - under IT: reacting to headline vs core inflation, temporary increase in inflation target vs no change; role of credibility; - under peg: step appreciation, step depreciation, no change in parity; - role of real wage flexibility; - policy mistakes from uncertainty about shock size and duration. ### Peg vs. inflation-targeting (IT) regimes (simulation outcomes) - Under both temporary and permanent shocks: - rise in inflation is higher and output fall smaller under a peg compared with IT. - Greater interest rate response under IT dampens inflation (via nominal appreciation and demand contraction) but causes larger output and employment losses. - Peg with no parity change allows inflation to rise and mitigates real economy impacts because of absent interest rate reaction. - If shock is temporary: - inflation, output, nominal exchange rate, and interest rate return to steady state. - If shock is permanent: - output permanently lower under both regimes; - nominal exchange rate ends more appreciated under IT (final level depends on how much inflation central bank tolerates). ### Policy options under IT and credibility effects - Key IT central bank decision: react to headline inflation or hold back until core inflation rises, or raise the official inflation target. - Reacting to headline inflation: - more effective in keeping inflation under control; - requires significant interest rate increase and significant exchange rate appreciation; - leads to larger output loss. - Reacting only to core inflation: - aims to trade somewhat higher inflation for higher output and employment; - can achieve smaller decline in output if policies to attain future inflation targets are fully credible and shock is relatively short-lived; - may help restore employment if wages are relatively inflexible by facilitating faster downward real wage adjustment. - Credibility matters: - under imperfect credibility, inflation expectations become more backward-looking and rise in proportion to degree target is overshot; - inflation therefore rises more and output falls more (larger interest rate reaction needed) compared to full credibility; - ignoring full inflation impact is risky for central banks establishing credibility (e.g., 'lite IT'ers). - Temporarily raising the inflation target (e.g., for 2 years) produces no substantial benefit: - initial interest rate need not rise as much, but overall inflation increases as expectations adjust to higher target; - if target not brought back sufficiently soon, interest rates must increase more later to return inflation to pre-shock levels; - gain in output will be negligible, if any. - Models do not incorporate potential permanent negative effects of higher inflation on resource allocation and growth beyond some threshold. ### Policy options in peg regimes - Authorities constrained to adjusting the parity: revalue, devalue, or keep unchanged. - Parity revaluation: - helps contain inflation faster but leads to lower output (compared to no change or devaluation); - real and nominal interest rates rise more because of higher risk premium associated with negative competitiveness effect on net exports; - higher real interest rates and lower exports dampen production and consumption more, helping to contain inflation faster. - Parity devaluation: - rise in inflation is higher and output decline lower (compared to revaluation or no change); - devaluation increases imported inflation but lowers real interest rates and improves competitiveness (manifested by lower nominal interest rates and risk premium), dampening output decline. ### Impact of uncertainty about size and duration of the shock - Possible policy mistakes when a temporary shock is mistakenly believed permanent: - three policy reaction cases simulated (agents expect shock permanent in simulations): - (i) interest rates react to headline inflation assuming shock permanent; - (ii) interest rates ignore higher headline inflation and react only to external balance developments; - (iii) interest rates remain unchanged. - Ignoring inflationary effects of a temporary shock (interest rate unchanged) can limit output decline by about 2 percentage points with no appreciable deterioration in inflation performance; inflation profile dominated by first-round impact without significant second-round effects. - Not responding to rise in inflation when shock is actually permanent and recognition later: - delayed reaction leads to inflation rising by 3 percentage points more compared to immediate reaction; - output decline is still lower with delayed than immediate reaction, but central bank faces dilemma over how much inflation to tolerate for higher output. - Quick interest rate reactions can ex post exacerbate stagflation by unduly depressing output if shock is temporary, but would limit overall rise in inflation and expectations if shock is permanent. - Policy choice depends on policymakers’ weighting of output-inflation trade-off given uncertainty. ### Key conclusions (selected) - Model simulations illustrate a policymaker’s dilemma over how much inflation to tolerate while output and employment fall. - Allowing higher inflation (looser policy: responding to core vs. headline inflation, raising inflation target) can mitigate negative output and employment effects, but outcomes depend on shock length, monetary framework, and policy credibility. - Model does not account for possible long-term detrimental growth effects of inflation beyond threshold. - Nature of the shock affects long-run levels: permanent shocks worsen terms of trade permanently, forcing real adjustments (lower consumption, production, real wage); long-term inflation and interest rates unaffected in level (though initial rises larger), exchange rate depends on shock length and policy. - Impact depends on monetary regime: rise in inflation higher and output decline smaller under peg vs. IT; parity revaluation under peg more effective in containing inflation but at expense of output. - Central bank credibility is crucial: reacting to core rather than headline inflation can reduce interest rate rise and output loss but depends on credibility; with imperfect credibility, inflation expectations rise and output falls more. - Temporarily raising inflation target produces no substantial benefit; expectations adjust and later tightening needed, limiting output gains. - Uncertainty over shock duration/nature implies risk of excessive tightening; quick rate hikes can exacerbate stagflation if shock temporary, while delayed reaction can be costly in inflation if shock permanent. Policy choice determined by weight given to output-inflation trade-off. *Source: APPENDIX VIII, “ILLUSTRATIVE SIMULATIONS FOR POLICY RESPONSES TO OIL PRICE SHOCKS.”* ### Appendix Figure 4. Different Propagation Mechanisms Under Peg and IT ### Appendix Figure 4. Different Propagation Mechanisms Under Peg and IT ### Key points from the figures and comparative analysis - The appendix contrasts transmission under Peg and Inflation Targeting (IT) across several shocks and policy responses: - Comparisons include Peg vs IT in response to Permanent Level Oil Price Shock and Temporary Oil Price Shock. - Role of policy credibility under IT is analyzed by comparing Perfect and Imperfect credibility for core inflation reactions to Temporary and Permanent Level Oil Price Shocks. - Options under IT considered: Temporary Target Change vs. No Target Change, with reactions of headline inflation to Temporary and Permanent shocks. - Options under a peg considered: step appreciation, step depreciation, vs. no parity change, for Temporary and Permanent Level Oil Price Shocks. - Risk associated with excessive monetary tightening ex post is illustrated by comparing reactions to headline inflation, reactions to external balance, and no reaction for both unexpected Temporary Oil Price Shocks and expected Permanent Level Oil Price Shocks. - The figures present four outcome variables repeatedly across scenarios: - Inflation (pp diff from base) - Production (% of base) - Exchange Rate (up appr) (% of base) - Interest Rates (pp diff from base) - Comparative themes emphasized by the figure set: - Exchange rate regime (Peg vs IT) alters propagation of oil price shocks across inflation, production, exchange rate, and interest rates. - Credibility under IT materially affects core inflation dynamics following oil price shocks (Perfect vs Imperfect credibility). - Under IT, authorities face a choice between keeping targets unchanged or making a temporary target change in response to oil price shocks, with differing dynamics for headline inflation. - Under a peg, parity adjustments (revaluation, devaluation, or fixed parity) yield distinct short- and medium-run impacts on inflation, production, exchange rates, and interest rates. - Different policy reaction functions (targeting headline inflation vs external balance vs no reaction) lead to materially different trade-offs in macro variables after shocks. ### Institutional and policy analysis (Appendix IX, Moving to Greater Exchange Rate Flexibility) - Context and motivations: - Many countries have adopted more flexible exchange rate regimes over the past decade.57 - Drivers include belief that greater flexibility provides more monetary policy autonomy and flexibility in responding to external shocks, including large and volatile capital flows. - Obstacles to moving away from pegs: - Concerns about losing policy credibility. - Adverse effects of potential appreciation on external balances. - Higher inflation from exchange rate pass-through, especially where technical/institutional capacity is limited and financial markets are under-developed. - Potential losses from currency mismatches when hedging markets/instruments are limited. - Difficulties in assessing the timing and choice of alternative regime. - Conditions for a smooth exit from a peg: - A smooth exit requires accompanying measures to mitigate risks, especially when elements supporting flexibility are not fully in place before the move. - An earlier IMF study concluded that for a successful transition to a floating regime, four “ingredients” were generally needed: - (i) developing a deep and liquid FX market, - (ii) setting up adequate systems to review and manage exchange rate risks, - (iii) formulating coherent intervention policies consistent with the new regime, and - (iv) establishing an appropriate alternative nominal anchor under the new monetary policy framework. - Coordination of the exit strategy with the four ingredients and early development of complementary markets and monetary operations capacity are important. - An effective communication strategy during transition is important. ### Lessons from detailed country experiences (selected findings) - Gradual transitions through increasingly flexible intermediate regimes offer time to prepare and reduce scope for policy reversals; avoiding moral hazard or implicit exchange rate guarantees was essential, with two-way risks reducing one-way bets and destabilizing strategies. - Balance caution with capacity building: premature flexibility can be damaging, but over-emphasis on meeting all preconditions can unduly prolong the move to a float and increase the risk of being forced out by markets at the wrong time; timely and reliable information is crucial in assessing preparedness. - Disorderly exits highlight the premium markets place on a consistent macroeconomic and financial policy mix under increased capital mobility; supportive fiscal policy and a strong financial system with low FX exposure helped reduce risks during transitions. - Coordinating the exit strategy with capital account liberalization may reduce pressure on macroeconomic policies and help avoid disorderly exits; establishing some flexibility prior to liberalization and removing asymmetric capital account restrictions (for example, liberalizing capital outflows) was often beneficial. - Implementing the recommended building blocks of greater exchange rate flexibility early facilitates transition to a floating regime; this process takes time and substantial capacity building. All four ingredients played key roles. - A transparent and effective communication strategy on monetary and exchange rate policies was essential in preparing for greater flexibility and contributing to credibility. - There is no unique sequencing to reach flexibility, but basic elements that were commonly put in place early included: laying the groundwork for an alternative monetary framework, establishing FX markets, and building FX risk management systems; intervention policies tended to be announced at the time of the exit. - Establishing supporting elements can be mutually reinforcing: allowing some exchange rate flexibility often spurred capacity buildup (e.g., gradual widening of bands stimulated FX activity and risk management). - Authorities played a crucial role: central banks initially acted as market-makers in illiquid markets, issued bills for monetary management, introduced hedging instruments, participated in FX derivatives markets, and later limited roles to market participants as markets matured; they also helped build FX risk-management capacity and regulated derivative activities cautiously. - Small degrees of flexibility when several ingredients are lacking may be beneficial (helps build ingredients), whereas too much flexibility without supporting elements can be risky. - Exits under market pressure, lacking preconditions, complicated transitions and stabilization and required intensive capacity-building, especially where public and private sector balance sheets were highly dollarized. - Disorderly exits can still be durable if lack of elements is quickly recognized and addressed with intensive capacity-building; efforts to establish IT preconditions, markets, and risk management supported the operation of floating regimes and contributed to restoring credibility. - Market testing of authorities’ commitment was common; credibility was often established once commitment was tested. Consensus and coordination among key parties, and consistent policies, were important to make tough decisions. *Source: Appendix Figures and Appendix IX text from the supplied content unit.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0901.pdf_