Perspectives and Lessons from Country Experiences with Inflation Targeting, Remarks at a Panel on Inflation Targeting, by Mr. Murilo Portugal, Deputy Managing Director, IMF
IMF News, May 17, 2007
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- Authors: Murilo Portugal Deputy Managing Director
- Published: May 17, 2007
Overview and purpose
- Remarks delivered at a panel on inflation targeting, employment creation, and economic development.
- Focus: address whether inflation targeting is compatible with growth, employment, and poverty reduction; how it can be adapted to take account of employment, competitiveness, and growth; and whether reasonable alternatives exist given increased international integration.
- Empirical base: experience of inflation targeting in emerging market economies over the prior decade.
Spread of inflation targeting
- First adopted by New Zealand in 1990.
- Adopted by 24 countries, of which 16 are emerging market and developing economies.
- Expectation: more emerging market and developing countries likely to move to inflation targeting within the next 10 years.
- Four main factors driving adoption:
- High and unpredictable inflation in the 1970s and 1980s undermined sustainable growth, external competitiveness, and employment.
- Financial innovation weakened the reliability of money and credit aggregates as intermediate targets.
- Greater international integration (goods and financial markets) made flexible exchange rates and a new nominal anchor more attractive.
- Perceived success in industrial countries: credibility, flexibility, better inflation and growth performance, and resilience to shocks, aided by policy transparency.
Empirical experience in emerging market and developing economies
- Comparison of periods: most emerging market and developing countries performed much better in growth and inflation since 2000 than during the 1990s.
- Inflation reductions: inflation targeters typically cut inflation from over 10 percent per annum to around 4 percent—roughly twice the reduction achieved by non-inflation targeters.
- Growth: both targeters and non-targeters enjoyed increases in real GDP growth rates, typically around 2/3 of a percentage point; differences in growth between groups were not statistically significant.
- Targeting practice:
- Neither industrial nor emerging market inflation targeters pursue strict short-term-only inflation targeting.
- Inflation targeters miss their targets far more often—around one-third of the time—and for long enough that strict targeting is not observed in practice.
- Emerging market inflation targeters typically experience lower variability of both growth and inflation than emerging markets with other monetary policy regimes.
- Overall empirical implication: flexible inflation targeting has been associated with substantial reductions in inflation without significant cost in terms of growth.
Flexibility and policy design choices under inflation targeting
- Elements of flexibility that can be adapted to country circumstances:
- Choice of price index (core vs. headline) depending on which better predicts future inflation.
- Numerical value of the target and the width of the tolerance band (wider bands for countries prone to external and supply shocks).
- Horizon for achieving the target, matched to the country-specific lags in the monetary policy transmission mechanism.
- Forward-looking stance: ability to choose which shocks to respond to and over what period, conditional on well-anchored inflation expectations.
- Credibility and expectations:
- The real anchor of the system is the credibility of the central bank's commitment to the inflation target.
- Well-anchored inflation expectations allow lengthening of maturities of fixed-rate instruments and can support long-term financing and growth.
Challenges and problematic issues observed
- Exchange rate versus inflation objective:
- Difficulty for central banks transitioning from exchange rate pegs to subordinating exchange rate and competitiveness concerns to the inflation objective.
- Market testing of central-bank commitment to inflation targeting has occurred in countries such as Chile, Hungary, and Romania.
- Long-term competitiveness is fundamentally a productivity issue; weak exchange rates can provide only temporary competitiveness gains.
- Shifts in investor sentiment and capital flows:
- Inflation targeters are vulnerable to disruptive shifts in investor sentiment affecting exchange markets, growth, and inflation.
- Episodes of strong capital inflows have put upward pressure on exchange rates and led to ballooning current account imbalances or foreign exchange reserves.
- Central banks have sometimes responded with intervention, administrative measures, or restrictions to slow short-term capital inflows.
- Domestic political or fiscal concerns have also triggered turbulence in cases such as Brazil in 2002 and the Philippines; Iceland experienced exchange market pressure linked to large current account imbalances and banking sector vulnerabilities.
- Despite pressures, such episodes have not led to breakdowns of inflation-targeting frameworks; they can strengthen policy credibility if the central bank maintains focus on the inflation objective.
- Limitations:
- Inflation targeting is not a panacea for insulating a country from external financial disturbances or real exchange rate influences on competitiveness; it performs similarly to alternative regimes in this respect.
Preconditions and minimum institutional requirements
- Three minimum requirements for successful adoption:
- Central bank autonomy and associated accountability to pursue a clear mandate, with government support in words and deeds; fiscal discipline contributes significantly to credibility.
- Effective instruments for influencing domestic spending and savings, which generally require functioning financial markets and a reasonably stable financial system.
- Adequate economic and financial data, analytical capacity, and a reasonable understanding of monetary transmission to respond in a timely manner to inflation pressures.
- Trade-offs and adaptability:
- Countries further along in developing these elements prior to adoption are likely to achieve greater credibility and better macroeconomic performance.
- However, successful adoption has occurred across widely differing initial conditions, illustrating the framework's flexibility and adaptability.
Key findings and policy implications
- No medium- to long-term trade-off between low inflation and growth; a credible commitment to low inflation is good for long-term growth.
- Flexible inflation targeting that takes short-term output and employment consequences into account is the prevalent and practical approach.
- Inflation targeting can achieve substantial reductions in inflation without significant growth costs when pursued flexibly.
- Central bank credibility, fiscal discipline, functional financial markets, data and analytical capacity are important enablers.
- Inflation targeting does not eliminate vulnerability to capital-flow volatility or exchange rate pressures; policy responses must weigh temporary vs. persistent effects and consider implications for productive capacity.
Source: Remarks at a Panel on Inflation Targeting by Mr. Murilo Portugal, Deputy Managing Director, International Monetary Fund, Washington D.C., May 17, 2007.