WORKSHOP ON MONETARY FRAMEWORKS
Setting Inflation Target Remains an Effective Tool
By Mark Horton, Anna Bordon, and Alina Luca
IMF Middle East and Central Asia Department
and Douglas Laxton
IMF Research Department
May 31, 2011
- Central bankers discuss experiences with inflation-forecast targeting
- Participating countries face serious post-crisis challenges, fragile recovery
- Change in mindset, clear communications, better analytical tools are required
Adopting an inflation-forecast targeting regime can help reduce economic uncertainty and the severity of boom-and-bust cycles—two benefits that were borne out in several countries during the recent crisis and the subsequent rise in food and fuel prices, economists said at a seminar in Armenia.
But for this method to succeed, policymakers must change their mindset and embrace flexible exchange rates, communicate more clearly, and strengthen their analytical tools.
These were some of the key conclusions of central bankers and other policymakers from emerging Europe, Central Asia, and the Caucasus as they gathered in late April to share their experiences with inflation-forecast targeting. The eight-day workshop—held in Yerevan and Tshakhkadzor, Armenia—was jointly organized by the International Monetary Fund, the European Bank for Reconstruction and Development, and the Central Bank of Armenia.
As with traditional inflation targeting, a central bank using inflation-forecast targeting adopts a formal, public target for the inflation rate and then attempts to steer actual inflation toward the target through the use of interest rate changes and other monetary instruments.
However, this type of targeting involves greater degree of transparency and communication of monetary policy decisions, centered on publication of a forecast for inflation and interest rates (or assumptions underpinning the forecast). At times, the inflation forecast may represent an intermediate target that the central bank aims to bring back to the formal target over time.
Other hallmarks of the regime—which evolved from traditional inflation targeting—are public discussion of the forecasts, communicating the reasons for missed targets, and explaining how policy will act to return inflation to the target in the future.
Central banks in emerging Europe, Central Asia and the Caucasus face difficult challenges. The recovery is fragile, some economies are highly dollarized, financial sectors remain underdeveloped and in some cases impaired from the crisis, and fiscal space is limited. The region has been confronted by volatile capital flows and a large increase in food and fuel prices—a phenomenon that is strongly felt by consumers in these countries, who spend a large proportion of their income on food.
These challenges—particularly the emerging threat of inflation—provided the impetus for the conference.
Conference organizers Douglas Laxton of the IMF’s Research Department, Mark Horton of the IMF’s Middle East and Central Asia Department, and Ashot Mkrtchyan of the Central Bank of Armenia noted that, where flexible inflation-forecast targeting has been applied seriously, it has been beneficial in keeping inflation down and anchoring longer-term inflation expectations. (In such circumstances, long-run market views on inflation are not sensitive to the daily news, a sign that the public has confidence that the central bank will keep inflation under control over time.)
Countries that have adopted inflation-forecast targeting chose it in most cases because previous monetary policy frameworks had failed to maintain low and stable inflation. In those countries, price stability has become accepted as the best contribution that monetary policy can make to improving the performance of the economy. Greater transparency, integral to inflation-forecast targeting, was also seen as fully consistent with ongoing moves toward good governance.
Three basic elements
Andy Berg of the IMF’s Research Department described the three key elements of inflation-forecast targeting: a quantitative inflation target, an inflation forecast that plays a central role in decision-making, and transparency and accountability. Central bankers must have clear objectives and sufficient capacity and independence to provide these key elements, he stressed.
Most countries that adopt inflation-forecast targeting do not have all these elements in place at the outset, but in almost all cases, their modeling and forecasting capability, transparency and policy communication, and exchange rate flexibility have improved over time.
Successful inflation-forecast targeting also requires a change in mindset—policymakers must accept the notion that achieving low inflation is the primary objective of monetary policy (while minimizing the variability of movements in the real economy in the course of achieving and maintaining the target rate of inflation), that central bank instrument independence is of paramount importance, and that fiscal policy concerns cannot dominate monetary policy choices.
Range of experiences
New adopters of inflation-forecast targeting are benefiting from the success of the pioneers. The Czech Republic was the first transition country to introduce it in 1997. Zdeněk Tůma, a former Czech National Bank Governor, explained that this new regime was challenging at first because of the disruptions of frequent shocks and volatile capital flows.
Júlia Király of the Bank of Hungary recounted her country’s early experience, noting that the regime was not consistent with the exchange rate band Hungary had in place during 2001-08. The band prevented necessary currency appreciation—a key channel for disinflation (a slowing of the rate of inflation). This, combined with difficulty in assessing the cyclical position of the economy and large household currency mismatches, limited the authorities’ ability to bring inflation down and anchor long-term inflation expectations.
Bojan Markovic reviewed challenges faced by the Bank of Serbia, including a highly euroized economy (that is, the euro is widely used for transactions and savings) and high food and headline inflation volatility. In such circumstances, he said, a strong and rapid policy response in response to shocks is needed to anchor inflation expectations. Also, macro-prudential policy instruments are useful in complementing conventional monetary policy instruments, and if applied carefully, can improve the effectiveness and credibility of inflation-forecast targeting regimes.
The Central Bank of Armenia’s Nerses Yeritsyan described the host country’s 2006 shift to implicit inflation-forecast targeting (in other words, targeting a certain level of inflation but not announcing the level publicly) as targeting of the money supply became less and less reliable. The authorities faced a number of challenges—high dollarization; relatively weak linkages between changes in the central bank’s policy interest rate and changes in other interest rates, in economic activity, and in the rate of inflation; shallow financial markets; and a difficult fiscal situation.
After some success, they are now aiming at full-fledged inflation-forecast targeting with reforms to better control liquidity and to improve communications, as well as introducing indexed bonds, and moving decisively away from smoothing the exchange rate to anchoring inflation expectations through a more comprehensive application of inflation-forecast targeting.
Change in mindset needed
Zdeněk Tůma noted that inflation-forecast targeting requires a change in mindset, as the central bank must adopt a flexible exchange rate regime. Central banks should also get over their fear of not hitting near-term targets and accept the fact that targets will sometimes be missed.
But it is crucial that they continually explain publicly how policy will act to return inflation to the target in the future, and publish the new inflation and policy interest rate forecasts consistent with inflation returning to target. It is equally important for central banks to abandon the view that less communication is better (common when the exchange rate is fixed) and move toward more open communication, which will help align expectations with policy objectives.
The bottom line is that inflation-forecast targeting is as much about missing the targets over the short term as hitting them, and policymakers should not feel compelled to do “whatever it takes” to meet targets on a period-by-period basis. This attitude could be very costly and counterproductive for the both economy and for the central bank’s credibility.
According to Tůma, inflation-forecast targeting puts an end to “real-time attention” on the exchange rate and replaces it with painstaking analysis of the economy. The switch enables decision-making under uncertainty. Policy moves away from responding to every market movement to reacting to expected movements in economic variables, relying on a model that forecasts inflation paths with internally consistent and time-consistent updates of interest rate trajectories.
Guy Meredith, a former Bank of Canada and IMF official, noted that countries that adopt such a regime need to learn to live with exchange rate volatility. While not ignoring movements of the exchange rate, responses under inflation-forecast targeting should also not unduly limit them. Policymakers could also implement strategies to weaken incentives to build up excessive foreign exchange exposures.
On the question of whether exchange rate volatility should be resisted more in dollarized economies, Archil Mestvirishivili of the National Bank of Georgia pointed out that exchange rate volatility can help reduce dollarization over time by educating the public about the risks of foreign exchange holdings and borrowing.
Communication is crucial
Inflation-forecast targeting requires greater transparency through various forms of communication. Central banks need to communicate that they cannot—and are not trying to—determine the inflation rate over the short run. Rather, they are focusing on taking policy actions to return the rate of inflation to its target over the medium run following shocks to the economy and thereby anchoring long-term inflation expectations.
Former Bank of Canada official Jack Selody explained that communications generally improve over time, as central banks repeatedly explain how their monetary policy actions will bring inflation back to target along a forecast path and as they educate the market about the implications of uncertainty.
Selody also highlighted a major difficulty of inflation-forecast targeting: striking the right balance between flexibility and credibility. Flexibility in achieving the inflation objective (for example, a gradual return to the target following a shock) may well enhance credibility, but flexibility that temporarily abandons the target in favor of other objectives will be costly in terms of lost credibility.
In the early stages of inflation-forecast targeting, foregoing flexibility (in the sense of returning inflation to its target more quickly than might otherwise be optimal) may help earn credibility. Good communication of the reasons for, the benefits of, and the limits to flexibility is central to maintaining credibility.
Modeling and forecasting staff from 14 central banks in the region stayed on for a week of training in the analytical tools needed to support full-fledged inflation-forecast targeting frameworks.
From left: Zdeněk Tůma, Tibor Hledik, and Tomas Holub of the Czech Republic listen to a speaker at the conference (photo: Lusine Khachatryan)