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This volume is based on the proceedings of a conference co organised by the OECD Economics Department and the Bank of England’s Centre for Central Bank Studies on monetary policymaking in inflation targeting emerging market economies (see Seminar on Monetary Policy in Emerging Markets ). The conference, held at the OECD Headquarters in Paris on 28 February 2007, brought together central bank officials from three OECD member countries (Czech Republic, Mexico and Turkey) and four non member countries (Brazil, Chile, Indonesia and South Africa).
The volume contains a cross-country chapter that focuses on Latin America. The experiences of Brazil, Chile, Czech Republic, Indonesia, South Africa and Turkey are discussed in separate case studies.
The cross country analysis and the case studies highlight a rich array of experiences with inflation targeting (IT). In all countries under examination, fully fledged IT was adopted at different points in time over the last ten years or so as the underlying framework for the conduct of monetary policy. The economic circumstances under which IT was put in place vary considerably among these countries, but a few common lessons and policy challenges can be highlighted. The main conclusions that have emerged from the conference are:
IT was implemented in virtually all countries under examination after the collapse of exchange rate pegs or the abandonment of alternative nominal anchors, such as monetary targeting. The need to put in place a monetary regime to both guide policymakers when setting monetary policy and to anchor inflation expectations was particularly important in countries that had used managed exchange rates to break inflationary inertia following long periods of high inflation. This is the case of Brazil and Turkey, for example. Experience with monetary targeting in environments of unstable money demand also prompted countries, such as Indonesia, for example, to adopt IT. Another consideration is the search for a credible monetary regime in countries where efforts towards disinflation needed to be complemented by policy initiatives to liberalise prices in the course of structural reform. This is the case of the Czech Republic, for example.
Different, looser forms of IT were experimented with prior to, and often in preparation for, the adoption of fully fledged IT. For example, Chile only abandoned exchange rate targeting in 1999, having put in place a looser form of IT, including by granting the central bank operational autonomy and announcing explicit inflation targets, in the early 1990s. Turkey combined monetary targeting with the announcement of inflation targets until 2006, when the money base targets were abolished. Brazil, however, adopted IT in June 1999, soon after the collapse of the exchange rate peg in January of the same year, but did not rely on an intermediate nominal anchor during the transition period.
IT was adopted in all countries under examination, even though many of the standard preconditions associated with this policy framework had not been fulfilled. There is now broad agreement that for IT to be effective, not only do formal targets need to be set and announced, but the central bank also needs to develop its internal modelling and forecasting capabilities, in addition to putting in place vehicles for formal reporting of monetary policy decisions and communications with the public. Nevertheless, most central banks examined in the case studies lacked adequate analytical tools, such as a structural model of the economy, and surveys of market expectations when IT was adopted. In others, it has often been argued that inflation was too high, as in Turkey, and fiscal imbalances too large, as in Brazil, for monetary policy to be conducted effectively under IT. The case studies suggest that, by and large, these deficiencies have not undermined the implementation of IT where policy efforts have been focused on addressing them. An emphasis on the need to build credibility from the outset called for considerable emphasis in the early days of IT on upgrading internal analytical capabilities in most countries and on strengthening reporting and communications tools.
Fiscal and financial dominance are among the main obstacles to successful IT in many emerging market economies. The main policy challenge brought about by fiscal dominance is that monetary policy is constrained by its effect on public finances, especially when the debt dynamics is considered unsustainable. The experiences of Brazil and Turkey are particularly interesting in this regard. Both countries went through periods of fiscal retrenchment as the cornerstones of macroeconomic adjustment and disinflation. Concern about the sustainability of the public debt often resulted in confidence crises, as in the case of Brazil in 2002, which called for decisive action by the monetary authorities. The case of Indonesia is also illustrative of the challenges posed by substantial capital inflows in the course of disinflation. In any case, when monetary policy is constrained, or perceived to be constrained, by its expected effect on public finances and/or capital flows, the central bank’s commitment to – and capacity to act in pursuit of – the inflation target is compromised.
Supply side considerations also pose challenges for IT in emerging market economies. The option for accommodating the first round effects of adverse supply shocks in a volatile economic environment, while reacting to the second round effects of these shocks, may affect inflation expectations and undermine the monetary authorities’ efforts to build credibility in the policy regime. Structural reform also often creates one off inflation shocks that need to be dealt with by the central bank. This is the case of changes in price setting that are related to overall economic liberalisation following central planning, as in the case of the Czech Republic, for example. It is also the case of supply bottlenecks and distribution hurdles in Indonesia. These considerations have a direct bearing on the definition of the inflation index to be targeted, including the option of selecting core/trimmed, rather than headline, inflation. This issue has nevertheless not yet been resolved in some countries. The targeted inflation indices have also changed over time in some countries, including the Czech Republic and Indonesia, for example.
IT appears to be working well, despite general agreement that there are options for improving the policy framework and addressing upcoming challenges in most countries. It is not easy to ascertain the extent to which changes in macroeconomic performance are due to adoption of IT alone. In some cases, the time span for empirical analysis is too short for reliable inference to be made. In others, implementation of IT was part and parcel of broader structural reform, which affects the economy at large, and the monetary transmission and price setting mechanisms in particular, in ways that go beyond the conduct of monetary policy. The nature of the shocks hitting the economy also changes over time, reflecting global economic and financial conditions that are beyond the control of policymakers in individual countries. But, all in all, there is fairly compelling evidence for some countries under examination that inflation has become less volatile and persistent in the post IT period, interest rates have become less volatile and inflation expectations more responsive to monetary policy moves.
How to obtain this publication
The complete text of edition of Monetary policies and inflation targeting in emerging economies is available from:
Further information can be obtained from the Brazil, South America and Indonesia Desk at the OECD Economics Department at [email protected]