SETTING INFLATION TARGET REMAINS AN EFFECTIVE TOOL
International Monetary Fund
May 31 2011
By Mark Horton, Anna Bordon, and Alina Luca, IMF Middle East and
Central Asia Department and Douglas Laxton, IMF Research Department
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.
Difficult times
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 Lazarian 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. ZdenÄ~[k 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
ZdenÄ~[k 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.