Monetary policy based on inflation targeting is typically associated with industrial countries, such as Canada, New Zealand, Sweden, and the United Kingdom, where the strategy was pioneered in the early 1990s. Today, however, two-thirds of countries that implement inflation targeting are nonindustrial, and that number is likely to double within the next five years. Drawing on the experience of nonindustrial countries since the 1990s, a recent IMF staff paper explores the extent to which inflation targeting has delivered better macroeconomic results than have alternative policy frameworks. It surveys two groups of nonindustrial countries—some with inflation targeting and some without—and compares their macroeconomic performance. It finds that countries adopting inflation targeting regimes have improved their macroeconomic performance—lowering inflation at no cost in terms of growth—both over time and relative to countries with alternative monetary policy regimes.
When industrial countries began adopting inflation targeting frameworks for monetary policy in the 1990s, a common view, including at the IMF, was that inflation targeting was not a suitable strategy for nonindustrial countries because of the institutional and technical requirements necessary for its successful implementation: effective institutional autonomy for the central bank; well-developed analytical capabilities at the central bank, together with the necessary data; largely unregulated and market-determined prices; and a sound financial system with effective transmission mechanisms for monetary policy.
Preconditions for inflation targeting
The IMF study questions the appropriateness of setting such preconditions for two reasons. First, they are important for any monetary policy framework and may be even more so for non-inflation targeting regimes. For example, if a country has a fiscal dominance problem, or its financial system is unsound, an exchange rate peg may be more difficult to sustain than an inflation targeting regime. It is therefore incorrect to assume that, if the various preconditions for inflation targeting are not met, another regime will necessarily perform better.
Second, it is difficult to gauge the extent to which a country meets the conditions necessary for inflation targeting to succeed. In practice, most countries have been able to begin inflation targeting regimes even with significant economic policy deficiencies. An IMF Research Department survey of central banks suggests that improvements in conditions have generally accompanied or followed, rather than preceded, the adoption of inflation targeting. Other empirical evidence indicates that having standard preconditions in place was not more critical to macroeconomic performance in nonindustrial inflation-targeting countries than it was in other nonindustrial countries. This suggests that it may be more appropriate to think of the traditional technical conditions for successful inflation targeting as “co-requisites” rather than as prerequisites for adopting inflation targeting.
That said, nonindustrial countries do generally have more difficulty in achieving their inflation targets, perhaps in part because they have weaker initial conditions. However, performance has tended to improve quickly, which suggests that there are benefits from learning by doing. Although good initial conditions are likely to improve inflation targeting performance, they may be less important for establishing the credibility of an inflation targeting regime and anchoring expectations. More important is a strong commitment by political authorities to support the policy framework and foster the development of the conditions for its success.
Executive Board discusses inflation targeting
At a recent Board seminar, Directors welcomed the study because emerging markets and developing countries are increasingly adopting inflation targeting. Directors agreed that inflation targeting in emerging market economies has been associated with more significant improvements in macroeconomic performance than have alternative monetary frameworks and that countries adopting the regime were able to commit to credible strategies to reduce inflation.
Directors pointed out that important caveats should be considered before drawing conclusions about the potential benefits of inflating targeting relative to those of other regimes—namely, the short experience with inflation targeting; the relatively small sample of countries studied; the difficulty of pinpointing success because of benign global conditions and the general decline of inflation, which have benefited all countries; and a broader shift in country preferences toward price stability.
The technical and institutional conditions needed for inflation targeting may be less stringent than previously believed, Directors noted. They underscored the importance of preconditions for success, particularly the need for central bank autonomy, fiscal consolidation, and adequate financial market development. They highlighted the need for a clear commitment to the inflation targeting framework by both the monetary and fiscal authorities, firm political support, and a consistent fiscal policy. Many Directors cautioned against viewing inflation targeting as a macroeconomic panacea because many countries would still need to overcome substantial operational and capacity constraints.
What might make inflation targeting unsuitable? Five key factors stand out.
Weak feasibility. In some countries, the central bank’s operational capacity may be too weak, or the financial system too underdeveloped, for any independent monetary policy.
External determination of wages and prices. Wages and prices may be almost fully determined by foreign prices and the exchange rate, in which case inflation targeting would not reduce output or inflation volatility better than an exchange rate peg.
High initial inflation. There is little experience with starting inflation targeting in a high-inflation environment, and this may reflect the perception that the risks of missing targets for disinflation would not enhance the credibility of the inflation targeting framework.
Inadequate political support. Without a clear political commitment—to central bank independence and the adoption of fiscal and wage policies consistent with the inflation targets—the credibility of the inflation targets may be severely undermined.
Inability to follow through. Inflation targeting should be adopted only if central banks are prepared to follow through with decisions and actions; in particular, the inflation objective must consistently be their top priority.
Inflation targeting is not a one-size-fits-all framework. The challenges of implementation differ among countries. In nonindustrial countries, challenges include weak public sector financial management, weak financial institutions and markets, low monetary policy credibility, extensive dollarization of financial liabilities, and vulnerability to sharp changes in capital flows and international investor sentiment. Many of these countries also face greater uncertainty about the structure of their economies and the monetary policy transmission mechanism, and data weaknesses may make it more difficult to judge the cyclical position of the economy.
Weak financial institutions and markets alter the relative efficiency and speed of different channels of monetary policy transmission. Extensive dollarization can significantly modify monetary policy transmission, often amplifying the impact of exchange rate movements on activity. In such circumstances, more smoothing of the exchange rate may be appropriate. Prudential measures and other reforms may also be necessary to strengthen financial systems, especially to reduce vulnerabilities to exchange rate changes.
Nonindustrial countries have often adopted inflation targeting as part of a more comprehensive package of economic reforms. Capital account liberalization, together with privatization and new investment opportunities, has led to strong capital inflows in a number of countries, putting significant upward pressure on exchange rates. A commitment to the inflation target may then conflict sharply with pressures to maintain exchange rate stability and external competitiveness. Heavy foreign exchange market intervention or administrative measures have been used to contain exchange rate pressures, but the effectiveness of such measures may be limited and raise doubts about the central bank’s policy priorities. The proper role of foreign exchange market intervention in an inflation targeting framework is not clear-cut, and additional research is needed to develop approaches to intervention that are consistent with inflation targeting.
Data limitations and uncertainty about economic structure and monetary policy transmission may also lead to adjustments in inflation targeting implementation. Ambiguity about the current state of the economy, and how quickly or effectively policy adjustments will be transmitted to inflation, can be reflected in the policy choice and the degree of aggressiveness in adjusting policy settings to prospective inflation developments and risks.
The bottom line
The study shows that the level and volatility of inflation declined more in nonindustrial countries with inflation targeting than in countries without, but not at the cost of weaker or more volatile growth. Both groups of countries experienced similar increases in growth over the 1990s, and inflation targeting countries experienced a slight decline in output volatility. However these results should be interpreted cautiously because correlation does not imply causation. For example, it is difficult to distinguish between the specific impact of inflation targeting and the general impact of more far-reaching concurrent economic reforms.
As more nonindustrial countries adopt inflation targeting, the IMF is likely to experience an even higher demand for technical assistance. Meeting this demand may lead to changes in how assistance is delivered. Methods of IMF surveillance will need to be modified and research on inflation targeting issues stepped up. IMF-supported programs and conditionality may also need to be further adapted. In 2000, the framework for applying conditionality in IMF-supported programs was modified for inflation targeting countries. However, because few countries have used this framework to date, it is difficult to judge its effectiveness. Currently under discussion is whether conditionality could be made more forward looking by focusing on indicators of future inflation.
Nicoletta Batini and Kalpana Kochhar, IMF Research Department
Peter Breuer, IMF Policy Development and Review Department
Scott Roger, IMF Monetary and Financial Systems Department