FRBSF Economic Letter
2001-01 | January 12, 2001
Economists are often accused of not agreeing with each other. Believe it or not, the 1990s may have produced an exception. Beginning with New Zealand in 1989, a growing number of countries have adopted a so-called “inflation-targeting” approach to monetary policy (e.g., Great Britain, Canada, Australia, and Sweden). Although debates about the precise definition of inflation targeting quickly begin to sound like medieval scholasticism, the basic idea is that a central bank adopts (or is assigned) an explicit numerical target range for inflation, and makes achievement of this target its primary objective. This doesn’t mean the central bank ignores unemployment or the rate of economic growth. As long as inflation remains within the stated range, the central bank is free (and indeed expected) to stabilize the economy. However, if at some point inflation threatens to break out of the permissible range, then the central bank must make the inflation target its overriding objective.
Although inflation targeting has yet to be recession-tested, economists do agree that at least so far it has been quite successful. Inflation targeting countries have experienced low and stable inflation rates, with no apparent sacrifice in the growth or stability of the economy. (New Zealand stumbled a bit following the Asian financial crises, but this is attributed to their unwillingness to let the exchange rate depreciate enough, rather than to inflation targeting per se.) For once economists agree on something!
Now, nothing breeds imitation like success, and the apparent success of inflation targeting has attracted the attention of many developing countries. The currency crises of the 1990s caused many of these countries to lose faith in fixed exchange rates as a means to control inflation. Unfortunately, it is not enough simply to say that you are now going to adopt a flexible exchange rate policy. Flexible exchange rates are consistent with a vast array of alternative monetary policies, and market participants need to have some idea about what this policy is in order to provide an anchor for their price level expectations. Historically, the anchor most often proposed was to have the central bank target the growth rate of the money supply. Experience suggests, however, that this is a poor target during periods of financial market development and innovation, because such changes make the demand for money unstable, thereby weakening the link between monetary policy and the economy. These conditions are likely to prevail in many developing countries. So, as a result of the disillusionment with fixed exchange rates and the skepticism about money growth targeting, many developing countries are seriously considering adopting an inflation-targeting regime. In fact, Brazil, Chile, and Thailand have already done so.
This Economic Letter evaluates the prospects for the successful implementation of inflation targeting in developing countries. I argue that if inflation targeting is to be successful, it is essential to recognize and account for the structural differences between the economies of developed and developing countries. Although the defining distinction between the two groups is in terms of per capita income, I argue that for the purposes of monetary policy the key differences are in terms of: (i) openness, (ii) policy credibility, and (iii) financial fragility.
It is important to realize that while inflation targeting gives the central bank a goal, it doesn’t tell the central bank how to achieve it. Indeed, this is regarded as an advantage of inflation targeting, as it allows the central bank to adapt its operating procedures to changing conditions. However, it does raise the question of what is the best way to actually hit an inflation target while, at the same time, balancing other objectives.
Most formal analyses of this question are in terms of rules for setting a short-term nominal interest rate (e.g., the federal funds rate) in response to changes in inflation and output, the most popular rule being the so-called Taylor Rule. Taylor’s Rule says that the central bank should raise interest rates when inflation and output rise above their target levels, with the inflation response being somewhat greater than the output response. Conversely, when inflation or output falls below its target, the central bank should cut interest rates.
Although most studies conclude that Taylor’s Rule is reliable—and robust to a host of real world uncertainties—these studies are potentially misleading when applied to developing countries. This is because Taylor’s Rule ignores the exchange rate, and the exchange rate is especially important in developing countries due to their reliance on international trade.
Extensions of Taylor’s Rule to incorporate exchange rates have been carried out by Ball (1999) and Svensson (2000). From the perspective of inflation targeting, exchange rates influence the economy in two principal ways. First, and most directly, the exchange rate affects the price of imported goods and, therefore, the inflation rate. Second, the exchange rate affects the competitiveness of domestic goods on world markets and, hence, the level of aggregate demand in the economy. Aggregate demand in turn affects inflation through the so-called “Phillips Curve.” Empirical evidence suggests that the first effect operates pretty quickly, i.e., within a few months, since it only requires prices to adjust. In contrast, the second effect operates with a substantial lag, since it involves buyers and sellers finding new customers and sources of supply.
Ball and Svensson show that this lag discrepancy can produce poor results if the central bank is too diligent about hitting the inflation target. Because the import price effect operates quickly, by frequently adjusting the exchange rate the central bank can be quite successful at hitting the inflation target. Unfortunately, these frequent exchange rate adjustments tend to produce a “whiplash” effect on the rest of the economy, since they will produce subsequent output responses. Hence, targeting inflation too closely in open economies can produce instability in growth and unemployment.
To avoid this whiplash effect, Ball and Svensson show that the standard Taylor Rule needs to be modified in two ways. First, rather than simply targeting the inflation rate, central banks in open economies should target something like a “long-run” inflation rate, which removes any temporary effects of the exchange rate. For example, if the currency is regarded as being temporarily strong and likely to depreciate in the future, then the target inflation rate should leave room for this by being lower than it otherwise would be. Adjusting the target in this way prevents the central bank from overreacting to the temporarily low inflation rate caused by the temporarily strong currency. Second, rather than just use a short-term nominal interest rate as a policy instrument, central banks in open economies should recognize the fact that, via asset arbitrage, interest rate changes produce exchange rate changes that amplify the economy’s response to interest rates. For example, raising interest rates lowers output and inflation by depressing the level of spending in the economy. However, in open economies it also appreciates the exchange rate, which further reduces output and inflation by depressing net exports and lowering the price of imports. To account for these additional effects, Ball and Svensson propose the use of a “Monetary Conditions Index,” which consists of an average of the current interest rate and exchange rate.
Policymakers in all countries are concerned about their credibility. A policy that would be beneficial if the public believed it would last could actually turn out to be counterproductive if it were thought to be temporary. Temporary policies tend to produce intertemporal arbitrage opportunities, which then trigger hoarding, capital flight, and other speculative activities. Such speculation can be quite destabilizing.
While credibility is an issue for all countries, it is especially important in developing countries. Almost by definition, many of these countries have a history of economic and political instability, which has produced a legacy of mistrust and suspicion. This makes the task of establishing and maintaining credibility especially difficult for policymakers in developing countries.
The importance of credibility to the success of inflation targeting in developing countries has been discussed by Masson, Savastano, and Sharma (1997), and analyzed more formally by Kumhof (2000). Masson, et al., point out that central banks in many developing countries are in a position of “fiscal dominance.” Due to weak tax systems and underdeveloped capital markets, governments in developing countries must often finance a significant share of their expenditures by printing money. When this is the case, the exigencies of the budget take precedence over the control of inflation. Clearly, in a situation like this, inflation targeting is not a credible policy.
Kumhof (2000) studies what happens when the public (correctly) believes that inflation targeting will not last. He shows that when it is costly to change prices, so that prices are “sticky,” inflation targeting will produce an excessively tight monetary policy. Because the policy is viewed as temporary, domestic firms will not incur the costs of adjusting their prices in line with the newly stated inflation target. As a result, most of the burden of hitting the target will fall on import prices, via the exchange rate channel. As noted earlier, this tends to produce a destabilizing whiplash effect on the rest of the economy. In fact, Kumhof comes to the provocative conclusion that a noncredible inflation-targeting regime is even worse than a noncredible exchange rate peg!
One of the lessons to emerge from recent currency crises is the role of “balance sheet effects” in determining the outcome of a devaluation. Devaluations that would otherwise be expansionary (because they enhance competitiveness) can quickly become contractionary if domestic firms have large unhedged foreign currency exposures. When this is the case, a devaluation erodes the net worth of firms. If financial market imperfections make internal finance cheaper than external finance, this decline in net worth forces firms to cut back investment, which then further depresses asset prices and net worth.
Like credibility, this so-called “financial accelerator” is of concern to all countries, since it is widely regarded as a source of business cycle amplification. However, it is of special concern to developing countries. Underdeveloped financial markets make internal finance constraints especially important in developing countries. At the same time, relatively weak financial supervision and regulation often provide incentives to incur foreign currency liabilities, since foreign interest rates are typically lower. This combination makes developing countries vulnerable to exchange rate changes.
Devereux and Lane (2000) study inflation targeting when domestic firms borrow abroad while facing collateral constraints. Not surprisingly, they find that balance sheet effects greatly amplify the economy’s response to external shocks. They also conclude that balance sheet effects diminish the attractiveness of inflation targeting relative to exchange rate targeting, although inflation targeting does remain preferable on net. These findings suggest that countries contemplating a move toward inflation targeting should also take steps to improve the functioning of their financial markets.
In principle, there is no reason why inflation targeting cannot work in developing countries. However, inflation targeting is not a “one-size-fits-all” policy. Inflation targeting rules that work well in the U.S. are not likely to work well in Thailand or Korea. Developing countries need to be aware of three key differences. First, the exchange rate is an additional monetary policy transmission channel, which tends to operate rather quickly; and unless both the instruments and targets of monetary policy are modified, inflation targeting in developing countries could produce destabilizing output fluctuations. Second, inflation targeting won’t be credible, and hence desirable, if the government must rely on the inflation tax to finance its expenditures. This means that for many countries inflation targeting needs to be accompanied by fiscal reforms. Finally, inflation targeting will likely involve larger swings in the exchange rate than many of these countries are used to. If inadequate regulation and other financial market imperfections create incentives to incur unhedged foreign currency liabilities, these exchange rate changes could be destabilizing. For many developing countries, this means that inflation targeting must also be accompanied by financial market reforms.
Ball, Laurence. 1999. “Policy Rules for Open Economies.” In Monetary Policy Rules, ed. John Taylor. Chicago: University of Chicago Press.
Devereux, Michael B., and Philip R. Lane. 2000. “Exchange Rates and Monetary Policy in Emerging Market Economies.” Working Paper. Department of Economics, University of British Columbia.
Kumhof, Michael. 2000. “Inflation Targeting under Imperfect Credibility.” Working Paper. Department of Economics, Stanford University.
Masson, Paul, Miguel Savastano, and Sunil Sharma. 1997. “The Scope for Inflation Targeting in Developing Countries.” Working Paper No. 130. International Monetary Fund.
Svensson, Lars E. O. 2000. “Open-Economy Inflation Targeting.” Journal of International Economics 50, pp. 155-183.
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