From Monetary Targeting to Inflation Targeting

1. From Monetary Targeting to Inflation Targeting Abdul Naseer Monetary and Capital Markets Department International Monetary Fund April 14, 2017

2. Context • Motivation • Economies becoming more developed • Somewhat weaker money and inflation correlation • Stronger short-term tradeoffs • Inflation, growth, and exchange rate stabilization • Economic agents and financial institutions are relatively more sophisticated • LIC central banks also want to be modern and copy advanced countries • Evolving process

3. Context (guidance…) • Board Paper • Evolving monetary policy frameworks in low income countries • Working Papers • The Journey to Inflation Targeting: Easier Said than Done The Case for Transitional Arrangements along the Road • TA experience

4. Principles……… A formal adoption of IT requires that: • CB has clear legal mandate and operational independence to pursue price stability as its primary medium-term objective • The CB announces its objective to formally adopt an IT regime • Decision making process is streamlined and responsibilities (within the bank) clarified • Forward-looking monetary policy strategy with clear and effective operational framework • Economic analysis and forecasting capabilities improved • Enhanced effectiveness of monetary operations and use of “policy rate” • Accountability and Transparency practices are strengthened • Clear and effective communication

5. Realities: Multiple objectives and incoherent frameworks • Unclear role of exchange rate • Weak/shallow markets (financial system and interbank) and monetary policy transmission • Operational issues, instruments, collateral • Inconsistent operations • Fiscal dominance (direct or indirect) • Political control of interest rates/exchange rate • Serious liquidity forecasting challenges and opaque liquidity management • Weak analytical and operational capacity—lack of (quality) data • Ineffective and incoherent communications

6. Principles of Effective Monetary Policy Frameworks I Clear mandate, operational independence & accountability V Operational framework and operational target II, III, & IV Primacy of price stability Numerical inflation objective Other objectives VI Forward looking strategy that maps objectives to operations VII Effective communications

7. Mandate, Independence & Accountability (I) • CBs should have a clear mandate + operational independence to pursue this mandate • Given independence and mandate, CBs should be accountable • Political commitment is critical for long term success • Independence sometimes hampered by fiscal dominance and political pressure to keep rates too low or exchange rate fixed/stable • Financial independence – balance sheet

8. Price Stability as Primary Objective (II) • Price stability should be the primary and overriding objective of monetary policy • Multiple, potentially inconsistent, objectives with no clear hierarchy leads to confused frameworks • Output, employment, exchange rate, interest rates and credit growth objectives often given importance along with price stability • Which objective will prevail if they come in conflict? • Which objective will the CB be held accountable for?

9. Adopting a Medium-Term Inflation Objective (III) • A numerical medium-term inflation objective operationalizes the price stability mandate • Establishing an inflation objective should be a priority: • Explicit commitment early on may help… • may wish to strengthen capacity before committing

10. OtherObjectives: Output and Financial Stability (IV) • CBs have flexibility regarding the magnitude and pace of policy adjustments warranted by the inflation objective to consider impact on output and market volatility • Credibly establishing the primacy of price stability gives CBs more room to take other objectives into account

11. The Operational Framework (V) Operations should ensure…that banks can place surplus liquidity with, and obtain short-term funding from…each other or the central bank…at rates that are reasonably stable and predictable. • A short-term interest rate should be the operating target • Operations should align interbank market rates with policy rate and minimize volatility • Reserve money as operating target warranted in case of fiscal dominance and lack of operational independence

12. Policy Formulation and Strategy (VI) • CBs should have a forward-looking strategy • Full assessment of the economic outlook and monetary transmission mechanism • Changing role of exchange rate and monetary aggregates as capacity develops and understanding of transmission deepens:

13. Communications (VII) • CBs should have clear and effective communications • CBs should: • Explain past outcomes and deviations from target • Explain actions necessary to bring expected inflation in line with objective • Emphasize the variables that matter for private sector behavior • Target a wide range of stakeholders • Helps anchor expectations when words are confirmed by actions and outcomes

14. The challenge • Transition from (strict) monetary targeting to a more flexible forward looking framework without risking undesirable outcomes • Liquidity management framework that (i) supports market development, (ii) improves policy transmission and (iii) is consistent with overall policy framework • Maintain nominal anchor and policy discipline • Underlying assumption: targeting inflation (But not necessarily IT)

15. Two-Pillar Framework • An appropriate framework is anywhere on continuum from adherence to a money rule to formal IT. • The framework should: • Retain a role for money • Include elements of forward-looking analysis • Include operating procedures that enhance interest rate transmission • The options depend on: • Conformity with best practices for effective monetary policy • Status of the transmission channels.

16. Building blocks: General considerations • Institutional • Legal framework for the central bank • The 3 pillars of modern central bank governance • Macro-financial • Ensure macroeconomic stability: coordination of monetary, fiscal, and foreign exchange policy • Promote financial stability: critical for an effective interest rate channel of transmission • Technical and organizational • Under the direct control of the central bank… • … but capacity building can be a long term exercise

17. Building Blocks for Effective Monetary Policy

18. Policy Regimes A continuum… … from strict adherence to monetary targets… … to formal inflation targets where money is a residual (i.e., inflation targeting)

19. Background • Most central banks are targeting inflation • Almost all CBs have price stability as one of their primary objectives • In parallel, central bank independence has been strengthened • CB independence improved significantly over the past 2 decades • A bumpy Journey to Inflation Targeting for “frontier countries” • Frontier countries: countries with shallow/ less developed financial markets; weak analytical capacity; weak enabling macro and financial environment • Aspirations: achieve an inflation objective with: (i) forward-looking approach to policy making; (ii) interest-rate focused operating procedures • Balancing exercise: mitigate risks of undesirable outcomes from rigid reliance on money targets; avoid premature shift to interest rates as the operating target of monetary policy • Case for Transitional Monetary Arrangements along the road

20. A multi-dimensional process • A multi-dimensional process… • One trajectory does not fits all: need for a conceptual framework to guide the modernization process • Benchmarking: a set of best practices for effective monetary policy • Mapping exercise:mapping options and conformity with best practices • …with multiple stakeholders, going beyond the central bank • Central bank plays a catalytic role… • …but several issues lie outside its direct responsibility: consensus in society at large/Parliament on monetary policy objective(s); supportive fiscal policy; sound financial sector; timely and high-frequency data series to support monetary analysis

21. Choosing a monetary framework • Instrument & targets: (i) aligned with strength of transmission channels; (ii) supporting the transmission channels • Level of development of financial markets: rely on monetary frameworks “friendly” to monetary policy transmission • Clarity on the role assigned to key macroeconomic variables • Monetary aggregates: what is the information content of money? • Exchange rate: flexibility for independent monetary policy • Interest rates: monetary policy is essentially about setting the appropriate level of interest rates • Effective communication: critical (not sufficient) to anchor expectation – In transitioning countries, communication to raise financial literacy of the public at large – Build consensus on role of monetary policy

22. Monetary Versus Inflation Targeting Orthodox textbook view Monetary Targeting • Controlling the quantity of liquidity and credit in the short run and over the medium term • Public communication and commitment opaque or non-existing Inflation Targeting • Commitment to keeping inflation on target over the medium term • Communication, transparency, and commitment are key • Operations, in practice, focused on interest rates

23. Monetary Versus Inflation Targeting 2In practice • All are targeting Inflation, but all are not IT • Intermediate Target derived from numerical Inflation Target • Also for MT in LICs, and often published • Operational Target: Short term interest rates • Advanced country MTs, but not LIC MTs

24. The Question (and solution) • Choice of Objective • Price stability • Target inflation and publish target, but not necessarily IT • Role of Interest Rate Rules, Money Aggregates, and Modeling in Policy Formulation • Yes all of the above, and it depends!! • Role of Interest Rates and Money Aggregates in Operations • Interest rates as target for short term liquidity management • Focus of Communication and Commitment • Interest rates and inflation (target), not monetary aggregates • Clarity, Relevance, and Consistency of Policy Actions and Signals essential

25. Regimes and Targets, cont. FX FMT EMPA IT

26. The solution • Fix short term liquidity management • Goal: stabilize and steer short term interest rates • Consistency with rest of the framework • Improve financial system’s health and develop interbank market • Also need to develop capital and government bond market • This will provide needed collateral for interbank and CB operations • Improve policy communications and commitment • Clarity on price stability as the objective • Target inflation, and publish target, but maybe not formal IT (yet) • Commitments not credible if not achievable and in the long run achieved (Non-credible commitment worse than no commitment) • Risk of premature adoption of formal IT • Consistency of actions and communications: • Do as you say—say as you do • Improve modeling, and monetary and economic analysis to better guide the setting of the policy stance

27. Short-term Liquidity Management Goal: stabilizing short term interest rates • Also for countries that rely on monetary aggregates for policy guidance • Key to strengthening the transmission mechanism • Price signals better understood • Lower interest rate volatility help: • Anchoring the yield curve • Fostering security market development • Strengthen transmission along the yield curve to retail rates • Focus operations on Excess Reserves and Short-Term Market Interest Rates

28. Interest Rate Corridors and Policy Rate Systems • Policy rate range - pure corridor systems • Full access standing facilities—hard ceiling/floor • Point policy rate systems • Target (explicit or implicit), not an instrument • Commitment to steer interbank rates to the target • Mid-corridor systems • Flexible-rate fixed-quantity auctions • Fixed-at-policy-rate full allotment auctions • Floor systems • CB deposit facility rate the floor and policy rate

29. Width of the Corridor? • Narrow • Less volatility • Clearer signal • Easier to price securities • Less incentives for interbank trading • Too wide • Volatility • Unclear signal • Less trading – reserve hoarding

30. Reserve averaging to Reduce Volatility(2–week, 1–month or longer?) • Inter-temporal arbitrage—encourage interbank trading • Less need for frequent OMO interventions • But: Need to anchor expectations for the end-of-maintenance-period interest rate • Fine-tuning OMOs on settlement day • Mid-week position of settlement day • MPC meetings at beginning of period • Align maturity of OMO instruments

31. Instruments Keep it simple • Structural operations • To address structural shortages or excess liquidity • Infrequent. Longer-term CB or government securities • Fine-tuning • Short term CB instruments • Repos, SWAPS • At policy rate, full allotment if liquidity forecasting is weak • Alternative to floor with more incentive for trading • Quantity- price-feedback from market ? • Variable rate, fixed quantity if liquidity forecasting is strong • Price feedback from market • Min/Max offering to signal commitment to trade at policy rate

32. Money and Interest Rates Targeting both? Feasible? How? Horizon and degree of target softness?

33. Relevance of Monetary Targeting (MT) • Conventional monetary targeting • Broad monetary program (BMP) • Reserve money program (RMP) • MT remains relevant when CB faces severe constraints • Lack of clarity on objectives of monetary policy • No clear separation between fiscal & monetary policy • High political pressures to keep interest rates low or exchange rate stable • Low level of financial intermediation • Limited analytical & statistical capacity at CB

34. Flexible Monetary Targeting and bridging short-and long-term liquidity management • Reserve Money Program as Policy Guide • Longer-term operational target that constrain liquidity operations • Daily target: total reserves (and interest rates) • Policy rate range/corridor • What to do when rates are at the floor or ceiling? • Adjust corridor? Or revise RM target and program assumptions? • Broad Money as Policy Guide • No reserve money target • Interest rate focused operations • Point policy rate • Mid-corridor • Floor or full allotment systems • What to do when money growth differ from target? • Adjust policy rate? Or revise broad money program assumptions?

35. Flexible Monetary Targeting • Quantities as Operating Target • Reducing volatility by: • Setting the reserve money targets over a pre-specified (e.g., quarterly) period, on average terms, and possibly within a band • Deriving a path for total reserves that are consistent with the longer-term reserve money target • use it as the operating target. • Combine with corridor?

36. Enhancing the Analytical Capacity and Toolkit • Start early—never ending endeavor • Invest in data • Work with, and advocate on behalf of, statistical office • Multiple tools • Near term forecasting • Medium term policy analysis models • Tailored to country circumstances • Multiple indicators • Forward looking information in monetary aggregates? • The exchange rate as a leading indicator? • Adapt and update as circumstances changes

37. Communications • Tailored • Transparency requires consistency • Do as you say, if not…. • Don’t say before you are ready • Clear communication requires • Clarity on objective • Coherent framework • Analytical capacity to tell the story

38. To announce or not? Early announcement of reforms (incl. IT) can: • Build consensus and facilitate reforms • If followed up • Create resistance that makes complicates reforms • Do first and talk later? Or talk first and do later? Early announcement of changes in framework can: • Enhance anchoring of expectations and improvements to transmission • If delivered on • If not: undermined credibility, unanchored expectations and weakened transmission

39. Pace (Jump or not to Jump?) • Depends!! • Initial conditions, capacity and consensus (building Blocks !!!) • Intermediate transitional regimes • IT lite • Flexible money targeting • Money as intermediate target, interest rates as operating target, Inflation as objective • Two-pillar approaches-Enhanced Monetary Policy Analysis • Money as intermediate target/information variable • Policy analysis based on multiple approaches (money aggregates and policy models)

40. Transitional Frameworks

41. A Stylized Reform Agenda Money guides policy and operations The exchange rate guides policy and operations Multiple and sometimes inconsistent objectives Develop analytical tools for policy making Increase exchange rate flexibility Establish a coherent interest rate based operation framework to enhance monetary policy transmission Combine Monetary and Economic Analysis Inflation forecast Cross checking role of monetary analysis Single objective Price Stability Flexible exchange rate Intervention strategy aimed at supporting market functioning Interest rate based operating framework Operations align market rates with the policy rate

42. THANKS………….