Inflation Targeting at 20: Achievements and Challenges

1. Inflation Targeting at 20:Achievements and Challenges By Scott Roger IMF Prepared for the 6th Norges Bank Monetary Policy Conference Oslo, 11-12 June 2009

2. Overview • Since start of IT in 1989, 29 countries adopting IT. Currently 26 IT countries of which 11 high income and 15 emerging market and developing countries • Topics: • IT frameworks • Macroeconomic performance under IT • Issues and challenges facing IT

3. Inflation Targeting Frameworks Main elements: • Policy mandates • Policy accountability • Inflation targets • Policy formulation

4. Inflation Targeting Frameworks Policy mandates • Instrument autonomy, not goal autonomy • Target specification usually set jointly or by central bank Accountability • Corollary of instrument autonomy, but also reinforces it • Standard mechanisms for providing accountability • Increasingly forward-looking approach—emphasis on transparency of policy process and decision making

5. Inflation Targeting Frameworks Target specifications • CPI 12 month rate as target • Range or point target with bands • Centered on 2 to 3 percent • Bands typically +/- 1 percentage point; ranges 2 percentage points • Target horizons 1 to 2 years • Monitoring & reporting of a range of core inflation measures: CPI ex; trimmed means; median

6. Inflation Targeting Frameworks Policy formulation • Flexible IT • Forecast-based, but significant differences in capability; Standard New Keynesian models • Differences in treatment of exchange rate • Differences in implementation/operational frameworks—preference for market-based over rules-based instruments, but some countries actively using both.

7. Performance under IT Focus on three aspects of performance: • Performance in achieving inflation targets • Macroeconomic performance compared with alternative frameworks • Resilience of framework in face of 2007-09 global commodity price and financial shocks

8. During disinflation: For high income countries, average outcome close to target, but target range missed 60% of time; For low income countries, average outcome 2.3% above target, target range missed 67% of time; Inflation outcomes during disinflation 1. Performance in achieving inflation targets

9. During stable inflation: For high income countries, average outcome a little above target above target; miss target range 47% of the time For low income countries, average outcome a little above target; miss target ranges 36% of time Inflation outcomes during stable inflation 1. Performance in achieving inflation targets

10. 1. Performance in achieving inflation targets Assessment: • Misses of target ranges very common—may undermine usefulness of ranges • Harder to control inflation during disinflation • Countries with weaker conditions may be too ambitious on pace of disinflation • Countries might use wider bands during disinflation (+/- 2 to 2.5), narrowing during stable IT (+/- 1.25 to 1.5) • Supply shocks an important factor in misses by low income countries

11. 1991-00 vs. 2001-08 based on median adoption of IT in low income countries Low income IT improvement greater than non-IT: growth gain of 0.7%; inflation down 5.8% High income IT: inflation unchanged, small growth gain Inflation and growth rates: 2001-08 vs. 1991-00 2. Performance of IT compared to alternative frameworks

12. Low income IT experienced bigger declines in both inflation & growth than non-IT countries High income IT experienced smaller reductions in both inflation & output volatility Inflation and growth volatility 2001-08 vs. 1991-00 2. Performance of IT compared to alternative frameworks

13. During stable inflation: For high income countries, average outcome a little above target above target; miss target range 47% of the time For low income countries, average outcome a little above target; miss target ranges 36% of time Inflation outcomes during stable inflation 1. Performance in achieving inflation targets

14. 2. Performance of IT compared to alternative frameworks Econometric analyses based on differences in differences, controlling for external factors: • IMF (2005), Mishkin & Schmidt-Hebbel (2005); Vega & Winkelried (2005) • Differences mainly in terms of selection of comparators • Findings: • IT associated with significant reduction in inflation and inflation volatility relative to non-IT, at least for non-industrial countries • No trade-off of inflation or inflation volatility vs. output: shift of efficiency frontier, not a movement along it

15. Commodity price shock: Low income IT countries experienced less increase in inflation than in non-IT countries (2.3% vs. 4.7), but only slightly bigger fall in growth (-1.6% vs. -1.3%) High income IT have lower inflation rise (1.9%) but bigger growth decline (-2.8%) Need to disentangle from financial crisis & other factors Inflation and growth rates, 2006-08 3. Resilience to 2007-09 global commodity price and financial shocks

16. Financial shock: Several IT countries amongst hardest hit by crisis (Iceland, CEE countries), but not clear that IT made economies more vulnerable, or effects worse Deterioration in CDS spreads less for IT emerging markets, suggesting markets see less risk of crisis in these countries CDS spreads, 2007-09 3. Resilience to 2007-09 global commodity price and financial shocks

17. Consensus forecasts vs. 2001-08 averages: Growth expected to fall less in low income IT countries than in non-IT (-3.7% vs. -4.8%), and inflation to fall by slightly more (-2% vs. -1.7%) Growth in high income IT countries expected to fall by 3.4%, and inflation by 1%, relative relative to 2001-08 averages Growth and inflation: 2009-10 forecasts vs. 2001-08 performance 3. Resilience to 2007-09 global commodity price and financial shocks

18. Issues & Challenges • Conditions for IT • Adapting IT to emerging market and developing countries • Role of the exchange rate in IT • IT and financial stability • Price path targeting

19. Issues & Challenges Conditions for IT & adapting IT to emerging markets & developing countries • Conditions fewer, but significant challenges: • Fiscal dominance • Weak credibility • Dollarization • Data weaknesses • Limited human capital • Limited financial market development • Communications issues • Cultural issues

20. Issues & Challenges Role of the exchange rate in IT • Important issue in emerging markets & developing countries • Conventional wisdom: exchange rate should not be a target in its own right because: • Exchange rate taken into account indirectly through effects on inflation & output • Appropriate response to exchange rate movements depends on cause, so policy should avoid automatic responses

21. Issues & Challenges • More recent analysis more equivocal: • With high dollarization, limited access to international capital markets, exchange rate can have perverse balance sheet effects which may justify leaning against the wind (Cespedes & others (2004), Moron & Winkelried (2005), Roger & others (2009)) • Policy rule including exchange rate may be more robust to incorrect specification of model of exchange rate determination (Wolmershauser (2006)

22. Issues & Challenges IT and financial stability • Mixed views on benefits of reacting directly to financial indicators: • Arguments analogous to including exchange rate in policy reaction function—react indirectly to implications for output & inflation • But most models do not adequately capture macro-financial interaction • Extending policy horizon: How good are forecasts? • Overburdening monetary policy: Should we focus on other policy instruments?

23. Takk!