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Inflation Targeting at 20: Achievements and Challenges

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This paper provides an overview of inflation targeting frameworks and macroeconomic performance under inflation targeting. Inflation targeting frameworks are generally quite similar across countries, and a broad consensus has developed in favor of "flexible" inflation targeting. The evidence shows that, although inflation target ranges are missed frequently in most countries, the inflation and growth performance under inflation targeting compares very favorably with performance under alternative frameworks. Inflation targeters also tentatively appear to be coping better with the commodity price and financial shocks in 2007-2009 than non-inflation targeters. Key issues going forward include adapting inflation targeting to emerging market and developing countries, and incorporating financial stability issues into the framework.
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WP/09/236


Inflation Targeting at 20:
Achievements and Challenges
Scott Roger


© 2009 International Monetary Fund
WP/09/236




IMF Working Paper


MCM


Inflation Targeting at 20: Achievements and Challenges


Prepared by Scott Roger

Authorized for distribution by Karl Habermeier

October 2009

Abstract

This paper provides an overview of inflation targeting frameworks and macroeconomic
performance under inflation targeting. Inflation targeting frameworks are generally quite similar
across countries, and a broad consensus has developed in favor of “flexible” inflation targeting.
The evidence shows that, although inflation target ranges are missed frequently in most
countries, the inflation and growth performance under inflation targeting compares very
favorably with performance under alternative frameworks. Inflation targeters also tentatively
appear to be coping better with the commodity price and financial shocks in 2007-2009 than
non-inflation targeters. Key issues going forward include adapting inflation targeting to
emerging market and developing countries, and incorporating financial stability issues into the
framework.

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.



JEL Classification Numbers: E31, E52

Keywords: inflation targeting, monetary policy

Author’s E-Mail Address: sroger@imf.org


2

Contents
Page
I. Introduction ............................................................................................................................3
II. The Shift Toward Inflation Targeting ...................................................................................4
III. Elements of Inflation Targeting Frameworks ......................................................................7
A. Central Bank Mandates.............................................................................................8
B. Policy Accountability and Transparency ..................................................................8
C. Inflation Targets ......................................................................................................12
D. Policy Formulation and Implementation.................................................................13
IV. Performance Under Inflation Targeting.............................................................................14
A. Performance in Achieving Inflation Targets...........................................................14
B. Macroeconomic Performance under Alternative Monetary Policy Regimes..........17
C. Resilience of Inflation Targeting.............................................................................20
V. Issues and Challenges for Inflation Targeting ....................................................................23
A. Adapting Inflation Targeting to Emerging Market and Developing Countries ......23
B. Inflation Targeting and Financial Stability .............................................................25



3
I. INTRODUCTION 1, 2
1. Inflation targeting (IT) was first adopted in the early 1990s by industrial countries,
but is being adopted by a growing number of emerging market and developing countries. As
of mid-2009, 26 countries are classified as inflation targeters, including 11 high income
countries and 15 lower income emerging market and developing countries. This paper
provides a review of the experience with IT, together with an overview of some issues and
challenges facing its future.
2. Section II briefly documents the spread of IT and, especially, the increasing
dominance of emerging market and developing country inflation targeters; a trend that is
expected to continue.
3. Section III begins with an overview of the major elements of IT frameworks,
including: (i) the specification of the inflation target and the handling of policy trade-offs; (ii)
governance and decision-making frameworks; and (iii) communications and accountability
arrangements. Broadly speaking, the analysis finds that a fairly standard model of IT has
emerged. IT specifications are generally quite similar—perhaps too much so—and a broad
consensus has developed in favor of “flexible” IT, which takes not only inflation but also
output considerations into account in policy formulation. Policy accountability and
communications arrangements also appear to be converging on an increasingly transparent
model.
4. Section IV reviews macroeconomic performance under IT, focusing on three main
issues: (i) how well countries have done in meeting their inflation targets; (ii) whether IT has
tended to deliver better macroeconomic performance than alternative policy frameworks; and
(iii) whether IT has delivered better macroeconomic results than alternative frameworks in
response to the global commodity price and financial shocks. The results indicate that IT
ranges are missed frequently in most countries, but especially in countries that are in the
process of disinflation. Tentative evidence also indicates that inflation targeters have coped
better with the commodity price and financial shocks in 2007-2009 than non-inflation
targeters.
5. Section V concludes with a discussion of issues and challenges in IT. These include
challenges in adapting IT to emerging market and developing countries and more effectively
incorporating financial stability issues into IT frameworks.

1 An earlier version of this paper was presented at the Norges Bank 2009 Monetary Policy Conference
“Inflation Targeting Twenty Years On,” 11–12 June 2009, Oslo, Norway. I am grateful to conference
participants, as well as IMF colleagues, for useful comments and suggestions. Remaining errors and omissions
are my own.
2 I would like to thank Claudia Jadrijevic Zenteno for excellent research assistance.

4
II. THE SHIFT TOWARD INFLATION TARGETING
6. Since New Zealand adopted IT in 1989, twenty-nine countries have introduced
IT frameworks
(Table 1).3,4 In addition, several other central banks, including the European
Central Bank (ECB), the Swiss National Bank, and the Federal Reserve in the United States,
have moved toward regimes that have many of the attributes of IT. Through the 1990s, IT
was almost entirely confined to advanced “industrial” countries. Since the late 1990s,
however, an increasing number of emerging market and developing economies have adopted
the framework and such countries are now the substantial majority of inflation targeters.
7. The spread of IT has often been spurred by exchange rate crises. As shown in
Figure 1, exchange rate pegs of various kinds accounted for two-thirds of monetary policy
regimes in industrial countries in 1989.5 The ERM crisis in 1992 served as a spur to the
adoption of IT in Europe. Among emerging market economies, the shift toward IT has been a
more gradual process. In Latin America, movement toward IT began in the early 1990s, but
full-fledged IT was adopted only in the late 1990s and early 2000s, following the 1998
financial crisis. In Europe, the transition economies of Central and Eastern Europe began
introducing IT in the late 1990s as part of their comprehensive economic reforms, while in
East Asia, IT began to be adopted in the early 2000s, as countries emerged from monetary
targeting under Fund-supported programs following the 1997 Asian financial crisis. At least
until the global financial crisis erupted, IT was expected to continue to spread among
emerging markets and developing economies.6 The outlook for the spread of IT now seems
likely to depend very much on how well the framework is perceived to have coped with the
oil price shock and the subsequent global financial shock.

3 New Zealand passed the legislation for IT in late 1989, with implementation from the beginning of 1990.
4 Finland and Spain ceased IT when they entered the euro area in January 1999, and Slovakia ceased IT in
January 2009 with its ERM II entry.
5 To facilitate comparisons over time, the figures include separately the various republics of the former Soviet
Union and Yugoslavia, which became independent during the 1990s. In the pre-independence period each of the
constituent republics is treated as having the same monetary policy as the federation. This avoids having the
break-up of the federations affecting the relative proportions of different policy regimes. The establishment of
the euro zone is shown as a shift by ERM countries to from exchange rate targeting to a multiple targets
framework.
6 IMF discussions with member states in 2006 suggested that the number of inflation targeters in developing
and emerging market economies was likely to increase four-fold over the next decade, consistent with the
estimate by Husain, Mody, and Rogoff (2005) that the number of countries with exchange rate pegs may almost
halve in the next 10-15 years.

5

Figure 1. Evolution of Monetary Policy Regimes, 1989-2008
Industrial Countries
Non-industrial Countries
100
100
100
100
80
80
80
80
60
Inflation targets
60
60
60
Monetary targets
Inflation Targets
40
40
40
40
Monetary targets
Managed floats & Multiple
targets
Managed floats & Multiple targets
20
Exchange rate targets
20
20
20
Exchange rate targets
0
0
0
0
1989
1993
1997
2001
2005
1989
1993
1997
2001
2005
Source: IMF.

8. In most countries adopting IT, there has been an initial phase of disinflation.
This phase has typically involved setting year-by-year targets for reducing inflation.
Disinflation has typically begun from a level of about 4.8 percent among high income
countries, and from 6.5 percent in low income countries.7 Once inflation has been brought
down, the regime shifts to targeting stable, multi period, or indefinite horizon targets,
typically around 3 percent. In about one-third of cases, however, stable inflation targets were
adopted at the outset.

7 High and low income country groups are based on the World Development Indicators classification of the
World Bank.

6

Table 1: Adoption of Inflation Targeting

Country Effective
IT
CPI inflation
Disinflation
CPI inflation
Stable IT period
adoption date
rate at start
period
rate at start
of
of stable
disinflation
targeting
New Zealand1
1990Q1 3.3
1990Q1-1992Q4
1.8
1993Q1-present
Canada1
1991M2 6.9
1991M2-1994M12
0.2
1995M1-present
United Kingdom1
1992M10

4.0
1992M10-present
Sweden1
1993M1

1.8
1993M1-present
Finland1
1993M2

2.6
1993M2-1998M12
Australia1
1993M4

2.0
1993Q2-present
Spain1
1995M1 4.2
1995M1-1997M12

1998M1-1998M12
Czech Republic1
1997M12 6.8
1997M12-2001M12
4.1
2002M1-present
Israel1
1997M6 8.1
1997M6-2002M12
6.5
2003M1-present
Poland2
1998M10 10.6
1998M10-2003M12
1.7
2004M1-present
Brazil2
1999M6 3.3
1999M6-2005M12
5.7
2006M1-present
Chile2
1999M9 3.2
1999M9-2000M12
4.5
2001M1-present
Colombia2
1999M9 9.3
1999M9-present


South Africa2
2000M2

2.6
2000M2-present
Thailand2
2000M5

0.8
2000M5-present
Korea1
2001M1

2.8
2001M1-present
Mexico2
2001M1 9.0
2001M1-2002M12
5.7
2003M1-present
Iceland1
2001M3 4.1
2001M3-2003M12
2.7
2004M1-present
Norway1
2001M3

3.6
2001M3-present
Hungary1
2001M6 10.8
2001M6-2006M12
6.5
2007M1-present
Peru2
2002M1

-0.1
2002M1-present
Philippines2
2002M1 4.5
2002M1-present
1.8

Guatemala2
2005M1 9.2
2005M1-present
0.2

Slovakia1
2005M1
5.8
2005M1-2008M12

IT concluded in
2008M12
Indonesia2
2005M7 7.4
2005M7-present

Romania2
2005M8 9.3
2005M8-present

Turkey2
2006M1 7.7
2006M1-present

Serbia2
2006M9 10.8
2006M9-present

Ghana2
2007M5 10.5
2007M5-present

All countries

5.7

3.1

14 High income1
4.8

3.2

15 Low income1
6.5

3.0

Source: Author’s calculations.
1/ High income countries, based on World Bank Development Indicators classification; 2/ Low income countries, based on
World Bank Development Indicators classification.



7
III. ELEMENTS OF INFLATION TARGETING FRAMEWORKS 8
9. The emergence of IT frameworks draws on a number of insights gained from
theory and practical experience.
9 On a practical level, the decision to pursue inflation
targets directly has often resulted from the failure of indirect approaches, based on either
monetary or exchange rate targeting, to yield acceptable results.10 Both theory and experience
also point towards some basic guiding principles for a monetary policy framework. These
include: (i) the central bank cannot consistently pursue and achieve multiple goals with only
one basic instrument—the policy interest rate; (ii) over the long-term, monetary policy can
control nominal but not real variables; (iii) high inflation harms growth and the equitable
distribution of income; and (iv) expectations and credibility matter greatly for the
effectiveness of monetary policy and the potential short-term trade-offs between inflation and
other macroeconomic objectives.
10. These insights pointed towards a policy framework in which monetary policy is
assigned a clear and credible objective of achieving and maintaining low inflation.
In
addition, and drawing upon developments in the principal-agent literature, the framework
recognized that policy credibility would be enhanced by strengthening the operational
autonomy of the central bank, while at the same time ensuring a high degree of policy
transparency and accountability.
11. From the outset, IT frameworks have included the following basic elements: 11

An explicit central bank mandate to pursue price stability as the primary objective of
monetary policy, together with accountability for performance in achieving the
objective;

A high degree of transparency of monetary policy strategy and implementation;

Explicit quantitative targets for inflation; and

8 This section draws on Heenan and others (2006).
9 A revealing review of the development of the original IT framework in New Zealand is provided by Reddell
(1999).
10 In the case of monetary targets, instability in money demand relationships—commonly associated with
financial system reforms and opening of capital markets—undermined the usefulness of monetary aggregates as
policy guides. In the case of exchange rate pegs, real exchange rate targets provided no nominal anchor, while
nominal exchange rate pegs left both prices and activity vulnerable to shocks affecting equilibrium real
exchange rates.
11 See also Mishkin (2004).

8

Policy actions based on a forward-looking assessment of inflation pressures, taking
into account a wide array of information.
A. Central Bank Mandates
12. The objective of price stability is frequently embedded in central bank
legislation and the target specification.
However, legislated goals often do not clearly
define price stability as the primary objective of monetary policy (Table 2). Consequently,
the specification of the inflation target plays a particularly important role in defining the IT
mandate. In most countries, target specifications are established jointly between the central
bank and the government, but even in countries where one or the other has sole authority to
specify the target, close consultation is the norm.
13. IT central banks typically have a high degree of instrument or operational
autonomy.
In several emerging market economies, revisions to central bank acts have
explicitly ruled out the provision of credit to the government, eliminated government vetoes
over policy decisions, and strengthened measures to insulate central bank policy decision-
makers from potential pressures from the government.
14. Even where there are limits on instrument autonomy, these do not appear to be
binding in practice
. As indicated in Table 2, in many countries where IT has been
implemented successfully, instrument autonomy is, in principle, potentially constrained by
the potential for central bank financing of government, government powers to override the
central bank’s instrument-setting decisions, or direct participation by government officials in
monetary policy decision-making. This underscores that de jure autonomy matters less than
de facto autonomy. In this regard, a strong government commitment to the inflation-targeting
framework is crucial.
B. Policy Accountability and Transparency
15. Central bank accountability for performance in relation to the inflation target is
a natural corollary of autonomy in policy implementation, and helps to reinforce such
autonomy.
Having to account for inflation performance provides strong incentives for the
central bank to focus on meeting its targets and to communicate its decisions and actions
transparently. The need to explain policy decisions to the public also serves as a powerful
internal discipline on the central bank’s approach to policy analysis and decision-making.
Public accountability also provides an incentive for the central bank to resist external
pressures to let factors outside its remit unduly influence policy. From this perspective, high
standards of policy accountability help the central bank to maximize its autonomy to pursue
its mandate, while minimizing its incentives to be distracted by other considerations.



9

Table 2. Central Bank Autonomy

Country Goal
Autonomy Target
Instrument Autonomy
Autonomy

Target
Government
Credit to
Gov’t Participation in
Legislated Goal
Specification 1/
Override 2/
Government 3/
Policymaking 4/
Australia
Multiple goals
G+CB
Yes
Yes
Voting member
Brazil Inflation
target
G
No
No
No
Canada
Multiple goals
G+CB
Yes
Yes, limited
Non-voting
Chile Price
+
financial
CB Yes No Non-voting 5
stability
Colombia
Price stability
CB
Yes
No
Voting member
Czech
Price stability
G+CB
No
No
Non-voting
Republic
Ghana
Price stability
G+CB
No
Yes, limited
Voting member
Guatemala
Price stability
CB
No
No
Voting member
Hungary Price
stability G+CB
No
No
Non-voting
Iceland Price
stability G+CB No
No
No
Indonesia Currency
stability
G+CB
No
No
No
Israel Price
stability
G
No
No
No
Korea Price
stability
G+CB No
Yes
Non-voting
Mexico Price
stability CB
No
Yes
Non-voting
New Zealand
Price stability G+CB
Yes
Yes
No
Norway
Low, stable inflation
G
Yes
No
No
Peru
Monetary stability
CB
No
No
Voting member
Philippines
Price stability
G+CB
No
Yes, limited
Voting member
Poland Price
stability CB
No
No
Non-voting
Romania Price
stability G+CB
No
No
No
Serbia
Low, stable inflation
G+CB
No
Yes, limited
Non-voting
Slovakia Price
stability CB
No
No
No
South Africa
Currency stability G+CB
Yes
Yes
No
Sweden Price
stability CB
No
No
Non-voting
Thailand Monetary
stability
CB
No
Yes
No
Turkey Price
Stability G+CB No
No
Non-voting
United
Price stability
G
Yes
No
Non-voting
Kingdom
Notes and Sources: 1/ G = Government; CB = Central Bank; 2/ Roger and Stone (2005), Table 3; 3/ Tuladhar (2005),
Table 6; 4/ Tuladhar (2005), Table 3; 5/ Finance Minister may delay implementation of decisions for two weeks.


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