Public Information Notice No. 06/40

Public Information Notice: IMF Executive Board Discusses Inflation Targeting and the IMF

April 18, 2006

On February 17, 2006, the Executive Board of the International Monetary Fund (IMF) held a seminar to discuss the experience with inflation targeting in non-industrialized member countries. The Executive Board's discussion was focused on the staff paper Inflation Targeting and the IMF.

Background

Inflation targeting is being adopted in a growing number of emerging market and developing countries. The staff paper presents evidence indicating that inflation targeting has generally been associated with positive macroeconomic performance in non-industrial countries, even when institutional and operational arrangements were not well-developed until after the introduction of inflation targeting. The evidence thus helps to explain the growing popularity of inflation targeting in non-industrialized countries seeking an alternative nominal anchor to a fixed exchange rate or monetary targeting. The paper also considers the scope for adapting inflation targeting to particular circumstances of non-industrial countries, but also recognizes that there are countries where, for structural, institutional, or operational reasons, inflation targeting may be unsuitable as a monetary policy framework in the foreseeable future. The staff paper also considers the implications for the Fund in the areas of surveillance, technical assistance and the design of monetary conditionality under Fund-supported programs.

Executive Board Assessment

Executive Directors welcomed today's paper and seminar discussion on inflation targeting, which they considered timely in view of the increasing interest in this approach among emerging market and developing countries, and its important implications for many areas of the Fund's work. Directors had a wide-ranging exchange of views on the various aspects of the inflation targeting approach, especially as they relate to the Fund's work.

The staff paper suggests that inflation targeting in emerging market economies has been associated with more significant improvements in macroeconomic performance compared with alternative monetary policy frameworks. The paper also notes that the benefits from inflation targeting have accrued partly because countries adopting the regime were able to commit to a credible strategy to reduce inflation. In considering these findings, Directors noted that some important caveats should be borne in mind in drawing conclusions about the potential benefits of inflation targeting relative to other regimes. In particular, and as indicated in the staff paper, they pointed to the short experience with inflation targeting and the relatively small sample of countries studied. Further, while acknowledging that all countries had benefited from benign global conditions and the accompanying general decline in inflation during the period under study, some Directors observed that the success of inflation targeting may be difficult to discern in these circumstances. A number of Directors also pointed to possible self-selection in the sample, and considered that this success may reflect a broader shift in country preferences toward price stability, as, in many cases, inflation targeting coincided with a range of reforms consistent with a shift in preference towards greater macroeconomic stability. A few Directors also questioned the sample classification used to categorize countries under the various regimes. For these reasons, Directors agreed with staff that it is difficult to infer causality from inflation targeting to the observed outcomes, and that the evidence outlined in the paper should be seen as suggestive rather than definitive.

Directors noted the staff's finding that the positive experience in emerging market countries suggests that the technical and institutional conditions needed for inflation targeting may be less stringent than previously believed, and less important than developing capabilities following adoption of inflation targeting. Some Directors agreed that these conditions are important for successful implementation of any monetary policy regime. While seeing some scope for the necessary conditions to be developed after a country adopts inflation targeting, and for a somewhat less mechanical view on the preconditions for inflation targeting, Directors, nevertheless, generally underscored that a number of preconditions remain important for success. In particular, they stressed the need for institutional autonomy of the central bank, fiscal consolidation, and adequate financial market development. Directors also highlighted the need for establishing a clear ex ante commitment to the inflation targeting framework, by both the monetary and fiscal authorities. In this vein, Directors noted the importance of firm political support and a consistent fiscal policy. Effective communication and outreach of policy intentions were also seen as essential. The views that Directors have offered on the country-specific factors that might affect the success of inflation targeting will help sharpen our thinking on these issues.

At the same time, adoption of inflation targeting should not be seen as a macroeconomic panacea, and substantial operational and capacity constraints would need to be overcome in many of the countries contemplating adoption of inflation targeting, a point noted by many. Moreover, in some countries, capacity constraints and other structural features of their economies might make inflation targeting unsuitable for the foreseeable future. More generally, Directors considered that, while the inflation targeting framework can offer significant benefits for a number of countries, it should be recognized that it may not be appropriate in all cases. Rather, Fund advice to member countries on the choice of the appropriate monetary policy framework—and associated exchange rate policy—should be provided on a case-by-case basis, taking into account the costs and benefits pertinent to each country and country-specific determinants of the inflation process.

Directors saw a key role for the Fund in helping countries to develop or strengthen their capacity to conduct effective monetary policy generally. In this context, Fund training courses and technical assistance (TA) programs will need to be adapted to assist an increasing number of members with preparing or strengthening their capacity to implement inflation targeting. Some Directors suggested that Fund TA should give priority to advice on how to improve policy credibility and establish a commitment to stability, with less focus on sophisticated modeling. In this regard, Directors advised that demands for such assistance be assessed relative to other TA priorities, in the context of existing budget constraints, and drawing on the guidance provided by the recent Independent Evaluation Office recommendations on the provision of TA. It was also suggested that such support should focus on countries deemed best placed to meeting the prerequisites for inflation targeting in a fairly short period of time. Several Directors emphasized the importance of ensuring that Fund surveillance be enhanced to address the needs of countries pursuing inflation targeting, including by further developing related analytical capabilities.

Directors expressed interest in further research on issues that are particularly relevant to the conduct of inflation targeting in emerging market and developing countries. There was a sense that the issues of most importance at present are those relating to inflation targeting in dollarized economies and relatively underdeveloped financial systems, as well as to foreign exchange market intervention and the role of the exchange rate more generally in inflation targeting frameworks. Some Directors reiterated the need to take into account budget constraints, and other priorities within the Fund's research program.

Conditionality in Fund-supported programs with members that are inflation targeting has been tailored in a pragmatic, country-specific manner. Directors have noted that outcomes have been positive but, as the experience so far is limited, a broader consideration of the policy should await further experience. A few Directors recognized that countries may decide to begin inflation targeting at differing stages of institutional development, and that therefore there may be a need for a firmer approach to program design and conditionality in some cases, particularly with members that have yet to establish monetary policy credibility. A number of other Directors, however, considered that a more flexible approach may be warranted. Several others held the view that, under credible inflation targeting regimes, monetary conditionality—when needed—should be limited to supporting the inflation target. Some Directors considered that, by shifting the focus of program monitoring in inflation targeting countries from monetary aggregates to macro-critical structural weaknesses, including by focusing on the need to develop technical infrastructure and sound banking systems, the problem of overburdening the inflation targeting framework with multiple objectives would be attenuated. Some Directors also saw merit in exploring in future programs whether Fund conditionality might be aligned better with the forward-looking character of inflation targeting, although, as the paper notes, this approach raises some difficult technical issues.

Directors have made many thoughtful points and suggestions relating to the use of inflation targeting, and staff will take these into consideration in carrying forward our analytical work and policy advice in this area.