Inflation Targeting in Emerging Market Economies

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Inflation Targeting in Emerging Market Economies

• Arminio Fraga
• Ilan Goldfajn
• André Minella
• Preliminary Version
• April 2003
• Comments are Welcome

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1. Introduction

• Motivation
• Inflation targeting (IT) is doing well in
  general, although a bit less so in emerging
  market economies (EMEs)
• Paper looks at EMEs and asks what have we learned
• In a way, our experience in Brazil can be seen as
  a stress test of IT!

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Inflation Before and After the Adoption of
Inflation Targeting
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Main issues

• EMEs seem to face a lot of shocks, large shocks
• Some of them may be endogenous due to weak
  institutions, historical problems, etc.
• We discuss mainly how to manage monetary policy
  when confronted with shocks. Other policy
  recommendations are implicit or briefly discussed
• Key issue credibility versus flexibility
• We discuss the role of a communication strategy,
  of bands, horizons, etc.

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2. Stylized facts about inflation targeting in EME

• Higher volatility of inflation, GDP growth,
  interest rate and exchange rate
• Higher inflation level

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Comparison of volatilities
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Trade-off Volatilities
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3. Model

• Macro model for simulation
• Small open economy
• Combines features of Batini, Harrison, and
  Millards (2001), and McCallum and Nelsons
  (2001) formulations
• Derived from the intertemporal optimization of
  households and firms
• Price rigidity

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4. Why is volatility higher?

• Credibility building and disinflationary needs
• Dominance issues financial and fiscal
• Larger shocks

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4.1. Credibility building and disinflationary
needs

• Both cases appear in the old macro literature
  adaptive expectations and inertia (or
  persistence)
• IT is an attempt to accelerate the process of
  building credibility

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Inflation before IT adoption
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Inflation Target Averages
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Brazilian case Central Banks reaction function
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Brazilian case Aggregate supply curve
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4.2. Dominance issues

• General central bank will/may inflate
• Fiscal dominance
• Financial dominance
• External dominance (sub-investment grade)

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4.3. Shocks and sudden stops

• Exchange rate volatiliy
• Importance as shock factor

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5. How to deal with higher volatility

• Answer good communications and a high degree of
  transparency

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5.1. Target bands, horizons and core

• In a perfect world bands/horizons have no role
  central bank responds optimally given exact size
  and nature of shock, parameters of the economy,
  and preferences concerning inflation
• So, what, if any, is their role?
• Bands signalling/check point (focus on point
  target)
• Horizon seems arbitrary
• Core no really good measure, confusing
• Calendar year issues

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5.2. Monetary policy committees, meeting minutes,
and inflation reports

• Existence of a monetary policy committee (MPC)
• Timely publication of detailed minutes of MPC
  meetings
• Quarterly Inflation Report

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5.3. Shocks and adjusted targets the case of
Brazil

• Methodology
• Compute shocks (supply shocks) - include future
  path
• Accommodate direct impact, i.e., announce an
  adjusted or intermediate target (path)
• The chosen path will be a function of parameters
  of the economy (e.g., inertia) and inflation
  aversion

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Brazil Adjusted target 2003
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5.4. IT and IMF programs

• Net domestic assets (NDA) or monetary aggregates
  targeting makes little sense
• Forward-looking quarterly targets with
  consultation bands was the solution we found

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6. Conclusions

• To deal with this more volatile environment, we
  recommend
• High degree of transparency and a good
  communications strategy
• A methodology to calculate the convergence path
  following a shock (adjusted targets)
• Better IMF conditionality under inflation
  targeting