Does inflation targeting live up to all the hype?

Comment on “Indian Monetary Policy in the Time of Inflation Targeting and Demonetization”

[Author Affiliation]Chi-Young Choi, cychoi@uta.eduYoung Se Kim[Acknowledgment]The authors are grateful to coeditor Kent Kimbrough and two anonymous referees for constructive comments that helped to improve this article. The authors also wish to thank Steve Cecchetti, Kang Liu, Shin-Ichi Nishiyama, Margie Tieslau, Taka Tsuruga, and the seminar participants at the Academia Sinica, National Chung Cheng University, National Sun Yat-Sen University, National Taiwan University, Texas Tech University, and the University of Texas at Arlington for helpful comments and Vikas Kakkar for providing CPI data for Hong Kong. Any remaining errors are the authors'.1. IntroductionVariability in relative prices is known to be a major channel through which inflation can induce welfare costs by impeding an efficient allocation of resources in the economy. Consequently, substantial effort has been devoted in the literature to examining the link between relative price variability (RPV) and aggregate inflation. Although much of the existing theoretical and empirical literature points to a positive monotonic relationship, newer contributions suggest that the relationship between inflation and RPV is more complicated, particularly in terms of its sensitivity to the inflation regime.1The primary purpose of this study is to investigate whether the connection between inflation and RPV is influenced in an important way by the monetary policy framework chosen by a central bank. Specifically, this article focuses on exploring whether the adoption of an inflation targeting (IT) framework exerts any significant impact on RPV as measured by the standard deviations of sectoral inflation rates relative to the aggregate rate. Since it was first implemented in New Zealand more than two decades ago, the popularity of IT has spread, with some twenty-five countries worldwide implementing the framework to date (Freedman and Laxton 2009). The literature is now replete with studies pointing to reductions in both the level and the volatility of inflation in countries that have adopted IT (e.g., Mishkin and Schmidt-Hebbel 2007).2 While studies of the impact of IT on aggregate inflation performance are plentiful, little attention has been paid to the impact of IT on RPV.The question of whether and indeed how IT affects RPV is an important one for several reasons. First, exploring the potential connection between IT and RPV is a worthwhile exercise given the popularity of IT as a monetary framework and the centrality of RPV to the current generation of macromodels. The importance of RPV is recognized in standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models, where the variance of relative prices is viewed as a useful summary statistic. As noted by Amano, Ambler, and Rebei (2007), for example, in DSGE models, the optimal rate of target inflation and the optimal variability of inflation relative to output depend on the quantitative effects of price dispersion on macroeconomic equilibrium. Second, answering the question helps us identify the driving force behind the change in RPV, distinguishing between IT adoption itself and its subsequent impact on inflation. If the relationship is monotonically positive, as is often believed in the literature, one should expect that IT adoption would bring about a decline in RPV in the same way as it has led to a decline in inflation. If the relationship is more complex, however, the effect of IT adoption on reducing RPV may hinge on the change in inflation regimes after IT adoption. Third, our answer to the question also sheds additional light on the empirical evidence for the relative effectiveness of IT across different stages of development. While there is strong evidence that developing countries benefit more from IT than industrial countries in combating inflation and its volatility (e.g., Petursson 2004; Lin and Ye 2009), we are aware of no empirical research that has assessed this issue with respect to RPV. …

Comment

The author examines changes in monetary policy in industrial countries by evaluating, and providing case studies of monetary targeting, and inflation targeting. Inflation targeting has successfully controlled inflation, with some qualifications. It weakens the effects of inflationary shocks, as examples from Canada, Sweden, and the United Kingdom show. It can promote growth, and does not lead to increased fluctuations in output. But inflation targets do not necessarily reduce the cost of reducing inflation. The key to success of inflation targeting, is its stress on transparency, and communication with the public. Inflation targeting increases accountability, which helps ameliorate the time-inconsistency trap (in which the central bank tries to expand output, and employment in the short run, by pursuing overly expansionary monetary policy). Time-inconsistency is more likely to come from political pressures on the central bank, to engage in overly expansionary monetary policy. A key advantage of inflation targeting, is that it helps focus the political debate on what a central bank can do in the long run (control inflation) rather than what it cannot do (raise economic growth, and the number of jobs permanently through expansionary monetary policy). By increasing transparency, and accountability, inflation targeting helps promote central bank independence. Accountability to the general public seems to work as well as direct accountability to the government. Inflation targeting is consistent with democratic principles. In discussing operational design, the author explains, among other things, that: 1) Inflation targeting is far from rigid rule. 2) Inflation targets have always been above zero with no loss of credibility. 3) Inflation targeting does not ignore traditional stabilization goals. 4) Avoiding undershoots of the inflation target, is as important, as avoiding overshoots. 5) When inflation is initially high, inflation targeting may have to be phased-in after disinflation. 6)The edges of the target range, can take on a life of their own. 7) Targeting asset prices, such as the exchange rate, worsens performance.

Purpose – Inflation targeting (IT) is a practice that central banks around the world began to adopt as early as 1990. Due to the high accountability and high transparency of central banks under IT policy, the practice expected that inflation targets would have better inflation performance. In this study, it is explored whether inflation targeting policy has positive effects on inflation performance, focusing on inflation persistence. Also, it is explored whether the behavior of inflation rates overshooting or undershooting a target range (or a tolerance band around a target level) is asymmetric. Design/Methodology/Approach – An autoregressive (AR) model is adapted with a self-exciting threshold autoregressive (TAR) model to study inflation persistence before and after inflation targeting was adopted, respectively. To address issues that events unrelated to inflation targeting policy could explain the findings, counterfactual exercises for non- inflation target are conducted. Findings – It was found that inflation target, particularly developed inflation target, have experienced a decrease in inflation persistence after implanting inflation targeting. Also, there is limited evidence on the asymmetrical behavior of inflation rates between overshooting and undershooting an inflation target range, or tolerance band, around a target level. Research Implications – The findings in this study support the positive effect of IT policy on inflation performance. In particular, it is stronger for developed inflation target than less developed inflation target. In addition, the findings support that most central banks do not show asymmetrical responses to inflation rates between overshooting and undershooting a target range or tolerance band around a target level.

India adopted Inflation Targeting (IT) 2016 under the Monetary Policy Framework Agreement (MPFA) to maintain price stability and strengthen economic resilience. A research investigation measures IT effectiveness through a review of inflation patterns combined with volatility observations and GDP performance analysis and RBI policy reaction monitoring and exchange rate steadiness evaluation during the 2010-2024 timeframe with results from before and after IT implementation. The study obtains data from RBI and combines it with information from the Ministry of Finance, IMF, and the World Bank to evaluate the success of inflation control under IT while maintaining continuous economic development. The data shows a substantial decrease in inflation volatility because of Inflation Targeting after 2016, indicating its positive effects post-2016. The Reserve Bank of India (RBI) obtained increased credibility, which prompted better-inflation expectations to take root. Even so, numerous obstacles persist. Present market conditions linked to supply-chain disruptions and worldwide commodity value changes persist in creating volatile price movements for food and fuel. Weaker GDP growth occurred due to the assertive inflation control methods, leading people to question the economic growth versus price stability balance. The IT framework has faced numerous challenges from rapid oil price increases and new external disturbances, including the COVID-19 pandemic and continuing high fiscal deficits. Implementing Inflation Targeting (IT) has encountered various obstacles despite achieving its main goals. Although inflation management under IT has gained transparency, its long-term success requires active supply-side interventions, better fiscal-monetary coordination, and the highest priority for policy flexibility. This research emphasizes how essential it is for India to update its IT framework by developing a system that combines inflation management with economic expansion while practicing inclusiveness during monetary decision-making. The investigation advances the policy discourse about IT in developing economies and recommends clear steps to enhance India's money management system. Future research needs to explore how IT affects employment statistics, income splits, and stability in financial market operations.

(ProQuest: ... denotes formulae omitted.)Over the last twenty years, nearly thirty countries have adopted inflation- targeting regimes to conduct monetary policy. In addition to the announce- ment of specific inflation targets, inflation-targeting regimes have been characterized by increased transparency, enhanced communication with the public, and explicit accountability mechanisms. Moreover, their policy strategy is based on setting short-run interest rates rather than on targeting monetary aggregates. In principle, inflation-targeting regimes also increase exchange rate flexibility.The performance of inflation-targeting regimes has been a matter of exten- sive research. For instance, Ball and Sheridan and Lin and Ye conclude that in industrialized countries, inflation targeting did not make a difference in inflation and output behavior.1 The spirit of these conclusions is echoed in two recent surveys on the performance of inflation targeting.2 Another line of research on inflation targeting in industrialized countries studies its impact on sacrifice ratios-output losses per point of inflation during monetary-driven disinflations. According to proponents, inflation targeting anchors inflation expectations, and it should thus allow for less costly disinflation processes. While Goncalves and Carvalho find strong evidence supporting this hypoth- esis in developed countries, Brito shows that the results are not robust to the inclusion of time effects.3 De Roux and Hofstetter conclude that inflation targeting allows for less costly disinflations even when controlling for time effects, but only if disinflations are slow.4 For fast disinflations, it does not yield less costly disinflations.For developing countries, the evidence is less conclusive. Goncalves and Salles find that inflation targeting allows for a greater reduction in inflation and lower output volatility, a result confirmed by Lin and Ye.5 Brito and Bystedt, however, suggest that the greater inflation reduction came at the expense of poorer output growth.6 In the surveys, Walsh concludes that evidence on inflation targeting in developing countries is clearly favorable to the regime, while Ball is more skeptical, calling the outcomes inconclusive.7More recently, de Carvalho Filho shows that during the recent global finan- cial crisis, inflation-targeting nations outperformed non-inflation-targeting nations on several dimensions for both developed and developing economies: their policy response was more aggressive, they allowed the exchange rate to more effectively absorb the shocks, and they recorded a stronger macro- economic performance (output, industrial production, and unemployment).8The vast empirical literature comparing performance across different mon- etary regimes stands in contrast to the relatively scant research on the tools, strategies, goals, and dilemmas faced by inflation-targeting central banks, espe- cially in developing countries. While there is good information on the overall comparative performance of these regimes, little information is available on the political economy dimensions, the increasing variety of instruments and goals of inflation-targeting central banks, and the challenges that lie ahead for them.In this paper, we fill part of this gap by examining the experience of the Cen- tral Bank of Colombia (Banco de la Republica) over the last decade, a period of consolidation and innovation of its inflation-targeting strategy. Colombia is one of five large Latin American economies that have well-established inflation-targeting regimes, along with Brazil, Chile, Mexico, and Peru. All of these countries adopted inflation targeting more than ten years ago, yet their performance, tools, and goals have not been extensively studied. Cen- tral banks in the region have used a variety of tools beyond short-run policy interest rates, including liquidity and reserve requirements, credit provisions, capital controls, and interventions in the foreign exchange markets. …

Sustainability of Macroeconomic Policies, Inflation Targeting, and Crowding out

The paper assesses the co-movement of local and foreign interest rate for developing countries with a full-fledged inflation targeting framework during and after the 2008 financial crisis. A panel linear optimizing monetary model is estimated by the fixed effects with spatial correlation standard errors over quarterly span from Q12007 to Q2 2019. The results suggest that inflation targeters are highly vulnerable to external monetary shocks, even after years of notable efforts to de-dollarization and complete shift towards a full-fledged inflation targeting. From a regime evaluation prospective, the inflation targeters’ response to world monetary shocks is compared to that of a group of fixed exchange rate rule economies and managed exchange rate countries with other monetary regimes. The findings provide evidence that inflation targeting countries are not different in their interest rate response to world monetary shocks compared to non-inflation targeting countries’, and instead of having more flexibility, inflation targeters show stronger reaction to world monetary shocks. These results are found robust when generated out from different subsamples and under assumptions of strict and flexible inflation targeting and policy inertia. The findings indicate that adopting inflation targeting as a framework for monetary policy does not by itself support the overall macroperformance and independence of monetary policy or force continuing commitment to the inflation targeting conditions.

Introduction Inflation targeting was first adopted in the early 1990s by industrial countries, but now it is being adopted by a growing number of emerging market and developing countries. As of mid-2009 twenty-six countries are classified as inflation targeters, including eleven high-income countries and fifteen lower-income emerging market and developing countries. This chapter provides a review of the experience with inflation targeting, together with an overview of some issues and challenges facing the future of inflation targeting. Section 4.2 briefly documents the spread of inflation targeting and, in particular, the increasing dominance of emerging market and developing country inflation targeters – a trend that is expected to continue. Section 4.3 begins with an overview of the major elements of inflation-targeting 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 inflation targeting has emerged. Inflation target specifications are generally quite similar – perhaps too much so – and a broad consensus has developed in favour of ‘flexible’ inflation targeting, 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.

Inflation targeting policy is a monetary policy framework that ensures a low inflation rate, close to an objective that is usually 2%. Due to deterioration of the relationship between monetary variables and aggregates in many economies, this policy is emerging as a new monetary strategy. Bank Al-Maghrib is part of this process, and thus Morocco has taken the first step in this direction by adopting a more flexible exchange rate regime. Nevertheless, the transition to this regime requires knowledge of the transmission of the interest rate on inflation and output.
 In this article, we determine the optimal monetary rule to accomplish Morocco's transition to inflation targeting. We evaluate this rule by first constructing a DSGE model for a closed economy and then estimating through Bayesian estimation four sub-models (four monetary rules).
 The comparison between models shows that the rule associated with inflation and output targeting with interest rate smoothing allows for better transmission of monetary policy. It is therefore the optimal monetary rule for the eventual implementation of inflation targeting policy in Morocco.
 Keywords: inflation targeting, credibility, economic growth, Neo Keynesian model, monetary rule.

Inflation Targeting in Colombia, 2002–12 Franz Hamann (bio), Marc Hofstetter (bio), and Miguel Urrutia (bio) Over the last twenty years, nearly thirty countries have adopted inflation-targeting regimes to conduct monetary policy. In addition to the announcement of specific inflation targets, inflation-targeting regimes have been characterized by increased transparency, enhanced communication with the public, and explicit accountability mechanisms. Moreover, their policy strategy is based on setting short-run interest rates rather than on targeting monetary aggregates. In principle, inflation-targeting regimes also increase exchange rate flexibility. The performance of inflation-targeting regimes has been a matter of extensive research. For instance, Ball and Sheridan and Lin and Ye conclude that in industrialized countries, inflation targeting did not make a difference in inflation and output behavior.1 The spirit of these conclusions is echoed in two recent surveys on the performance of inflation targeting.2 Another line of research on inflation targeting in industrialized countries studies its impact on sacrifice ratios—output losses per point of inflation during monetary-driven disinflations. According to proponents, inflation targeting anchors inflation expectations, and it should thus allow for less costly disinflation processes. While Gonçalves and Carvalho find strong evidence supporting this hypothesis in developed countries, Brito shows that the results are not robust to the inclusion of time effects.3 De Roux and Hofstetter conclude that inflation [End Page 1] targeting allows for less costly disinflations even when controlling for time effects, but only if disinflations are slow.4 For fast disinflations, it does not yield less costly disinflations. For developing countries, the evidence is less conclusive. Gonçalves and Salles find that inflation targeting allows for a greater reduction in inflation and lower output volatility, a result confirmed by Lin and Ye.5 Brito and Bystedt, however, suggest that the greater inflation reduction came at the expense of poorer output growth.6 In the surveys, Walsh concludes that evidence on inflation targeting in developing countries is clearly favorable to the regime, while Ball is more skeptical, calling the outcomes inconclusive.7 More recently, de Carvalho Filho shows that during the recent global financial crisis, inflation-targeting nations outperformed non-inflation-targeting nations on several dimensions for both developed and developing economies: their policy response was more aggressive, they allowed the exchange rate to more effectively absorb the shocks, and they recorded a stronger macroeconomic performance (output, industrial production, and unemployment).8 The vast empirical literature comparing performance across different monetary regimes stands in contrast to the relatively scant research on the tools, strategies, goals, and dilemmas faced by inflation-targeting central banks, especially in developing countries. While there is good information on the overall comparative performance of these regimes, little information is available on the political economy dimensions, the increasing variety of instruments and goals of inflation-targeting central banks, and the challenges that lie ahead for them. In this paper, we fill part of this gap by examining the experience of the Central Bank of Colombia (Banco de la República) over the last decade, a period of consolidation and innovation of its inflation-targeting strategy. Colombia is one of five large Latin American economies that have well-established inflation-targeting regimes, along with Brazil, Chile, Mexico, and Peru. All of these countries adopted inflation targeting more than ten years ago, yet their performance, tools, and goals have not been extensively studied. Central banks in the region have used a variety of tools beyond short-run policy interest rates, including liquidity and reserve requirements, credit provisions, capital controls, and interventions in the foreign exchange markets. [End Page 2] We employ several strategies to study these issues. We propose and estimate a small-scale open economy policy model for the Colombian economy. This allows us to pinpoint crucial parameters through which we can study some of the policy trade-offs and policy reactions of the central bank. We also provide narrative and anecdotal evidence for understanding some important episodes, tools, challenges, and trade-offs that marked the first decade of inflation targeting. Several findings are worth noting. Our model’s estimates suggest that the impact of foreign variables on domestic outcomes is small and often insignificant. The pass-through of...

Central banks and inflation targeting in perspective

Inflation targeting (IT) was started in 1990 and spread subsequently to 35 other advanced and emerging/developing countries until now. Drawing from existing and new research, this paper takes stock of IT’s past performance and limitations, and discusses its main challenges to remain the monetary regime of choice in the future. Adopting and developing IT takes different forms but central bank gradually converge to a common policy framework—although the framework itself continues evolving over time. There is significant evidence on the success of IT—in particular for emerging economies and lower income countries—in improving central bank’ institutional set-up, conduct of monetary policy, and macroeconomic performance. The last decade presented the greatest challenges to IT, due to the commodity price shock of 2006–2007 and then the Global Financial Crisis and its aftermath. The future of IT in general, and in developing countries in particular, will be determined by how well central bank manage the transition toward full-fledged stationary target IT; improve their independence, transparency, and accountability; strengthen flexible IT without giving up low inflation as the key policy mandate; and evaluate seriously adoption of price-level targeting. Continuing IT adoption in developing countries, including India recently, is an encouraging sign of their capacity to face these challenges.

This chapter attempts to analyze mainly the interactions between the implementation of inflation targeting (IT) policy and performance in the conduct of economic policies (fiscal and exchange rate) in emerging countries. More precisely, empirical studies conducted in this chapter aim to apprehend the feedback effect of this strategy of monetary policy on the budget deficit and volatility of exchange rate performance. This said, we consider the institutional framework as endogenous to IT and analyze the response of authorities to the adoption of this monetary regime. To do this, the retained methodological path in this chapter is an empirical way, based on the econometrics of panel data. First, our contribution to the existing literature is to evaluate the time-varying treatment effect of IT’s adoption on the budget deficit of emerging inflation targeters, using the propensity score matching approach. Our empirical analysis, conducted on a sample of 34 economies (13 IT and 21 non-IT economies) for the period from 1990 to 2010, show a significant impact of IT on the reduction of budget deficit in emerging countries having adopted this monetary policy framework. Therefore, we can say that the emerging government can benefit ex post and gradually from a decline in their public deficits. Retaining the same econometric approach and sample, we tried secondly to empirically examine whether the adoption of IT in emerging inflation targeters has been effectively translated by an increase in the nominal effective exchange rate volatility compared to non-IT countries. Our results show that this effect is decreasing and that this volatility is becoming less important after the shift to this monetary regime. We might suggest that this indirect and occasional intervention in the foreign exchange market can be made by fear of inflation rather than by fear of floating hence in most emerging countries that have adopted the IT strategy. Finally, we can say that our conclusions corroborate the literature of disciplining effects of IT regime on fiscal policy performance as well as the two controversial effects of IT on the nominal effective exchange rate volatility.