Inflation Targeters Do Not Care (Enough) About Financial Stability: A Myth? Investigation on a Sample of Emerging Market Economies

Abstract

The 2008/2009 financial crisis raised issues related to the monetary policy doctrine of the last two decades. Inflation targeting has been criticized, as its main objective of inflation stabilization might have diverted central banks from other concerns, such as financial stability. As a first attempt in the literature on emerging countries, the aim of this study is to investigate (i) whether inflation targeting can be associated with greater financial instability and (ii) whether inflation targeting central banks are less responsive to financial imbalances than non-targeters. Relying on a sample of 26 emerging countries, of which 13 have adopted the inflation targeting regime, we provide empirical evidence that targeters, on average, are more financially unstable than the others. Estimations of the central banks’ reaction functions, however, reveal that most emerging-market inflation targeters are concerned with financial instability when setting the policy rate. At least for emerging countries, these findings call into question the criticism that inflation targeting central banks neglect developments in the financial sector and instead highlight the need to strengthen prudential measures to address the issue of financial instability.