Singular Focus or Multiple Objectives? What the Data Tell Us about Inflation Targeting in Latin America

Abstract

(ProQuest: ... denotes formulae omitted.)IntroductionIn the last decade and a half several Latin American countries have adopted inflation targeting as their monetary framework, moving away from other intermediate targets, such as monetary aggregates, and allowing, at least on paper, more exchange rate flexibility. While the literature so far has not delivered a clear verdict on the impact of inflation targeting on macro- economic performance in general-particularly in comparison to other mon- etary frameworks that have faced the same global environment-it is evident that countries that have adopted inflation targeting have generally succeeded both in stabilizing inflation at relatively low rates and in anchoring the public's expectations at levels near the target.1One recurring question that arises regarding the use of inflation targeting concerns the flexibility that policymakers need to implement it. Namely, to what extent should exchange rate fluctuations or financial stability concerns also be incorporated into the policy of a central bank that aims at achiev- ing a preannounced target for inflation? This is particularly relevant given that such targeting relies critically on policy credibility and effective com- munication with the public, thus the perception that multiple-and possibly conflicting-objectives are being pursued might undermine such credibility, thereby endangering the integrity of the policy.Regarding the exchange rate, the question is whether inflation targeting can or should accommodate a certain degree of fear of floating (Calvo and Reinhart, 2002)-that is, a policy reaction directed at preventing or smooth- ing out exchange rate fluctuations. In the most narrow sense, it is clear that central banks using inflation targeting should respond to these movements when, via a pass-through, they are likely to be transmitted to inflation or inflationary expectations. However, beyond this pass-through effect, there is also a case for reacting to exchange rate movements, as these could gen- erate supply-side effects through their impact on the prices of intermediate inputs. They could also affect competitiveness and-particularly in highly dollarized economies-lead to balance-sheet effects that feed into financial instability.In fact, there is evidence that countries using inflation targeting do react to exchange rate movements. Estimating a monetary reaction function for a panel of advanced and emerging economies during 1996-2011, Munoz and Schmidt-Hebbel (2012) find that the short-term policy rate in countries both with and without inflation targeting (known as IT) reacts to changes in the nominal exchange rate. Using a similar approach, but focusing on emerging economies, Aizenman, Hutchinson, and Noy (2011) find that the policy rate reacts to changes in the real exchange rate, particularly in commodity export- ing countries. Note that it is not possible to determine from these studies whether there is a separate exchange rate objective at play, as opposed to the exchange rate being treated as one more signal regarding future inflation- ary pressures. From a different perspective, Berganza and Broto (2012) focus their attention directly on foreign exchange (forex) interventions by central banks. Consistent with the presumed greater exchange rate flexibility of IT, they find that exchange rates are indeed more volatile in inflation-targeting countries than in countries that do not target inflation. However, forex inter- vention is far from absent in the targeting countries, and it is found to be effective in reducing exchange rate volatility.On the second question, whether financial stability concerns should be incorporated into an inflation-targeting framework, there is also a case for expanding the set of instruments at the disposal of policymakers-making use of macroprudential tools such as dynamic provisioning, countercyclical capital requirements, and loan-to-value limits-and even complementing these instruments with an explicit reaction of the policy rate to an appropriate financial stability indicator. …