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The evolution of inflation targeting strategy in Poland

The evolution of inflation targeting strategy in Poland. Jerzy Pruski National Bank of Poland EMU and the new Member States – a year after accession 3-4 October 2005, Sofia. Outline. Why new strategy? Monetary policy in 1999-2003 Monetary policy after 2003

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The evolution of inflation targeting strategy in Poland

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  1. The evolutionof inflation targeting strategy in Poland Jerzy Pruski National Bank of Poland EMU and the new Member States – a year after accession 3-4 October 2005, Sofia

  2. Outline • Why new strategy? • Monetary policy in 1999-2003 • Monetary policy after 2003 • Current monetary policy framework – some remarks • Conclusions

  3. Outline • Why new strategy? • Monetary policy in 1999-2003 • Monetary policy after 2003 • Current monetary policy framework – some remarks • Conclusions

  4. Monetary policy in Poland in the pre-DIT period • An “eclectic” strategy - elements of exchange rate targeting, inflation targeting, and monetary targeting • The intermediate targets: • crawling band (Zloty devalued against a basket of currencies) • reference value for M2 annual growth announced • Initially, given the limited links between the Polish economy and the global financial market, the strategy allowed inflation to be smoothly reduced

  5. Macroeconomic environement in the pre-DIT period • Strong domestic demand, increase of the CA deficit and high inflation rate • Monetary response: • Tihgtening of interest rate policy • Increasing of the mandatory reserves ratio • Introduction of deposits for the households priced directly by the NBP But…

  6. Problems with eclectic strategy • Factors lowering the effectiveness of the monetary measures: • Rising inconsistency in controlling both: exchange rate and interest rate under openness of capital account (impossible trinity problem) • Relatively loose fiscal policy • Roots of the consumption boom – exscessively optimistic expectations after a very long period of low consumption • Weak response of interest rates in banking sector to the NBP policy

  7. Selected macreoeconomic indcators 1995-1998 Source: NBP

  8. The Foreign Exchange Interventions and PLN’ s NEER

  9. Effects of FX interventions in 1995-1998 • Frequent FX interventions resulted in the soar of the FX reserves to the safe level But… • Sterlilised interventions created significant fiscal costs • Led to liquidity surplus in the banking sector – long-lasting problem for the monetary policy effectiveness

  10. Foreign exchange reserves in Poland

  11. Costs of open market operations Source: NBP

  12. NBP Balance Sheet as at 31 December 1995, 1998, 2000, 2004

  13. Eclectic strategy – final considerations • Continuation of eclectic monetary policy strategy impossible • Nominal anchor - important • For inflation expectations • For transparent criteria for monetary policy decisions Need for a new strategy

  14. Outline • Why new strategy? • Monetary policy in 1999-2003 • Monetary policy after 2003 • Current monetary policy framework – some remarks • Conclusions

  15. New legislation laid foundations for the new strategy • New Constitution of 1997 named price stability as the primary objective of the National Bank of Poland „The central bank of the State shall be the National Bank of Poland. It shall have the exclusive right to issue money as well as to formulate and implement monetary policy. The National Bank of Poland shall be responsible for the value of Polish currency.” • The institutional proccess of monetary policy decision-making changed in the beginning of 1999 (Monetary Policy Council) following the new NBP Act

  16. Why inflation targeting? • Free of drawbacks related to a strategy based on intermediary targets • Explicit and comprehensive monetary policy goal • Openness makes NBP subject to public scrutiny, thus enhancing credibility of the monetary policy • Increasing central bank credibility minimises costs of lowering inflation expectations • Increased flexibility in the application of monetary policy instruments allows the NBP to select the reaction, depending on the type of events that might threaten the achievement of the inflation targets

  17. Medium-term strategy of monetary policy (1999-2003) • Strategic goal – integrate Polish economy with EU (convergence criteria) • Lower the inflation rate to below 4% by the end of 2003 (focus on CPI) • Year-end inflation targets announced for each year • NBP information policy aimed at convincing the public about central bank comittment – Inflation Report as main analytical document • Work towards full floatation of the Zloty; FX interventions not excluded

  18. Exchange rate floatation • De facto floatation already in July 1998, when MPC abandoned FX interventions (official floatation April 2000) • After floatation exchange rate became more volatile (2000-2001 strong appreciation; 2002-mid 2004 strong depreciation) PEG BAND FLOAT

  19. Year-end inflation targets – main challenge • Year-end inflation targets announced in Monetary Policy Guidelines for each year (in the fall of the preceeding year) • required by law • allowed to increase understanding and thus credibility of DIT • DIT introduced to support the disinflation process – short-term targets very important • However, year-end targets - not free of drawbacks • in practice, horizon was inconsistent with lags in monetary transmission mechanism Being aware of the above pros and cons, as well as of the probability of missing year-end targets, the MPC decided that short-term targets will be conducive to lowering inflation

  20. Medium-term target of below 4% by end-2003 met • Deviations from year-end targets smaller in terms of net CPI • But in communicating with the public, the relative importance of both types of inflation targets seemed to change in 1998-2003, with a gradual increase in the weight of the medium-term target Inflation rate vs. MPC targets Net CPI – CPI excluding food and fuel prices

  21. Reasons behind target misses • way of setting the annual targets • total CPI sensitive to changes in food prices; average weight of food prices in 1998-2004 in total CPI – 30% • unexpected fiscal expansion combined with easy monetary policy led to an acceleration of inflation and the overshooting of inflation targets in 1999-2000 • subsequent sharp tightening of monetary policy and its slow relaxation in the absence of further easing of fiscal policy reduced inflation sharply and produced a significant undershooting in 2001-2003

  22. Interest rate policy

  23. Assesment of DIT in 1998-2003 • DIT was introduced to support the disinflation process • Disinflation succesfully completed by 2003 • Mounting CA deficit one of the problems in the pre-DIT period • CA deterioration brought to a halt • GDP slowdown in 2001-2002 due to, inter alia: • Russian crisis • slowdown in the world economy • previous overheating of the Polish economy

  24. Selected macreoeconomic indicators 1998-2004 Source: NBP

  25. Outline • Why new strategy? • Monetary policy in 1999-2003 • Monetary policy after 2003 • Current monetary policy framework – some remarks • Conclusions

  26. Monetary policy strategy beyond 2003 • DIT – appropriate framework to stabilize inflation • permanent inflation target of 2.5% +/- 1 percentage point • lead Poland to the euro zone in the nearest possible future • maintain floating Zloty until ERM II membership - the policy of adjusting the exchange rate could force interest rate changes inconsistent with the adopted inflation target

  27. Why 2.5% is appropriate? • Once in the EU, inflation had to be stabilised at a level consistent with the euro-zone accession • Inflation of 2.5% comes close to the expected reference value for the inflation criterion • In case of lower reference value any subsequent attempts to bring inflation to the criterion will not require a substantial reduction in inflation over a short period of time • Given the estimate of the Balassa-Samuelson effect, target of 2.5% assessed as appropriate and consistent with strong economic growth

  28. Why permanent inflation target? • Appropriate framework for stabilization of the inflation rate • Year-end targets – problematic in view of monetary policy implemenation in 1998-2003 • Consistent with the lags in monetary transmission mechanism • Supports forward-looking monetary policy • Introduction of a permanent inflation target proved to be a good decision already in 2004

  29. Inflation increased in 2004 following the EU entry • Permanent inflation target allowed the MPC to focus on the long-term (and not the short-term) challenge • In August 2004 inflation projection – inflation rate above the MPC target in 2006 • Thus, the adjustement in interest rate - appropriate Inflation rate vs. MPC target

  30. Monetary policy reaction to increase in inflation in 2005 • Changing outlook for future inflation resulted in adjustment in policy rates to historically low levels

  31. Outline • Why new strategy? • Monetary policy in 1999-2003 • Monetary policy after 2003 • Current monetary policy framework – some remarks • Conclusions

  32. Reaction of inflation to temporary 1 pp increase in interest rate (for 6 quarters) Reaction of inflation to temporary 1 pp increase in ER risk premium (for 6 quarters) The role of exchange rate in current monetary policy in Poland Inflation response to interest rate and exchange rate impulse

  33. Exchange rate in Poland Volatile exchange rate renders the control of inflationary processes more difficult

  34. Transparency issues • Until mid-2004 - no inflation projection • Thus – need for improvement: • First inflation projection published in August 2004, first GDP projection published in May 2005 • As a result - more forward-looking analysis in the IR since 2004… • …press releases after the MPC meeting brought in line with the analysis presented in the IR… • … and outlook for future inflation presented in the form of balance of risks.

  35. Macroeconomic projections CPI GDP Source: Inflation Report, August 2005, www.nbp.pl National Bank of Poland is complying with international standards in terms of publishing its marcoeconomic projections

  36. DIT in Poland – future challenges • Reconciling direct inflation targeting strategy with simultaneous membership in a guasi-fixed exchange rate system • DIT strategy within ERM II will be bound by the expected interpretation of exchange rate stability criterion • Symmetrical wide band (+/-15%): large enough not to limit freedom of DIT monetary policy • Asymmetrical band (close to parity with more tolerance for appreciation): more constraining for monetary policy • If Maastricht reference value for inflation (in the reference period) is below NBP’s permanent inflation target - potential short-term cost of fulfilling the inflation criterion

  37. Outline • Why new strategy? • Monetary policy in 1999-2003 • Monetary policy after 2003 • Current monetary policy framework – some remarks • Conclusions

  38. Conclusions • Permanent inflation target of 2.5% +/- 1 percentage point is assessed as consistent with long-term economic growth • Large share of food prices in the total CPI renders the index very sensitive to its changes • Volatile Zloty exchange rate hardens stabilization of inflation … • …but there is no reasonable alternative to inflation targeting in Poland • Hence DIT should be pursued until euro adoption • Reconciling DIT and ERM II participation major challenge

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