Inflation Targeting in Emerging Market Economies

1. Inflation Targeting in Emerging Market Economies Arminio Fraga Ilan Goldfajn André Minella Preliminary Version April 2003 Comments are Welcome

2. 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!

3. Inflation Before and After the Adoption of Inflation Targeting

4. 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.

5. 2. Stylized facts about inflation targeting in EME • Higher volatility of inflation, GDP growth, interest rate and exchange rate • Higher inflation level

6. Comparison of volatilities

7. Trade-off Volatilities

8. 3. Model • Macro model for simulation • Small open economy • Combines features of Batini, Harrison, and Millard’s (2001), and McCallum and Nelson’s (2001) formulations • Derived from the intertemporal optimization of households and firms • Price rigidity

9. 4. Why is volatility higher? • Credibility building and disinflationary needs • Dominance issues: financial and fiscal • Larger shocks

10. 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

11. Inflation before IT adoption

12. Inflation Target Averages

13. Brazilian case: Central Bank’s reaction function

14. Brazilian case: Aggregate supply curve

15. 4.2. Dominance issues • General: central bank will/may inflate • Fiscal dominance • Financial dominance • External dominance (sub-investment grade)

16. 4.3. Shocks and “sudden stops” • Exchange rate volatiliy • Importance as shock factor

17. 5. How to deal with higher volatility • Answer: good communications and a high degree of transparency

18. 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

19. 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

20. 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

21. Brazil: Adjusted target 2003

22. 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

23. 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