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The Past and Future of Inflation Targeting: Implications for Emerging-Market and Developing Economies

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Monetary Policy in India

Abstract

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.

We thank Ken Kletzer for very useful comments on a first draft.

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Notes

  1. 1.

    We follow the IMF regarding both the classification of economies into AEs and EMDEs, and the IT country list (IMF 2015).

  2. 2.

    The foundation of flexible IT is illustrated best by legal acts related to IT in New Zealand. The assigned policy objective for the Reserve Bank of New Zealand (RBNZ) was established in clause 8 of the RBNZ Act of December 1989: “The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices.” The flexible part of IT is reflected a decade later by the 1999 Policy Target Agreement between the Government of New Zealand and the RBNZ: “In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate” (Grimes 2013; Walsh 2015).

  3. 3.

    The variables in each category are: (i) for institutional independence: full legal independence, goal independence, and operational independence; (ii) for well-developed central bank infrastructure: technical infrastructure, data availability, and systematic inflation forecasting and modeling capabilities; (iii) for developed economic structure: full price deregulation, no excess sensitivity of inflation to commodity prices and the exchange rate, low dollarization, and low trade openness; (iv) healthy financial system: six measures of banking and capital market development.

  4. 4.

    This paper expands the existing literature in five ways: allowing for a broader specification that encompasses a wide set of potential determinants of the likelihood of IT; using a large dataset for a treatment group comprised by all IT countries and a large control group of non-IT countries, with three decades of annual data; for robustness checks, applying different panel-data estimation techniques for discrete-choice dependent variables, comprising pooled data estimators for logit and probit models, the conditional logit estimator for fixed effects, and logit and probit estimators for random effects; conducting robustness checks of the preferred specification by testing its validity for different country and time sub-samples; and subjecting the preferred specification to alternative measures of our treatment group, varying IT starting dates.

  5. 5.

    Dincer and Eichengreen (2014) present a wealth of data on central bank independence and transparency, for 120 central bank until 2010, and report regression results to relate fundamentals to the two latter measures, as well as their impact on inflation and inflation volatility. However, they do not report descriptive or empirical results for central bank by different monetary regimes, like IT.

  6. 6.

    Further studies include Wu (2004), who finds that IT significantly reduces inflation in a cross-section of 22 AEs. However, Willard (2006), using the same dataset as Wu, but different methods, finds only small and non-significant effects for AEs. Other studies, focusing only on EMDEs, find that the introduction of IT has reduced inflation rates, including Goncalves and Salles (2008), Biondi and Toneto (2008), Brito and Bystedt (2010), and Yamada (2013).

  7. 7.

    This conclusion on the effect of IT on output volatility is in contrast to Svensson’s (2010) earlier review of the literature, where he reports that IT has reduced output volatility in both AEs and EMDEs.

  8. 8.

    Ehrmann’s panel of 10 advanced countries/regions includes three important economies that are not conventionally classified as ITers (and therefore are also excluded from our set of 36 IT countries): the Euro Zone, Switzerland, and the U.S. It is likely that these three economies suffer more from persistently weak inflation than the other 7 IT countries. Therefore it is possible that the author’s reported better anchoring of expectations in IT countries is under-estimated.

  9. 9.

    The authors also report that fiscal outcomes (deficit and debt levels) were stronger for both AE and EMDE ITers, compared to NITers, during the 2007–2012 period.

  10. 10.

    Walsh (2009) reports counter-factual simulation results for the stabilizing effects of PLT on U.S. inflation expectations, if the Federal Reserve had implemented a PLT regime since the start of the Great Financial Crisis.

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Authors and Affiliations

  1. Catholic University of Chile, Santiago, Chile

    Klaus Schmidt-Hebbel & Martín Carrasco

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  1. Klaus Schmidt-Hebbel
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Correspondence to Klaus Schmidt-Hebbel .

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  1. Economics and Planning Unit, Indian Statistical Institute, New Delhi, India

    Chetan Ghate

  2. Department of Economics, University of California, Santa Cruz, California, USA

    Kenneth M. Kletzer

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Schmidt-Hebbel, K., Carrasco, M. (2016). The Past and Future of Inflation Targeting: Implications for Emerging-Market and Developing Economies. In: Ghate, C., Kletzer, K. (eds) Monetary Policy in India. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2840-0_18

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