This paper analyses the evolution of inflation targeting policies in Central European countries. The origins of their inflation targeting strategies are examined, above all the commitment to price stability as well as the inability of prior policy regimes to engender financial stability. Recent policy modifications toward greater flexibility of inflation targeting are reviewed and a system of targeting the differentials between the domestic and the euro area inflation forecast is advocated as conducive to achieving euro-convergence.
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Specifically, the Czech Republic, facing exceptionally strong contagion effects from Asia, scrapped the currency peg in May 1997 moving to a managed float. Poland widened the currency fluctuation band already in May 1995 but maintained a crawling band system until April 2000. Hungary replaced a hard peg with crawling devaluation (with a narrow band) in March 1995, yet maintained it until October 2001. For a detailed analysis of CEECs exit strategies from hard pegs, see for instance Corker et al. (2000).
A revealing lesson on experiments with regimes alternative to a currency peg is provided by the National Bank of Poland, which enacted interest rate targeting in 1996, followed by a brief period of monetary-based and broad money growth targeting during 1997 and 1998 – all proven to be unsuccessful in containing prolonged, double-digit inflation (Orlowski, 2004).
The term direct inflation targeting exemplifies a monetary policy framework that aims at hitting an explicitly specified inflation target, as opposed to indirect inflation targeting that helps stabilise prices via fulfilling some other related targets, such as a stable exchange rate.
For a discussion of the Maastricht convergence criteria in the context of their suitability for the countries converging to the euro, see for instance Kenen and Meade (2003).
A monetary policy ‘information’ or ‘indicator’ variable is an observable variable for policy-makers that is correlated with another unobservable variable. Policy indicator variables such as the monetary aggregates, market interest rates and exchange rates are normally included as regressors in central bank reaction functions or instrument rules. By monitoring these variables, policy-makers can adjust the policy instruments in order to optimise achieving the policy goals (Svensson and Woodford, 2004).
The experience of Poland provides compelling evidence of the failure of alternative policy strategies. After abandoning the exchange rate anchor in May 1995, the NBP applied interest rate targeting. Yet, large capital inflows in 1996 precipitated interest rate instability, making the official target highly inappropriate. Consequently, the NBP moved to monetary base targeting in 1997 and money growth targeting in 1998. Money-based policies were equally unsuccessful due to the instability of money balances exacerbated by contagion effects of the 1997/1998 financial crises and by the rapidly increasing degree of monetisation of the Polish economy (Orlowski, 2004).
Although this paper focuses on the DIT regimes in the three largest CEECs, valuable lessons can also be learned from the experience of Slovakia. Following the country's EU accession in 2004, the National Bank of Slovakia (NBS) announced a strategy for adopting the euro in 2009. Consistently, it enacted a DIT framework labelled as ‘inflation targeting in the conditions of ERM2’ (NBS, 2004). The NBS has specified asymmetric targets for the year-end headline inflation measured by the harmonised index of consumer prices set ‘below 2.5%’ for December 2006 and ‘below 2%’ for December 2007. Yet, the NBS has also specified a number of escape clauses from realisation of the targets that may potentially dilute the policy effectiveness. The December 2006 target was clearly missed as the headline inflation reached 3.7%. Although the Slovak DIT is too new for assessing its effectiveness, some gains in policy credibility can already be observed as the path of headline inflation appears to be on the right track with its monthly annualised rate averaging 1.9% during the first half of 2007.
The RIFT framework designed as a ‘dual target–dual instrument’ strategy differs from the ‘dual target–one instrument’ framework discussed by Jonas (2006). In principle, the use of a single policy instrument may entail a number of conflicts between the two policy targets. As argued by Orlowski and Rybinski (2006), some of the key conflicts between inflation and exchange rate targets are effectively alleviated under the ‘dual target–dual instrument’ policy scenario due to the prescribed dichotomy between the two policy instruments (ie central bank interest rates and foreign exchange market intervention).
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Orlowski, L. Advancing Inflation Targeting in Central Europe: Strategies, Policy Rules and Empirical Evidence. Comp Econ Stud 50, 438–459 (2008). https://doi.org/10.1057/ces.2008.29
- inflation targeting
- monetary convergence
- euro adoption
- EU new member states