Inflation Targeting in Emerging Economies

Ensayos sobre Política Económica Volumen 36, Núm. 85 • Edición especial de 2018 7 Inflation Targeting in Emerging Economies Todd B. Walker* Article Info: Received 31 October 2017; accepted 18 November 2017 JEL Classification C11 C32 E62 H39 Keywords: Inflation Targeting Emerging Economies Abstract I document the decline in the rate of inflation in 14 emerging economies after the implementation of an inflation targeting (IT) regime. I briefly describe how each country implements the IT, and argue that the new regime forced policy coordination amongst various governmental units, allowed for a more singular focus, and more transparent policy making process. This allowed agents to better coordinate expectations which precipitated the decline in the rate of inflation. I also document the difficulty with hitting a precise inflation target over a short period of time in the same countries. A model of policy coordination is presented to show how inflation is determined by joint behavior of monetary and fiscal policies. Inflación Objetivo en Economías Emergentes Resumen Clasificación JEL C11 C32 E62 H39 Palabras clave: Inflación objetivo Economías emergentes. Documento el descenso de la tasa de inflación después de la implementación del régimen de Inflación Objetivo (OI) en 14 economías emergentes. Describo brevemente cómo cada país implementó IO y argumento que el nuevo régimen forzó una coordinación de políticas entre varios entes gubernamentales, esto último facilitado por un proceso de toma de decisiones más transparente y con un enfoque más puntual. Esto permitió que los agentes económicos coordinaran mejor sus expectativas induciendo así una reducción en la tasa de inflación. Para los mismos países, también documento la dificultad de acertar a una meta de inflación precisa en un corto período de tiempo. Para mostrar cómo la inflación está determinada por la acción conjunta de las políticas fiscal y monetaria, presento un modelo de coordinación de políticas. https://doi.org/10.32468/espe.8501 * Invited Article. I would like to thank Eric Leeper for many helpful discussions. Junjie Guo provided excellent research assistance. Prepared for the 2017 ESPE Conference. Department of Economics, Indiana University, 8 Inflation Targeting in Emerging Economies Todd B. Walker / 7–20 1. Introduction The purpose of this paper is to document the decline in the rate of inflation in emerging economies that implemented an inflation targeting (IT) regime. I examine 14 emerging economies that implemented IT: Brazil, Chile, Colombia, Mexico, Peru, the Czech Republic, Hungary, Poland, South Africa, Indonesia, Korea, Israel, Philippines, and Thailand. The average rate of inflation in these countries declined by double digits in many cases throughout the implementation period, and have remained low and relatively stable despite the significant shocks that have hit over the last decade. By any measure, IT has been an amazing success story [Mishkin and Schmidt-Hebbel (2007)]. Section 3.1 plots the rate of inflation in these countries several years prior to the IT regime, up to the present. Because IT was implemented in these countries at different times, one cannot argue that synchronization of “good luck” shocks played a significant role in reducing inflation. In Section 3.2, I also document the inability of these countries to hit an exact inflation target over the last decade. However, I view this as a success story given the amount of turbulence that hit these economies over that time frame. Inflation expectations appear to be well anchored despite the sizable shocks faced by policy makers. Why has IT been so successful in these countries? To get a better understanding of this question, Section 2 documents the policies and procedures put in place during the implementation of the inflation targeting regime. Two aspects stand out: First, the IT regime brought with it enhanced policy coordination among various governmental agencies. In nearly all countries, committees composed of central bankers and other government officials work together to set the inflation target. In some countries (e. g., Israel), committee members include academics and other private citizens. Section 4 lays out standard theory of policy coordination. Without coordination, rational expectations equilibrium do not exist in well-developed monetary models. Second, transparency in the policy making process increased substantially with IT. Nearly all central banks publish inflation targets several years out. Nearly all central banks publish minutes of policy meetings or hold scheduled press conferences. When inflation targets are not hit, a few central banks make public explanations as to why the target was missed. Also, by targeting inflation, private agents have a much better understanding of the policy goal (as opposed to a stated goal of a “strong currency”, for example). The release of information and transparency associated with IT has allowed agents to anchor expectations on specific inflation targets. Section 4 lays out a well-established theory that emphasizes the importance of policy coordination in determining the price level. The theory shows how monetary and fiscal policy work together to control inflation and stabilize government debt. If this coordination is not forthcoming, the price level cannot be determined and expectations are not anchored. This theory supports the notion that because IT forced policy makers to focus on a specific goal, expectations of inflation became better anchored. Section 2 provides prime facie evidence that IT did indeed bring policy makers together in order to set the inflation target and implement policy to achieve the inflation target. 2 Inflation Targeting Regimes This section briefly documents how inflation targeting (IT) is implemented in 14 countries that are labeled “emerging economies” by Ball (2010). The countries are Brazil, Chile, Colombia, Mexico, Peru, the Czech Republic, Hungary, Poland, South Africa, Indonesia, Korea, Israel, Philippines, and Thailand. The purpose is to highlight specific aspects of the policy that are common across the countries, as opposed to thoroughly documenting the history and implementation of IT. Specifically, IT regimes have at least two things in common: increased transparency and a movement toward policy coordination. Section 3 shows the impressive success of IT in bringing down the rate of inflation in all 14 countries. Some countries, like Brazil, had rampant inflation prior to IT. While I do not perform any rigorous econometrics to test what factors were most important, the experiment was obviously a success. The goal of this section is to document how each central bank describes IT in their own words in order to provide evidence of commonalities across countries. 2.1 Brazil The Central Bank of Brazil’s (BCB) Monetary Policy Committee (COPOM) was created on June 20th 1996 with the stated goal of enhancing monetary policy trans (...truncated)