Inflation Targeting in Emerging Countries Research Paper

Introduction

Inflation Targeting is the public announcement of numerical targets for inflation for the year. This has become part of some governments in the emerging economies. They are usually made during budgets or before after budgets in a form of economic plans. In words of Mishkin (2004) inflation targeting is much more than the public announcements. He has listed five elements of inflation targeting which include:

1. The public announcement of short term and medium-term numerical targets for inflation
2. An institutional commitment to price stability as the primary goal of monetary policy, to which other goals can be subordinated.
3. An information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments;
4. Increased transparency of the monetary policy strategy through communication with the public and the market about the plans, objectives, and decisions of the monetary authorities and
5. Increased accountability of the central bank for attaining its inflation objectives.

Emerging economies use inflation targeting to avoid fluctuations. There are a number of reasons why emerging market economies according to Ades A., Buscaglia M. and Masih R (2002) (1) as lack of credibility (Calvo and Reinhart, 2002), (2) a high pass-through coefficient (Goldfajn and Werlang, 2000), (3) the existence of large foreign currency debt, and a high degree of dollarization. Some emerging market countries that engage in inflation targeting have gone too far in the limitation of exchange rate flexibility, with the risk of transforming the nominal exchange rate in the nominal anchor in the eyes of the public argues Mishkin (2004). He suggests that one possible way to avoid this problem is for central banks in emerging market countries to adopt a transparent policy of smoothing short-run exchange rate fluctuations, while making it clear that they will allow exchange rates to reach their long run level commented Ades A., Buscaglia M. and Masih R (2002).

How does emerging economies differ from developed economies in inflation targeting?

Calvo and Mishkin, (2003) outlined essential institutional differences between emerging market countries and developed market economies that must be taken into account to derive sound theory and policy advice. They highlighted them as follows:

• Weak fiscal institutions.
• Weak financial institutions including government prudential regulation and supervision.
• Low credibility of monetary institutions.
• Currency substitution and liability dollarization.
• Vulnerability to sudden stops of capital inflows.

In his Mishkin (2004) argued that developed economies are no exception or immune to problems with their fiscal, financial and monetary institutions. He stated that, Weak fiscal institutions, weak financial institutions including government prudential regulation and supervision and low credibility of monetary institutions will be experience but there is dissimilarity in the degree of the problem in emerging market economies.

Fragile institutions in emerging market countries make them very vulnerable to high inflation and may lead to currency crisis. When there is currency crisis in the emerging market countries there may be threat that domestic residents may switch to a foreign currency leading to currency substitution (Calvo and Végh, 1996). This happen in the democratic republic of Congo during their civil war that lead to removal of Mobutu. Currency substitution is likely to be due not only to past inflationary experience but also to the sheer fact that a currency likes the U.S. dollar is a key unit of account for international transactions( Mishkin,2004). This phenomenon being experienced in Zimbabwe although the central bank has moved to allow banks to offer foreign exchange deposits transactions. If the switch is allowed to take place without proper check then we shall nhave a bank run. However, “ sudden switch away from domestic and into foreign money need not result in a bank run, since in the presence of foreign exchange deposits, such a portfolio shift could be implemented by simply changing the denomination of bank deposits” ( Mishkin,2004).

Mishkin (2004) added that foreign exchange deposits induce banks—partly for regulatory reasons that prevent banks from taking exchange rate risk—to offer loans denominated in foreign currency, usually dollars, hence leading to what is called liability dollarization.

Developing strong fiscal and financial institutions

We must have a safe and sound financial system for the success of an inflation-targeting regime in any country. A feeble banking system is particularly dangerous. Once a banking system is in a weakened state, a central bank cannot raise interest rates to sustain the inflation target because this will likely lead to a collapse of the financial system. Not only can this cause a breakdown of the inflation targeting regime directly, but it can also lead to a currency collapse and a financial crisis that also erode the control of inflation argued Mishkin (2004). In order to avoid inflation instability the following institutions must be strengthened according to Mishkin (2004):

1. Prudential regulation of the banking and financial system must be strengthened in order to prevent
2. The safety net provided by the domestic government and the international financial institutions set up by Bretton Woods might need to be limited in order to reduce the moral hazard incentives for banks to take on too much risk.
3. Currency: mismatches need to be limited so that currency devaluations do not destroy balance sheets. Although prudential regulations to ensure that financial institutions match up any foreign-denominated liabilities with foreign-denominated assets may help reduce currency risk, they do not go nearly far enough. Even when the banks have equal foreign-denominated (dollar) assets and liabilities, if banks dollar assets are loans to companies in dollars who themselves are unhedged, and then banks’ are effectively unhedged against currency devaluations because the dollar loans become nonperforming when the devaluation occurs. Thus limiting currency mismatches may require government policies to limit liability dollarization or at least reduce the incentives for it to occur.
4. Policies to increase the openness of an economy may also help limit the severity of financial crises in emerging market countries. Many emerging market economies have adopted float regimes as opposed to inflation targeting but they are experiencing difficulties. Some have decided pursue inflation targeting recently. Therefore, central banks in emerging market countries should smooth exchange rates, but they can go too far. To cope with potential problems of financial instability, but preserve the focus on inflation control, central banks could increase the transparency of any intervention in the foreign exchange market by making it clear to the public that the purpose of the intervention is to smooth “excessive” exchange-rate fluctuations and not to prevent the exchange rate from reaching its market determined level over longer horizons (Mishkin, 2004). However, continuing exchange market interventions, particularly unspecialized ones, are likely to be counterproductive because they are not transparent.

Instead, exchange rate smoothing via changes in the interest rate instrument will be more transparent and indicate that the nominal anchor continues to be the inflation target and not the exchange rate. Central banks could also explain to the public the rationale for exchange rate intervention in a manner analogous to that for interest-rate smoothing, i.e., as a policy aimed not at resisting market-determined movements in an asset price, but at mitigating potentially destabilizing effects of abrupt and sustained changes in that price.

It is also important for central banks to recognize that the pass-through from exchange rate changes to inflation is likely to be regime dependent. After a sustained period of low inflation engineered by an inflation-targeting regime, the affect of the exchange rate on the expectations formation process and price setting practices of households and firms in the economy is likely to fall. Thus, inflation targeting is likely to help limit the pass-through from exchange rates to inflation and the view that a currently high pass-through is a barrier to successful inflation targeting is unwarranted.

References

1. Mishkin F. S. (2004) Can inflation targeting work in emerging market countries?
2. Ades A., Buscaglia M. and Masih R (2002); Inflation targeting in Emerging Market Countries. Too Much Exchange Rate Intervention? A Test;
3. Calvo, Guillermo and Carmen Reinhart (2002), “Fear of Floating”, Quarterly Journal of Economics, vol. 117, 2, pp. 379-408.
4. Goldfajn, Ilan, and Sergio Werlang (2000), “The Pass-Through from Depreciation to Inflation: A Panel Study”, Discussion Paper No.423, Department of Economics, PUCRIO.
5. Calvo, Guillermo A. and Carlos A. Végh (1996). “From Currency Substitution to Dollarization and Beyond: Analytical and Policy Issues,” in Guillermo A. Calvo, Money, Exchange Rates, and Output (Cambridge, MA: The MIT Press): 153-175.
6. Calvo, Guillermo and Frederic S. Mishkin, “The Mirage of Exchange Rate Regimes for emerging Market Countries,” Journal of Economic Perspectives, Vol. 17, No. 4 (2003).