INFLATION TARGETING DOESN’T MATTER FOR EMERGING MARKETS
The monetary policy credibility of emerging markets economies is not significantly different after adopting inflation targeting compared with similar countries that have not. This raises doubts about whether inflation targeting actually matters for these countries. That is the central finding of research by Matteo Lanzafame and Reginaldo Nogueira, presented at the Royal Economic Society’s 2010 annual conference.
Many economists have argued that inflation targeting increases the credibility of a government’s pledge to achieve low and stable inflation. This study examines one measure of this credibility: the extra return on government bonds that need to be offered compared with the benchmark of a US Treasury bond. The bigger the difference, the less the credibility of a country’s monetary policy.
Comparing this measure across emerging markets that have adopted inflation targeting, including Brazil, Mexico and Thailand, with similar countries that have not, the study finds no significant effect on credibility.
Understanding the causes of credibility is crucial for understanding countries on the verge of a crisis. The authors conclude that many emerging market countries that adopted inflation targeting were suffering from high inflation and/or banking and exchange rates crises at the time – when things could not get much worse. The resulting stability that followed has been unfairly ascribed to inflation targeting and not enough credit has been given to other policies or outside factors.
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The economists Felipe Morande and Klaus Schmidt-Hebbel once described inflation targeting as ‘the new kid on the block of monetary regimes’. Indeed, since the seminal introduction of explicit inflation targets by the Reserve Bank of New Zealand at the beginning of the 1990s, more than 20 countries have adopted this framework for monetary policy.
At first, most of the countries adopting inflation targeting were industrial ones. After a decade or so, the tide had reached emerging markets’ shores, with countries such as Mexico, Turkey and Thailand opting for this new approach.
Interestingly, although inflation targeting has proved to be such a popular monetary regime, there is no consensus about its true usefulness. Hypothetically, inflation targeting should reduce the cost of disinflating an economy, that is, lower output loss per percentage of inflation decrease, as it helps anchoring inflation expectations around the central bank’s target.
But in a 2005 article, two economists, Laurence Ball and Niamh Sheridan, have shown that there is no significant gain from adopting this regime. In fact, they have argued that most of the economies opting for a targeting strategy were suffering from either high inflation or financial and exchange rate instability. Under those circumstances, inflation targeting was a desperate last attempt of taming inflation expectations.
Since these countries were on the brink of macroeconomic collapse, there was not much room for making things worse, but surely a lot of room for making things better. Therefore, those economies were very much likely to improve in the following years regardless of which monetary regime was in place, and the fact that they adopted inflation targetingmayhave been just a coincidence. In the end the economy moved back to equilibrium, as it was likely to, and the new targeting strategy was undeservedly held responsible for that.
Our study takes another look at Ball and Sheridan’s hypothesis. We focus on a particular set of countries that fit into their argument: emerging market economies. The countries in our study have, in most cases, adopted inflation targeting after banking and exchange rate crises.
A clear-cut example is that of Brazil, which adopted inflation targeting just after a serious attack on its exchange rate; the new regime was put in place just six months after the abrupt devaluation of the real, even though there was no preparation whatsoever about changing the monetary regime in the previous months.
We follow an approach used by Sarantis and Piard (2004) to estimate directly the effect of the adoption of inflation targeting on credibility. We assume that interest rate differentials with respect to a leading economy – that is, the excess return on a bond with similar maturity with respect to a ‘risk-free’ benchmark (which in our case is the US Treasury bond) – is a viable indicator of overall monetary policy credibility.
The higher the differential, that is, the more a given country has to pay in excess of the US Treasury bill rate to sell its bonds, the lower its credibility. Moreover we also compare the differential in a given emerging market with the average differential of all emerging markets.
This means that our measure shows (i) the credibility gap with respect to the leading, risk-free, economy, and (ii) the credibility gap with respect to similar economies. Our approach allows us to extract a single number summarising the overall relative credibility in each country, and plot it over time, so that onecanassess what happens to credibility after the adoption of inflation targeting.
As in medical experiments, we use a ‘control group’ to check what is happening with credibility among similar countries that haven’t adopted inflation targeting over the same time horizon. We then test if the new regime has generated changes in credibility by more than what was observed within the ‘control group’.
Our results show that although credibility has indeed increased among countries that adopted inflation targeting, it hasn’t done so significantly more than among similar countries that haven’t. Therefore, our results bring support to Ball and Sheridan’s hypothesis that inflation targeting doesn’t really matter.
ENDS
‘Credibility in emerging economies: Does inflation targeting matter?’ by Matteo Lanzafame (DESMaS ‘V. Pareto’, Università degli Studi di Messina, Italy) and Reginaldo Nogueira (Escola de Governo, Fundação João Pinheiro, Brazil)