1
FROM MONETARY TARGETING TO
INFLATION TARGETING
Abdul Naseer
Monetary and Capital Markets Department
International Monetary Fund
April 14, 2017
Context
2

Motivation



Economies becoming more developed
Somewhat weaker money and inflation correlation
Stronger short-term tradeoffs




Inflation, growth, and exchange rate stabilization
Economic agents and financial institutions are relatively more
sophisticated
LIC central banks also want to be modern and copy
advanced countries
Evolving process
Context (guidance…)
3

Board Paper
 Evolving
monetary policy frameworks in low income
countries

Working Papers
 The
Journey to Inflation Targeting: Easier Said than
Done The Case for Transitional Arrangements along the
Road

TA experience
Principles………
4
A formal adoption of IT requires that:








CB has clear legal mandate and operational independence to pursue price
stability as its primary medium-term objective
The CB announces its objective to formally adopt an IT regime
Decision making process is streamlined and responsibilities (within the bank)
clarified
Forward-looking monetary policy strategy with clear and effective
operational framework
Economic analysis and forecasting capabilities improved
Enhanced effectiveness of monetary operations and use of “policy rate”
Accountability and Transparency practices are strengthened
Clear and effective communication
Realities: Multiple objectives and incoherent frameworks
5









Unclear role of exchange rate
Weak/shallow markets (financial system and interbank)
and monetary policy transmission
Operational issues, instruments, collateral
Inconsistent operations
Fiscal dominance (direct or indirect)
Political control of interest rates/exchange rate
Serious liquidity forecasting challenges and opaque
liquidity management
Weak analytical and operational capacity—lack of
(quality) data
Ineffective and incoherent communications
Principles of Effective Monetary Policy Frameworks
6
I
Clear mandate, operational independence & accountability
II, III, & IV
Primacy of price
stability
Numerical inflation
objective
Other objectives
VI
Forward looking
strategy that maps
objectives to
operations
VII
Effective communications
V
Operational
framework and
operational
target
Mandate, Independence & Accountability (I)

CBs should have a clear mandate + operational
independence to pursue this mandate

Given independence and mandate, CBs should be
accountable

Political commitment is critical for long term
success

Independence sometimes hampered by fiscal
dominance and political pressure to keep rates
too low or exchange rate fixed/stable

Financial independence – balance sheet
7
Price Stability as Primary Objective (II)
8

Price stability should be the primary and overriding
objective of monetary policy

Multiple, potentially inconsistent, objectives with no
clear hierarchy leads to confused frameworks

Output, employment, exchange rate, interest rates and credit
growth objectives often given importance along with price
stability

Which objective will prevail if they come in conflict?

Which objective will the CB be held accountable for?
Adopting a Medium-Term Inflation Objective (III)
9

A numerical medium-term inflation objective
operationalizes the price stability mandate

Establishing an inflation objective should be a priority:

Explicit commitment early on may help…

may wish to strengthen capacity before committing
Other Objectives: Output and Financial Stability (IV)
10

CBs have flexibility regarding the magnitude and pace
of policy adjustments warranted by the inflation objective
to consider impact on output and market volatility

Credibly establishing the primacy of price stability gives
CBs more room to take other objectives into account
The Operational Framework (V)
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Operations should ensure…that banks can place surplus
liquidity with, and obtain short-term funding from…each
other or the central bank…at rates that are reasonably
stable and predictable.
•
A short-term interest rate should be the operating target


Operations should align interbank market rates with policy
rate and minimize volatility
Reserve money as operating target warranted in case of
fiscal dominance and lack of operational independence
Policy Formulation and Strategy (VI)
12

CBs should have a forward-looking strategy

Full assessment of the economic outlook and monetary
transmission mechanism

Changing role of exchange rate and monetary
aggregates as capacity develops and understanding of
transmission deepens:
Communications (VII)
13

CBs should have clear and effective communications

CBs should:


Explain past outcomes and deviations from target

Explain actions necessary to bring expected inflation in line
with objective

Emphasize the variables that matter for private sector
behavior

Target a wide range of stakeholders
Helps anchor expectations when words are
confirmed by actions and outcomes
The challenge
14


Transition from (strict) monetary targeting to a more flexible
forward looking framework without risking undesirable
outcomes
Liquidity management framework that (i) supports market
development, (ii) improves policy transmission and (iii) is
consistent with overall policy framework

Maintain nominal anchor and policy discipline

Underlying assumption: targeting
(But not necessarily IT)
inflation
Two-Pillar Framework
15



An appropriate framework is anywhere on continuum
from adherence to a money rule to formal IT.
The framework should:
 Retain a role for money
 Include elements of forward-looking analysis
 Include operating procedures that enhance interest
rate transmission
The options depend on:
 Conformity with best practices for effective monetary
policy
 Status of the transmission channels.
Building blocks: General considerations
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


Institutional
 Legal framework for the central bank
 The 3 pillars of modern central bank governance
Macro-financial
 Ensure macroeconomic stability: coordination of
monetary, fiscal, and foreign exchange policy
 Promote financial stability: critical for an effective
interest rate channel of transmission
Technical and organizational
 Under the direct control of the central bank…
 … but capacity building can be a long term exercise
Building Blocks for Effective Monetary Policy
Specifications
Data and Analytical Capacity
Macro-Financial
Institutional
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Best Practices
Price stability de jure primary objective of CB.
Independence Independence in policy formulation and in setting the policy rate.
De facto operational
Accountability Framework making the CB accountable to society.
Transparency
Adequate level of CB disclosure and publications.
Fiscal policy
Sound financial relationship between the CB and the government, no CB direct or
indirect monetary financing or quasi-fiscal activities.
FX policy
Articulate role of the ER in monetary strategy and related intervention policy.
Financial
sector
Stable financial sector.
Deep and active interbank market.
Effective financial market infrastructure for the settlement of interbank transactions.
Liquidity
management
CB makes liquidity forecasts. Government produces cash flow projections.
Appropriate monetary and foreign exchange instruments in place for policy
implementation.
Availability of high-frequency data
Analytical and
Statistical tools and short-term forecasting instruments able to support a
research
comprehensive analytical framework. Minimum specifications based on the option.
Minimum specifications based on the way the transitional monetary regime is
Decisionoperated in practice.
making
Organization Minimum specifications based on option.
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Policy Regimes

A continuum…


… from strict adherence to monetary targets…
… to formal inflation targets where money is a residual (i.e., inflation
targeting)
Background
19

Most central banks are targeting inflation


In parallel, central bank independence has been strengthened



Almost all CBs have price stability as one of their primary objectives
CB independence improved significantly over the past 2 decades
A bumpy Journey to Inflation Targeting for “frontier countries”

Frontier countries: countries with shallow/ less developed financial markets; weak analytical
capacity; weak enabling macro and financial environment

Aspirations: achieve an inflation objective with: (i) forward-looking approach to policy making; (ii)
interest-rate focused operating procedures

Balancing exercise: mitigate risks of undesirable outcomes from rigid reliance on money targets;
avoid premature shift to interest rates as the operating target of monetary policy
Case for Transitional Monetary Arrangements along the road
A multi-dimensional process
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

A multi-dimensional process…

One trajectory does not fits all: need for a conceptual framework to guide the
modernization process

Benchmarking: a set of best practices for effective monetary policy

Mapping exercise: mapping options and conformity with best practices
…with multiple stakeholders, going beyond the central bank

Central bank plays a catalytic role…

…but several issues lie outside its direct responsibility: consensus in society at
large/Parliament on monetary policy objective(s); supportive fiscal policy; sound
financial sector; timely and high-frequency data series to support monetary analysis
Choosing a monetary framework
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Basic Components of a Monetary Policy Framework
Nominal Anchor
Instruments
Operational target
Intermediate target
Indicator variables
Ultimate objective

Instrument & targets: (i) aligned with strength of transmission channels; (ii) supporting
the transmission channels

Level of development of financial markets: rely on monetary frameworks “friendly” to
monetary policy transmission

Clarity on the role assigned to key macroeconomic variables
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Monetary aggregates: what is the information content of money?
Exchange rate: flexibility for independent monetary policy
Interest rates: monetary policy is essentially about setting the appropriate level of interest rates
Effective communication: critical (not sufficient) to anchor expectation – In transitioning
countries, communication to raise financial literacy of the public at large – Build
consensus on role of monetary policy
Monetary Versus Inflation Targeting
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Orthodox textbook view
Monetary Targeting
 Controlling the quantity of liquidity and credit in the short
run and over the medium term
 Public communication and commitment opaque or nonexisting
Inflation Targeting
 Commitment to keeping inflation on target over the medium
term

Communication, transparency, and commitment are key

Operations, in practice, focused on interest rates
Monetary Versus Inflation Targeting 2
In practice
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
All are targeting Inflation, but all are not IT


Intermediate Target derived from numerical Inflation
Target
 Also for MT in LICs, and often published
Operational Target: Short term interest rates

Advanced country MTs, but not LIC MTs
The Question (and solution)
24

Choice of Objective


Role of Interest Rate Rules, Money Aggregates, and Modeling
in Policy Formulation


Interest rates as target for short term liquidity management
Focus of Communication and Commitment


Yes all of the above, and it depends!!
Role of Interest Rates and Money Aggregates in Operations


Price stability
 Target inflation and publish target, but not necessarily IT
Interest rates and inflation (target), not monetary aggregates
Clarity, Relevance, and Consistency of Policy Actions and Signals
essential
Regimes and Targets, cont.
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Objectives
Intermediate
Target
Operational
target
Instruments
Communication
Commitment
FX
FX
FX Interventions
Broad money
Interbank rates
Reserve money
(and Reserves)
OMOs,
standing
facilities, others
Essential
(but risk of overcommitting)
OMOs,
standing
facilities, others
Essential
(Risk of overcommitting?)
and
Nominal Anchor
FX
FMT
EMPA
IT
FX
(Inflation?)
Inflation
Inflation forecasts
Inflation Inflation forecasts Interbank rates
The solution
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
Fix short term liquidity management


Improve financial system’s health and develop interbank market


Goal: stabilize and steer short term interest rates
 Consistency with rest of the framework
Also need to develop capital and government bond market
 This will provide needed collateral for interbank and CB operations
Improve policy communications and commitment
 Clarity on price stability as the objective
 Target inflation, and publish target, but maybe not formal IT (yet)

Commitments not credible if not achievable and in the long run achieved (Non-

Risk of premature adoption of formal IT
credible commitment worse than no commitment)
Consistency of actions and communications:
 Do as you say—say as you do
Improve modeling, and monetary and economic analysis to better guide the
setting of the policy stance


Short-term Liquidity Management
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Goal: stabilizing short term interest rates


Also for countries that rely on monetary aggregates for policy guidance
Key to strengthening the transmission mechanism


Price signals better understood
Lower interest rate volatility help:




Anchoring the yield curve
Fostering security market development
Strengthen transmission along the yield curve to retail rates
Focus operations on Excess Reserves and Short-Term Market
Interest Rates
Interest Rate Corridors and Policy Rate Systems
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
Policy rate range - pure corridor systems
 Full

access standing facilities—hard ceiling/floor
Point policy rate systems
 Target (explicit or implicit), not
an instrument
 Commitment to steer interbank rates to the target
 Mid-corridor
systems
 Flexible-rate
fixed-quantity auctions
 Fixed-at-policy-rate full allotment auctions
 Floor
 CB
systems
deposit facility rate the floor and policy rate
Width of the Corridor?
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
Narrow
 Less
volatility
 Clearer signal
 Easier to price securities
 Less incentives for interbank trading

Too wide
 Volatility
 Unclear
signal
 Less trading – reserve hoarding
Reserve averaging to Reduce Volatility
(2–week, 1–month or longer?)
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


Inter-temporal arbitrage—encourage interbank
trading
Less need for frequent OMO interventions
But: Need to anchor expectations for the end-ofmaintenance-period interest rate
 Fine-tuning
OMOs on settlement day
 Mid-week position of settlement day
 MPC meetings at beginning of period
 Align maturity of OMO instruments
Instruments
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Keep it simple
 Structural operations



To address structural shortages or excess liquidity
Infrequent. Longer-term CB or government securities
Fine-tuning

Short term CB instruments


At policy rate, full allotment if liquidity forecasting is weak
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
Repos, SWAPS
Alternative to floor with more incentive for trading
Quantity- price-feedback from market ?
Variable rate, fixed quantity if liquidity forecasting is strong


Price feedback from market
Min/Max offering to signal commitment to trade at policy rate
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Money and Interest Rates
Targeting both?
Feasible?
How?
Horizon and degree of target softness?
Relevance of Monetary Targeting (MT)
33

Conventional monetary targeting
 Broad
monetary program (BMP)
 Reserve money program (RMP)

MT remains relevant when CB faces severe constraints
 Lack
of clarity on objectives of monetary policy
 No clear separation between fiscal & monetary policy
 High political pressures to keep interest rates low or
exchange rate stable
 Low level of financial intermediation
 Limited analytical & statistical capacity at CB
Flexible Monetary Targeting and
bridging short-and long-term liquidity management
34

Reserve Money Program as Policy Guide
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
Longer-term operational target that constrain liquidity operations
Daily target: total reserves (and interest rates)
Policy rate range/corridor

What to do when rates are at the floor or ceiling?


Adjust corridor? Or revise RM target and program assumptions?
Broad Money as Policy Guide



No reserve money target
Interest rate focused operations
Point policy rate



Mid-corridor
Floor or full allotment systems
What to do when money growth differ from target?

Adjust policy rate? Or revise broad money program assumptions?
Flexible Monetary Targeting
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
Quantities as Operating Target

Reducing volatility by:
 Setting
the reserve money targets over a pre-
specified (e.g., quarterly) period, on
average terms, and possibly within a band
 Deriving
a path for total reserves that are
consistent with the longer-term reserve money
target


use it as the operating target.
Combine with corridor?
Enhancing the Analytical Capacity and Toolkit
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

Start early—never ending endeavor
Invest in data


Work with, and advocate on behalf of, statistical office
Multiple tools
Near term forecasting
 Medium term policy analysis models



Tailored to country circumstances
Multiple indicators
Forward looking information in monetary aggregates?
 The exchange rate as a leading indicator?


Adapt and update as circumstances changes
Communications
37


Tailored
Transparency requires consistency
 Do
as you say, if not….
 Don’t say before you are ready

Clear communication requires
 Clarity
on objective
 Coherent framework
 Analytical capacity to tell the story
To announce or not?
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Early announcement of reforms (incl. IT) can:
 Build consensus and facilitate reforms


If followed up
Create resistance that makes complicates reforms

Do first and talk later? Or talk first and do later?
Early announcement of changes in framework can:
 Enhance anchoring of expectations and improvements to
transmission


If delivered on
If not: undermined credibility, unanchored expectations
and weakened transmission
Pace (Jump or not to Jump?)
39

Depends!!


Initial conditions, capacity and consensus (building Blocks
!!!)
Intermediate transitional regimes


IT lite
Flexible money targeting


Money as intermediate target, interest rates as operating
target, Inflation as objective
Two-pillar approaches-Enhanced Monetary Policy
Analysis


Money as intermediate target/information variable
Policy analysis based on multiple approaches (money
aggregates and policy models)
Transitional Frameworks
40
FMT
EMPA
Main
Instruments
Option 1. OMOs
Standing facilities
Reserve requirement
Option 2. OMOs
Standing facilities
Reserve requirement
Operational
Target
Short term: Interest rate (range)
Longer term: average total reserves
Intermediate
Target
Broad money
Policy
Objective
Inflation
(implicit)
Interest rate
Broad money
(central bank controls excess reserves
to steers market rates to its policy rate)
Inflation
(implicit)
OMOs
Standing facilities
Reserve requirement
Interest rate
Inflation forecast
(central bank steers market rates to its Cross-checking role
policy rate)
of monetary analysis
Inflation
(explicit)
A Stylized Reform Agenda
Money guides
policy and
operations
The exchange rate
guides policy
and operations
Multiple and sometimes inconsistent objectives
Establish a coherent interest rate
based operation framework to
enhance monetary policy
transmission
Develop analytical tools
for policy making
Combine Monetary
and Economic Analysis
Inflation forecast
Cross checking role of
monetary analysis
Single objective
Price Stability
Interest rate based
operating framework
Operations align market
rates with the policy rate
41
Flexible exchange rate
Intervention strategy
aimed at supporting
market functioning
Increase exchange rate
flexibility
42
THANKS………….