IMF view of inflation targeting

Since then, macroeconomic performance has been characterized by relatively low and stable inflation which has been a primary factor in anchoring inflation expectations, strengthening Thailand’s economic resiliency, and providing the foundation for investor confidence and a stronger external position. This note briefly summarizes recent international experience with inflation targeting (IT), and its role in supporting macroeconomic performance. These conclusions have been supported by a number of international experts as well as IMF surveillance across a broad range of countries.
     Inflation targeting is a framework that explicitly recognizes that the primary role of monetary policy is to provide a nominal anchor for the economy. It also places weights on other objectives, but these need to be consistent with providing an anchor for inflation and inflation expectations. The framework is flexible enough to accommodate these other objectives, such as supporting growth, especially when there are shocks to output, while aiming to return inflation to the target range over the medium term.An effective inflation-targeting regime will have beneficial first-order effects on welfare by reducing uncertainty, anchoring inflation expectations and reducing the incidence and severity of boom-bust cycles. Because of lags in the transmission process, it is neither possible nor desirable to keep inflation exactly on target and in practice inflation targeting becomes inflation-forecast targeting. To be effective, central bankers must have reasonably clear objectives and sufficient independence from the political process to achieve these goals, and there should be monitoring and accountability mechanisms to ensure that central bankers are behaving in a manner consistent with the announced underlying objectives and that monetary policy is being based on sound practices.

Since New Zealand adopted inflation targeting in 1989, 29 countries have introduced an IT framework, including 15 lower-income and emerging market economies, with improved macroeconomic results. In addition, several other central banks including the ECB, the Swiss National Bank, the Bank of Japan, and the Federal Reserve have adopted many of the most important attributes of IT. While there are individual differences, the application of inflation targeting has been quite similar across countries, and a broad consensus has developed in favor of “flexible” inflation targeting which allows room for policy to adjust to support growth and recovery from cyclical downturns. Indeed, rather than focusing on achieving a specific “target”, the IT approach has emphasized achieving the target (or a target range) over the medium term—typically over a two- to three-year horizon. This allows policy to address other objectives—such as smoothing output—over the near term.

As a result, the inflation and growth performance of IT countries have been better than under alternative frameworks, and IT has been cited as one of the key factors behind low and stable inflation rates globally over the last decade. When otherwise similar countries are compared over the same time period, IT has been associated with about a 5 percentage point reduction in average inflation (and lower volatility) relative to other monetary policy regimes. For example, the successful implementation of inflation targeting frameworks was a prime reason behind the achievement of low inflation in many Latin American countries in the 1990s—a striking achievement given their history of high inflation—which contributed to macroeconomic stability and lower levels of poverty and inequality. The initial evidence also indicates that IT countries have coped better than others with the commodity price and financial shocks experienced since 2007.

Successful implementation of IT requires strong financial management. Emerging markets, in particular, face challenges when implementing IT if any of the following conditions are present: weak public sector financial management and/or fiscal dominance; weak financial sector institutions and markets; or extensive dollarization of financial liabilities. These factors have been largely absent in Thailand. Successful macroeconomic management has also contributed to policy credibility which reinforces and supports the success of the monetary policy framework. The credibility of any monetary policy framework, including IT, requires keeping public finances under control. Moreover, the adoption of IT has served as a catalyst for public sector financial reform by highlighting the inconsistency of a lack of fiscal discipline with low and stable inflation.

In addition to the international evidence supporting IT, a number of experts have judged Thailand’s experience in implementing an IT framework as successful. In a recent independent evaluation of how inflation targeting has performed, Dr. Stephen Grenville and Professor Takatoshi Ito concluded that the Bank of Thailand’s excellent inflation performance, well-anchored inflation expectations, and admirable standard of accountability, transparency, and external communications are due in part to its inflation-targeting framework which conforms to best international practice. The IMF in the context of Article IV surveillance has reached similar conclusions. The IMF Research and Monetary and Capital Markets Departments have been working with BOT staff to further strengthen its IT framework and see Thailand as one of the better examples of the successful implementation of an IT framework among emerging markets.

Recent IMF research has looked at the implementation of monetary policy and the IT framework in Thailand during three major shocks over 2008-11: the global financial crisis, the Japanese earthquake, and the Thai floods of 2011. During the six quarters when output was most severely affected by these shocks exchange rate flexibility and counter-cyclical monetary policy, guided by an explicit and credible inflation targeting framework, successfully supported growth and recovery. These results are in line with the favorable output stabilization properties of exchange rate flexibility dating back to the original work of Mundell and Fleming, and consistent with the international evidence of improved macroeconomic performance in countries implementing IT. Staff estimates that if this IT/flexible exchange rate policy had not been in place (e.g., a fixed exchange rate regime) the output loss would have been more severe (by an estimated 3.7 percent of GDP) during these three major shocks. Moreover, inflation targeting has helped to reconcile the challenges of strengthening a framework of strong governance, accountability, fiscal discipline, and transparency.