Evolution of Monetary Policy Frameworks: From Monetary Targeting to Inflation Targeting
Transitioning from monetary targeting to inflation targeting is a crucial step for central banks, driven by the need for a more sophisticated approach in the face of evolving economies. This evolution is motivated by the changing dynamics of money and inflation correlation, leading to stronger short-term tradeoffs in managing inflation, growth, and exchange rate stability. Central banks in low-income countries are also seeking to modernize and align with advanced economies, although they face challenges such as multiple objectives, weak market structures, operational issues, and political influences on monetary policy decisions.
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Presentation Transcript
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 V VI Operational framework and operational target Forward looking strategy that maps objectives to operations Other objectives VII Effective communications
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
OtherObjectives: 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) 11 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 inflation (But not necessarily IT)
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 16 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 Best Practices 17 Institutional Price stability de jure primary objective of CB. Independence in policy formulation and in setting the policy rate. De facto operational Framework making the CB accountable to society. Independence Accountability Adequate level of CB disclosure and publications. Sound financial relationship between the CB and the government, no CB direct or indirect monetary financing or quasi-fiscal activities. Articulate role of the ER in monetary strategy and related intervention policy. Stable financial sector. Deep and active interbank market. Effective financial market infrastructure for the settlement of interbank transactions. Transparency Macro-Financial Fiscal policy FX policy Financial sector Data and Analytical Capacity 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 Statistical tools and short-term forecasting instruments able to support a comprehensive analytical framework. Minimum specifications based on the option. Minimum specifications based on the way the transitional monetary regime is operated in practice. Minimum specifications based on option. Analytical and research Decision- making Organization
Policy Regimes 18 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 Almost all CBs have price stability as one of their primary objectives In parallel, central bank independence has been strengthened 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 20 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 21 Basic Components of a Monetary Policy Framework Nominal Anchor Instruments Operational target Intermediate target Ultimate objective Indicator variables 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 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 22 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 non- existing 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 23 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 Price stability Target inflation and publish target, but not necessarily IT Role of Interest Rate Rules, Money Aggregates, and Modeling in Policy Formulation Yes all of the above, and it depends!! Role of Interest Rates and Money Aggregates in Operations Interest rates as target for short term liquidity management Focus of Communication and Commitment Interest rates and inflation (target), not monetary aggregates Clarity, Relevance, and Consistency of Policy Actions and Signals essential
Regimes and Targets, cont. 25 Objectives Intermediate Target and Nominal Anchor Operational target Instruments Communication Commitment FX FX FX FX FX Interventions (Inflation?) Inflation Broad money Reserve money Inflation forecasts Interbank rates (and Reserves) OMOs, standing facilities, others Essential (but risk of over- committing) FMT EMPA IT Inflation Inflation forecasts Interbank rates OMOs, standing facilities, others Essential (Risk of over- committing?)
The solution 26 Fix short term liquidity management Goal: stabilize and steer short term interest rates Consistency with rest of the framework Improve financial system s health and develop interbank market 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- credible commitment worse than no commitment) Risk of premature adoption of formal IT 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 27 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 28 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 systems CB deposit facility rate the floor and policy rate
Width of the Corridor? 29 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?) 30 Inter-temporal arbitrage encourage interbank trading Less need for frequent OMO interventions But: Need to anchor expectations for the end-of- maintenance-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 31 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 Repos, SWAPS At policy rate, full allotment if liquidity forecasting is weak 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
Money and Interest Rates 32 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 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 35 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 36 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? 38 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 Main Operational Target Intermediate Target Broad money Policy Objective Inflation (implicit) Instruments Option 1. OMOs Standing facilities Reserve requirement Option 2. OMOs Standing facilities Reserve requirement Short term: Interest rate (range) Longer term: average total reserves FMT Interest rate (central bank controls excess reserves to steers market rates to its policy rate) Broad money Inflation (implicit) OMOs Standing facilities Reserve requirement Interest rate (central bank steers market rates to its policy rate) Inflation forecast Cross-checking role of monetary analysis Inflation (explicit) EMPA
A Stylized Reform Agenda Money guides policy and operations The exchange rate guides policy and operations Multiple and sometimes inconsistent objectives Develop analytical tools for policy making Increase exchange rate flexibility Establish a coherent interest rate based operation framework to enhance monetary policy transmission 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 Flexible exchange rate Intervention strategy aimed at supporting market functioning 41
42 THANKS .
