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Use of Inflation Targeting Regime by Countries Strengthens Resilience of Their Economies to Crises – NBU Workshop

Use of Inflation Targeting Regime by Countries Strengthens Resilience of Their Economies to Crises – NBU Workshop

The NBU’s workshop Inflation Targeting in Emerging Markets that was held in late November gathered over 170 participants from around the world.

The event speakers, including representatives from central banks of Ukraine, Poland, Georgia, the Czech Republic, Peru, and Romania, as well as from the World Bank, the European Bank for Reconstruction and Development, Morgan Stanley, OGResearch, Institute of International Finance, and Bilkent University, discussed the most pressing issues for EM central banks that target inflation.

“Inflation targeting in emerging markets is a timely and relevant issue, especially now that the world is trying to go back to normal after the coronavirus shocks. This regime has proved to be effective and today it is an integral part of monetary policy in 41 countries around the world. I am happy that Ukraine is one of them,” said NBU Governor Kyrylo Shevchenko while opening the event.

Here are the five most important conclusions made by the speakers at the NBU workshop:

Experience of emerging markets shows that the inflation targeting regime is the most effective way to maintain macroeconomic stability

At present, the inflation targeting regime is favored in the world. It was introduced by 41 central banks, including 30 central banks in emerging markets. 

David Vavra (OGResearch), the keynote speaker at the workshop said that inflation targeting combines the most recent best practices in the monetary policy implementation under the floating exchange rate regime. They allow regulators to boost confidence in their monetary policy, anchor inflation expectations, and, eventually, ensure economic stability that largely absorbs adverse shocks.

For example, David Vavra pointed out that after Ukraine’s transition to the inflation targeting policy with the flexible exchange rate regime in 2015, the levels of volatility of the hryvnia exchange rate substantially declined (the average annual depreciation rates equal to 0.5%) compared to the fixed exchange rate regime (40%).

Recalling their countries’ experience, Adrian Armas Rivas (Central Reserve Bank of Peru) and Mihai Copaciu (the National Bank of Romania) confirmed that inflation targeting for the emerging markets proves to be an effective regime even in dollarized economies.

In contrast to previous crises, emerging market central banks were able to countercyclically respond to the COVID-19 pandemic

Dimitar Bogov (EBRD) noted in his speech that crises in EMs usually pass through several typical stages: depreciation of the national currency, high inflation, and contraction of aggregate demand. Response from central banks of these countries was also typical: pursuing pro-cyclical monetary policy, i.e. raising the key rates, responding by foreign exchange interventions, and establishing control over capital flows.

Meanwhile, during the coronavirus crisis, central banks that target inflation in EM economies were able to act in a totally different way. They pursued a counter-cyclical monetary policy (cut the key policy rates to historic lows and introduced a full array of unconventional tools) to keep the economy from a sharper decline.

‪In her speech, Joanna Niedźwiedzińska (Narodowy Bank Polski) indicated an unprecedentedly active participation of EM central banks in the introduction of unconventional monetary tools in 2020. Some of them were implemented at the onset of the coronavirus crisis, while a number of others were introduced even earlier.

Commitment to price stability is key to anchoring inflation expectations and gaining confidence in the central bank’s policy

 Comprehensive and consistent work that was done before the crisis allowed EM central banks to significantly ease the monetary policy during the unfolding of the coronavirus crisis to enhance confidence in their policy.

As Dimitar Bogov (EBRD) said, central banks were building up trust by strengthening their independence and enhancing transparency, as well as conducting a consistent monetary policy, pursuing the floating exchange rate regime, and increasing international reserves.

David Vavra (OGResearch) noted that the world has experienced situations when central banks rapidly lost confidence due to the inconsistent monetary policy. He cited the example of 2015–2016, when the level of confidence in a number of EM central banks dropped because they revised their mid-term inflation targets upwards amid growing consumer prices.

EM central banks cannot afford to lose the hard-won trust and ignore the current inflation surge in the world

According to David Vavra, today’s surge in inflation is felt around the globe, and in some EMs inflation reached its highest point since 2000. At the same time, real interest rates currently remain at historical lows and the level of confidence in central banks is relatively high.

Archil Mestvirishvili (National Bank of Georgia) stressed that the level of confidence in a central bank plays an important role in the inflation targeting policy.  High level of confidence allows central banks to temporarily deviate from its goal and gradually bring inflation back down to its target without significant losses to the economy.  Declining confidence levels and worsening inflation expectations make it harder to bring inflation back to its target.

Volodymyr Lepushynskyi (NBU) also emphasized the value of confidence in the monetary policy.  He said that EM central banks that have relatively little experience in inflation targeting cannot afford to hesitate in making decisions on monetary policy due to the risks of worsening inflation expectations. Thus, the NBU was one of the first central banks to raise the key policy rate and phase out its anti-crisis measures in 2021. At the same time, the NBU is trying to be as predictable as possible and therefore publishes its intended further actions and the key policy rate forecast. Structural reforms, fiscal discipline, and central bank's independence are essential for effective inflation targeting

David Vavra (OGResearch) identified the following key components of a successful inflation targeting regime: an unchanged medium-term inflation target, central bank’s operational independence from the fiscal authorities, operational design based on interest rate, flexible exchange rate, development of policy based on the forecasting system and transparent communication.

Oleksandr Faryna (NBU) also said that usually the growth in a central bank’s efficiency is correlated with the duration of inflation targeting regime implementation: the longer the implementation, the higher the efficiency. At the same time, he noted that the important elements of a more effective monetary policy include its consistency and transparency, as well as the central bank’s independence in conditions of political stability and the rule of law.

Closing the event, Sergiy Nikolaychuk, Deputy Governor, noted that the coronavirus crisis has had an unprecedented impact on the economies around the globe: in the past, central banks had to deal with high volatility in financial markets and keep the economy from going into a deeper recession, and this year they had to respond to a surge in inflation in an increasingly uncertain environment. He said that in these circumstances, a reliable macroeconomic framework, prudent and independent monetary policy, and the development of deep and liquid financial markets are vital for effective inflation targeting.

The information about the workshop, the presentations of the speakers, and the video of the event are available on the NBU’s special microsite.  

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