The scope for inflation targeting in developing countries

Difficulties in conducting monetary policy using an exchange rate peg or some monetary aggregate as the main intermediate target led a number of industrial countries in the 1990s to adopt a framework for monetary policy that has become known as inflation targeting (IT). The framework aimed at improving inflation performance as well as the accountability and transparency of monetary policy in those countries. Though the IT framework has not been severely tested since its inception, it is widely viewed as having proved quite useful. This paper examines the relevance of IT for developing countries. It delineates the prerequisites and building blocks of this monetary policy framework and discusses some features of its implementation in advanced economies. The paper identifies two major prerequisites for adopting an IT framework: (1) the ability to carry out a substantially independent monetary policy, especially one not constrained by fiscal considerations; and (2) freedom from commitment to another nominal anchor like the exchange rate or wages. A country satisfying these two eequirements could choose to conduct its monetary policy in a manner consistent with IT, defined as a framework containing an explicit quantitative target for future inflation, a commitment to that target as an overriding objective, a model for predicting inflation, and an operating procedure for adjusting monetary instruments in case forecast inflation differs from its target. These fairly stringent technical and institutional requirements of IT cannot be met by many developing countries because seigniorage remains an important source of financing and/or because there is no consensus that attainment of low inflation should be the overriding objective of monetary policy. We thus conclude that the way to improve the monetary and inflation performance of developing countries may not be through the adoption of a framework akin to IT, at least not in the near term.