Monday, August 11, 2014

Inflation targeting – mission impossible?*

By Dmytro Sologub (Kyiv, Ukraine)
Fixed exchange rate regime has been the name of the game in Ukraine for the almost 15 years. But, no longer – the personnel changes in the National Bank in early 2014, coupled with the forceful breakdown of the exchange rate peg, prompted the radical shift in exchange rate policy. Namely, the new management of the central bank abandoned fixed exchange rate regime and declared the ultimate goal of introducing inflation targeting regime in the time frame of 12 months. This intention has been endorsed by the IMF and became one of the cornerstones of Fund’s US$ 17 bn bail-out programme for Ukraine.
One might argue that inflation targeting is not an appropriate monetary regime for Ukraine and it might be better search for other alternatives, ranging from currency board to the crawling peg. However, we believe that this discussion doesn’t make much sense at the moment for two reasons. First, the policymakers have already made a choice in favor of flexible exchange rate regime. Hence, to step back to any kind of fixed exchange rate arrangement doesn’t look really appropriate. Second, with the economy having experienced two severe balance of payment crises in 6 years it’s difficult to argue that the fixed exchange rate regime fits well for the country. Therefore, instead of again going through fruitless discussions on the most appropriate exchange rate regime for Ukraine, we suggest to concentrate on the question of what should be done by the policymakers to meet the IMF programme condition of introducing inflation targeting framework by mid-2015.
First of all, few words about inflation targeting per se. It became a popular policymaking tool in 1990s after the decades of academic discussions about the role and functions of the central banks in resolving the dilemma between low inflation and full employment. Being pioneered by the matured economies, like New Zealand and Canada, it then turned into the mainstream monetary regime for the emerging market economies and contributed to the sustainable disinflation in Emerging Europe countries in 2000s. Under the inflation targeting framework, the price stability is set as a primary policy goal for the central bank – it defines a mid-term inflation target, which is communicated to the economic agents. To achieve its inflation target the central bank is using all available conventional instruments, like policy rates, open market interventions and reserve requirements.
There are several main prerequisites to the efficiently functioning inflation targeting regime, including macroeconomic stability, absence of market distortions (such as administrative price controls and high degree of market monopolization), well-developed monetary transmission mechanism, based on efficient financial intermediation provided by the banking system and local financial markets. Unfortunately, Ukraine ticks practically no boxes in this respect at the moment. First, the country has been facing wide macroeconomic imbalances, namely high and volatile inflation rate, unbalanced external accounts and unfavorable growth dynamics. Second, the origins of high inflation are partially stemming from the structural imbalances (like poor anti-trust regulations and imperfect business climate) and thus are beyond the reach of the monetary authorities. Third, the monetary transmission mechanism is virtually non-existent as the policy decisions of the central bank (like changes in the key interest rate) have no effect on the financial market indicators and real economy variables. The reason for that is not only the shallowness of the domestic financial markets (i.e. low liquidity, lack of interest rate benchmarks, various administrative restrictions and controls), but also the weakness of the Ukrainian banking system, plagued by the poor loan quality, low operational efficiency, undercapitalization and imperfect corporate governance standards.
Hence, the challenges to the introduction of inflation targeting regime loom high. What is important to highlight is that the adoption of inflation targeting is not simply the change from one monetary regime to another. It requires comprehensive and systemic transformations in economic and structural policies. Without that, the new monetary policy framework will hardly be successful and the country will remain locked into the vicious inflation-devaluation circle. Therefore, the transition to IT framework might hopefully serve as the trigger of the radical improvements in the macroeconomic environment and domestic financial system.
What should be done for that? In the first area, macroeconomic policy, the initial focus of the authorities and IMF is on the short-term measures, which help to restore economic stability in the nearest future. Going beyond that, the improvement in coordination of fiscal and monetary policies emerges as an important success criterion of the new monetary framework. In particular, the National Bank should be no longer used as a “cash cow” for budget deficit financing. Also, we suggest to establish an institutional arrangement for policy coordination between the government and central bank either in the form of high-level policy committee or signing the joint memorandum on cooperation and coordination.
The structural measures should be focused on deregulation of the economy, improving business climate and raising the efficiency of anti-trust regulations. The improvement in the national statistics is important issue as well. In our opinion, the existing methodology of inflation calculation (in particular with the respect to the defining the weights of the goods in the consumer basket) is not fully adequate and creates the problems for the central bank in forecasting and targeting the level of inflation.
As for the banking system reform, the focus should be made on the measures, aimed at tackling the structural deficiencies described above. It first of all means the clean-up of the system (i.e. getting rid of non-transparent undercapitalized banks), boosting banks’ capital position, facilitating the resolution of non-performing loans, strengthening the banking supervision etc.
Finally, the development of the local financial markets is an important pre-requisite for the creation of efficient monetary transmission mechanism and ultimate success of the inflation targeting framework. The list of necessary measures is quite long, so we concentrate here on only several short-term pressing measures. First is the liberalization of FX market operations, including the removal or modification of FX purchase tax and the easing of restrictions on FX forward operations. Second is the block of the measures aimed at facilitating the liquidity management in the banking system – enhancing the refinancing framework of the central bank, facilitating the use of FX swap operations by the banks, improving the functioning of the funding market (i.e. resolving the issue of early deposit withdrawal and preventing unfair pricing competition at the deposit market). Also, the role of NBU interest rate policy should be strengthened. Specifically, the National Bank should more actively manage interest rate corridor, by adjusting the rates on its mobilization and refinancing facilities. Besides, the central bank, the government, market players and international financial organizations should work together to promote the establishment of interest rate benchmarks at the local money and bond markets.
How realistic is the implementation of all these measures, and thus the introduction of inflation targeting framework by mid-2015? The timeline set in IMF programme looks very tight and we don’t think that Ukraine will be able in 12 months to cover the distance, which took 3-5 years in other countries, like Poland or Romania. Essentially, MANY things should be built from scratch or to be overhauled completely (i.e. changing the way the things were done in the last 23 years). Nevertheless, we stress that these measures should be launched immediately in order to make the impact at some stage in the future. If this is done, we might witness the first fruits of the reforms next year, while full-fledged inflation targeting regime might be introduced as early as in 2017.
*This is an adopted version of the article published in Zerkalo Nedeli.


  1. I like very much this indirect approach: We focus on the inflation targeting because few in the politcal elite understand what it means. Thus, the elite might ignore this policy effort as something technical or irrelevant. Yet, in order to implement inflation targeting, many of the distortions in the economy, guarded by the elite, have to be removed. This is an example of an excellent proposal for attack on the existing system, which does not take the usual "head-on" approach and therefore is more likely to succeed.

  2. I think a big benefit of IT is that can be at least moderately successful even if other reforms aren't pursued; the only exception I can think of is central bank independence, but this usually goes hand in hand with IT. This I believe is part of the conventional wisdom, although it might be wrong in some cases (liquidity traps).

  3. I think the first issue with inflation targeting is whether the authorities will actually follow a inflation-interest rule of some sort.

    Some of the countries listed in your Dzerkalo Tyzhnia article don't seem to actually follow a rule, but are rather discretionary in their monetary policy - especially Serbia. While the government (and CB) there sets a target, its behaviour in interest rates is really inconsistent with a IT regime, it tightens and eases very rapidly each time, overshooting a lot in both directions and the actual inflation target seems to change often.

    The second big issue, replicated time and time again in many countries it that inflation targeting regimes are often "inflation nutters" or excessively hawkish.

  4. Inflation targeting would not reduce the risk of balance of payments crisis. Export is almost half of Ukrainian GDP and roughly half of export comprises of commodity goods like metals, agriculture and fertilizer. And the problem with commodity goods is that their prices are more volatile – we could easily see 20% decline in average price for Ukrainian export within one year, something you could hardly expect to see for most of other economies. Other things equal, 20% decline in exports value would mean an increase in current account deficit by 10% of GDP and hardly any change in domestic inflation (well, may be up to 3-4% decline due to lower food prices). Thus if National Bank follows inflation targeting, it would adjust exchange rate only slightly – may be by 6-8% because roughly half of the consumption is import-based. With historically low imports volume elasticity to exchange rate slump, import volumes would decline only by 2-4% unless business passes on lower export revenues on salaries. Consequently we end up with current account misbalancing by 7-9% of GDP if we simply follow inflation targeting.
    Of course, in this case export-oriented business would reduce its spending, cut capex, service purchase and salaries gradually which would be passed on lower consumer purchasing power and would eventually cut imported portion of consumption. This is however much longer adjustment and less favorable way from the government point of view. Because for business it is easier to lay off 10% personnel than to cut everybody’s salary by 10%. And capex is the easiest to cut – and most negative from state’s point of view.

    1. Of course, Ukraine's high trade openness poses the risk for proper functioning of IT framework. But, the point is that Ukraine shoud reduce this dependency on foreign trade. Having vast domestic market, relatively good human capital and wide production base, the role of domestic supply and demand should increase in the result of comprehensive macroeconomic and business reforms. For example, Poland (the country quite similar to Ukraine on many accounts) has a share of exports to GDP in the range of 30-40% and IT framework is working there pretty well. So, this particular issue again illustrates the point I wanted to highlight in the article - the smooth introduction of IT regime is impossible without radical changes in policies and environment

  5. Dmytro, totally agree with you that Ukraine should be less dependent on exports and have less commodities in its structure - but that is not something that NBU can affect or what can be changed over a couple of years.

    And Poland is not that much similar to Ukraine if we look at their export structure. Indeed, if you compare Poland ( and Ukraine ( in 2008 and 2009, you would see: Poland export dropped only about 22% yoy while Ukraine's - by 45%. That is a huge difference.

    I think if everything works well with reforming our country, we could think about inflation targeting in about 10 years or so.