Inflation targeting in the developing world: a minority policy regime?

In 1990, the central bank of New Zealand became the first country in the world to adopt an inflation targeting (IT) regime. Two years later, the founding members of the Eurozone adopted the Maastricht Treaty that included an inflation target along with fiscal rules. Other countries – such as Australia, Canada, UK and Sweden – became IT regimes between 1991 and 1993.  Low and middle-income countries followed with a significant lag, usually about 10 years.  By 2014, the IMF calculates that there were 34 IT regimes in the world in addition to all the countries that belong to the Eurozone and fall under the European Central Bank (ECB) which practices inflation targeting. The spread of IT regimes to the developing world has been rather limited . There are only 19 out of more than 90 middle-income economies and only one out of 31 low-income that can be classified as IT regimes – even on a de facto basis.

Monetary policy in the advanced economies has emerged as the preferred tool of short-run economic stabilization, while fiscal policy has primarily been assigned to deal with debts and deficits. This is a paradigm shift from the golden age of Keynesian economics when both monetary and fiscal policy shared the responsibility of short-run economic stabilization in the pursuit of the twin goals of price stability and full employment. It was also the period in which discretion rather than rules governed the conduct of macroeconomic policy. This has evolved into a distinct preference for rules and targets rather than discretion – or at least discretion constrained by the need to observe rules and targets.

In the case of low and middle-income countries, the spread and scope of IT has been rather limited despite the formidable intellectual and political influence of both academics and practitioners preaching the virtues of IT regimes. This is not necessarily an undesirable outcome. The institutional prerequisites for the successful conduct of an IT regime are not always in place in the developing world – such as the effective transmission of monetary policy, especially in low-income countries. More importantly, following the global recession of 2008-2009, IT regimes in developed countries have faltered significantly in terms of their effectiveness. Furthermore, an ideological allegiance to a particular framework in which monetary policy is given primacy over fiscal policy has constrained the capacity of macroeconomic policy managers in the advanced economies to use fiscal initiatives to kick-start growth in the wake of the global recession of 2008-2009. This in turn has prolonged the period of slow growth in the developed world. Such lacklustre growth in the rich nations has acted as a drag on global growth.

There are thus important lessons that low and middle-income economies can learn from the experience of IT regimes in the developed world. What one learns in particular is that the objective of low inflation needs to be combined with other development objectives. If IT regimes constrain, rather than empower, central banks in low and middle-income economies to pursue growth and employment objectives that are at the core of the development process, then there is a case for re-thinking the appropriate role of central banks without sacrificing their obligations with respect to price stability.


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