Challenges for Inflation Targeting in EM in View of the Current Global Crisis by Leonardo Leiderman Berglas School of Economics, Tel-Aviv University, Israel To be presented at the National Bank of Georgia’s international conference, Tbilisi, June 26-27, 2009

Initial concerns about using IT in EM… Once upon a time it was argued that: “IT will not work in EM” “There is a very high pass-through from exchange rates to prices” “To stabilize inflation it is essential to have a nominal exchange-rate anchor” “EM lack monetary policy credibility and transparency” “De facto, central banks will not have operational independence” “EM inflation dynamics will be mainly governed by fiscal dominance and not by monetary policy”

Yet, it is common to find EM where… IT is being used as the monetary policy framework for reducing and stabilizing inflation The nominal exchange rate has become flexible Fiscal discipline has been tightened Monetary policy has gained credibility Fiscal and monetary policy have become more transparent No immediate changes in this monetary regime (i.e., IT) are being contemplated

Brazil as a case where inflation targets are highly credible Source: Banco Central Do Brasil

Israel: strong IT credibility in spite of frequent deviations of inflation from target Inflation rate – year over year 12-month ahead break-even inflation Sources: Bank of Israel and Central Bureau of Statistics

Some ‘good news’ for EM in the context of the current global crisis EM are playing a stabilizing role for the global economy No major crises or imbalances in most EM; decoupling… Good functioning of FX markets Substantial gains in EM stock and bond markets YTD Inflation has remained under control

EM Growth is Expected to Lead the Global Recovery GDP growth rates – The figures for 2009/10 are IMF forecasts Sources: IMF

Single-digit inflation rates in EM: here to stay? Testing time ahead for monetary policy Source: IMF

Weaker fiscal discipline ahead: EM budget deficits as percent of GDP Source: IMF

The nominal exchange rate as a shock absorber: currency depreciation since the Lehman event of Sept. 15, 2008… % nominal exchange rate depreciation up to June 19, 2009 (LTD) and up to mid March (LTMAX) Sources: Bloomberg

…points to regime change in terms of a key monetary policy tradeoff A B Exchange Rate Variability Interest Rate Variability Now: Rely on ER flexibility Before the current crisis: fear of floating

Major difficulties and challenges ahead The return of fiscal dominance? A larger role for central banks as lenders of last resort? How to deal with growing risks of corporate debt defaults? Is there room for quantitative easing as a policy instrument? A larger role of asset prices in setting the policy rate? How to deal with commodity-price fluctuations? Weak growth but higher inflation: back to the Phillips curve dilemmas? In summary: the next few years will be a severe testing time for inflation targeting not only in emerging-market economies

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