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Too much, too soon:
IMF conditionality and inflation targeting

Gerald Epstein

September 2006

SARPN acknowledges the Bretton Woods Project as a source of this document:
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Gerald Epstein, co-director of the Political Economy Research Institute at the University of Massachusetts, finds that despite little evidence of the success of inflation targeting in promoting economic growth, employment creation or poverty reduction, the IMF is increasingly pushing its use. There is an urgent need for viable alternatives that focus on employment generation, poverty reduction, export promotion and investment enhancement to be given more attention.

Ironically, employment creation has dropped off the agenda of most central banks just as the problems of global unemployment, underemployment and poverty are taking centre stage as critical world issues. The ILO estimates that in 2003, approximately 186 million people were jobless, the highest level ever recorded. IMF economists estimate that economic growth needs to be sustained at seven per cent per year or more to reach the millennium development goal of reducing poverty by half by 2015.

Yet the so-called 'global best practice' approach to central banking has not focused on economic growth or employment generation; instead, the IMF promotes formal or informal inflation targeting, in which keeping a low rate of inflation - in the low single digits - has been proposed as the dominant and often exclusive target of monetary policy. According to this orthodox approach to monetary policy, the focus of policy is on stabilisation, rather than growth or development, with an implicit assumption that once stabilisation is achieved, economic growth, employment creation, and poverty reduction will follow.

This orthodox view not only specifies the appropriate target of monetary policy, but also the appropriate tools or instruments. The orthodox approach has emphasised indirect, market-based instruments of policy, such as short-term interest rates, as the primary and often exclusive tool of monetary policy. This is in contrast to the direct, quantitative tools often used by central banks which have involved credit allocation methods, interest rate ceilings, and other ways to direct credit to priority economic sectors and goals. In short, the IMF-sponsored orthodox approach has narrowed both the goals and the tools of monetary policy.

After several decades of experience with this inflation-focused market-based approach, the record has been disappointing. In a number of countries, inflation has come down, to be sure, but it is questionable to what extent the drop in inflation is due to changes in domestic monetary policy, rather than the overall global fall in inflation. But even if domestic monetary policy has reduced inflation, the hoped for gains in employment have generally not materialised; and, for many countries following this orthodox approach, economic growth has not significantly increased. The key point, then, is this: despite what the orthodox approach maintains, employment generation and economic growth are not automatic by-products of stabilisation-focused central bank policy.

Surprisingly, despite a disappointing record, this almost singleminded focus on inflation is gaining a more secure foothold in monetary policy circles and the circles are widening to include an increasing number of developing countries. According to a recent report by the IMF, an increasing number of central banks in emerging markets are planning to adopt inflation targeting as their operating framework. An IMF staff survey of 88 nonindustrial countries found that more than half expressed a desire to move to explicit or implicit quantitative inflation targets. Nearly three-quarters of these countries expressed an interest in moving to full-fledged inflation targeting by 2010.

Importantly, to support and encourage this movement, the IMF is providing technical assistance to many of these countries. In addition, the IMF is considering altering its conditionality and monitoring structures to include inflation targets. In short, despite little evidence concerning the success of inflation targeting in its promotion of economic growth, employment creation and poverty reduction, and mixed evidence at best that it actually reduces inflation itself, a substantial momentum is building up for fullyfledged inflation targeting in developing countries.

While it might seem obvious that stabilisation-focused central bank policy represents the only proper role for central banks, in fact, looking at history casts serious doubt on this claim. Far from being the historical norm, this focus by central banks on stabilisation to the exclusion of development represents a sharp break from historical practice, not just in the developing world but also in the now developed countries as well. In many of the successful developed and developing countries, development was seen as a crucial part of the central bank's tasks. Now, by contrast, development has dropped off the 'to-do list' of central banks.

The promotion of inflation targeting has implications for the type of conditionality that the IMF imposes. As the IMF states: "Conditionality in Fund-supported programmes is intended primarily to ensure that Fund resources are used to support adjustment toward sustained external viability, and thereby to safeguard the capacity to repay the Fund. Traditionally, monetary conditionality consists of limits on monetary aggregates...".

The IMF is concerned, however, that this approach could allow for higher inflation than they might like if, for example, larger than necessary increases in net international reserves result from inflows of capital. As a result, inflation targeting might require a further tightening of monetary conditions for countries undergoing IMF programmes in order to maintain inflation rates in the low single digits. To the extent that such tightening slows employment growth even further, inflation targeting as part of IMF conditionality could have more severe impacts on employment and poverty impacts for developing countries than current conditionality.

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