the evolution of inflation targeting strategy in poland

1

The evolutionThe evolutionof inflation targeting of inflation targeting

strategy in Polandstrategy in Poland

Jerzy PruskiNational Bank of Poland

EMU and the new Member States – a year after accession

3-4 October 2005, Sofia

2

OutlineOutline

1. Why new strategy?2. Monetary policy in 1999-

2003 3. Monetary policy after 20034. Current monetary policy

framework – some remarks 5. Conclusions

3

OutlineOutline




4

Monetary policy in Poland Monetary policy in Poland in the pre-DIT periodin the pre-DIT period

o An “eclectic” strategy - elements of exchange rate targeting, inflation targeting, and monetary targeting

o The intermediate targets: o crawling band (Zloty devalued against a basket of

currencies)o reference value for M2 annual growth announced

o Initially, given the limited links between the Polish economy and the global financial market, the strategy allowed inflation to be smoothly reduced

5

Macroeconomic environement in the Macroeconomic environement in the pre-DIT periodpre-DIT period

Strong domestic demand, increase of the CA deficit and high inflation rate

Monetary response:o Tihgtening of interest rate policy o Increasing of the mandatory reserves ratioo Introduction of deposits for the households priced

directly by the NBP

But…

6

Problems with eclectic strategy Problems with eclectic strategy

Factors lowering the effectiveness of the monetary measures:o Rising inconsistency in controlling both:

exchange rate and interest rate under openness of capital account (impossible trinity problem)

o Relatively loose fiscal policy o Roots of the consumption boom – exscessively

optimistic expectations after a very long period of low consumption

o Weak response of interest rates in banking sector to the NBP policy

7

Selected macreoeconomic indcators 1995-1998Selected macreoeconomic indcators 1995-1998

Source: NBP

14.221.719.716.5Gross fixed capital formation (%)

4.86.98.63.6Individual consumption (%)

-2.58-2.87-3.09-2.57General government deficit in % of GDP

-4.4-3.9-2.30.7Current Account in % of GDP

11.814.919.927.8CPI (Annual)

6.49.29.47.0Domestic demand (%)

4.86.86.07.0GDP (%)

1998199719961995Specification

14.221.719.716.5Gross fixed capital formation (%)

4.86.98.63.6Individual consumption (%)

-2.58-2.87-3.09-2.57General government deficit in % of GDP

-4.4-3.9-2.30.7Current Account in % of GDP

11.814.919.927.8CPI (Annual)

6.49.29.47.0Domestic demand (%)

4.86.86.07.0GDP (%)

1998199719961995Specification

8

The Foreign Exchange Interventions and PLN’ s The Foreign Exchange Interventions and PLN’ s NEERNEER

Market interventions (net)

-200

0

200

400

600

800

1000

1200

1995 1996 1997 1998

US

D m

illio

n

50

55

60

65

70

75

80

85

Dec

. 199

3 =

100

net interventions (lhs) NEER (rhs)

9

Effects of FX interventions in 1995-1998 Effects of FX interventions in 1995-1998

Frequent FX interventions resulted in the soar of the FX reserves to the safe level

But…Sterlilised interventions created

significant fiscal costsLed to liquidity surplus in the banking

sector – long-lasting problem for the monetary policy effectiveness

10

Foreign exchange reserves in Poland Foreign exchange reserves in Poland

0

5

10

15

20

25

30

1990 1991 1992 1993 1994 1995 1996 1997 1998

bln USD

11

Costs of open market operationsCosts of open market operations

0,00

0,20

0,40

0,60

0,80

1,00

1,20

1,40

USD BN

1996 1997 1998 1999 2000 2001 2002

Source: NBP

12

NBP Balance Sheet NBP Balance Sheet as at 31 December 1995, 1998, 2000, 2004as at 31 December 1995, 1998, 2000, 2004

0,00

5,00

10,00

15,00

20,00

25,00

30,00

35,00

40,00

45,00

US

D b

illio

n

1995 1998 2000 2004

FX Assets Assets in domestic currency Other assets

Banknotes in circulation Securities issued Capital and reserves Other liabilities

ASSETS LIABILITIES

56,76%

34%

75,74%

25,85%

79,74%

26,95%

92,28%

46,74%

30,01%

19,28%

14,30%

2,64%

13,24%

5,08%

5,96%

4,98%

8,75%

11,65%

23,58%21,73%16,27%

13,65%

24,25%19,69%40,98%

27,96%

25,22%32,73%

13

Eclectic strategy – final considerationsEclectic strategy – final considerations

Continuation of eclectic monetary policy strategy impossible

Nominal anchor - importanto For inflation expectationso For transparent criteria for monetary

policy decisions

Need for a new strategy

14

OutlineOutline




15

New legislation laid foundations for New legislation laid foundations for the new strategythe new strategy

New Constitution of 1997 named price stability as the primary objective of the National Bank of Poland

„The central bank of the State shall be the National Bank of Poland. It shall have the exclusive right to issue money as well as to formulate and implement monetary policy. The National Bank of Poland shall be responsible for the value of Polish currency.”

The institutional proccess of monetary policy decision-making changed in the beginning of 1999 (Monetary Policy Council) following the new NBP Act

16

Why inflation targeting?Why inflation targeting?

Free of drawbacks related to a strategy based on intermediary targets

Explicit and comprehensive monetary policy goal

Openness makes NBP subject to public scrutiny, thus enhancing credibility of the monetary policy

Increasing central bank credibility minimises costs of lowering inflation expectations

Increased flexibility in the application of monetary policy instruments allows the NBP to select the reaction, depending on the type of events that might threaten the achievement of the inflation targets

17

Medium-term strategy of monetary policy Medium-term strategy of monetary policy (1999-2003)(1999-2003)

Strategic goal – integrate Polish economy with EU (convergence criteria)

Lower the inflation rate to below 4% by the end of 2003 (focus on CPI)

Year-end inflation targets announced for each year

NBP information policy aimed at convincing the public about central bank comittment – Inflation Report as main analytical document

Work towards full floatation of the Zloty; FX interventions not excluded

18

PEG BAND

FLOAT

0,0

1,0

2,0

3,0

4,0

5,0

Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

PLN/Basket

PLN_Basket central parity PLN_Basket (market rate) Fluctuation band

Devaluation and introduction of

a basket

Devaluation

Devaluation

Revaluation

Official floatation

Basket change

Depre

ciati

on

Exchange rate floatationExchange rate floatationDe facto floatation already in July 1998, when MPC abandoned FX interventions (official floatation April 2000)After floatation exchange rate became more volatile (2000-2001 strong appreciation; 2002-mid 2004 strong depreciation)

19

Year-end inflation targetsYear-end inflation targets – main challenge – main challenge

Year-end inflation targets announced in Monetary Policy Guidelines for each year (in the fall of the preceeding year)o required by lawo allowed to increase understanding and thus credibility of DITo DIT introduced to support the disinflation process – short-term

targets very important

However, year-end targets - not free of drawbackso in practice, horizon was inconsistent with lags in monetary

transmission mechanism

Being aware of the above pros and cons, as well as of the probability of missing year-end targets, the MPC

decided that short-term targets will be conducive to lowering inflation

20

Inflation rate vs. MPC targetsInflation rate vs. MPC targets o Medium-term target of below 4% by end-2003 meto Deviations from year-end targets smaller in terms of net CPI

But in communicating with the public, the relative importance of both types of inflation targets seemed to

change in 1998-2003, with a gradual increase in the weight of the medium-term target

Net CPI – CPI excluding food and fuel prices

02468

1012141618

Jan-9

8

Jul-98

Jan-9

9

Jul-99

Jan-0

0

Jul-00

Jan-0

1

Jul-01

Jan-0

2

Jul-02

Jan-0

3

Jul-03

Jan-0

4

Jul-04

Jan-0

5

Jul-05

CPI net CPI inflation target

per cent

21

Reasons behind target missesReasons behind target misses

o way of setting the annual targets

o total CPI sensitive to changes in food prices; average weight of food prices in 1998-2004 in total CPI – 30%

o unexpected fiscal expansion combined with easy monetary policy led to an acceleration of inflation and the overshooting of inflation targets in 1999-2000

o subsequent sharp tightening of monetary policy and its slow relaxation in the absence of further easing of fiscal policy reduced inflation sharply and produced a significant undershooting in 2001-2003

22

Interest rate policyInterest rate policy

0

5

10

15

20

25

30

Jan-98

Jul-98

Jan-99

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

per cent

NBP reference rate CPI inflation rate (YoY)

23

Assesment of DIT in 1998-2003Assesment of DIT in 1998-2003

o DIT was introduced to support the disinflation processo Disinflation succesfully completed by 2003

o Mounting CA deficit one of the problems in the pre-DIT period o CA deterioration brought to a halt

o GDP slowdown in 2001-2002 due to, inter alia:o Russian crisiso slowdown in the world economyo previous overheating of the Polish economy

24

Selected macreoeconomic indicators 1998-2004Selected macreoeconomic indicators 1998-2004

Source: NBP

-5.58-5.37-5.95-5.00-2.93-3.24-2.58General government deficit in % of GDP

5.3-0.5-5.8-8.22.76.814.2Gross fixed capital formation(%)

3.43.13.32.12.85.24.8Individual consumption (%)

4.72.50.8-1.62.84.86.3Domestic demand (%)

5.43.81.41.04.04.14.8GDP (%)

-1.5-2.2-2.6-2.9-5.7-8.1-4.4Current Account in % of GDP

3.50.81.95.510.17.311.8CPI (Annual)

2004200320022001200019991998Specification

-5.58-5.37-5.95-5.00-2.93-3.24-2.58General government deficit in % of GDP

5.3-0.5-5.8-8.22.76.814.2Gross fixed capital formation(%)

3.43.13.32.12.85.24.8Individual consumption (%)

4.72.50.8-1.62.84.86.3Domestic demand (%)

5.43.81.41.04.04.14.8GDP (%)

-1.5-2.2-2.6-2.9-5.7-8.1-4.4Current Account in % of GDP

3.50.81.95.510.17.311.8CPI (Annual)

2004200320022001200019991998Specification

25

OutlineOutline




26

Monetary policy strategy beyond 2003Monetary policy strategy beyond 2003

o DIT – appropriate framework to stabilize inflation

o permanent inflation target of 2.5% +/- 1 percentage point

o lead Poland to the euro zone in the nearest possible future

o maintain floating Zloty until ERM II membership - the policy of adjusting the exchange rate could force interest rate changes inconsistent with the adopted inflation target

27

Why 2.5% is appropriate?Why 2.5% is appropriate?

o Once in the EU, inflation had to be stabilised at a level consistent with the euro-zone accession

o Inflation of 2.5% comes close to the expected reference value for the inflation criterion

o In case of lower reference value any subsequent attempts to bring inflation to the criterion will not require a substantial reduction in inflation over a short period of time

o Given the estimate of the Balassa-Samuelson effect, target of 2.5% assessed as appropriate and consistent with strong economic growth

28

Why permanent inflation target?Why permanent inflation target?

o Appropriate framework for stabilization of the inflation rate

o Year-end targets – problematic in view of monetary policy implemenation in 1998-2003

o Consistent with the lags in monetary transmission mechanism

o Supports forward-looking monetary policy

o Introduction of a permanent inflation target Introduction of a permanent inflation target proved to be a good decision already in 2004 proved to be a good decision already in 2004

29

Inflation rate vs. MPC targetInflation rate vs. MPC target Inflation increased in 2004 following the EU entry Permanent inflation target allowed the MPC to focus on the long-term (and not the short-term) challenge

• In August 2004 inflation projection – inflation rate above the MPC target in 2006

Thus, the adjustement in interest rate - appropriate

00,5

11,5

22,5

33,5

44,5

5

Jan-0

4

Mar

-04

May

-04

Jul-04

Sep

-04

Nov-

04

Jan-0

5

Mar

-05

May

-05

Jul-05

CPI inflation targetper cent

30

Monetary policy reaction to increase Monetary policy reaction to increase in inflation in 2005in inflation in 2005

o Changing outlook for future inflation resulted in adjustment in policy rates to historically low levels

0

1

2

3

4

5

6

7

Dec-03

Jan-04

Feb-04

Mar-04

Apr-04

May-04

Jun-04

Jul-04

Aug-04

Sep-04

Oct-04

Nov-04

Dec-04

Jan-05

Feb-05

Mar-05

Apr-05

May-05

Jun-05

Jul-05

Aug-05

Sep-05

per cent

NBP reference rate CPI inflation rate (YoY)

31

OutlineOutline




32

Inflation response to interest rate and exchange rate impulse

Reaction of inflation to temporary 1 pp increase in interest rate

(for 6 quarters)

Reaction of inflation to temporary 1 pp increase in ER risk premium

(for 6 quarters)

-0.35

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

-

1 2 3 4 5 6 7 8 9 10 11 12

-0.25

-0.20

-0.15

-0.10

-0.05

-

0.05

0.10

0.15

0.20

1 2 3 4 5 6 7 8 9 10 11 12

The role of exchange rate in The role of exchange rate in current current monetary policy monetary policy in Polandin Poland

33

Exchange rate in PolandExchange rate in Poland

Volatile exchange rate renders the control of inflationary processes more difficult

3,25

3,50

3,75

4,00

4,25

4,50

4,75

5,00

Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05

Dep

reci

atio

n PLN/EUR

34

Transparency issuesTransparency issues

Until mid-2004 - no inflation projection

Thus – need for improvement:• First inflation projection published in

August 2004, first GDP projection published in May 2005oAs a result - more forward-looking analysis in

the IR since 2004…o…press releases after the MPC meeting

brought in line with the analysis presented in the IR…

o… and outlook for future inflation presented in the form of balance of risks.

35

Macroeconomic projectionsMacroeconomic projections

National Bank of Poland is complying with international standards in terms of

publishing its marcoeconomic projections

Source: Inflation Report, August 2005, www.nbp.pl

GDPCPI

36

DIT in Poland – future challengesDIT in Poland – future challenges

Reconciling direct inflation targeting strategy with simultaneous membership in a guasi-fixed exchange rate system

DIT strategy within ERM II will be bound by the expected interpretation of exchange rate stability criteriono Symmetrical wide band (+/-15%): large enough not to

limit freedom of DIT monetary policyo Asymmetrical band (close to parity with more tolerance

for appreciation): more constraining for monetary policy If Maastricht reference value for inflation (in the

reference period) is below NBP’s permanent inflation target - potential short-term cost of fulfilling the inflation criterion

37

OutlineOutline




38

ConclusionsConclusions

o Permanent inflation target of 2.5% +/- 1 percentage point is assessed as consistent with long-term economic growth

o Large share of food prices in the total CPI renders the index very sensitive to its changes

o Volatile Zloty exchange rate hardens stabilization of inflation …

o …but there is no reasonable alternative to inflation targeting in Poland

o Hence DIT should be pursued until euro adoption

o Reconciling DIT and ERM II participation major challenge

the evolution of inflation targeting strategy in poland

Documents

rate policy

monetary measures

fiscal policy roots

exchange rate targeting

fx reserves

sofiaoutlinewhy new

eclectic strategy factors

frequent fx interventions