External shocks that depress economic activity, trigger temporary increases in inflation, pose a dilemma for policymakers in emerging economies, according to the International Monetary Fund’s (IMF) World Economic Outlook report issued on Wednesday.
The data shows that longer-term inflation expectations have become increasingly anchored (evaluated based on irrelevant information) in emerging economies over the past two decades, said the report authors, adding that there are sizable differences across emerging economies, and relative to advanced economies.
The extent of anchoring in, for example, Chile and Poland, is comparable to the average of advanced economies, but expectations are much less anchored in Russia and Argentina, adding ” we find that this dilemma is less pronounced when inflation expectations are well anchored.”
“The soundness of both monetary and fiscal policy frameworks is key for well-anchored inflation expectations. Policymakers should therefore keep improving the long-term sustainability of public finances, including adopting rules that limit the scope for policies that threaten debt sustainability, and building fiscal buffers in good times, that can then be relied upon during bad times,” noted the report authors.
Commitment to improving the credibility of central banks is very important for policy makers by consolidating and enhancing their independence, as well as through improvements in timeliness, clarity, transparency, and openness in their communications, mentioned the report authors.
“Anchoring inflation expectations takes time, so continuous effort is needed even in countries that have already made significant progress,” the report authors said.
Moreover, the report indicated that in countries where the credibility of monetary frameworks is relatively low, the emphasis should be on ensuring that fiscal sustainability is not a threat for their monetary objectives, and on communicating clearly the reasons for their monetary policy actions, including those taken in response to global developments.
“A temporary increase in inflation rates in emerging economies is to be expected if global financial conditions tighten, and emerging market currencies depreciate. But, if expectations are well anchored, price stability would not be jeopardised,” said the report authors.
Moreover, the report said that in the year following the 2008 financial crisis, economic activity declined in half of all countries in the world.
The study looked at a sample of 180 countries including advanced, emerging markets, and low-income developing economies, to measure the decline in economic activity in the decade after Lehmans (Lehman Brothers Holdings Inc. was a global financial services firm, which filled for bankruptcy in 2008 triggering the 2008 economic crisis).
Countries with more rapid credit growth, and larger excess current account deficits in the years running up to the crisis, found these constraints binding them more tightly, when financial conditions tightened after the crisis.
The ability to respond to the next crisis depends crucially on addressing such side effects of the exceptional policy efforts of the last 10 years.