The evolution of inflation targeting strategy in Poland

1

• The evolutionof inflation targeting strategy in
  Poland

Jerzy Pruski National Bank of Poland EMU and the
new Member States a year after accession 3-4
October 2005, Sofia
2
Outline

• Why new strategy?
• Monetary policy in 1999-2003
• Monetary policy after 2003
• Current monetary policy framework some remarks
• Conclusions

3
Outline

• Why new strategy?
• Monetary policy in 1999-2003
• Monetary policy after 2003
• Current monetary policy framework some remarks
• Conclusions

4
Monetary policy in Poland in the pre-DIT period

• An eclectic strategy - elements of exchange
  rate targeting, inflation targeting, and monetary
  targeting
• The intermediate targets
• crawling band (Zloty devalued against a basket of
  currencies)
• reference value for M2 annual growth announced
• 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 pre-DIT period

• Strong domestic demand, increase of the CA
  deficit and high inflation rate
• Monetary response
• Tihgtening of interest rate policy
• Increasing of the mandatory reserves ratio
• Introduction of deposits for the households
  priced directly by the NBP
• But

6
Problems with eclectic strategy

• Factors lowering the effectiveness of the
  monetary measures
• Rising inconsistency in controlling both
  exchange rate and interest rate under openness of
  capital account (impossible trinity problem)
• Relatively loose fiscal policy
• Roots of the consumption boom exscessively
  optimistic expectations after a very long period
  of low consumption
• Weak response of interest rates in banking sector
  to the NBP policy

7
Selected macreoeconomic indcators 1995-1998
Source NBP
8
The Foreign Exchange Interventions and PLN s NEER
9
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 costs
• Led to liquidity surplus in the banking sector
  long-lasting problem for the monetary policy
  effectiveness

10
Foreign exchange reserves in Poland
11
Costs of open market operations
Source NBP
12
NBP Balance Sheet as at 31 December 1995, 1998,
2000, 2004
13
Eclectic strategy final considerations

• Continuation of eclectic monetary policy strategy
  impossible
• Nominal anchor - important
• For inflation expectations
• For transparent criteria for monetary policy
  decisions
• Need for a new strategy

14
Outline

• Why new strategy?
• Monetary policy in 1999-2003
• Monetary policy after 2003
• Current monetary policy framework some remarks
• Conclusions

15
New legislation laid foundations for the 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?

• 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
(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
Exchange rate floatation

• De 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)

PEG
BAND
FLOAT
19
Year-end inflation targets main challenge

• Year-end inflation targets announced in Monetary
  Policy Guidelines for each year (in the fall of
  the preceeding year)
• required by law
• allowed to increase understanding and thus
  credibility of DIT
• DIT introduced to support the disinflation
  process short-term targets very important
• However, year-end targets - not free of drawbacks
• 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 targets

• Medium-term target of below 4 by end-2003 met
• 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
21
Reasons behind target misses

• way of setting the annual targets
• total CPI sensitive to changes in food prices
  average weight of food prices in 1998-2004 in
  total CPI 30
• unexpected fiscal expansion combined with easy
  monetary policy led to an acceleration of
  inflation and the overshooting of inflation
  targets in 1999-2000
• 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 policy
23
Assesment of DIT in 1998-2003

• DIT was introduced to support the disinflation
  process
• Disinflation succesfully completed by 2003
• Mounting CA deficit one of the problems in the
  pre-DIT period
• CA deterioration brought to a halt
• GDP slowdown in 2001-2002 due to, inter alia
• Russian crisis
• slowdown in the world economy
• previous overheating of the Polish economy

24
Selected macreoeconomic indicators 1998-2004
Source NBP
25
Outline

• Why new strategy?
• Monetary policy in 1999-2003
• Monetary policy after 2003
• Current monetary policy framework some remarks
• Conclusions

26
Monetary policy strategy beyond 2003

• DIT appropriate framework to stabilize
  inflation
• permanent inflation target of 2.5 /- 1
  percentage point
• lead Poland to the euro zone in the nearest
  possible future
• 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?

• Once in the EU, inflation had to be stabilised at
  a level consistent with the euro-zone accession
• Inflation of 2.5 comes close to the expected
  reference value for the inflation criterion
• 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
• 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?

• Appropriate framework for stabilization of the
  inflation rate
• Year-end targets problematic in view of
  monetary policy implemenation in 1998-2003
• Consistent with the lags in monetary transmission
  mechanism
• Supports forward-looking monetary policy
• Introduction of a permanent inflation target
  proved to be a good decision already in 2004

29
Inflation 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

30
Monetary policy reaction to increase in
inflation in 2005

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

31
Outline

• Why new strategy?
• Monetary policy in 1999-2003
• Monetary policy after 2003
• Current monetary policy framework some remarks
• Conclusions

32
Inflation response to interest rate and exchange
rate impulse
The role of exchange rate in current monetary
policy in Poland

• 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)

33
Exchange rate in Poland

• Volatile exchange rate renders the control of
  inflationary processes more difficult

34
Transparency issues

• Until mid-2004 - no inflation projection
• Thus need for improvement
• First inflation projection published in August
  2004, first GDP projection published in May 2005
• As a result - more forward-looking analysis in
  the IR since 2004
• press releases after the MPC meeting brought in
  line with the analysis presented in the IR
• and outlook for future inflation presented in
  the form of balance of risks.

35
Macroeconomic projections
GDP
CPI
Source Inflation Report, August 2005, www.nbp.pl
National Bank of Poland is complying with
international standards in terms of publishing
its marcoeconomic projections
36
DIT 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 criterion
• Symmetrical wide band (/-15) large enough not
  to limit freedom of DIT monetary policy
• 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 NBPs permanent
  inflation target - potential short-term cost of
  fulfilling the inflation criterion

37
Outline

• Why new strategy?
• Monetary policy in 1999-2003
• Monetary policy after 2003
• Current monetary policy framework some remarks
• Conclusions

38
Conclusions

• Permanent inflation target of 2.5 /- 1
  percentage point is assessed as consistent with
  long-term economic growth
• Large share of food prices in the total CPI
  renders the index very sensitive to its changes
• Volatile Zloty exchange rate hardens
  stabilization of inflation
• but there is no reasonable alternative to
  inflation targeting in Poland
• Hence DIT should be pursued until euro adoption
• Reconciling DIT and ERM II participation major
  challenge