The evolution
of 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
1
Outline
1.
2.
3.
4.
Why new strategy?
Monetary policy in 1999-2003
Monetary policy after 2003
Current monetary policy
framework – some remarks
5. Conclusions
2
Outline
1.
2.
3.
4.
Why new strategy?
Monetary policy in 1999-2003
Monetary policy after 2003
Current monetary policy
framework – some remarks
5. Conclusions
3
Monetary policy in Poland
in 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
4
Macroeconomic environement in the
pre-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 ratio
o Introduction of deposits for the households priced
directly by the NBP
But…
5
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
6
Selected macreoeconomic indcators 1995-1998
Specification
1995
1996
1997
1998
GDP (%)
7.0
6.0
6.8
4.8
Domestic demand (%)
7.0
9.4
9.2
6.4
Individual consumption (%)
3.6
8.6
6.9
4.8
Gross fixed capital formation (%)
16.5
19.7
21.7
14.2
CPI (Annual)
27.8
19.9
14.9
11.8
0.7
-2.3
-3.9
-4.4
-2.57
-3.09
-2.87
-2.58
Current Account in % of GDP
General government deficit in % of GDP
Source: NBP
7
The Foreign Exchange Interventions and PLN’ s NEER
1200
85
1000
80
800
75
600
70
400
65
200
60
0
55
-200
50
1995
1996
net interventions (lhs)
1997
Dec. 1993 = 100
USD million
Market interventions (net)
1998
NEER (rhs)
8
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
9
Foreign exchange reserves in Poland
10
Costs of open market operations
1,40
1,20
1,00
0,80
USD BN
0,60
0,40
0,20
0,00
1996
Source: NBP
1997
1998
1999
2000
2001
2002
11
NBP Balance Sheet
as at 31 December 1995, 1998, 2000, 2004
45,00
40,00
5,08%
2,64%
4,98%
USD billion
35,00
32,73%
30,00
25,00
13,24%
20,00
30,01%
79,74%
21,73%
16,27%
56,76%
5,00
25,22%
24,25%
19,69%
75,74%
10,00
14,30%
13,65%
40,98%
15,00
27,96%
5,96%
19,28%
11,65%
92,28%
23,58%
46,74%
8,75%
25,85%
34%
26,95%
0,00
1995
1998
ASSETS
FX Assets
Assets in domestic currency
Other assets
2000
2004
LIABILITIES
Banknotes in circulation
Securities issued
Capital and reserves
Other liabilities
12
Eclectic strategy – final considerations
Continuation of eclectic monetary policy
strategy impossible
Nominal anchor - important
o For inflation expectations
o For transparent criteria for monetary policy
decisions
Need for a new strategy
13
Outline
1.
2.
3.
4.
Why new strategy?
Monetary policy in 1999-2003
Monetary policy after 2003
Current monetary policy
framework – some remarks
5. Conclusions
14
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
15
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
16
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
17
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)
PLN/Basket
4,0
Depreciation
5,0
3,0
2,0
PEG
BAND
FLOAT
Official
floatation
Basket
change
Devaluation and
introduction of
a basket
Revaluation
Devaluation
1,0
Devaluation
0,0
Jan90
Jan91
Jan92
Jan93
Jan94
PLN_Basket central parity
Jan95
Jan96
Jan97
Jan98
Jan99
Jan00
PLN_Basket (market rate)
Jan01
Jan02
Jan03
Jan04
Jan05
Fluctuation band
18
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)
o required by law
o allowed to increase understanding and thus credibility of DIT
o DIT introduced to support the disinflation process – short-term
targets very important
 However, year-end targets - not free of drawbacks
o 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
19
Inflation rate vs. MPC targets
o Medium-term target of below 4% by end-2003 met
o 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
18
16
14
12
10
8
6
4
2
0
per cent
Net CPI – CPI excluding food and fuel prices
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
inflation target
Jan-02
Jul-01
Jan-01
net CPI
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
CPI
20
Reasons 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
21
Interest rate policy
per cent
30
CPI inflation rate (YoY)
NBP reference rate
25
20
15
10
5
0
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
22
Assesment of DIT in 1998-2003
o DIT was introduced to support the disinflation
process
o 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 crisis
o slowdown in the world economy
o previous overheating of the Polish economy
23
Selected macreoeconomic indicators 1998-2004
Specification
1998 1999 2000 2001 2002 2003 2004
CPI (Annual)
11.8
7.3
10.1
5.5
1.9
0.8
3.5
Current Account in % of GDP
-4.4
-8.1
-5.7
-2.9
-2.6
-2.2
-1.5
General government deficit in %
-2.58 -3.24 -2.93 -5.00 -5.95 -5.37 -5.58
of GDP
GDP (%)
4.8
4.1
4.0
1.0
1.4
3.8
5.4
Domestic demand (%)
6.3
4.8
2.8
-1.6
0.8
2.5
4.7
Individual consumption (%)
4.8
5.2
2.8
2.1
3.3
3.1
3.4
Gross fixed capital formation
(%)
14.2
6.8
2.7
-8.2
-5.8
-0.5
5.3
Source: NBP
24
Outline
1.
2.
3.
4.
Why new strategy?
Monetary policy in 1999-2003
Monetary policy after 2003
Current monetary policy
framework – some remarks
5. Conclusions
25
Monetary 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
26
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
27
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 proved to
be a good decision already in 2004
28
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
Jul-05
May-05
inflation target
Mar-05
Jan-05
Nov-04
Sep-04
Jul-04
CPI
May-04
Mar-04
per cent
Jan-04
5
4,5
4
3,5
3
2,5
2
1,5
1
0,5
0
29
Monetary policy reaction to increase
in inflation in 2005
o Changing outlook for future inflation resulted in
adjustment in policy rates to historically low levels
7
per cent
6
5
4
3
2
1
NBP reference rate
CPI inflation rate (YoY)
0
Sep-05
Aug-05
Jul-05
Jun-05
May-05
Apr-05
Mar-05
Feb-05
Jan-05
Dec-04
Nov-04
Oct-04
Sep-04
Aug-04
Jul-04
Jun-04
May-04
Apr-04
Mar-04
Feb-04
Jan-04
Dec-03
30
Outline
1.
2.
3.
4.
Why new strategy?
Monetary policy in 1999-2003
Monetary policy after 2003
Current monetary policy
framework – some remarks
5. Conclusions
31
The role of exchange rate in current monetary
policy in Poland
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)
0.20
-
0.15
-0.05
0.10
-0.10
0.05
-0.15
-
-0.20
-0.05
-0.10
-0.25
-0.15
-0.30
-0.20
-0.35
-0.25
1
2
3
4
5
6
7
8
9
10
11
12
1
2
3
4
5
6
7
8
9
10
11
12
32
Exchange rate in Poland
Volatile exchange rate renders the control of
inflationary processes more difficult
5,00
4,50
4,25
Depreciation
4,75
PLN/EUR
4,00
3,75
3,50
3,25
Apr-00
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
33
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
o As 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.
34
Macroeconomic projections
CPI
GDP
Source: Inflation Report, August 2005, www.nbp.pl
National Bank of Poland is complying with
international standards in terms of publishing its
marcoeconomic projections
35
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
o
o
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 NBP’s permanent inflation
target - potential short-term cost of fulfilling
the inflation criterion
36
Outline
1.
2.
3.
4.
Why new strategy?
Monetary policy in 1999-2003
Monetary policy after 2003
Current monetary policy
framework – some remarks
5. Conclusions
37
Conclusions
o
o
o
o
o
o
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
38