stephen grenville : inflation targeting in the world of volatile capital flows speech by mr stephen grenville, deputy governor of the reserve bank of australia, at the bank of thailand ’ s international economic conference “ practical experiences on inflation targeting ”, held in bangkok on 20 october 2000. * * * while a number of developed countries adopted inflation targeting in the early part of the 1990s, there was a commonly held view that it would not be easy to apply this approach to monetary policy in emerging countries. for instance, paul masson et al. ( 1997 ) set out the prerequisites and building blocks of this monetary framework, identifying the main ones as being : • the ability to carry out a substantially independent monetary policy, especially one not constrained by fiscal considerations ; and • freedom from commitment to another nominal anchor such as the exchange rate or wages. they concluded that “ these fairly stringent technical and institutional requirements cannot be met by many developing countries because seigniorage remains an important source of finance and / or because there is no consensus that attainment of low inflation should be the overriding objective of monetary policy. we thus conclude that the way to improve the monetary and inflation performance of developing countries may not be through the adoption of a framework akin to inflation targeting, at least not in the near term ”. in the short period since then, there has been a lot more attention and interest in inflation targeting in emerging - market countries. what has caused this change of view? one answer is that the literature had been overly influenced by the poor inflationary record in latin america in the 1980s, and as the better record in latin america in the 1990s became clearer, commentators and analysis came to recognise the benefits of an inflation targeting framework. perhaps more importantly still ( and relevant to this paper because of its emphasis on the external sector and capital flows ), decisions about exchange rate regimes have put inflation targeting more in the forefront. to the extent that a number of latin american countries had chosen a fixed exchange rate as the nominal anchor for their monetary policy, in the hope of driving down the rate of inflation and keeping it low by a commitment to a fixed exchange rate, there was no place for inflation targeting in this strategy : this was clearly an alternative strategy to inflation targeting. but over time, the fashionable paradigm on exchange rate regimes has shifted, for several reasons. first, a number of countries found the use of the exchange rate as a nominal target presented serious problems during the phase of inflation reduction. even

##lity, let me assert that flows of this kind will return, and will be the norm rather than the exception. what makes me confident in asserting this is the as policymakers we should be pleased by this view, because the alternative - that it is a mechanical process which can be captured by a relatively simple one - line rule - would mean that there is no serious job for us to do. existence of huge portfolios in the developed countries, in the form of actively - managed funds seeking the highest return in a globalised world. the managers will inevitably shift part of their portfolios to the countries of this region, if only because their actual degree of diversification is well below the theoretical norm : these portfolios do not yet have enough weight of emerging market assets. on top of this ( again a subjective assertion ), the countries of this region will have above - average profit opportunities over the next decades as they move towards the technological frontier. diversification and profit prospects will drive developed countries ’ portfolio managers to shift funds into this region. the question of scale is not simply that the supply of these funds comes from portfolios which are huge : the point that paul volcker has emphasised again and again is one of relative size, in that the recipient financial institutions and even the entire countries are quite small compared with the size of the portfolios which have already been built up in america and europe - and these portfolios seem likely to continue to grow strongly, as private individuals increasingly respond to concerns about their retirement incomes. one more subjective assessment : these flows are likely to be volatile ; this view comes from the persistent evidence that financial markets overshoot and behind this overshooting is herding and contagion - “ fear, greed and ignorance ” are still important motivations of capital flow, and are likely to remain so. so the starting point, the environment in which we will have to work, is one of large and volatile capital flows. exchange rate regimes this takes us directly to questions of exchange rate regime. while there will be legitimate and indeed powerful cases where individual countries might want to adopt a fixed rate ( hong kong is the classic example ), these are special cases driven by the specifics of their environment. the much more common case will encourage countries to move towards the flexible end of the exchange rate regime spectrum, and this immediately raises the issue : with the exchange rate floating or flexible, what will be the nominal anchor for monetary policy? the extra element which we should discuss here is