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The appropriateness of intermediate monetary targets adopted by Caribbean economies/Eficacia de las metas monetarias intermedias adoptadas por las economias caribenas/La Pertinence des Objectifs Monetaires des Economies de la Caraibe.

ABSTRACT

The question of the intermediate monetary target that Caribbean economies should adopt has recently gained prominence. Perspectives on this issue stem mainly from the move towards the formation of the CARICOM Single Market and Economy (CSME) and the performance of inflation under the current regimes. This paper assesses the suitability of the intermediate monetary targets adopted by Caribbean economies, with emphasis on Guyana, Jamaica and Trinidad & Tobago. These three economies make an interesting case study, since they are fully liberalized--a precondition for regional integration. They are classified as more developed countries in the Caribbean and a common intermediate target is applied in these economies.

The study concludes that the form of exchange rate targeting that is being pursued by some Caribbean economies is inappropriate for regional integration, while monetary targeting, which is largely influenced by the International Monetary Fund (IMF) Monetary Model (a major component of the IMF Financial Programming Model) has proven to be an ineffective tool in controlling inflation in the Caribbean. In light of this finding, inflation targeting is proposed as a suitable alternative for Caribbean economies.

El asunto de las metas monetarias intermedias que deben adoptar las economias caribenas ha ganado relevancia en tiempos recientes. Las perspectivas con respecto a este asunto surgen principalmente del movimiento favorable a la integracion del Mercado y las Economias de CARICOM (CSME) asi como de la tendencia de la inflacion bajo los actuales regimenes. El trabajo evalua la idoneidad de las metas monetarias intermedias adoptadas por las economias caribenas, especialmente Guyana, Jamaica y Trinidad y Tobago. Estas tres economias constituyen un interesante estudio de caso, dado que estan plenamente liberalizadas--una precondicion para la integracion regional. Han sido clasificados como los paises mas desarrollados en el Caribe y en estos momentos aplican una meta intermedia comun en sus economias.

El estudio llega a la conclusion de que la forma de tasa de cambio objetivo que se esta buscando en algunas economias caribenas es inadecuada para la integracion regional, y por su parte las metas monetarias, que estan significativamente influenciadas por el Modelo Monetario del Fondo Monetario Internacional (FMI) y que es un componente principal del Modelo de Programa Financiero del FMI, han demostrado ser un instrumento ineficaz para controlar la inflacion en el Caribe. A la luz de este hallazgo, la inflacion objetivo que se propone es una alternativa apropiada para las economias caribenas.

Quel objectifs monetaires les economies de la Caraibe devraient-ils se fixer? Sur cette question, qui a recemment gagne en importance, les perspectives decoulent principalement du processus de formation du CSME (Marche et Economie uniques du CARICOM) et des chiffres de l'inflation sous les regimes en vigueur actuellement. Cet article evalue la pertinence des objectifs monetaires adoptes par les economies de la Caraibe, en particulier le Guyana, la Jamaique et Trinite et Tobago. Ces trois economies constituent des etudes de cas interessantes dans la mesure ou elles sont entierement liberalisees--condition sine qua non pour toute integration regionale. Ces pays sont classes parmi les plus developpes de la Caraibe et l'on y applique un objectif monetaire commun.

Cette etude affirme en conclusion que le procede de fixation des taux d'echange applique par les economies de la Caraibe ne convient pas h l'integration regionale et que le choix des objectifs monetaires, largement influence par le Modele monetaire du FMI (Fond monetaire international) s'est avere inefficace dans la lutte contre l'inflation dans la Caraibe. A la lumiere de ces conclusions, se fixer des objectifs inflationnaires est presente comme une alternative appropriee pour les economies de la Caraibe.

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It has become widely accepted in academic literature that the main objectives of monetary policy are the achievement of internal and external price stability, while preserving economic growth. Pivotal to the achievement of these objectives is the choice of an appropriate intermediate target, since this policy variable has extremely important repercussions for future inflation performance and the credibility of a central bank. An intermediate monetary target is a nominal variable that links monetary instruments to the final objective of monetary policy, and in so doing serves as an operational guide to policymakers. Croce and Khan (2000) postulates that a credible intermediate target is expected to have, inter alia, a stable relationship with the ultimate objective of monetary policy. More importantly, the chosen variable must have the ability to clearly communicate the long-run objective of monetary policy to the general public.

Further, the choice of an intermediate target is dependent on the monetary instrument employed in the conduct of monetary policy. Laurens (2005) posits that central banks can administer direct instruments aimed at controlling money creation by commercial banks through administrative measures, such as credit ceiling and reserve requirements. Alternatively, indirect monetary instruments that focus on regulating liquidity conditions through reserve money management can be applied.

For small economies, with underdeveloped financial systems, direct instruments may be the only option for the central bank. Direct control, however, has potential disadvantages, as is discussed in Tovar (2007). First, heavy reliance on direct controls may lead to liquidity overhang, financial repression and disintermediation. Excess liquidity builds up because of the limits imposed on bank lending, while deposit growth is fuelled by an expansion of reserve money. Financial repression occurs because interest rates are kept artificially low, resulting in the unproductive use of savings. These developments create financial disintermediation, or a switch to other forms of indirect financial investment.

Similar findings were obtained by Khan (2003), and Alexander, Balino and Enoch (1995), who postulate in separate articles that in conducting monetary policy the use of direct instruments becomes ineffective as money and financial markets develop. Recent evidence reported by Laurens (2005) also showed that there are significant economic benefits to be derived from indirect monetary instruments.

It is well documented in Mishkin (2000) and Croce and Khan (2000) that prior to the end of the 1980s, the exchange rate and various forms of monetary aggregates were the intermediate targets that policymakers had at their disposal to anchor inflation. Masson, Savastono and Sharma (1998), however, noted that since the early 1990s, an increasing number of countries, beginning with the more advanced economies, have adopted an explicit value for inflation as an alternative intermediate target in their effort to address the difficulties that developed with the use of exchange rates and monetary aggregates as the nominal anchors. This trend is also evident in Latin American countries, hence, Frankel (2003) gives a detailed account of some of these countries that have been successfully implementing inflation targeting since 1999.

From a regional perspective, the financial and institutional developments that occurred in the Caribbean since the post-World War II period precipitated an evolution in the intermediate targets employed in conducting monetary policy. At the centerpiece of these developments were disbandment of British Caribbean currency boards; the establishment of Central Banks; the formation of a currency union; and the shift to market-based monetary policy operations in some economies. In this regard, beginning in the mid-1960s, Caribbean economies pursued an exchange rate anchor, with the pound sterling as the anchor currency. The global crisis that emerged in the 1970s resulted in a switch to a US dollar anchor that is still in place, with some level of variation in all of these economies, except for Guyana, Jamaica and Trinidad & Tobago, who, by virtue of their involvement with the IMF, were required to adopt monetary targeting.

Accordingly, there is now a wide variation in the monetary policy strategies employed in the Caribbean as is discussed in Tovar (2007). Notwithstanding, Chart 1 shows that chronically high inflation persists in some jurisdictions, with rates significantly above the conventional definition of price stability, (1) and far in excess of the inflation convergence criterion (2) endorsed by CARICOM (3) Central Bank governors.

[GRAPHIC 1 OMITTED]

It has also become quite evident in the theoretical literature that a prerequisite for an optimum currency area (OCA) is a high degree of convergence in inflation behaviour among member countries. (4) However, as is reflected in Table 1, achieving the inflation criterion has been a major challenge for the monetary targeting economies in the Caribbean.

Against this background, this paper concludes that the intermediate targets employed in Caribbean economies are inappropriate, and proposes inflation targeting (5) as a viable alternative for these economies. Because inflation targeting is a relatively new monetary policy framework being proposed for small open economies, there are only a few earlier studies on the applicability of this framework to the Caribbean. Rambarran (2001), Zahler and Thomas (2003), Nelson-Douglas (2004) and Yan (2005) all high-lighted the relevance of inflation targeting to Jamaica and Trinidad & Tobago. To the best of my knowledge, no such empirical work has ever been attempted for Guyana. This paper attempts to fill that gap, while adding value to the existing literature by discussing the issue within the context of regional integration.

The paper proceeds as follows. Section two examines the evolution of monetary policy strategies in Caribbean economies, focusing on the post-World War II era up to the present. Section three provides an overview of the experience of monetary-targeting Caribbean economies, highlighting the deficiencies in the current framework. Section four discusses the IMF Monetary Model and highlights its shortcomings. The fifth section discusses the CSME (CARICOM Single Market and Economy) and the choice of an appropriate nominal anchor. This section discusses the exchange rate and monetary-targeting anchors, after which the cost and benefits of inflation targeting are highlighted. The final section makes a conclusion.

The Evolution of Monetary Policy Strategies in the Caribbean

In the aftermath of World War II, a number of key forces led to unprecedented changes in the financial and monetary arrangements in the Caribbean. Efforts to accommodate these changes triggered an evolution in the modality of monetary policy formulation and implementation in these economies.

First, the British government established currency boards to cover all of its colonial territories. According to Worrell, Marshall and Smith (2000) these currency boards were established mainly to manage local currencies that were linked to the pound sterling. The British Caribbean Currency Board (BCCB) was established in 1951, had its headquarters in Trinidad & Tobago, and served the Eastern British Caribbean members, namely Barbados, British Guiana (renamed Guyana after its independence), the Leeward Islands, the Windward Islands and Trinidad & Tobago. Under the currency board arrangement, there was no active monetary policy, but the currency boards served as the centralized monetary authorities which ensured that money in circulation could have been redeemed on demand at fixed exchange rates.

After the achievement of political independence, and the establishment of their respective central banks, Guyana and Trinidad & Tobago withdrew from the BCCB in 1965, and commenced independent monetary policy practice. The withdrawal of these two countries resulted in the disbandment of the BCCB, and the establishment of the East Caribbean Currency Authority (ECCA) in 1965 (see Worrell, Marshall and Smith 2000). The statutory responsibility of the ECCA was to issue Eastern Caribbean currencies that were initially 100 percent backed by the pound sterling, but later adjusted to 60 percent. The anchor currency was later switched from the pound sterling to the US dollar, but the 60 percent external asset backing was retained. The Central Bank of Barbados was established in 1974, and this country relinquished its membership from the ECCA.

Admittedly, the operation of the ECCA was by all measures prudent. However, there arose the need for a more formalized and transparent financial system to facilitate the growth and development needs of the member states through the financial mobilization and transformation processes. Accordingly, the Organization of Eastern Caribbean States Currency Union was created on 18 June 1981, with the signing of the Treaty of Basseterre. This development changed the modality of monetary policy operations by members of this currency union.

At the end of the 1970s, all the colonial territories in the Caribbean, except for Belize, had achieved political independence and established central banks, making them eligible to have their own respective domestic currency and to pursue active monetary policy strategies. Many of these countries had also gained membership with international organizations such as the IMF and the World Bank. Accordingly, monetary policy strategies in some of these economies were dominated by the Bretton Woods System of Exchange, in line with the IMF Articles of Association. Under this arrangement, these countries were expected to maintain fixed exchange rates against the US dollar. Following the demise of the Bretton Woods System in the early 1970s, all of these economies adopted some form of exchange rate targeting, pegging the value of their currency to that of their major trading partners.

The early 1970s was characterized as a boom period for Guyana, Jamaica and Trinidad & Tobago. While Guyana and Jamaica enjoyed favorable world prices for their bauxite and sugar exports, Trinidad & Tobago benefited from the surge in the price of oil and other petroleum products. This economic peak was short-lived, and by the end of the 1970s the macro-economic conditions deteriorated in these economies. This was manifested in large and unsustainable fiscal deficits, balance of payments crises, and large debt overhangs. The economic downturn emanated from the global crisis that emerged in the late 1970s, resulting in a reduction in the demand and the international price for oil and non-oil exports. It was also during this period that these governments sought to transform their economies from private ownership to that of heavy government control, hence the privatization of some of the major enterprises in their economies (see El Hadj 1997). To restore macro-economic stability, these countries embarked on IMF-supported stabilization programs. The conditionalities attached to this form of assistance included, inter alia, a system of financial sector reform, notably the disbandment of fixed exchange rate systems and the adoption of floating exchange rates; liberalization of the domestic and external financial system; and the transition from the use of direct monetary instrument to indirect monetary instrument, namely open market operations (OMO), (6) with some form of monetary aggregates as the intermediate target.

The Experiences of the Monetary-targeting Caribbean Economies

Monetary targeting involves setting targets for the growth in specific monetary aggregates over a stipulated time period. This policy option was implemented in Guyana, Jamaica and Trinidad & Tobago in the 1980s, when these countries, in an attempt to reverse the downward macroeconomic trend in their respective economies, embarked on structural adjustment programmes under the tutelage of the IMF. By virtue of this initiative, these economies were confined to the IMF Monetary Model to guide their monetary policy operations. In this regard, these countries adopted some form of monetary targeting as the designated intermediate target, and open market operations (OMO) as the major tool for liquidity management.

In Guyana, the Economic Recovery Program (ERP), which was launched in 1989, resulted in an economic upturn that started in the mid-1990s, after a prolonged period of economic decline since the late 1970s. To accommodate the new modality of monetary policy practice as was stipulated by the ERP, the sale of 91 days government treasury bills commenced in June 1991, as a strategy for liquidity management. The frequency increased to biweekly in June 1994 and to weekly in February 1996. The 182 days and 364 days bills were introduced in April 1993 (Egoume-Bossogo et al. 2003). As is discussed in Singh (1996), a reserve money program to estimate monetary aggregates was also established as the forecasting framework to inform the central bank on liquidity conditions. Open Market-Type Operation continues to be the dominant tool to conduct monetary policy in Guyana, with broad money (M2) as the intermediate target.

It is important to note, however, that in spite of the switch to an indirect monetary instrument, the monetary policy strategy is inefficient and costly. A major challenge that the country faces is the high level of excess liquidity in the domestic financial system, and the rising domestic debt that stems mainly from liquidity sterilization activities. Excess liquidity stems mainly from over-performance of monetary targets and the surge in private capital inflows, particularly in the form of migrants' remittances.

By virtue of its abundant oil resources and the favorable oil price in the early 1970s, Trinidad & Tobago experienced a boom cycle throughout that decade. Watson (2003) noted that this development was translated into rapid economic growth, higher foreign reserves and higher government revenue. The unexpected decline in the price of oil in 1981/82 triggered a severe economic crisis in the country in 1983. After failed efforts to use domestic policy measures to correct this disequilibrium, an IMF Stand-by Arrangement was initiated in 1989. As is the common practice with IMF adjustment programmes, specific conditionalities were imposed on the country. Among them was the policy of financial liberalization and the transition from direct to indirect monetary instruments. In spite of these changes, the country's financial system is characterized by high levels of structural liquidity generated by the monetization of oil receipts to finance government deficits and a buoyant debt stock that stems from sterilization activities.

In Jamaica, after a period of major challenges for monetary policy management, a major IMF stabilization programme was undertaken in 1981. The measures imposed on the economy included, among other things, financial liberalization policies and the transformation in the conduct of monetary policy from the use of direct instruments to indirect instruments, which were not fully implemented until 1985, with the launch of another IMF-supported financial sector reform program. In this regard, the Bank of Jamaica (BOJ) commenced OMO, using the sale of certificates of deposit (CDs) in November 1985. Base money management targeting also commenced in 1985. It is important to note, however, that the transition to market-oriented monetary management did not achieve the desired results; hence a BOJ publication notes:

In spite of open market operations, the monetary base grew rapidly. This relative ineffectiveness in managing the monetary base could be attributed to the expanded role of monetary management through market instruments and the continued expansionary nature of fiscal operations. For these reasons monetary policy management was ineffective in containing money supply in the initial switch to indirect instruments (Bank of Jamaica 2004, 114).

In an effort to combat consistently high inflation, the country embarked on an exchange rate-based stabilization programme in 1996. According to Yan (2005), this stabilization program was highly successful, except for the latter part of 2002 and early 2003. Not-withstanding this level of success, there are some major challenges that the economy still faces, for example, the financial system is plagued with high levels of excess liquidity, emanating mainly from the monetization of large fiscal deficits and the buoyant flows of migrants' remittances. More importantly, the country has a growing stock of public debt that threatens its sustainability.

To reinforce the ineffectiveness of the monetary policy strategy that is pursued in Jamaica, Allen and Robinson (2004) in their study found that inflation in Jamaica, particularly since the 1990s, has been driven primarily by shocks to the exchange rate relative to demand- pull factors associated with the credit channel, which is advocated by the IMF Monetary Model.

[GRAPHIC 2 OMITTED]

The evidence from these three economies confirms that monetary aggregates have been an ineffective target to conduct monetary policy in the Caribbean. As is reflected in Chart 2, changes in monetary aggregates have not behaved in a similar pattern with the inflation rates, making it an inappropriate communication device for monetary policy. The movement of the money supply stems from, among other things, high capital flows in the form of remittances, foreign direct investment and other development assistance. In fact, according to the World Bank (2008), Guyana and Jamaica are listed among the world's top recipients of remittances as a share of GDP. Another significant contributor is the widespread use of electronic banking and new payment mechanisms such as credit and debit cards.

Regarding the OMO procedure, which is designed to target the reserves held by commercial banks and sterilize same to avoid excessive lending to the private sector, this strategy does not auger well for long-run growth in these economies and creates a growing domestic debt that has to be monetized, contributing to excess liquidity in the financial systems. This action also contradicts the empirical evidence, which suggests that private sector credit is a very effective tool to promote growth and eliminate excess liquidity.

The IMF Monetary Model

The IMF Monetary Model is a major component of the IMF Financial Programming Model pioneered by Jacques Polak in the 1950s, and bears some resemblance to the monetary approach to the balance of payments. At the time of its implementation, the unavailability of vital macroeconomic data from many of its member countries caused the model to focus mainly on trade and banking statistics data that was readily available (Polak 1997). Although only minor changes were made to the core of the model, it is still the basis for the conditionalities applied to IMF lending and surveillance to its member countries, particularly those classified as low and middle income. The model is presented in the six equations below.

[DELTA]MO = [kappa][DELTA]Y (1)

where MO represents money supply, [kappa] is the inverse of the velocity of money and Y represents income. This equation is derived from the famous monetarist identity

M = mY (2)

where M represents imports, Y, income and m is the marginal propensity to import.

[DELTA]MO = [DELTA]R + [DELTA]D (3)

where MO represents money supply, R, international reserves and D represents credit to the banking system.

[DELTA]R = X - M + K (4)

where R represents international reserves, X represents exports, M represents imports and K represents the net capital inflows of the non-banking sector.

[DELTA]H = [DELTA]R + [DELTA]DCB (5)

where H represents reserve money, which consists of currency in circulation plus the reserves of the commercial banks, and DCB, domestic credit of the central bank.

[DELTA]MO = q[DELTA]H (6)

where q denotes the money multiplier (which is assumed to be constant). Therefore, a change in money supply is equal to an equivalent change in reserve money.

Shortcomings of the Model

Although this model is generally used as a guide for IMF conditionalities to grant financial and technical assistance to member countries, particularly low-income countries, it seems to be riddled with major discrepancies.

First, money targeting, which is based on the assumption that there is a strong relationship between monetary aggregates and inflation, is the foundation of this model, a view that has lost its validity since the early 1980s. In fact, Anderson (1985) opined that for this assumption to be true, the money multiplier and the velocity of money must be predictable or at least stable. In practice, however, this does not hold, since the movement in the money multiplier is determined by the behaviour of commercial banks and the general public. It is this unpredictability of the velocity of money that has caused many developed and emerging economies to relinquish various forms of monetary aggregates and adopt a specified pre-announced inflation rate as the intermediate target to conduct monetary policy. Ironically, this view was reiterated in an IMF publication, which states:

Money targets are based on the assumption that Central Bank has full control of the nominal money stock--that is, the money multiplier is predictable and that money velocity is predictable--that is the long run relationship between money growth and nominal income growth (and therefore inflation for given trend real growth) is stable. In practice, money targets were often missed, leading people to question their usefulness as an intermediate target. The only countries that still target money today are developing countries, although even there, neither the money mul-tiplier nor the velocity of money appears stable over time (World Economic Outlook Sept 2005, 164).

Another fundamental flaw in the model is the assumption that domestic credit of the banking system will have a significant impact on money supply and ultimately inflationary pressures in an economy. In light of this notion, the IMF, in making projections for borrowing countries, imposes a ceiling on private sector credit. From this perspective, a common situation in many developing countries is to have inflationary pressures present in an economy, although the programme targets are achieved. This situation arises if international reserves improved by more than is expected. If this outturn is not accompanied by a similar increase in money demand, the excess money supply must be absorbed through open-market operations that can be very costly.

In fact, Polak (1997) notes:

A study of the IMF financial arrangement with 36 countries over the period 1988 to 1992 showed that targets for broad money growth were overshot by wide margins in about two thirds of the programme years, in most countries this reflected mainly larger-than-expected foreign assets (Polak 1997, 13).

The omission of domestic interest rate is another profound shortcoming of the model. In fact, with financial liberalization and a floating exchange rate, the interest rate becomes an important policy variable. For this reason, there is the recent trend for economies with floating exchange rates and a system of capital mobility to compute and utilize monetary conditions indices (MCI). (7) From a regional perspective, Claney (1997) constructed a MCI for Jamaica, and found that the phenomenon is applicable to that country since the deregulation and liberalization of the financial sector in 1991. There is no documented evidence of other Caribbean economies adopting this strategy, but anecdotal evidence suggests that given the nature of these economies, this communication device might also be relevant to them.

Against this background, Agenor and Montiel (1999) echoed the inappropriateness of the IMF Monetary model in their Development Macroeconomics text. The authors noted that although all of the World Bank and IMF models examined had been applied frequently in policy formulation in developing nations, they were subject to limitations that constrain the usefulness for both policy guidance and analytical work as medium-term models. More importantly, within the context of regional integration, Polak (1997) postulates that the IMF monetary model is not appropriate for a monetary or economic union, since under this arrangement there is no individual country currency in circulation and by extension national money supply.

CSME and the Choice of a Nominal Anchor

The choice of an appropriate monetary anchor is one of the most fundamental policy issues that must be addressed as economic policies are harmonized to facilitate CSME. Generally, the monetary policy instrument and the exchange rate regime in place determine the degree of latitude that policymakers have in their choice of a nominal anchor. In this regard, the theoretical literature categorically states that for a country with a fixed exchange rate regime, the nominal anchor should be the exchange rate; while for countries with floating exchange rate regimes, the two possible choices of a nominal anchor are monetary aggregates or inflation targeting.

In the case of an exchange rate anchor, although this strategy provides some advantages, for example, inflation moves in line with that of the anchor country, and the monetary policy objective can be clearly communicated to the general public. There are some economic costs that are inevitable for exchange rate-targeting economies. First, these economies lose their monetary independence and the seigniorage revenue (8) attached to it. Moreover, since these countries cannot use monetary policy as a tool to respond to shocks, the central bank is exposed to speculative attacks on its domestic currency. For this reason, although the empirical evidence shows that the exchange rate-targeting economies in the Caribbean exhibit better inflation performance than the monetary-targeting economies, the economic cost of adopting this policy measure must be borne in mind. More importantly, given the Mundell-Flemming theory of the "Impossible Trinity", (9) despite strong arguments in support of exchange rate targeting, this policy initiative will not be a viable option as economic policies are harmonized in the integration process. It is also important to note that over the past decade geopolitical developments and global aggregate shocks have resulted in frequent depreciation of the US dollar against major trading currencies. This development has put severe pressure on the central bank's ability to maintain the exchange rate parity and fuels inflation.

Regarding monetary targeting, while this policy initiative has overcome many of the shortcomings of exchange rate targeting, for example, it has the advantage of insulating the economy from shocks. There has been much debate among academics over the past decade regarding the effectiveness of this policy regime in the pursuit of a successful inflation framework. The common consensus has been--particularly among post-Keynesians--that a prerequisite for a successful monetary targeting strategy is a stable demand for the chosen monetary aggregate. However, beginning in the 1980s, there has been a surge in technology that has resulted in financial innovation and a move to integrate the global financial system. These developments resulted in, among other things, the demand for money becoming volatile and unpredictable, undermining the usefulness of this nominal anchor. Moreover, the experience of the monetary-targeting economies in the Caribbean has solidified this view and underscores the need for an alternative regime.

Potential Benefits and the Cost of Inflation Targeting

A consensus has emerged among economists over the past decade that there are major benefits to be derived from an inflation-targeting regime when compared to other monetary policy anchors. First, inflation targeting builds credibility for a central bank and anchor inflation expectation faster than other strategies. In fact, inflation targeting involves more transparency; hence the public can make a better judgement about the monetary policy stance and the performance of inflation, reducing speculation, which is a major contributor to inflation. Moreover, Mishkin (2000), in his study, postulates that inflation targeting can be an instrument used to increase accountability and, by so doing, can help to ameliorate the time-inconsistency problem central banks face, through increased communication and transparency. In like manner, Jonsson (1999) posits that concentration on an explicit inflation target may serve as a better focus for price setters than in the case of monetary and exchange rate targeting. Additionally, since the public can easily follow developments with respect to the pre-announced rates of inflation, a deviation from the projected target will not be interpreted as an outright failure.

Also, in light of the proven track record of the favourable performance of inflation in countries that have pursued this monetary policy strategy, as is recorded by Jonsson (1999) and Mishkin (2000), the economic cost of a monetary policy failure under an inflation-targeting strategy is lower than under any other nominal anchor. Under this regime the only cost to the society and the central bank is a higher-than-expected inflation rate, which can be corrected quickly using domestic policy measures, such as interest rates. A failure under an exchange rate regime can result in a loss of international reserves, higher inflation and possibly public debt default. Under a system of monetary targeting, the interest cost of mopping up excess liquidity can be very high and jeopardize the fiscal sustainability of the country.

In the context of regional integration, Laurens (2005) identified some benefits of an inflation-targeting framework in a monetary union. He postulates that for small countries participating in a monetary union, an inflation-targeting regime could help to foster fiscal discipline, and assist in the coordination of monetary and fiscal policy. More specifically, the establishment of a monetary union with a single currency and a regional central bank will put in place several of the underlying conditions that are necessary for the successful operation of inflation targeting.

Notwithstanding the benefits of inflation targeting, this policy framework is not without its costs and limitations. One potential downside to this initiative is its inability to respond fast enough to an economic downturn, which has the potential to trigger a recession or intensify its effects. In like manner, an inappropriate policy response to a negative supply shock (major imports such as oil) can intensify the effects on an economy. There is also the possibility that policymakers can strive to achieve the targeted inflation rate at the expense of the other macroeconomic policy objectives, such as economic growth and employment.

In light of the foregone, although inflation targeting cannot be prescribed as the cure for all economic ills, it is the best option currently available to Caribbean economies.

Conclusions and recommendations

The main objective of this paper was to evaluate the appropriateness of the current intermediate targets adopted by Caribbean economies. The results suggest that these targets are not suitable for regional integration and therefore inflation targeting should be pursued.

More importantly, it has been strongly supported by empirical evidence that monetary policy is generally more effective when the general public can easily understand and follow the measures. In this regard, Croce and Khan (2000) submitted that an inflation-targeting framework can result in more efficiency in monetary policy operation, since it is easier for the public to follow a pre-announced rate of inflation than the movement of monetary aggregates.

While it is expected that some Caribbean economies, particularly the exchange rate targeters, may be reluctant to abandon their current system to adopt this new framework as part of the integration process, the long-run benefits of joining a monetary union should be the overriding factor. Worrell (1990), in his justification for a monetary union, focused on the balance of payments stability these countries can enjoy, in light of the fact that Caribbean economies are price-takers that are vulnerable to external shocks and natural disasters. More recently, Baladi (2007) identified the fiscal and monetary benefits that stem from a monetary union. Moreover, the establishment of the CARICOM Development Fund, which makes provisions for disadvantaged and vulnerable economies, is another safety net for these economies.

More importantly, it became evident since the Asian crisis that central banks globally are rapidly moving away from monetary policy strategies that are based on the management of intermediate targets, such as monetary aggregates and exchange rate, and toward frameworks that are more forward-looking. In fact, Allen, Baumgartner and Rajan (2006) reported that approximately 50 percent of developing countries and 95 percent of developed countries have so far adopted varying versions of an inflation-targeting regime. Against this background, this paper concludes that in order to curb the inflationary spiral in the monetary-targeting Caribbean economies, and re-establish public confidence, inflation targeting should be implemented.

Earlier studies on the feasibility of an inflation-targeting regime for some Caribbean economies include Rambarran (2001), who found that the use of base money as a nominal anchor in Trinidad & Tobago has not been very effective. He notes that the monetary authority has pursued multiple and conflicting monetary objectives, resulting in an ineffective monetary policy and the inability of the monetary authorities to achieve the desired monetary objective. He posits that inflation targeting is a more viable option for Trinidad & Tobago. Zahler and Thomas (2003) found that the adoption of an inflation-targeting regime by Jamaica could reduce the exchange rate pass-through. Nelson-Douglas (2004) also argues that inflation targeting is a viable option for Jamaica. More recently, Yan (2005) reviewed the Jamaican economy and proposed an inflation-targeting lite framework (10) for the country in the absence of some of the preconditions for a full-fledged inflation-targeting regime.

Regarding the time of implementation of this framework, Carare et al. (2002) state that the list of initial conditions for the successful implementation of an inflation-targeting regime is not meant to constitute strict prerequisites. That is, the absence of some of these conditions should not stand in the way of the adoption of inflation targeting, especially when policies are being introduced to establish them in the short and medium term. In this regard, a fundamental step towards the transition to a full-fledged inflation-targeting regime in the Caribbean would be for these economies to adopt a more eclectic approach to the conduct of monetary policy, while the logistics for the full implementation of a single market and economy is being worked out.

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(1) Stanley Fischer (1996) suggests the long-run goal of monetary policy should be defined as inflation of about 2 percent on average with a range of 1 to 3 percent per year.

(2) The inflation convergence criterion stipulates that the inflation rate in member states should not exceed the average rate for the three countries with the lowest, but positive rates of inflation, plus 1.5 percent.

(3) CARICOM is comprised of fifteen member states: Antigua, Barbuda, The Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St Lucia, St. Kitts and Nevis, St Vincent and the Grenadines, Suriname and Trinidad & Tobago; and five associate members, namely Anguilla, Bermuda, British Virgin Islands, Cayman Islands and Turks & Caicos Islands.

(4) See Mongelli (April 2002)

(5) A monetary policy rule in which the Central Bank makes a commitment to use monetary policy primarily to achieve a publicly pre-announced inflation target within a specified time.

(6) This is a situation in which the central bank buys and sells monetary instruments to influence the level of reserves in the banking system. OMO can be either active or passive. The former targets a given quantity of reserves and allows the interest rate to fluctuate, while the latter sets targets for the interest rate and allows the quantity of reserves to fluctuate.

(7) A MCI reflects the transmission mechanism of monetary policy through an index number calculated from combined financial variables that are relevant to monetary policy. The concept was developed in Canada in the early 1990s in response to the need for alternative intermediate and operating monetary policy targets that are easily communicated to the public.

(8) Seigniorage is the net revenue derived from issuing one's domestic currency. In the case of coins, it is the difference between the face value of a currency and the cost of production, distributing and retiring it from circulation. For bank notes, it is the difference between the interest earned on securities acquired in exchange for bank notes and the cost of producing and distributing those banknotes.

(9) The theory states that it is impossible to achieve a combination of an independent monetary policy, a high degree of capital mobility and a fixed exchange rate simultaneously. In this regard, since the Revised Treaty of Chaguramas makes provision for the free movement of capital among member states, and a pre-requisite for a successful monetary union is an independent monetary policy, targeting the exchange is not possible. It is important to note, however, that with the adoption of a monetary union and a common Caribbean dollar, a special type of fixed exchange rate policy can be put in place, with all of the member states relinquishing their individual currencies and making the Caribbean dollar legal tender.

(10) Stone (2003) used the term "Inflation Targeting Lite (ITL)" to describe a situation in which an emerging market economy is using an inflation target to define its monetary policy framework, but is unable to maintain the inflation target as the foremost policy objective.

Debra Roberts, The paper was done while the author was a senior economist at the Central Bank of Guyana. The views expressed in the paper are those of the author and not necessarily those of the Central Bank.
Table 1: Failure to meet Inflation Criterion (2001-2009)

Territory                    No of times

The Bahamas                      0
Barbados                         4
Belize                           0
ECCU                             0
Guyana                           7
Jamaica                          9
Trinidad & Tobago                8

Source: CCMS Report on Economic Performance and
Convergence and CARICOM Secretariat Statistical Unit
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