Inflation targeting and financial stability in emerging markets

- We investigate whether inflation targeting central banks do not respond to financial imbalances.
- And, whether the inflation targeting regime is associated with higher financial instability.
- Targeting central banks are found to be more sensitive to financial risks, compared to others.
- However, the financial sector appears to be more fragile for targeters, compared to their peers.

This paper aims at investigating whether emerging market inflation targeters are more financially vulnerable than their non-targeting counterparts. It further assesses the extent to which targeting central banks are less responsive to financial imbalances, compared to those implementing alternative policy strategies. Based on a sample of 26 emerging countries, including 13 targeters, the analysis suggests that monetary policy in targeting countries is relatively more sensitive to financial risks. However, despite stronger central banks' responses to financial imbalances, the financial sector appears to be more fragile for targeters. Our conclusion therefore challenges the view that central banks, through their policy interest rates, can guarantee the stability of the financial system. It rather suggests that the control of inflation should remain the primary monetary policy objective, while a (macro)prudential authority would be in charge of the financial stability objective.