Monetary Policy Transmission and Inflation Dynamics under Inflation Targeting in an Emerging Economy

Abstract

The effectiveness of inflation targeting in emerging economies depends on how strongly and how quickly changes in the policy rate are transmitted to market interest rates, credit, the exchange rate, expectations and, finally, inflation. In economies that have recently moved from a fixed or managed exchange rate and directed lending to a market-based monetary framework, these channels may be weak or distorted. The aim of this study is to assess the structure of the monetary policy transmission mechanism in Uzbekistan, which formally adopted an inflation targeting regime in 2020, and to develop proposals for strengthening it. The study applies a systematic review of theoretical and empirical literature on transmission in emerging and low-income countries, institutional analysis of the monetary framework of the Central Bank of the Republic of Uzbekistan, and a structural vector autoregression framework together with a forward-looking policy rule for future empirical estimation. The analysis shows that the exchange rate and expectations channels play the leading role, whereas the interest rate and credit channels are weakened by dollarisation, a high share of state-directed and subsidised lending, administered prices and shallow financial markets. A channel-strength assessment matrix and a set of measures are proposed, including the phasing out of preferential lending, de-dollarisation, development of the government securities market and improved central bank communication. The results can be used to improve the effectiveness of monetary policy.