Inflation Targeting vs. Exchange-Rate Pegs: How Emerging Markets Choose Between Two Imperfect Anchors

Emerging market economies seeking to control inflation generally choose between two dominant monetary anchors: inflation targeting, in which the central bank publicly commits to a numerical inflation objective and steers interest rates toward it, and exchange-rate pegs, which fix or manage the currency against a major foreign currency and import stability indirectly. Neither is free. Research by Fraga, Goldfajn and Minela for the NBER found that emerging markets under inflation targeting face "more acute trade-offs" than developed economies—both output and inflation are more volatile, and inflation runs at higher levels—because of fragile institutions, imperfect credibility, and larger external shocks. Pegs, meanwhile, carry their own documented danger: Mexico's peso peg, which appeared "highly successful" from 1987 until December 1994, illustrates how abruptly an exchange-rate anchor can fail.

Introduction to Inflation Control in Emerging Markets

Controlling inflation in a developing economy is not simply a harder version of the same problem advanced economies face. The NBER analysis by Fraga, Goldfajn and Minela identifies a structural difference: emerging markets operate in a more volatile macroeconomic environment with weaker institutions and lower central bank credibility, which produces sharper trade-offs between price stability and everything else a central bank must protect—output, employment, and financial stability.

The practical stakes are visible in the numbers. In the emerging markets those researchers studied, deviations of inflation from central targets ran 81% higher than in developed economies, and deviations from the upper bounds of target ranges were 167% higher. The same framework that delivers discipline in London or Ottawa delivers something noisier in economies where shocks are larger and institutional anchors are thinner.

Since the late 1990s, most emerging market central banks have nonetheless converged on inflation targeting as their framework of choice, following the lead of developed countries, as Eswar Prasad and Ravi Kanbur noted in a 2010 Brookings commentary. The question for any given economy is not which strategy is superior in the abstract, but which set of risks its institutions and external position can actually absorb.

Inflation Targeting: Mechanism and Requirements

Under inflation targeting, the central bank's priority is to maintain price increases at a target level or within a specified range, using its policy interest rate as the primary instrument. The mechanism aims squarely at price stability as the primary objective, and its power depends on anchoring expectations: if households and firms believe the bank will hit the target, wage- and price-setting behavior adjusts around that belief, doing much of the work before rates move at all.

That is also the framework's vulnerability in emerging markets. Anchoring expectations requires strong central bank independence, clear communication, and credibility—assets that are precisely what fragile institutions lack. Prasad and Kanbur observe that broader central bank objectives invite more political interference and less credibility in maintaining low inflation, a tension heightened in emerging markets where central banks have traditionally carried a wide array of social and economic goals alongside price and financial stability.

The result, documented by Fraga, Goldfajn and Minela, is a self-reinforcing problem: low credibility and fragile institutions on one side feed higher macroeconomic instability and vulnerability to external shocks on the other. Breaking this "vicious circle" is, in their words, a long process of acquiring credibility as an institution committed to price stability in a context of higher instability. Inflation targeting in emerging markets is therefore not a switch that is flipped, but a reputation that is built—and output volatility can be the price paid while it is being built.

Exchange-Rate Pegs: Mechanism and Implications

The alternative anchor is the exchange rate itself. The central bank commits to maintaining a fixed or managed rate against a major foreign currency—often sacrificing independent monetary policy in the process—so that domestic prices are indirectly disciplined by the anchor currency's stability. Exchange-rate stability is prioritized, and inflation control follows as a derivative effect rather than a direct objective.

The peg's viability rests on two requirements: sufficient foreign exchange reserves to defend the chosen rate, and the fiscal discipline to avoid pressures that make the rate indefensible. The ability to manage the exchange rate, particularly during periods of external pressure, is crucial; a peg that cannot be defended is worse than no peg at all, because the collapse itself becomes an inflationary shock.

Mishkin's account of Mexico, in a 1997 Reserve Bank of Australia conference volume, is the canonical caution. After very high inflation, Mexico pegged the peso to the dollar in December 1987 and moved to a crawling peg in January 1989. Up until December 1994, the strategy appeared highly successful—until it did not. The lesson is not that pegs never work, but that their apparent success can conceal accumulating vulnerability, and the eventual reversal can arrive suddenly and with severe consequences for lending, investment, and economic activity.

Unique Challenges for Emerging Market Economies

Three structural features make inflation control categorically harder in emerging markets than in advanced economies, and they interact with both strategies.

Institutional fragility and imperfect credibility. The NBER research attributes emerging markets' weaker inflation performance to fragile institutions and imperfect credibility, compounded by the nature and magnitude of the shocks these economies face. A central bank whose commitment markets doubt must tighten more aggressively to achieve the same disinflation, deepening the output cost.

Heightened macroeconomic volatility. Both output and inflation are more volatile in emerging markets, and inflation levels are higher, so the same policy framework operates in a noisier environment with less margin for error.

Vulnerability to external shocks and capital flows. A 2020 Bank for International Settlements working paper on inflation risks found that the exchange rate has a quantitatively important and non-linear impact on the inflation outlook in emerging markets: a depreciation is associated with larger increases in the upper quantiles of the inflation distribution, increasing its right skewness. Tightening financial conditions likewise raise both upside and downside tail risks, especially in emerging markets. Prasad and Kanbur add that capital controls offer some breathing room but are porous and impose their own economic costs.

Comparative Analysis of Inflation Control Strategies

The table below contrasts the two frameworks across a consistent set of criteria—mechanism, requirements, risks, and emerging-market-specific challenges—so the reader can judge which strategy's demands fit a given institutional and external context.

Read side by side, the comparison reveals the underlying logic of the choice. Inflation targeting demands institutional assets—credibility, independence, communication—that take years to accumulate but leave monetary policy in domestic hands. A peg substitutes an external anchor for domestic credibility, which is attractive precisely when institutions are weak, but it shifts the binding constraint onto reserves and fiscal discipline, and its failure mode is abrupt. The BIS finding that depreciations disproportionately inflate the upper tail of the inflation distribution explains why the exchange rate cannot be ignored under either regime: even inflation targeters in emerging markets feel currency movements more sharply than their advanced-economy counterparts.

Navigating Inflation Control in Emerging Markets

Emerging market policymakers must carefully weigh institutional capacity, credibility, and vulnerability to external shocks when selecting or refining their inflation control strategy. The evidence supports a clear diagnostic sequence: an economy with weak credibility but ample reserves and fiscal discipline may find a peg viable as a temporary discipline device, while one with stronger institutions but heavy exposure to capital flow reversals is better served by inflation targeting with its flexibility on the exchange rate—provided it accepts the output volatility that comes with a credibility still under construction.

The measurable indicator of success, whichever framework is chosen, is the sustained reduction in inflation volatility and output stability, alongside strengthening institutional frameworks and central bank independence. The NBER researchers' central insight bears repeating as the closing test: the difference between emerging and developed economy outcomes lies not in the framework itself but in the institutions and shocks surrounding it, so the durable fix is institutional, not merely technical.

Sources

• NBER
• Strategies for Controlling Inflation — Reserve Bank of Australia
• Emerging Markets Need to Target Inflation — Brookings
• Inflation at risk in advanced and emerging market economies — Bank for International Settlements