Modern Economy, 2010, 1, 89-99
doi:10.4236/me.2010.12009 Published Online August 2010 (http://www. SciRP.org/journal/me)
An Inflation Targeting Regime in Egypt:
A Feasible Option?
Tarek Ghalwash
Department of Economics, Mansoura University, Mansoura, Egypt
Received June 6, 2010; revised July 10, 2010; accepted July 15, 2010
Abstract
This paper addresses first whether scientific evidence—theoretical and empirical—exists to support the in-
flation targeting regime and, secondly whether inflation target is worthwhile for Egypt. The method in this
paper builds on a literature review of the theoretical and empirical research in the field of economics. Our
conclusion shows that there is incomplete evidence from a number of countries supporting the inflation tar-
geting regime as an effective monetary policy framework for the achievement of macroeconomic stability.
The paper concludes that the Central Bank of Egypt and the Egyptian economy is not yet ready for the im-
plementation of an inflation targeting regime.
Keywords: Inflation Targeting, Monetary Regimes, Granger Causality Test
1. Introduction
The fact that the inflation problem has received increas-
ing attention in recent years has led to an increased in-
terest in the effects of different monetary policy regimes.
By “effects” we partly mean what governments want to
achieve (i.e., a price stability, output growth), but also
the effects on the economy performance so that it can
succeed in an increasingly competitive world market. In
other words, the interest in price stability policy issues is
not only related to the “benefit side” but also the “cost
side.” It is well known that the main focus of monetary
policy should be attaining low, stable inflation, since any
deviating from this objective may have serious conse-
quences in terms of growth stability and economic wel-
fare [1].
There seems to be a wide consensus among econo-
mists that high and volatile inflationary rates distort rela-
tive prices, discourage savings and investment, hinder
economic growth and development, and can induce so-
cial and political instability. In the quest to avoid this ma-
laise, there are traditionally three aggregates that serve as
an anchor for monetary policy management: a monetary
aggregate, exchange rate, and inflation itself, which is
called inflation targeting.
Recently, Inflation target has become the dominant
monetary policy prescription for a number of developing
and industrialized countries and has been widely talked
about as an economic policy1. Many countries have ado-
pted inflation targeting as a monetary policy with the
hopes of effectively reducing inflation and increasing
economic and price stability. Even though it is often
claimed that inflation targeting has helped these coun-
tries achieve lower and more stable inflation along with
more stable output, there is no conclusive evidence that
inflation targeting directly caused the improved eco-
nomic performance [3].
The adoption of an inflation targeting monetary fram-
ework that started in New Zealand in 1990, is currently
popular among a number of emerging market countries
such as Brazil, Chile, Colombia, The Czech Republic,
Hungary, Israel, Korea, Mexico, Poland, South Africa,
Thailand and Turkey. In the West African sub-region,
Ghana has also adopted inflation-targeting monetary fra-
mework and other African countries are at various pre-
paratory stages of adopting it.
The debate over the effectiveness of inflation targeting
to reduce price levels has been overshadowed in recent
year by the financial crisis originating in the sub prime
mortgage market and the run up in energy and food
prices. It has focused on the view that inflation targeting
places too much emphasis on inflation, potentially at the
expense of other monetary policy goals. Some critics of
inflation targeting see recent macroeconomic develop-
1Inflation targeting is a monetary regime that was first introduced in
N
ew Zealand in 1990 and as of 2006 had been adopted by more than
twenty advanced and emerging economies (See Roger and Stone [2]).

T. GHALWASH
90
ments as being the downfall of inflation targeting2.
Economists have started debating the pros and cons
for developed and developing countries to shift from the
current regime to inflation targeting. In light of these
debates, one can view the debate in, for example, Egypt
with regard to the country’s desire to be at the forefront
of switching to an inflation targeting regime especially in
the Middle East area3. On that front, the Central Bank of
Egypt (CBE) announced in June 2005, its intention to
“put in place a formal inflation targeting framework to
anchor monetary policy once the fundamental prerequi-
sites are met”.
To our knowledge, there are few earlier studies deal-
ing with whether Egypt is ready for inflation targeting,4
as there are a number of requirements to be met for such
regime to be a sensible option as a monetary regime.
Investigation is also needed as to whether the Egyptian
Centre Bank (ECB) has considered the full implications
of shifting to inflation targeting, in particular as to how
this monetary regime will contribute to other objectives
of the country, such as growth, employment creation and
poverty reduction. Therefore, the main contribution of
the present paper is to fill this gap in the debate.
This paper will not assess the pros and cones of infla-
tion targeting as this has been extensively discussed in
previous studies: See, for example, [6-9]. It has, however,
been observed by [10] that the growing number of coun-
tries that target inflation and the perceived success of this
monetary policy strategy serve as a stimulus for coun-
tries that engage in alternative regimes—such as mone-
tary or exchange rate targeting. This consideration raises
the question of how to evaluate whether a country is
ready to join the group of inflation targeters now, later or
even never.
This paper aims to give a systematic review of the in-
flation targeting regime. The fundamental question is
whether scientific evidence—theoretical and empirical—
exists to support the inflation targeting regime. If infla-
tion targeting can be supported, does it only apply within
specific preconditions? Furthermore, a closer look at the
case of Egypt is presented by reviewing recent evidence
to asses whether it is ready to switch to inflation target-
ing. Thus, the main objective in this paper entails not
only a full understanding of the theoretical basis under-
lying inflation targeting but also attempts to answer the
question, is inflation targeting worthwhile in general, and
especially for Egypt?
The method along of this paper builds on a literature
review of the theoretical and empirical research in the
field of economics. The rest of the paper is structured as
follows: Section 2 provides a systematic assessment of
what is meant by the inflation targeting policy and what
are the important preconditions for applying it. One of
the objectives of this section is to provide an overview of
the current understanding in the literature with respect to
the applicability and relevance of the inflation target re-
gime. Section 3 discusses the empirical evidence on the
effects of inflation targeting in developed and developing
countries and some of the lessons for monetary policy
that can be drawn from the experiences of inflation tar-
geting of Central Banks. Section 4 discusses whether
Egypt satisfies the preconditions for adopting inflation
targeting. Section 5 concludes with a summary of current
knowledge and to what extent this information can pro-
vide guidance to Egyptian policy-makers.
2. Monetary Policy Instruments, what does
Inflation Targeting Mean?
2.1. Definition of Inflation Targeting
Economists and monetary policy makers have long belie-
ved that successful monetary policy should have a “nom-
inal anchor”, a variable that the central bank could use to
discipline their policy decisions and convince agents in
the economy that the central bank was disciplined [11].
Various nominal anchors have been used in countries:
examples are monetary aggregates and the exchange rate.
In recent times, many countries in the world have moved
towards a system/framework for conducting monetary
policy known in academic and policy circles as “Infla-
tion Targeting”. As the name indicates, the nominal an-
chor is the inflation rate: the central bank is supposed to
follow a monetary policy that is designed to achieve a
stated objective with regard to the inflation rate.
A review of the literature reveals several interpreta-
tions of the definition of the inflation target. Inflation
targeting is often defined as a framework for monetary
policy, characterized by the public announcement of of-
ficial quantitative targets (or target ranges) for the infla-
tion rate, over one or more time horizons, and by explicit
acknowledgment that low, stable inflation is the mone-
tary policy’s primary long run goal ( see [12,13] and
[14]). According to [15], inflation targeting is not a
method to reduce the current inflation but an anchor to
monitor and control price stability in an economy after a
thorough disinflation period.
With regards to literature discussions, [16] argues that
the inflation targeting regime encompasses five main
elements:1) the announcement to the public of an explicit
quantitative target or range for a period of time; 2) an
institutional commitment to price stability as the primary
goal of monetary policy, to which other goals are subor-
dinated, meaning that a country is more likely to adopt
2Joe Stiglitz, for example, has written that “Today, inflation targeting is
being put to the test —and it will almost certainly fail”.
3Israel and Turkey are already adopting inflation targeting as a mone-
tary policy framework.
4[4] and [5] examined whether Egypt is ready to adopt inflation targe
t
or not without examining whether this policy would be good for Egyp-
tian economy as a whole.

T. GHALWASH
91
inflation target in the absence of fiscal and financial do-
minance; 3) the central bank should have powerful mod-
els to make inflation forecasts, which use some indica-
tors and variables containing information on future infla-
tion; 4) increased transparency of the monetary policy
strategy through communication with the public and the
markets about plans, objectives, and decisions of the
monetary authorities; and 5) increased accountability of
the central bank for attaining its inflation objectives.
These defining features of inflation targeting require that
the country's monetary authorities have the technical and
institutional capacity for modeling and forecasting do-
mestic inflation and have some idea or prediction of the
time it takes for the determinants of inflation to have
their full effect on the inflation rate. The inflation target
provides full transparency in the implementation of
monetary policy that enables financial institutions in the
market to foresee the future with less uncertainty and
behave accordingly.
The conclusion that can perhaps be drawn from the
previous discussion about the inflation targeting is that:
the inflation targeting entails much more than a public
announcement of numerical targets for inflation for the
year ahead. This is important in the context of emerging
and developing markets because many of them routinely
reported numerical inflation targets or objectives as part
of the government’s economic plan for the coming year,
and yet their monetary-policy strategy should not be
characterized as inflation targeting, as it requires all the
elements mentioned above for it to be sustainable over
the medium term. The main issue raised right now is how
an inflation target model as a monetary policy regime
works?
2.2. Inflation Target Model
The simple version of this model can be written as fol-
lows (see [17]):
***
2113
()()
ittt ttttt
HH

 

  (1)
)()( 1
*
1ttttttttErrHEH 

  (2)
)()( *
2
*
1
*
tttttt HHrr  (3)
where

is inflation rate, *

is the central bank’s
inflation target, t  is Expectation on time t, )( *
tt HH

is output gap and
r
is interest rate and the symbol *
refers to target or long-run variables (or ‘natural’ in the
case of interest rate; *

is the full-employment NAIRU
level of output)5. The last term, t  is an error term refl-
ecting unobserved shock (random shock).The model con-
tains three equations and three unknowns, namely, output,
inflation and the interest rate. Firms are assumed to index
their prices to their assessment of the central bank’s in-
flation target, and *
t

is the public’s current estimate of
the central bank’s target.
Equation (1) is a price equation or a simple forward-
looking Phillips curve6. The output gap explains the in-
flation gap. In this model, inflation is caused by the out-
put gap and the latter is caused by interest rate policies
(see Equation (2)). Equation (2) is the expectation IS
curve. Interest rate deviations from the target explain the
output gap. If the central bank sets the interest rate below
the natural rate, firms will find it profitable to borrow
from the banking system to finance their Investment
plans. Thus output will grow and the output gap will de-
crease. Equation (3) is Taylor’s rule. It does not contain a
random error because it is assumed that monetary policy
operates without random errors. It is also assumed that
0
1

for stability of the equilibrium. If actual output
gets close to the potential or if inflation rises above target,
the central bank will increase nominal interest rates (and
indirectly real interest rates).
To see how the model works, consider the central
bank announcement to the public regarding the formal
target inflation rate. This can align the public’s expecta-
tions of current and future target rates with the actual
goals of the central bank. For example, reducing the pub-
lic’s assessment of the current and future target inflation
rates would allow average inflation to fall without any
associated cost in terms of real economic activity. This
implies that the monetary authorities can set any inflation
target they desire without having any effect on the real
equilibrium of the economy, i.e., the equilibrium level of
real output is unaffected by a shock; only the equilibrium
level of inflation changes7. This also implies that, given
the independence of the real economy from the inflation
target, inflation targeting becomes an autonomous policy
objective. Therefore, the stability of the system is guar-
anteed by the countercyclical role of the central bank in
setting interest rates.
In the same manner, the inflation target regime can
also allow the central bank to reduce both inflation and
output volatility by anchoring the public’s beliefs about
future inflation. If a positive inflation shock causes the
public to, (incorrectly), adjust upwards their estimate of
the central bank’s target, a larger decline in the output
gap is necessary in order to limit the rise in actual infla-
tion through rising of interest rates. Greater stability of
inflation expectations should reduce the volatility of in-
flation and improve the short-run inflation—real activity
5The literature interprets r* as the rate that is consistent with ‘neutral’
monetary policy. This means that if the real funds rate is equal to the
natural rate, then monetary policy will be consistent with
b
oth the
inflation and output and output targets.
6The forward-looking specification is an attempt to overcome the pa-
rameter instability commonly found after structural breaks. It is also
motivated by the natural assumption that, as the inflation targeting
regime gains credibility, expectations tend to converge to the targeted
value.
7Because the changes on the interest rates policy will bring π closer to
π*.

T. GHALWASH
92
trade off faced by the central bank. This, in turn, means
that the volatility of both inflation and real activity would
be lower under inflation targeting. In addition, when
monetary policy is based on an inflation target regime,
the central bank inflation forecast plays a key role in this
regime. Therefore, the corresponding interest rate path is
necessary for the private sector to determine the central
bank’s forecast of potential output because providing
interest rate projection is very important for reducing
uncertainty. According to the theoretical model, a feasi-
ble, and optimal, policy would set both inflation and the
output gap equal to zero for all t. In this case, an interest
policy consistent with such equilibrium would ensure
that rt = *
t
r for all t. Given zero inflation, it is clear that
the output gap only depends on the current and expected
future interest rate gaps. This means that the inflation
target can reduce the public’s uncertainty about either the
current target or future targets. This can be easily seen by
rewriting the Phillips curve as
t
HH tt
T
ttt
T
tit

 
)(
)(
*
3
1121

(4)
Where:

Ttt T
ttt/
 (5)
The new random error term in the Equation (4), is now
composed of the original random shock and errors in the
public’s forecast of the central bank’s inflation target.
Thus, reductions in forecast errors associated with the
public’s assessment of the inflation target, like a reduc-
tion in the variance of the cost shock, allow both infla-
tion (around target) and the output gap to become more
stable. In this case, the interest rate projection would
only provide the public with the central bank’s assess-
ment of future demand shocks to which the policy rate
will presumably be adjusted to offset.
Following the pervious analysis, it seems that the main
argument in favor of inflation targeting is that an official
announcement of an inflation target makes a central
bank’s policy more credible, which helps to alleviate the
dynamic inconsistency problem, and thus should lead to
lower (expectations of) inflation and inflation variability8.
Further, one can draw the conclusion that the transpar-
ency on how monetary policy operates under inflation
targeting makes the formation of inflation expectations
easier, thereby strengthening the ability of central banks
to achieve inflation targets, and therefore, prompting
other central banks to mimic this practice.
2.3. Preconditions for Inflation Targeting
Regime
The literature and experience of long-time inflation tar-
geters have identified preconditions which have to be
fulfilled in order to implement successful inflation tar-
geting [18]. The first and probably the most important
precondition for implementing the inflation targeting is
that the central bank must be given complete independ-
ence to adjust freely its instruments of monetary policy
toward the attainment of the objective of low inflation.
Central bank needs to have the freedom to set its instru-
ments of monetary policy in a way it believes that the
objective will be achieved most adequately. Instrument
independence mainly implies that the central bank is not
constrained by the need to finance the government
budget9. In addition, there should not be any political
pressure on the central bank to raise the rate of economic
growth in such a way that is inconsistent with the
achievement of the inflation target [19].
The second precondition for implementation of infla-
tion targeting is the existence of efficient monetary pol-
icy instruments. According to this condition, monetary
authorities have to be able to model inflation dynamics in
the country and to forecast the inflation to a reasonable
degree [20]. So, the monetary authorities should have
access to policy instruments that are effective in influ-
encing the macroeconomic variables. And also, there
must be sufficiently developed money and capital mar-
kets to react quickly to the use of those instruments be-
cause the monetary policy’s tools to achieve an inflation
target may weaken the positions of the banks and may
lead to the undershooting of the inflation target.
The third, but not less important precondition for in-
flation targeting is closely connected to the credibility.
Under the inflation target regime, the country should
incorporate transparency and accountability into the cen-
tral bank’s function. Both, accountability and transpar-
ency are dominantly determined by the quality of central
banks communication to the public. It is very important
for the central bank to inform the public about every cir-
cumstance connected to its policy, in order to make its
goals and instruments clear and controllable. The public
can use this information to form better expectations
about future policy actions and keep track of the central
bank’s performance. In addition, the increased account-
ability of inflation targeting enables the monetary au-
thority to monitor and enhance the understanding of ex-
pectations. It also decreases the possibility of a time in-
consistency trap, which leads to deviations from mone-
tary authority’s long-term objective. Moreover, it pro-
vides a good benchmark that can easily be observed by
the agents in the economy [21]10. A transparent monetary
policy makes it more difficult for a central bank to devi-
ate from set targets, since such behaviour would have
serious and long-lasting impact effects on its credibility.
8If credible, inflationary expectations are more accurate allowing busi-
nesses and consumers to better plan their production and spending.
9This means that the central bank should not be required to attain low
interest rates on public debt or to maintain a particular nominal ex-
change rate.
10Usually, accountability is not established by explicit legislation, but
through the transparency of monetary policy that inflation targeting
creates.

T. GHALWASH
93
Central bank transparency should involve making infla-
tion target explicit and public. This means that the cen-
tral bank should have some form of published commu-
nication which not only announces the target but also
describes the policy actions needed to reach and maintain
the inflation target.
To conclude, the previous discussion has highlighted
the importance of preconditions for successful inflation
targeting.
3. Inflation Targeting in Emerging
Countries: Empirical Evidence
The objective in this section is to review the empirical
literature for developed and developing countries that is
relevant to the objectives of this paper. An attempt will
be made to present a systematic review, considering dif-
ferent aspects of inflation targeting regime, such as
regulatory effects on 1) inflation rate, 2) real economy,
and 3) expected inflation.
3.1. Evidence in Developed Countries
As mentioned above the academic debate around the in-
flation target regime started soon after New Zealand first
instituted this monetary policy framework in early 1990.
Since that time, 22 countries have formally adopted in-
flation targeting, and no country that has adopted it has
abandoned it, although inflation targeting contribution to
overall economic performance is still being debated.
There is an extensive empirical literature related to the
connection between inflation targeting regime as a mo-
netary policy and economic performance. The finding of
empirical studies shows that inflation targeting countries
have succeeded to reduce inflation and the volatility of
inflation and to obtain inflation outcomes closer to target
levels [22].
Reference [6] compares average inflation levels for
seven inflation targeting countries with 7 countries ex-
cluding nontargeters countries. This contribution finds a
much steeper decline in inflation in the case of the for-
mer group, concluding that inflation targeting is useful
for countries facing lack of anti-inflation credibility. [23]
interpret similar results as a process of ‘convergence’, in
that on average inflation targeting countries converge to
the inflation rates of the non- inflation targeting countries
in the targeting period. [24] are able to conclude that
inflation targeting countries have been able to meet their
inflation targets and reduce inflation volatility11.
Closely related to the previous results, [25] employ
cross-section difference-in-difference regressions to ex-
amine the treatment effects of inflation targeting in 20
OECD countries, seven of which adopt inflation target-
ing. They discover that after adopting inflation targeting,
the economic performance of these countries improves.
But, non-targeting countries also experience improve-
ments around the same time. Thus, they argue that better
economic performance reflects factors other than the
monetary regime and conclude that inflation targeting
does not produce a major effect. In other words, inflation
targeting is irrelevant.
However, there are other studies that show a some-
what different result. [26] Provide a comparative analysis.
They match three inflation-targeting countries (New Zea-
land, Canada, and the United Kingdom) with three near-
by non-inflation-targeting countries (Australia, the Uni-
ted States, and Germany), finding little empirical evide-
nce that an inflation-targeting regime performs better
than a non-inflation-targeting regime. In addition, [27]
states that “there is no evidence that inflation targeting
has been detrimental to growth productivity, employment,
or other measures of economic performance”, a view
supported by [28] in his comparison of 5 industrial coun-
tries that have been targeting inflation for at least 10
years and 6 non-inflation targeting industrial countries.
Finally, [29] use matching methods to evaluate the tre-
atment effects of adopting inflation targeting on seven
industrial countries with fifteen non-inflation targeting in-
dustrial countries as the non-treatment group. They show
no significant effects on inflation and its variability, ar-
guing the window-dressing view of inflation targeting.
[30] uses the same method and sample data as [29], find-
ing that inflation targeting does not significantly affect
output growth or its variability. [31], however, show that
inflation targeting OECD countries suffer smaller output
losses in terms of sacrifice ratio during the disinflation-
ary period than non-targeting counterparts. [32], employ-
ing intervention analysis, find lower inflation rates, well-
anchored and accurate inflation expectations for both
targeting and non-targeting countries.
In summary, we can say that the empirical studies re-
viewed fail to produce convincing evidence that IT im-
proves inflation rate and economic stability. In addition,
as [23] argue, the environment of the 1990s was in gen-
eral terms a stable economic environment, “a period fri-
endly to price stability” and inflation was on a downward
trend in many countries, especially developed countries.
3.2. Evidence in Developing Countries
Recently, more than a dozen developing countries have
officially adopted inflation targeting. Thus, a complete
evaluation of the effectiveness of inflation targeting req-
uires further evidence from developing countries. But, in
11Comparing the pre-targeting period with the post-targeting period
may not capture the impact of inflation targeting per se, but rather a
re-orientation of monetary policy towards lowering inflation (which
could be achieved with or without inflation targeting). Comparisons
between inflation-targeting countries and non-targeting countries are
weaker and
,
a
g
ain
,
de
p
end on the control
g
rou
p
used.

T. GHALWASH
94
general, most developing countries—whether they tar-
geted inflation or not—performed much better in terms
of growth and inflation since 2000 than during the 1990s.
The evidence also shows that those that adopted inflation
targeting tended to see bigger improvements than others,
both in terms of inflation and growth performance12.
Reference [29] evaluates the effect of inflation targeting
on inflation and inflation variability in thirteen developing
countries that have adopted this policy by the end of 2004,
using a variety of propensity score matching methods.
They found that inflation targeting has quantitatively large
and statistically significant effects on lowering both in-
flation and inflation variability in these countries. On
average, the adoption of inflation targeting has led to a
reduction in the level of inflation by nearly 3 percent13.
Following the methodology, [35] focus specifically on
developing economies, excluding industrial economies
from among their inflation targets and their non-inflation
targets. They found that the effects of inflation targeting
were statistically and economically significant.
On the another hand, [36] used panel data to assess the
effect of inflation target in developing countries, and
found no evidence that the inflation targeting regime
improves performance of inflation and output growth in
developing countries. That is, inflation targeting regimes
do not lower the costs of disinflation. Finally, a group of
scholars from Cambridge University conducted a pains-
taking research in the effect of inflation target, they con-
cluded in these words: “We have attempted in this study
to gauge empirical evidence for both developed and
emerging countries that adopted the new monetary policy
strategy that has come to be known as inflation targeting
(IT). It may very well be the case that IT countries, de-
veloped and emerging, have been successful in taming
and controlling inflation. But then there is also evidence
that clearly suggests that non-IT central banks have also
been successful in achieving and maintaining consis-
tently low inflation rates”.
The previous empirical findings produce mixed evi-
dence in economic performance for developing and de-
veloped countries, but it seems developing countries gain
more from inflation targeting policy than do developed
countries.
The main conclusion that we can draw from these
discussions is that it may very well be the case that infla-
tion targeting countries, developed and emerging, have
been successful in taming and controlling inflation. But
then there is also evidence that clearly suggests that non-
inflation targeting central banks have also been success-
ful in achieving and maintaining consistently low infla-
tion rates. Our overall conclusion, then, is that the avail-
able evidence we have managed to gauge clearly sug-
gests that a central bank does not need to pursue an infla-
tion targeting strategy to achieve and maintain low infla-
tion, particularly during the mature phase of stationary
targeting. The main question that arises is, is inflation
target worthwhile for Egypt’s Economy? To answer this
question, we will try to assess, theoretically and empiri-
cally, if Egypt meets the preconditions for adopting an
inflation target with some general comments on inflation
targeting itself as a monetary policy.
4. Is Egypt Ready for Adopting Inflation
Targeting
In this section, we try to analyze the prerequisites and ap-
plicability of inflation targeting in Egypt to evaluate its
feasibility. The main focus will be on the assessment of
whether the preconditions of inflation targeting are satis-
fied in Egypt. In order to do that, we explore three basic
elements that are the precondition for adopting the infla-
tion target: 1) Independence status of the Central bank of
Egypt (CBE); and 2) inflation forecasting capability in
Egypt; and 3) existence of relationship between the mo-
netary policy instruments and inflation.
4.1. Independence Status of the Central Bank of
Egypt (CBE)
Related to the institutional conditions discussed in the
precondition requirements for adopting inflation target-
ing, the independence of the central bank seems to be
the first feature that should be implemented. This am-
biguity arises from the fact that there are several kinds of
independence: political and economic, de jure and de-
facto,14 constitutional and statutory, independence within
and independence from the government, strategic (to
formulate policy) and tactical (day-to-day operations),
instrument independence but not goal independence [37],
and independence of the executive, judiciary, and legis-
lative [38]. In this manner, we try to asses whether Egypt
has satisfied the first preconditions for an IT regime in
such a way that it makes the adoption of an IT regime in
Egypt feasible to anchor individuals’ expectations
around the potential inflation targets. In order to do that,
we explore two basic elements that are related to the in-
stitution conditions: 1) Independence status of the CBE
from the government; and 2) absence of fiscal domi-
nance including no obligation for the CB to finance
budget deficits.
4.1.1. Independence Status of the CBE from the
Government
In Egypt, the central bank governor is appointed by de-
12[33], and [34] are among those who find more significant and positive
effects of inflation targeting.
13These findings are consistent with the earlier conclusions of [24], and
[23].
14De jure CBI would be equivalent to CBI as measured on the basis o
f
legal documents whereas de facto CBI would be equivalent to CBI as
factually implemented.

T. GHALWASH
95
cree from the president of Egypt, for a renewable term of
four years. The governor has two deputies appointed by
decree and chosen on the proposal of the governor, for a
renewable term of four years. The remaining nine mem-
bers of the board of the CBE are also appointed by the
president for a renewable four year15. While all board
members (Governor, deputies and nine experienced per-
sons) are nominated by a decree from the President of
the Republic, the remuneration and attendance allow-
ances of the nine specialized members are determined by
a decree of the Prime Minister, upon a proposal from the
Governor16. The board is the authority responsible for
realizing the objectives of the CBE, by formulating and
implementing monetary, credit, and banking policies.
The board also determines the instruments required to
achieve the objectives; particularly, the instruments of
monetary policy to be followed, the structure of credit
and discount rates, the regulatory and supervisory stan-
dards to guarantee the soundness of the financial position
of banks, and the regulation of auctions and tenders.
Even though the explicit mention of monetary stability
grants the CBE a degree of independence in implement-
ing monetary policy vis-à-vis the government; law No.
93 of 2005, grants the CBE a higher degree of instrument
independence, as it is free to set its discount rate and
upper and lower limits for bank borrowing and lending
rates and, in the absence of such limits, to make rules and
directives to influence interest rate setting and credit ex-
pansion. However, the existence of government repre-
sentatives as voting members on the Monetary policy
committee and the fact that the governor are appointed
by the decree of the president for a short term of four
years, reflecting that the CBE still be seen as not fully
independent according to law (de jure).
4.1.2. Absence of Fiscal Dominance Including no
Obligation for the CBE to Finance Budget
Deficits
As we mention before, to achieve effective inflation targ-
eting, the central bank must not only have full legal au-
tonomy but should be seen and act as one that has it and
consequently be free from fiscal and political pressures
that have the capacity to trigger objective that are in con-
flict with the inflation targeting goal. As it is with the
redenomination so it is with large fiscal deficits. This has
continued to undermine the autonomy of the central bank
with respect to monetary management. No matter how
fiscal deficits are financed, they always have deleterious
inflationary consequences. But this is worse when it is
financed by ways and means usually in response to the
pressure from the government. Egypt’s fiscal disposition
is largely characterized by a tradition of deficit budgeting
financed mainly by means particularly during the last
five years. Egypt’s budget deficit has been high and the
level of public debt has been around 65 percent of GDP.
Table 1 exhibits some macroeconomic indicators in
Egypt.
As we can see from Table 1, both the inflation rate
and the output growth rate in Egypt have increased. A
high output growth rate, in addition to the revenue com-
ing from the privatization process, have both contributed
to a lower budget deficit in FY 2006 and 2007. Impres-
sively, however, the inflation rate witnessed a rise in
2007 to 2009 when it turned out to be in a double digit
during this period and this is a not good outcome for IT.
A fiscal profile of the government shows that the high
ratio of both the budget deficit and the public debt for the
period of 2003-2009 were in conjunction with the high
contribution of both the banking system and the CBE to
financing the budget deficit17. Indeed, the structural
budget deficit has been much higher than the transitory
deficit, and fiscal discipline remains a problem. In Egypt,
the rate of fiscal deficit has increased after 2005 and has
been around 7% during the 2006-2008 period. Unless
this trend is radically changed, which is socially and po-
litically a real challenge, sooner or later, this fiscal gap
will generate excessive pressures on monetary policy.
The current fiscal deficit is also the outcome of the pres-
sures on fiscal revenues due to trade liberalization, and
most of all to the high degree of tax evasion, in addition
to inefficiency of the public expenditure.
On another hand, the public debt is also growing and
putting an extra burden on the budget through debt inter-
est payment. On average, the level of public debt in Eg-
ypt exceeds 60%. Such a situation is emerging as a seri-
ous concern. Reducing this public debt ratio and in parti-
cular that of foreign currency dominated debt is therefore
Table 1. Selected Macroeconomic Indicators in Egypt 2003
-2009.
2003 2004 2005 2006 2007 2008 2009
Real GDP Growth 3.24.1 4.5 6.8 7.17.25.5
CPI inflation(average) 3.78.1 8.8 4.2 11.011.717.1
Current account (% GDP)2.44.3 3.2 0.8 1.40.5–1.8
Budget deficit (% GDP) –9.5–9.6 –8.2 –7.3 –6.8–6.9–5.8
Public debt( % of GDP) 60.460.3 79.8 71.4 62.358.555.1
Source: IMF and central bank of Egypt
15One can only criticize the subordination of the board members' re-
muneration to the head of the government because, in such circum-
stances, the autonomy of the members' decisions becomes question-
able.
16The CBE has a board of directors under the chairmanship of the gov-
ernor, with fourteen members (two deputy governors, the chairman o
f
the Capital Market Authority, three members representing the minis-
tries of finance, planning and foreign trade, and eight experts in mone-
tary, financial, banking, legal, and economic affairs.
17According to [5], the contribution of the banking system to budge
t
deficit was, on average, 45% of the overall budget deficit for the period
of 2003-2006, while the involvement of the CBE in financing the
budget deficit was, on average, 58% of the banking system contri
b
ution
during the same period of 2003-2007, excluding the year 2006.

T. GHALWASH
96
necessary to reduce the vulnerabilities in a context of a
more exchange rate flexibility. For the time being, in
Egypt, despite the progress achieved in the ratio of pub-
lic debt in 2007-2009 compared to the previous periods,
the government still relies on seigniorage revenues in
order to close the transitory gap between its revenue and
its expenditure flows. It is true that the reliance on
seigniorage revenues is often higher in developing coun-
tries due to low and unstable incomes and poor tax col-
lection procedures but this is not consistent with inflation
targeting, and is likely to hamper the central bank’s in-
dependence.
The conclusion one can draw from the previous facts
is that the legal instrument independence granted to the
CBE is sketchy and does not go beyond the de jure in-
dependence18. Consequently, the existence of govern-
ment representatives as voting members on the MPC and
the coercion of the CBE to extend finance to the gov-
ernment are two elements sufficient to undermine any
meaning of the de facto independence of the CBE.
4.2. Inflation Forecasting Capability in Egypt
As mentioned above, the inflation forecast is central to
any inflation-targeting regime and requires a well-de-
veloped technical infrastructure, including quality data,
construction of an appropriate price index, and forecast-
ing and modeling capabilities. A forward-looking infla-
tion targeting framework is, in fact, “inflation forecast
targeting” [40]. Indeed, inflation targeting is not applied
mechanically and does not focus only on current infla-
tion but on containing inflation as a medium-term goal.
Central banks pay attention to indicators that can predict
future inflation [41].
To what extent is this technical infrastructure currently
available in Egypt? Regarding the quality of data, unre-
liability of data is one of the major problems facing
econometric modeling and estimation in Egypt which
incidentally is central to price-inflation forecasting for
inflation targeting. Even with so many reforms and im-
provement of the data collection in Egypt19, timely and
reliable data availability remains an issue20. The absence
of this desideratum means that we cannot meet the de-
mands for full, timely, and accurate information on key
variables such as GDP, financial and trade data etc. over
required time periods. Since forecasting is at the heart of
inflation targeting, such forecasts may not be as robust as
should be expected by its advocates since data is neces-
sary to implement them. Although the CBE generates its
own data, in some cases, particularly in the past, there
are significant divergences among the data series being
published on the same subject by other organizations
with data-generating responsibility. These could have a
consequence of fundamental disparities in data generat-
ing and reporting procedures.
Moreover, the use of the consumer price index (CPI)
in Egypt for evaluating the inflation behaviour may serve
a useful tool, but it will be risky if the CBE is planning to
use it for the purpose of inflation targeting. As in all de-
veloping countries, choosing such an index is problem-
atic. The first reason is that foodstuffs, which make up a
large part of the basket, have highly variable prices be-
cause of their sensitivity to weather conditions. This high
variability translates into more volatile CPI inflation.
Second, goods and services with subsidized prices have a
substantial share of the basket. Large movements in
regulated prices, which have a direct impact on the over-
all price level, may lead to poor control of inflation and
damage the central bank’s credibility. In the Egyptian
case, food & non alcoholic beverages accounted for more
than 50% of the old CPI basket, and still account for al-
most 40% of the current one. Within this category, bread,
cooking oil and sugar benefit from consumption subsi-
dies. Also subsidized are petroleum products (rent, po-
wer and fuel represent around 10% of the basket) phar-
maceuticals (medical care represents 4%), water, elec-
tricity & gas (around 12%), (CAPMAS, 2005). Given
this information, one can conclude that having a target
limited to the CPI in Egypt is a serious problem, because
it will underpin any meaning of expectations about future
inflation: a key determinant of actual inflation. The ef-
fectiveness of monetary policy as a nominal anchor de-
pends on what is targeted and how. One of the funda-
mental problems arising from this framework is therefore
the absence of a valid price index.
4.3. Existence of Relationship between the
Monetary Policy Instruments and Inflation
In this section, we examine one of the main preconditi-
ons for a successful adoption of inflation targeting fram-
ework as expounded in many empirical studies and gives
a solid understanding of the relationship between mone-
tary policy instruments and macroeconomic outcomes
via the monetary transmission mechanism. In order to
quantify the importance of monetary policy variables in
determining changes in the consumer price index (CPI)
in Egypt, this paper adopts the Granger causality tests in
both bivariate and multivariate using the baseline VAR
model form which is employed by [43] and, more re-
cently, by [44]. The baseline VAR model representation
18One of the tough critiques of the CCMP came from the Morgan
Stanley report about the government, specifically the prime minister,
overriding both the CCMP and the MPC of the CBE [39].
19In 2005, Egypt subscribed to the IMF’s Special Data Dissemination
System (SDDS), which requires prompt posting of various macroeco-
nomic datasets, compiled in line with best International practice and
comparable across countries.
20[42] using the Data Quality Assessment Framework (DQAF) to as-
sess the quality of data in Egypt. the most defects in the Egyptian data
were found in the accuracy and reliability.

T. GHALWASH
97
is given by:
1
() ()
tt t
YALYLZ



 (6)
where t Y is a k vector of endogenous variables, t Z is
a d vector of exogenous variables, and A and

are
matrices of coefficients, and t

is a vector of structural
shocks with the variance covariance matrix ()



.
In the baseline model, the vector of endogenous vari-
ables consists of the gross domestic product (GDP),
consumer price index (CPI), Broad money supply (M2),
Government fiscal spending (FS), interest rate (R) and
exchange rate (EX)21:
),,,,2,,(EXRFSMCPIGDPZt (7)
In order to apply the Granger casualty test in a VAR
framework, the general mathematical representation of
the test can be written as:
111
11
mm
ttjtj jtjt
jj
yyz




 
 (8)
222 2
11
mm
tjtjjtjt
jj
zzz




 
 (9)
where i  are the constant terms, m is the lag order,
and it  are error terms and assumed to be serially un-
correlated with zero mean and finite covariance matrix.
In order to test causality from
z
to y, the null hypo-
thesis )(01 H is expressed as 10 (1,2,...,)
jjm


and the alternative is at least one of ),,...,2,1(
1mj j
is significantly different from zero. Similarly, )(02 H of
testing the causality from y to
z
is 20 (
jj



),...,2,1 m against at least one of 02  is not zero.
The paper used annual data from 1998Q1 to 2009Q4
gathered from the International Monetary Fund’s Inter-
national Financial Statistics, and Central Bank of Egypt.
Table 2 presents the results of the bivariate and multi-
variate block Granger causality tests for CPI and GDP in
Egypt.
As we can see in Table 2, the results suggest the ca-
usal link between the policy variables on consumer price
index and gross domestic product. The joint probabilities
for the multivariate tests suggest the rejection of the null
hypothesis. The bivariate tests for Cosumer price index
(CPI) suggest that all the variables except interest rate
and money supply cause significant variations in CPI.
This means that the level of output, exchange rate and
fiscal spending cause variations in the level of prices or
the CPI22. The findings support that the fact that fiscal
policy is also important for achieving price stability and
economic growth. In addition, the bivariate tests show
that money supply has a significant Granger-effect on
output but not on prices. The empirical results suggest
that Egypt’s exchange rate is quite significant with re-
spect to GDP as with CPI. This is not surprising given
the recent float of the Egyptian currency, and the subse-
quent positive effects on exports and the rate of growth
of GDP. The results also show consumer price index,
money supply, and government fiscal spending signifi-
cantly drive GDP.
The previous results show that the interest rate and
money supply as a monetary target regime are not suffi-
cient in the Egyptian economy to send the right message
to individuals to adjust their expectation about inflation.
Meaning that, the mechanism of the inflation targeting
model, as presented in Section 2, undermines the infla-
tion target.
Another important point of concern is about the indi-
rect effect between the money supply and inflation. It
seems that the impact of money supply adjustments on
inflation is not a one-time strike on inflation. Therefore
when the monetary policy rate is adjusted in order to
influence other rates, which invariably affects the spend-
ing decisions of economic actors, it neither affects the
economy nor inflation in a manner that is readily pre-
dictable.
The transmission mechanism of monetary policy has
long and variable lags because the economy takes time to
adjust to changes in monetary conditions. Inflation tar-
geting however does not seem to operate within this
frame of reasoning which suggests that the actual infla-
tion can be adjusted to hit the target inflation within a
short period if a deviation is observed. This belief is just
deceptive. What happens is merely the suppression of the
truth about the prevailing conditions of inflation. Ac-
cording to the previous points, if we recognize the causes
and uproot the inflation in Egyptian economy, then that
problem is almost solved. It is expected that the focus of
Table 2. Granger Causality Tests: Baseline VAR, 1998–
2009 1/.
Effect on
CPI Chi-square probability Effect on GDP Chi-square probability
GDP 15.14 0.001* CPI 10.57 0.004*
M2 3.10 0.681 M2 6.61 0.092**
FS 8.45 0.057** FS 8.59 0.064**
R 5.66 0.249 R 4.89 0.138
EX 12.84 0.003* EX 11.59 0.005*
Jointly33.67 0.000* Jointly 41.27 0.000*
Source: Authors’ calculations.
1/ The block Granger causality test for exclusion of a variable is based
on a Wald test and follows a χ² distribution; * and ** denote rejection
of the exclusion at the 1 and 5 percent level.
21All variables are in logs for all variables except interest rate where we
have used the level.
22This is expected since in a small open economy like Egypt, prices o
f
traded goods return rapidly to world levels following an exchange rate
appreciation.

T. GHALWASH
98
monetary policy should be on the management of the
primary source of inflation which in itself is unrestricted
fiscal, monetary and credit expansion by the government
using the instrumentality of the bank. What this means is
that the central bank should first of all manage the
money creation process from both the financing of gov-
ernment’s fiscal deficits as well as the growing penchant
for loosening banks credit creation capacity. Once this is
resolved within the context of the rule of law, the effi-
cient justice system for the protection of private property
rights, and eradication (or serious reduction) of public
sector corruption, inflation will naturally drop to very
low minimums and the economy will grow very strongly.
5. Concluding Remarks
This paper gave a systematic review of the Inflation tar-
geting regime. The fundamental question was whether
scientific evidence—theoretical and empirical—exists to
support the inflation targeting regime. A closer look at
the Egypt case was presented by reviewing recent evi-
dence to assess whether it is ready to switch to the infla-
tion target or not.
The paper concludes that: 1) There is insufficient evi-
dence to show that an inflation targeting regime is effec-
tive as a monetary policy framework for the achievement
of macroeconomic stability or price stability, and 2) the
Central bank of Egypt and by extension, Egypt, is not yet
ready for the implementation of the inflation targeting
framework. This is because the stringent conditions re-
quired—based on the experiences of countries who have
adopted it—are not yet met, and 3) more research should
be conducted on main sources of inflation in the Egyp-
tian economy in order to give a more informed picture to
policy makers so they can to adopt better policies ac-
cording evidence.
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