Does the level of capital openness explain “fear of floating” amongst the inflation targeting countries?

Abstract Under the assumption of perfect capital mobility, inflation targeting (IT) requires central banks to primarily focus on domestic inflation and to let their exchange rate float freely. This is consistent with the macroeconomic trilemma suggesting monetary independence, perfect capital mobility and a fixed exchange rate regime are mutually incompatible. However, some recent empirical evidence suggests that many developed and developing countries following an IT regime are reacting systematically both to deviations of inflation from its target and to exchange rates. I empirically examine whether the responsiveness of the interest rate to exchange rate fluctuations can be explained in terms of limited capital openness. Applying Arellano-Bond dynamic panel estimation method for 22 IT countries, I find that short-term interest rates do respond to real exchange rate fluctuations. However, the responsiveness of the interest rate to the exchange rate declines significantly as capital market openness increases. The results indicate that capital controls have a significant impact on the exchange rate policy of the IT central banks, as the central banks have relatively less control over the exchange rate movements with greater openness of the capital market.