Monday, October 20, 2014
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Monetary Regime Transition in the Emerging World

SANTIAGO – Is inflation targeting – the rule that most of the world’s major central banks (though not the United States Federal Reserve) use to set interest rates – in its death throes? Many analysts seem to think so.

Mark Carney, currently Governor of the Bank of Canada, has not even taken over his new job at the helm of the Bank of England, yet he has already announced that he might change the BoE’s policy anchor. In Japan, the Liberal Democrats won December’s general election after having promised a more expansionary monetary policy. And in the US, the Fed has announced that it will keep interest rates low until unemployment reaches 6.5%.

None of this is as new as it seems. Among rich countries, inflation targeting has been on its way out since the 2008-2009 financial crisis. The large-scale asset purchases carried out by the European Central Bank, for example, have little to do with any definition of inflation targeting.

But inflation targeting has also been losing its hold on policymakers in emerging-market economies. Starting in the 1990’s, central banks in Brazil, Chile, Mexico, Colombia, Peru, South Africa, South Korea, Indonesia, Thailand, and Turkey adopted varieties of the scheme. But things changed with the global financial crisis. In joint research with Roberto Chang and Luis Felipe Céspedes, we show that all inflation-targeting central banks in Latin America have used a range of non-conventional policy tools, including currency-market interventions and changes in reserve requirements. Again, this is a far cry from the textbook version of inflation targeting.

What comes next? In the developed world, the leading contender to replace inflation targeting is nominal-GDP targeting. This seems to be what Carney has in store for Britain. Under the proposed new system, if the BoE would like to keep inflation around, say, 2%, and expects the trend rate of GDP growth to be 3%, it should announce a target for nominal GDP growth of 5%.

This new regime might help rich-country central banks to keep their economies suitably stimulated. But, from the point of view of emerging countries, changing the monetary-policy regime in this way makes little sense. Central banks in Asia and Latin America have had three problems with inflation targeting from the outset, but moving to nominal-GDP targeting solves none of them.

The first problem concerns capital inflows and exchange-rate appreciation. When rich-country central banks cut interest rates, capital moves south and east. Some inflows are always welcome. But when the flow becomes a flood, the currency strengthens sharply. Commodity exports typically continue to grow, but industrial and non-traditional exports suffer.

Increasing interest rates only attracts more capital, while cutting rates can cause the economy, already stimulated by the foreign inflows, to overheat. Faced with this dilemma, many emerging-market countries have turned to exchange-rate intervention, and then to raising banks’ reserve requirements, in order to make foreign borrowing less attractive.

This is a problem that concerns the composition of output (traditional versus non-traditional exports), not just its level. Moving to nominal-GDP targeting would not make a difference.

The second problem is shared by rich and middle-income countries’ central banks: how to ensure that monetary policy addresses the need to maintain financial stability. Inflation targeting concerns itself with the prices of goods and services, not the prices of financial assets. If “irrational exuberance” set in and a bubble developed in real-estate or equities markets, well, so be it, the standard theory maintains.

After the devastation wrought by the boom-and-bust cycle of recent years, not many economists are comfortable with the “so be it” attitude anymore. Nor are many emerging-market countries’ central banks, which are adopting changes in reserve requirements and loan-to-value ratios, among other measures, to prick asset-price bubbles in their early stages.

Advocates of nominal-GDP targeting claim that these prudential measures could be added to create an extended version of their preferred regime. Perhaps, but they could be added to the standard inflation-targeting regime as well. Moving from one system to the other helps little in this regard.

The final problem concerns central banks’ role as lenders of last resort in a crisis. This job is especially important – and difficult – in emerging markets, because a significant share of debt, both public and private, is typically in foreign currency. As a result, lending in crisis situations implies using international reserves and providing foreign-currency liquidity. This, too, is alien to the standard target-inflation-and-float-the-currency regime. But it would be just as alien to a system in which the central bank targeted nominal GDP and the currency floated.

These considerations suggest that the way out does not lie in moving from one simple, one-size-fits-all rule to another. Emerging markets need a monetary-policy regime that takes explicit account of capital-flow volatility, asset-price misalignments (including the exchange rate, which is the price of foreign currency), and the resulting financial instability.

The feedback from these factors to interest rates probably should not be the same in tranquil and turbulent times. A comprehensive regime should encompass two rules – one for crisis situations and one for “the rest of the time” – plus explicit guidelines for moving from one to the other and back.

We are far away from being able to formulate and apply such a rule. But at least the debate has now begun. The floor is open.

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  1. CommentedJonathan Lam

    Gamesmith94134: Monetary Regime Transition in the Emerging World

    As long as the central banks of the developed nations chose their targets either on the inflation, GNP, or unemployment, most emerging market nations may felt the chill because the heated economies are flooded with inflows of foreign investment.

    Commodity exports typically continue to grow, but industrial and non-traditional exports suffer; “irrational exuberance” set in and a bubble developed in real-estate or equities markets, and lending in crisis situations implies using international reserves and providing foreign-currency liquidity. These are not only the problems to the standard target-inflation-and-float-the-currency regime; ” A comprehensive regime should encompass two rules – one for crisis situations and one for “the rest of the time” – plus explicit guidelines for moving from one to the other and back.” Therefore, cash inflow must be taxed uniformly in order to give the leverage to the local currencies to interact during the heated market; and to identify these inflow each continent like OAS or ASEAN must have a zone policy. So, as I would suggest that IMF could restore the more standardized multiple currencies exchange rate in due course that sovereignty rule must be respected and its own currencies must be honored through the zone policy just in order to trade. Perhaps, Euro-dollar, or yen are not just the answer to the inflationary emerging market through the hot cash.

    The center of the problems issued on the competitiveness the developed nations lost from the labor cost and cheaper resources, but there is an advantage of the dominated currencies on valuation in the international trading in its settings. In the recent trading, yen and euro are devalued through the liquidity of the dollar, but dollar remains strong for its exchange and the emerging market nations restored dollar’s value in reversing their reserves to cut the heat on their inflation. In contrast, the dollar did not devalued through its liquidity motion or enhanced its competitiveness with other currencies. So, the problem on competitiveness based on its monetary regime may never be resolved; instead, it imported with value-added goods will continue to accelerate to its deficits. As usual, our government may execute a lower-profit profile on enterprise to cut inflation, but the process will further damage the profitability and creditability of the American Companies. Eventually, we are talking of the huge cash flow of these companies could be cut and their expansion as business as usual might turn negative to credit.
    More of the monetary stimulation through the Bank of Japan, it suggested more merger and purchase in foreign soil. However, it may become a trigger on migration of funds or reserves to its native land on protectionism; then, the stock market would be more volatile than ever, with its see-saw motion till global recession comes. Dependency on dollar’s liquidity may harm the global economy and its competitiveness. If the giant falls, then no one can escape even for China which is not consummating with its consumption route to make Chinese to spend more with lesser exports.

    In order to restore competitiveness in each economy and flexibility to growth, we must talk more on currencies exchange of its rate and system to revive the global economy. Liquidity is only buying time and advantage of arithmetic use can be delusional ; self efficiency is the key to prosper even for money printing nations.

    May the Buddha Bless you?

  2. CommentedDarko Oracic

    "The boom-and-bust cycle of recent years" was a result of inflation targeting. For example, when inflation was above the target in 2008, the ECB raised the interest rates and that caused the Great Recession in 2009. Inflation was again above the target in 2011, the ECB raised the interest rates, and that caused another recession in 2012.

  3. CommentedKen Presting

    Mr. Velasco brings together many valuable observations in a stimulating article. But I want to chime in on a topic he breezes past.

    "The boom-and-bust cycle of recent years" was a purely economic phenomenon in many countries, but in the USA, Italy, and Greece there is substantial evidence of corruption in either government or financial institutions or both.

    Most of us who think about economic issues simply assume that the laws of arithmetic and rules of accounting are never questioned. But once we start to apply economic reasoning to public policy, we need to remember that accounting is not physics - those rules can be broken.

  4. CommentedProcyon Mukherjee

    We are slowly and steadily moving towards lesser and lesser independence of the Central banks as monetary stances are being orchestrated that have broader mandates than just the stability of the monetary system; the BOJ example of increasing the inflation target after repeated dozes of stimuli, may be an extreme one, but surely every other Central Bank cannot afford to playing truant to the more fiscal role that needs to be taken up by the Government, any more.

    For the emerging countries, in India for example, the Central banks continue to withstand immense political pressure on lowering of interest rates and India is still leading the pack on macro-prudential fiduciary responsibility that it has to deliver, not many examples of which exist in the rest of the emerging system.

    Procyon Mukherjee

  5. CommentedJohnny (MoneyWonk)

    While I embrace the end of an inflation target and welcome a nominal regime change, I do not think QE deviates from an inflation targeting mandate. Ever since the Fed has expanded its balance sheet through LSAPs, inflation has stayed within the 2-3% mandate and avoided the serious deflation that inevitably would have followed the "Great Contraction."

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