(Version in Español)
The global financial crisis has reminded emerging market economies, if they needed reminding, that capital flows can be highly volatile and that crises need not be home grown.
Emerging markets have been affected in a variety of ways, not least by the sharp ups and downs in exchange rates that volatile capital flows engender.
These ups and downs may be less benign in emerging markets than they might be in advanced economies for a number of reasons.
- First, emerging markets may have more fragile balance sheets—essentially they are less well hedged against currency risk—so depreciations may engender financial distress and even bankruptcies and adverse effects on economic activity.
- Second, they may be less flexible, so that when the exchange rate strengthens and the traded goods sector loses competitiveness, this may have permanent effects on the economy even if the exchange rate later reverts to its initial level.
These factors mean that emerging markets are likely to care a lot about exchange rate volatility. They also care about macroeconomic stability and maintaining low inflation. This is one reason a number of them have adopted inflation targeting frameworks in recent years to guide their monetary policy.
Inflation targeting is helpful because it can anchor expectations, which may have become unhinged during earlier periods of high or even hyper-inflation.
But is inflation targeting compatible with concern about the exchange rate?
You might think there is a possible inconsistency between the two. Inflation targeting implies that your monetary policy instrument—the policy interest rate—must be adjusted whenever the path of inflation diverges from the inflation target. If inflation looks to be getting out of control but the exchange rate is already too strong, you can’t be worried about the latter when you set monetary policy.
Conversely, if you are in a recession and a lot of firms are going under, you want to lower interest rates to get inflation back up to target even if this might cause more trouble for firms with unhedged dollar or euro debt. These kinds of scenarios have led some to conclude that inflation targeting is not compatible with a concern about the exchange rate since the policy interest rate will not in general be able to hit both the inflation and exchange rate targets.
Can you have your cake and eat it too?
It would certainly help if there were another instrument that policymakers could use—say foreign exchange (FX) market intervention (official purchases and sales of dollars for local currency). In such a case, they would have two instruments (FX intervention and the policy interest rate), and two targets (the exchange rate and the inflation rate), which would indeed make life a lot easier. Is this the case?
First off, one should look at the actions of policymakers in emerging market economies, rather than any rhetoric. These strongly suggest emerging markets believe they can influence exchange rates through their policy actions. Interest rates and FX intervention respond systematically to periods of overly strong or overly weak exchange rates, and policymakers seem to lean against the wind when the exchange rate strays too far from levels that are consistent with medium-run fundamentals.
Of course it is possible that policymakers are just spinning their wheels, and that their actions do not in the end help to smooth out the ups and downs of exchange rates. Here the evidence is more mixed, but is certainly more favorable for emerging market economies than for advanced economies (which are much more integrated in global markets and, as such, much less able to influence exchange rates when the central bank acts to buy or sell foreign currency).
Squaring the circle
In a recent paper, I—together with my co-authors Atish Ghosh and Marcos Chamon—conclude that central banks in emerging markets do have a second instrument (FX intervention, in addition to the policy rate) that can be used to manage both inflation and exchange rates.
And, more to the point, use of this second policy instrument is likely to make central banks more, rather than less, credible. The reason is that when the exchange rate gets too far out of line (in relation to medium-run fundamentals, and looked at from a multilateral, rather than a unilateral perspective), obstinately refusing to acknowledge the issue is not tenable. Much better to adjust both policy instruments in an effort to achieve dual targets.
The idea of using more tools to address economic problems is one that has been gaining traction in the wake of the financial crisis, which has brought home that a narrow view in which all will be well as long as central banks deliver stable consumer prices simply doesn’t hold water.
Policymakers need to target many aspects of economic performance, and make use of a broad array of tools (including macroprudential regulation, capital controls, etc.) to deliver macro-financial stability.
To be sure, excessive policy activism has its costs (and those lessons should not be forgotten), but the crisis suggests that leaving available policy instruments on the table is not the right answer either.
Is FX intervention costless? Of course not, and the costs (both for the country, and for the system as a whole) need to be factored in.
This is why, for example, the optimal response to a mean-reverting shock (a shock that lasts for a while, but is not permanent) never involves sustained one-way intervention in the FX market (which would be too costly), but rather initial official purchases of foreign exchange followed by sales (in the case of favorable shocks, and conversely for adverse ones), with reserves returning to their initial level in the long run.
In the face of permanent shocks, of course, the central bank should simply allow the exchange rate to adjust. We also believe that, by stabilizing currency values around their multilaterally-consistent medium-run levels, making use of the FX intervention policy instrument is likely to get us closer to a globally cooperative outcome than foreswearing use of that instrument.
Simply put: two instruments are better than one in achieving two policy targets.