It is often claimed that inflation targeting , to be successful, needs to include a high degree of exchange rate flexibility, with the policy rate geared to stabilizing inflation and the exchange rate allowed to fluctuate freely. But a new paper from the IMF examines the case for using two policy instruments—the policy interest rate and sterilized foreign exchange market intervention—in emerging market countries aiming to maintain low inflation while avoiding the damage that large and abrupt currency movements may engender. It argues that in a world of volatile capital movements, and sharp ups and downs in exchange rates, there are important benefits to making use of all available policy instruments, both from a single country’s perspective, and from a global standpoint. Provided policymakers are clear about their objectives, there is no conflict between an inflation targeting framework and making use of the foreign exchange market intervention instrument to attenuate deviations of exchange rates.
Abundant global liquidity and high exposure to capital movements have put foreign exchange intervention at center stage of the policy debate in Latin America. Although intervention is widely used, there is limited evidence about its effects on the exchange rate (particularly in terms of slowing the pace of currency appreciation). In the latest Regional Economic Outlook: Western Hemisphere we took a fresh look at intervention practices and effectiveness for a group of economies in Latin America and other regions during 2004-10. Our analysis suggests that foreign exchange market interventions may help to mitigate appreciation temporarily. However, the impact depends on the circumstances and characteristics of each country.