I Executive Summary

Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
Published Date:
November 2009
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The exchange rate plays a more important role in monetary policy for emerging economies that have adopted inflation targeting than for their advanced economy counterparts. Inflation-targeting emerging economies generally have less flexible exchange rate arrangements and intervene more frequently in the foreign exchange market. The enhanced role of the exchange rate reflects these economies’ greater vulnerability to exchange rate shocks and their less developed financial markets. However, their sharper focus on the exchange rate may cause some confusion about the commitment of their central banks to the inflation target and may also complicate policy implementation. These tensions were heightened by the inflation pressures, greater exchange rate volatility, and financial stress arising from the global financial turmoil that began in mid-2007 and the subsequent economic crisis.

This paper explores the policy and operational role of the exchange rate within the broader monetary framework of inflation-targeting emerging economies. It also examines how emerging economies with other anchors make the transition to inflation targeting. The analysis is based on case studies and detailed documentation of exchange rate practices in a variety of countries and on simulations using a small model tailored to open, inflation-targeting economies. The key findings are these:

  • Model-based analysis provides measured support for an explicit but limited role for the exchange rate in the inflation-targeting frameworks of emerging economies under certain circumstances.

  • The benefits of a more explicit policy role for the exchange rate depend on the structure of the economy, the shocks to which it is exposed, and how the exchange rate is taken into account in the policy rule.

  • Intervening in the foreign exchange market plays a larger role in policy implementation for inflation-targeting emerging economies than for advanced economies, but it is a special challenge for emerging economies, and modalities diverge considerably among them.

  • The country experience suggests that a systematic, transparent, and market-based policy implementation approach can help reduce policy conflicts.

  • A more systematic and market-based role for the exchange rate greatly enhances the transition of those emerging economies moving toward an inflation-targeting regime.

  • The inflation episode of 2007–08 and the economic crisis that intensified in late 2008 confirm the relatively large role played by exchange rate policy for inflation-targeting emerging economies and, so far at least, demonstrate the resilience of inflation targeting to major global shocks.

Summary of Key Findings

An Enhanced Role for the Exchange Rate in Inflation-Targeting Emerging Economies

The enhanced role of the exchange rate in inflation-targeting emerging economies reflects strong, uncertain, and heterogeneous exchange rate channels. First, pass-through from the exchange rate to inflation is especially important for emerging economies, in part reflecting lower policy credibility. Second, many emerging economies manage the exchange rate to mitigate the impact on output of relatively short-term currency movements. A third, longstanding motivation for active management of the exchange rate is to promote financial stability, particularly against the impact of a potential depreciation on balance sheets with currency mismatches. Fourth, exchange rate management can also help avoid or mitigate the adverse consequences for external stability of a sudden stop in capital inflows. Fifth, underdeveloped domestic financial markets reduce the scope for exchange rate flexibility by amplifying exchange rate shocks and constraining policy implementation. Finally, a high degree of overall policy credibility frees up the exchange rate to float and enhances policy implementation and thus is necessary for the adoption of a full-fledged inflation-targeting nominal anchor.

The Appropriate Role for the Exchange Rate in the Monetary Policy Rule

A quantitative assessment of the trade-offs among monetary policy objectives demonstrates the circumstances under which different roles for the exchange rate in the policy rule can improve macroeconomic performance. The policy trade-offs are gauged in this paper using a small economic model to simulate the impact of shocks on advanced and emerging economies under different policy rules. The model demonstrates that inflation/output volatility is inherently higher for emerging economies. In general, the analysis tends to confirm the finding of earlier analyses that advanced, financially robust economies have little to gain from including the exchange rate explicitly in their policy reaction function, particularly in response to demand shocks.

At the same time, the analysis suggests that financially vulnerable emerging economies might benefit from including the exchange rate in the reaction function in a limited way, but that too much emphasis on the exchange rate is likely to be harmful. Including the exchange rate in the policy reaction function appears to help mitigate the impact of risk-premium shocks and cost-push shocks, especially by dampening interest rate and exchange rate volatility. These results do not amount to a ringing endorsement of active exchange rate management in inflation-targeting emerging economies, but they do shed some light on why the exchange rate plays an important role for most of these economies. Of course, it is not possible to draw strong policy conclusions for diverse economies on the basis of simulation results using small and necessarily simplified models, and there is great scope for further work.

The Role of Foreign Exchange Market Intervention in Inflation Targeting

An effective role for the exchange rate in policy implementation under an inflation-targeting framework can reduce conflicts between the inflation objective and other considerations. However, establishing strong policy implementation can be especially challenging for inflation-targeting emerging economies due to their policy legacy and their less developed financial markets. Under inflation targeting, the interest rate is the main monetary policy tool for influencing activity and inflation. Country experience suggests that foreign exchange market intervention should be implemented in the most systematic way possible. Transparency for the role of the exchange rate with respect to policy objectives, operational procedures, and ex post evaluation reduces the possibility of confusion about the inflation target. Of course, there are limits to the transparency of foreign exchange policy implementation, and country experience offers some sound policy transparency practices. The existence of deeper foreign exchange and domestic money markets enhances the effectiveness of changes in the policy stance, including through better signaling of policy intentions. Money market development makes it possible to use domestic monetary instruments rather than relying excessively on foreign exchange intervention, and it also facilitates sterilization.

The Role of the Exchange Rate during the Transition to Inflation Targeting

The exchange rate plays an important yet ill-defined role in the policy framework of emerging economies that have a flexible exchange rate but not a full-fledged inflation-targeting framework (referred to here as “emerging economies with other anchors”). These economies manage the exchange rate more actively, and policy implementation tends to be based on foreign exchange intervention that is more ad hoc and less market based. Exchange rate channels are probably stronger and more uncertain for typical emerging economies with other anchors because they are less financially developed, are more dollarized, and have less overall credibility compared to inflation-targeting emerging economies.

Establishing a more systematic, consistent, and market-based role for the exchange rate is a key to making the transition to inflation targeting. Model simulations suggest that giving the exchange rate a larger weight in the interest rate reaction function, or using the exchange rate as the operating policy target, can generate better macroeconomic performance than using a policy reaction function dominated by the interest rate. The degree of domestic money market development helps shape the choice of the operating target during the transition. Reducing the weights of the exchange rate in the reaction function over time is a sensible way to transition to an inflation-targeting regime. Central banks moving toward inflation targeting generally need to strengthen their macroeconomic analysis and develop a systematic approach to policy decision-making. Financial market development improves policy implementation by reducing the need to depend on foreign exchange intervention and by facilitating sterilization.

Implications of Recent Global Shocks

The inflation episode of 2007–08 and the subsequent global economic crisis had several broad implications for the role of the exchange rate in inflation-targeting emerging economies. First, these economies were more vulnerable to exchange rate pressures than inflation-targeting advanced economies. Second, foreign exchange intervention has been more prominent among inflation-targeting emerging economies, and some of this intervention has been nonmarket based. Third, inflation-targeting regimes have been broadly resilient to the shocks, with just two economies having adjusted their inflation target ranges and only Iceland, the smallest inflation-targeting economy, having dropped the regime altogether.

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