VIII Conclusions

Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
Published Date:
November 2009
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The role of the exchange rate in the broad monetary framework for inflation-targeting emerging economies raises four questions, which are addressed in turn in this section:

  • Why are emerging economies particularly concerned about the exchange rate?

  • How should the exchange rate be taken into account in an inflation-targeting framework?

  • What is the appropriate role of foreign exchange market intervention in inflation-targeting policy implementation?

  • What key issues warrant further work?

Why Are Emerging Economies Particularly Concerned about the Exchange Rate?

The exchange rate plays a major role in the broad monetary policy framework of most inflation-targeting emerging economies, in contrast to most inflation-targeting advanced economies, according to descriptive data and the case studies. Inflation-targeting emerging economies generally do not have an independent float exchange rate arrangement, do not intervene regularly, and seem to take the exchange rate into account when setting the policy interest rate. The more prominent role for the exchange rate in these economies reflects strong exchange rate channels, which in turn can be attributed to greater vulnerability to shocks, lower policy credibility, concerns about financial and external stability, and underdeveloped domestic financial markets.

How Should the Exchange Rate Be Taken into Account in an Inflation-Targeting Framework?

The model-based analysis in this paper provides modest support for an explicit role for the exchange rate in some inflation-targeting emerging economies but also cautions against active exchange rate management. The analysis indicates that the benefit of an explicit role for the exchange rate in policy formulation depends not only on the structure of the economy, but also on the types of shocks to which it is exposed and the particular way in which the exchange rate is taken into account in the policy rule. In general, the analysis tends to confirm the finding of earlier analyses that financially robust advanced economies have little to gain from including the exchange rate explicitly in their policy reaction function, particularly if the main source of macroeconomic disturbance is aggregate demand.

At the same time, the analysis suggests that financially vulnerable emerging economies may benefit from including the exchange rate in the policy 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 be particularly helpful in mitigating 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 light on why the exchange rate plays an important role for most of them. Furthermore, putting some priority toward avoiding significant exchange rate misalignments may also improve macroeconomic performance, particularly for financially vulnerable emerging economies. Of course, it is not possible to draw strong policy conclusions for diverse countries on the basis of simulation results using small and necessarily simplified models. Therefore, there is much room for further work, as described below.

What Is the Appropriate Role of Foreign Exchange Market Intervention in Inflation-Targeting Policy Implementation?

Appropriate policy implementation helps support an effective role for the exchange rate, but foreign exchange intervention poses especially difficult challenges for inflation-targeting emerging economies. Case studies indicate that they use intervention more than the interest rate to influence the exchange rate. Smoothing volatility is an intervention objective for most, and some also intervene to correct exchange rate misalignment and manage reserves. For most, intervention is more frequent and less transparent, and in general, the role of the exchange rate in policy implementation is less systematic, reflecting their less developed financial markets.

The case studies suggest that a systematic, transparent, and market-based policy implementation approach can help reduce conflicts between the inflation objective and other considerations in an inflation-targeting framework. Use of the interest rate as the main monetary tool to influence inflation is crucial for maintaining the clarity of the commitment to the inflation target. As a general rule, implementation should be as transparent as possible, recognizing that there are delicate trade-offs for emerging economies created by their vulnerability to large shocks and financial stability concerns, especially in the context of exchange-rate-based inflation-targeting regimes. Developed foreign exchange and domestic money markets improve policy implementation by reducing exchange rate volatility and facilitating foreign exchange risk transfer. Developed markets also foster the signaling channel of intervention, which fits well within the inflation-targeting framework.

What Key Issues Warrant Further Work ?

Much more analytical work remains to be done on the role of the exchange rate in inflation targeting for emerging economies. The robustness of policy rules to uncertainty regarding the structure of the economy and key parameters in the transmission mechanism is particularly relevant for emerging economies. Embodying key aspects of financial structure in the framework in order to clarify its role in policy transmission and the implications for the inflation-targeting framework is a second area for further work. A third is to look more closely at the evolution of expectations and the implications for policy transmission and the role of the exchange rate.

Similarly, there is wide scope for further work on the role of foreign exchange intervention in policy implementation. Of particular importance is identifying operational ways to improve transparency—intervention rules, for example—with a minimal increase in uncertainty. The gradual steps being taken by central banks toward improving communication and transparency may offer important lessons. Another area is whether to use the policy interest rate or foreign exchange market intervention to influence the exchange rate.

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