The Case for a Managed Float under Inflation Targeting

IMF Blog, February 29, 2012

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"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 by "the sharp ups and downs in exchange rates that volatile capital flows engender."
Reasons emerging markets are more vulnerable:
- "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."
- "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."
Many emerging markets "have adopted inflation targeting frameworks in recent years to guide their monetary policy."
Inflation targeting is valuable because it "can anchor expectations, which may have become unhinged during earlier periods of high or even hyper-inflation."

Inflation targeting requires adjusting "the policy interest rate" whenever inflation diverges from the target.
Trade-offs described:
- 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."
- In a recession "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 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."

Proposal: use foreign exchange (FX) market intervention (official purchases and sales of dollars for local currency) as a second instrument.
Rationale:
- With two instruments (FX intervention and the policy interest rate) and two targets (exchange rate and inflation), policymakers can better pursue both objectives: "they would have two instruments... and two targets... which would indeed make life a lot easier."
Empirical indication:
- "one should look at the actions of policymakers in emerging market economies" which "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."
- Evidence on effectiveness is "more mixed, but is certainly more favorable for emerging market economies than for advanced economies."

Authors' conclusion: "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."
Use of the second instrument is "likely to make central banks more, rather than less, credible."
- Reason: when the exchange rate is "too far out of line... obstinately refusing to acknowledge the issue is not tenable. Much better to adjust both policy instruments in an effort to achieve dual targets."
Broader policy context:
- The financial crisis supports "the idea of using more tools to address economic problems" including "macroprudential regulation, capital controls, etc." to "deliver macro-financial stability."
- Caveat: "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."

FX intervention is not costless: "Of course not, and the costs (both for the country, and for the system as a whole) need to be factored in."
Recommended approach to shocks:
- For mean-reverting shocks: optimal response "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."
- For permanent shocks: "the central bank should simply allow the exchange rate to adjust."
Multilateral perspective: stabilizing currency values "around their multilaterally-consistent medium-run levels" via FX intervention "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."

Jonathan D. Ostry — February 29, 2012

Staff Discussion Note
- Staff Discussion Note (Markdown version)
- Staff Discussion Note (PDF)