Speech

Opening Remarks by Naoyuki Shinohara, Deputy Managing Director, International Monetary Fund, at a Joint ADB-IMF-Reserve Bank of India Seminar on Managing Inflation in an Era of Commodity Price Volatility

May 3, 2013

Good afternoon to you all! First of all let me thank the organizers for putting together this panel discussion on managing inflation in the context of commodity price volatility. It is a pleasure for me to kick off the discussion on a very relevant topic for many Asian economies.

As you know, volatility of international food and oil prices has intensified greatly since 2007, driven not just by supply shocks but also by large swings in world output. At their peaks in the summer of 2008 and in early 2011, international food prices were on average twice as high as they were at the beginning of the millennium, and the price of crude oil was even five times higher. At the beginning of 2009, in the aftermath of the global financial crisis, fuel and food prices fell in only 7 months by 60 and 30 percent, respectively. These are huge swings.

These movements in world commodity prices play a major role in driving headline inflation in the region. This is especially the case in emerging and developing economies where commodities are a sizable share of consumer price baskets. If the changes in consumer prices are large, household real incomes will decline and poverty increase. For example, a 20 percent increase in the relative price of food is estimated to increase the poverty rate—defined as the proportion of the population below the “dollar-a-day” poverty line—by almost 6 percentage points in Cambodia and 5 percentage points in Bangladesh.

Dealing with commodity price volatility is a major challenge for policymakers. But if left unaddressed, surges in food and energy prices may also foster expectations of rising inflation that could spill over into higher wage demands and underlying inflation. And these second-round effects tend to be larger in emerging markets.

The typical monetary policy response to commodity prices shocks is to accommodate the first-round effects of food and energy price changes on the consumer price index to minimize output fluctuations, but not the second-round effects. This is appropriate if commodity price shocks are temporary. However, recent commodity prices shocks have been larger and more persistent than in the past. In many low-income countries, food price shocks are more persistent than non-food price shocks. This complicates the monetary policy response.

In addition, attempting to stabilize inflation with policy rate hikes could also exacerbate the output costs of the shocks. However, there are other factors that affect the effectiveness of the policy response to commodity price increases. I will mention two.

First, exchange rate adjustments can further influence the policy response. A net importer of commodities may see its currency depreciate, creating even further pressure on inflation. Instead, a net exporter is likely to experience an improvement in the terms of trade.

Second, capital flows volatility is another such factor. In 2010 to early-2011, concerns that wider interest rate differentials could give rise to further capital inflows induced some Asian central banks to keep policy rates low, even as commodity prices started to rise from their 2009 slump and headline and core inflation pressures began to surface.

The policy response to commodity price shocks also depends on the monetary policy framework that has been adopted. Several central banks around the world and in Asia—for example, Indonesia, the Philippines and Thailand—have chosen inflation as the main objective for monetary policy and formally adopted the inflation targeting framework.

This framework has been credited for having contributed to inflation stability in many economies worldwide. However, in the aftermath of the global financial crisis, economists, including at the IMF, have started to question whether inflation should be the only target for central banks. Whether their explicit mandate should also include financial stability, possibly to be pursued with complementary macro-prudential policies. This debate is ongoing.

Another debated question is the inflation indicator that the central bank should target. On the one hand, headline inflation is simple, widely recognized, and more representative of household spending, which can strengthen the transparency and credibility of the central bank. However, some fluctuations in food and energy prices are supply-driven and transitory, which argues for targeting core inflation—as done by the Bank of Thailand, for instance. In practice, majority of the inflation targeters in Asia aim to stabilize medium-term headline inflation, and they have been rather successful.

Before I finish, I want to turn briefly to an important issue that has been facing the region and other emerging markets. Exceptionally loose monetary policy in advanced economies will affect exchange rates and generate capital flows to Asia, although we have seen some moderation in recent weeks. This may threaten financial stability through higher asset prices, and rapid credit growth. The appropriate policy response—including, as needed, macro-prudential and complementary capital flow management measures—will depend on country-specific factors such as the nature of the imbalances, the position in the business and credit cycles, or the exchange rate regime.

I have raised a number of open issues that will be the subject of today’s discussion. I look forward to our panelists’ insights on these difficult questions.

Thank you!