Emerg­ing-mar­ket tar­get prac­tice

Financial Mirror (Cyprus) - - FRONT PAGE -

Cen­tral bankers want only a few things. To achieve any of them they usu­ally seek to nudge in­fla­tion ex­pec­ta­tions, demon­strate the trans­parency of mon­e­tary pol­icy, and es­tab­lish their in­sti­tu­tions’ cred­i­bil­ity. To com­mu­ni­cate their in­ten­tions sim­ply and clearly, they may set an ex­plicit tar­get range in terms of a par­tic­u­lar eco­nomic vari­able, or an­nounce a fore­cast for the vari­able, or of­fer for­ward guid­ance by spec­i­fy­ing a thresh­old value for it that must be met be­fore chang­ing in­ter­est rates.

But what should that one eco­nomic vari­able be? In the 1980s, ma­jor ad­vanced coun­tries tried the money sup­ply. Af­ter the mon­e­tarist ap­proach failed, some switched to tar­get­ing the in­fla­tion rate. But they re­peat­edly missed their tar­gets.

Un­til the cur­rency crashes of the 1990s, emerg­ing and de­vel­op­ing coun­tries tended to tar­get their ex­change rates. Many then also switched to in­fla­tion tar­gets; but they tend to miss these tar­gets even more of­ten than the ad­vanced coun­tries do.

The prob­lem with these ap­proaches to mon­e­tary-pol­icy tar­get­ing is that even though a par­tic­u­lar nu­mer­i­cal tar­get may be rea­son­able when it is set, sub­se­quent un­ex­pected de­vel­op­ments of­ten make the tar­get hard to live with. The mon­e­tary au­thor­i­ties are then con­fronted with a harsh choice be­tween vi­o­lat­ing their an­nounced tar­get, and thus un­der­min­ing the cred­i­bil­ity that was the point of the ex­er­cise, or set­ting pol­icy too tight or too loose, thus do­ing un­nec­es­sary dam­age to the econ­omy.

Ma­jor cen­tral banks can gen­er­ally with­stand fail­ure to achieve tar­gets with­out a fa­tal loss of cred­i­bil­ity.

The Bun­des­bank rou­tinely missed its money-sup­ply tar­gets, and yet re­mained a cred­i­ble, ad­mired in­sti­tu­tion. More re­cently, in­fla­tion ex­pec­ta­tions in the United States and the United King­dom re­mained well an­chored even when the Federal Re­serve and the Bank of Eng­land had to walk away from the un­em­ploy­ment thresh­olds they had an­nounced.

The sit­u­a­tion is dif­fer­ent in emerg­ing and de­vel­op­ing economies. These coun­tries’ need to es­tab­lish pol­icy cred­i­bil­ity tends to be more acute, whether as a re­sult of his­to­ries of high in­fla­tion, an ab­sence of cred­i­ble in­sti­tu­tions, or po­lit­i­cal pres­sure to mon­e­tize budget deficits. They need tar­gets with which they can re­ally live.

Noth­ing seems to work. When the IMF comes around ask­ing what their nom­i­nal an­chor is, many de­clare them­selves to be in­fla­tion tar­geters. But they have trou­ble abid­ing by their tar­gets.

If they are hit by an ad­verse sup­ply shock or terms-of­trade shock in the mean­time, the right step would be to loosen mon­e­tary pol­icy suf­fi­ciently that the cur­rency de­pre­ci­ates. But tar­get­ing the con­sumer price in­dex pre­cludes this, be­cause de­pre­ci­a­tion would raise the price of im­ported oil, food, and other trad­able com­modi­ties.

In­deed, if the shock is an in­crease in the dol­lar price of oil, an in­fla­tion tar­get in the­ory dic­tates tight­en­ing mon­e­tary pol­icy enough that the cur­rency ap­pre­ci­ates. But such a pol­icy would mean that the ad­verse shock is re­flected in a sharp fall in out­put.

In prac­tice, an in­fla­tion-tar­get­ing cen­tral bank usu­ally aban­dons the tar­get for price sta­bil­ity in such a case. It tries to ex­plain the fail­ure to the pub­lic in terms of “core in­fla­tion”: what has hap­pened is only an in­crease in the cost of fill­ing their gas tank or buy­ing gro­ceries. But this de­feats the very pur­poses – trans­parency, cred­i­bil­ity, and pre­dictabil­ity – for which a tar­get was an­nounced in the first place.

Emerg­ing-mar­ket coun­tries ought to con­sider tar­get­ing nom­i­nal GDP. Rel­a­tive to in­fla­tion tar­get­ing, the great virtue of NGDP tar­get­ing is that it is ro­bust with re­spect to sup­ply shocks and terms-of-trade shocks, mean­ing that the cen­tral bank is not faced with a choice be­tween aban­don­ing the tar­get and hurt­ing the econ­omy.

Pro­pos­als to tar­get NGDP are fa­mil­iar in ma­jor in­dus­tri­al­ized coun­tries, first aris­ing in the 1980s. In the wake of sharp price in­creases in the 1970s, cen­tral banks wanted to com­mit cred­i­bly to mon­e­tary dis­ci­pline in or­der to fa­cil­i­tate dis­in­fla­tion.

The pro­posal was never adopted. Yet the idea was sud­denly re­vived two or three years ago. The con­text this time was a de­sire to achieve ex­pec­ta­tions of greater mon­e­tary stim­u­lus, in or­der to fa­cil­i­tate re­cov­ery from the great re­ces­sion of 2008-2009.

There are good rea­sons to think that NGDP tar­get­ing is bet­ter suited to emerg­ing and de­vel­op­ing economies than to in­dus­tri­al­ized coun­tries. These economies are more fre­quently sub­ject to ad­verse terms-of-trade shocks, such as in­creases in world oil prices or de­clines in prices for their com­mod­ity ex­ports. Their economies also tend to suf­fer larger sup­ply shocks from nat­u­ral dis­as­ters, other weather events, so­cial un­rest, and un­ex­pected pro­duc­tiv­ity changes.

The ad­van­tage of a nom­i­nal GDP tar­get is that ad­verse shocks of these sorts are re­flected equally in out­put and in­fla­tion, rather than im­pos­ing the en­tire bur­den in the form of a loss in out­put. This pro­vides the sort of re­sponse that one would want any­way, while still re­tain­ing the ad­van­tages of a rule (com­mu­ni­cat­ing the cen­tral bank’s plans in such a way that it can live with what it has promised to do).

Many emerg­ing and de­vel­op­ing coun­tries need to bring in­fla­tion down, much as ad­vanced coun­tries needed to do 30 years ago. One ex­am­ple is In­dia, which is cur­rently con­sid­er­ing adopt­ing in­fla­tion tar­get­ing to en­hance mon­e­tary dis­ci­pline.

But the coun­try is reg­u­larly hit by sup­ply shocks such as good or bad mon­soons. Sta­tis­ti­cal es­ti­mates sug­gest that an at­tempt to set the path of in­fla­tion in the face of such shocks would lead to un­de­sir­ably large swings in real GDP, com­pared to an­chor­ing pol­icy to the path of NGDP.

The tar­get path for nom­i­nal GDP can be set at what­ever level of mon­e­tary dis­ci­pline is de­sired. The ro­bust­ness of NGDP tar­get­ing to un­known fu­ture shocks is sim­i­lar whether the ob­jec­tive is to ease money, tighten money, or stay the course, and whether the cen­tral bank wants to an­nounce a fore­cast, a tar­get range, or a thresh­old for for­ward guid­ance.

If it is worth com­mu­ni­cat­ing a plan, it is worth choos­ing a plan that one can live with. NGDP tar­get­ing is that plan.

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