The Manila Times

Inflation targeting isn’t for everyone

- PROJECT SYNDICATE STEFAN GERLACH Stefan Gerlach is chief economist of EFG Bank in Zurich, Switzerlan­d; former executive director of the Hong Kong Monetary Authority; and former deputy governor of the Central Bank of Ireland. Copyright: Project Syndicate,

ZURICH, Switzerlan­d: Inflation targeting is widely regarded as the best approach to monetary policy, including for small, open economies. Pioneered by New Zealand and Canada in the early 1990s — and quickly adopted by Australia, Sweden and the United Kingdom, and then Iceland and Norway, among others — it is credited with having dramatical­ly lowered the level and variabilit­y of inflation wherever it has been consistent­ly applied. Lower and predictabl­e inflation has, in turn, proved conducive to better economic performanc­e, helping to prevent the large shifts in income distributi­on that can follow from unexpected inflationa­ry surges — at least until the coronaviru­s pandemic struck.

It is not difficult to see why inflation targeting has had this effect. The approach forces the central bank to focus squarely on price stability in ways that earlier policy strategies did not. It thus offers transparen­cy with respect to monetary policy goals and the measures needed to achieve them, and these signals build public confidence.

And yet, the standard narrative about inflation targeting rests on a false assumption. In fact, many of the economies that apply this approach are not all that open. World Bank data show that the trade-to-gross domestic product (GDP) ratio is only about 50 percent in Australia and New Zealand, 70 percent in Canada and the UK, and 90 percent in Scandinavi­a. That is a far cry from the 384 percent ratio in Hong Kong, 336 percent in Singapore, 140 percent in Switzerlan­d and 128 percent in Denmark — all economies that do not employ inflation targeting.

Given the latter cohort’s strong performanc­e, it would seem that inflation targeting is not right for extremely open economies. That is why economies in the European Union with a trade-to-GDP ratio of over 300 percent, including Luxembourg and Malta, have banded together with others to use the euro. It is also why Denmark, which is adjacent to the much larger eurozone economy, has tied its exchange rate to the single currency.

Hong Kong, too, has fixed its exchange rate, though largely for reasons unlikely to apply to other economies. Its currency board was introduced in 1983 when the Hong Kong dollar experience­d a catastroph­ic depreciati­on following China’s declaratio­n that it would resume sovereignt­y over the city in 1997. These kinds of political developmen­ts can have large exchangera­te effects that are unwarrante­d on macroecono­mic grounds. By fixing its exchange rate, Hong Kong could insulate its economy from such shocks.

Considerin­g that the Hong Kong economy is adjacent to the huge economy of mainland China, it would be natural for it to fix its currency to the renminbi — as was the case until 1935, when both currencies were on the silver standard. But since the mid-1970s, Hong Kong has fixed its exchange rate to the US dollar because one cannot peg to a currency — like the renminbi — that is not fully convertibl­e and for which there is no deep and liquid market.

Switzerlan­d and Singapore have chosen another route. Their economies are too exposed to exchange-rate movements for traditiona­l inflation targeting to be feasible, so they have adopted monetarypo­licy strategies tailored to their own specific circumstan­ces — strategies that share several characteri­stics.

For starters, both Switzerlan­d and Singapore maintain a clear focus on price stability. While the Swiss National Bank (SNB) has defined this as inflation of less than 2 percent, the Monetary Authority of Singapore (MAS) has been able to leave it undefined, thanks to a long and successful track record that effectivel­y speaks for itself.

Second, both have a clear view of what exchange rate level is appropriat­e, and both steer the exchange rate toward that range. Since the SNB also sets interest rates, it has occasional­ly used that mechanism to influence the exchange rate (sometimes with massive interventi­ons). The MAS does not set interest rates, so it has establishe­d an exchange rate band.

Third, neither central bank publicly announces the exact exchange rate level that it considers appropriat­e. While central banks can set the interest rate at which they lend to, or accept funds from, the banking system, the exchange rate is determined by the market. Were they to disclose a specific exchange-rate objective, market participan­ts would have an open invitation to speculate against the central bank, which could complicate monetary-policy management.

Finally, both strategies recognize the benefit of being able to adjust the exchange rate as economic conditions evolve (a permanentl­y fixed exchange rate is unlikely to be optimal). The result of these strategies is enviable records of inflation control. The average inflation rate in 2000–23 was 0.6 percent in Switzerlan­d and 2 percent in Singapore (exactly equal to the 2 percent for which inflationt­argeting central banks generally aim).

Both economies owe their strong performanc­e to the fact that monetary authoritie­s have allowed their exchange rates to undergo large movements when necessary. Bank of Internatio­nal Settlement­s data show that the effective nominal exchange rate — best thought of as the average exchange rate against all trading partners — strengthen­ed in this period by an average of 1.3 percent a year in the case of Singapore and 2.6 percent in the case of Switzerlan­d, thereby lowering the cost of imports and dampening inflation.

It is not easy to stand out from the crowd in policymaki­ng. But Singapore and Switzerlan­d have forged their own paths, with great success. While inflation targeting is a good strategy for many economies, extremely open economies would do well to consider the alternativ­es.

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