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IMF paper questions view on Inflation Targeting
Contrary to the common wisdom that Inflation Targeting economies should adapt a free floating exchange rate, a new IMF study indicates that some intervention in the foreign exchange is likely to be optimal
Ahmed Feteha, Friday 2 Mar 2012
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Emerging markets should use both interest rate adjustment and foreign exchange market intervention in order to keep inflation under control while maintaining a stable exchange rate, according to a paper published by the International Monetary Fund (IMF).

The paper, published Tuesday, asks if economies that adopt an inflation targeting policy intervene to protect its exchange rate against large fluctuations.

Inflation Targeting (IT) refers to a policy direction where interest rates and other monetary tools are used by central banks to anchor price expectations and navigate actual inflation to an announced target.  

Such policy, however, might fall into odds with keeping local currency apart from substantial deviations of the exchange rate from its consistent vale. It is often said that keeping an eye on exchange rates will undermine efforts to keep inflation steady.

Titled ‘Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies’ the paper explains that many early adopters of IT have been explicitly committed to allowing a free floating  exchange rate.

During recessions when lots of firms struggle, lowering interest rates is used to restore inflation up to target but those firms exposed to dollar or euro debt might suffer, one of the authors indicates in a blog post.

According to Jonathan D. Ostry, this could means that IT is in itself not compatible with concerns about exchange rates. Meddling with interest rate policy is not enough to achieve both inflation and exchange rate target.

That is why two policy instruments (interest rate and FX intervention) are better than one to achieve two policy targets (the exchange rate and the inflation rate).

The paper acknowledges that direct intervention by central banks allows for maximum flexibility in responding to unexpected shocks, such as sudden outflows or inflows of capital. This is called fully discretionary monetary and exchange rate policies.

Yet such policies can be costly.

“It [full discretionary policies] may result in conflicting signals about the central bank’s objectives, thus undermining credibility,” said the paper.

Accordingly, “some intervention in the foreign exchange (FX) market is likely to be optimal even under an IT regime.”

The advisable intervention, however, should only be undertaken against “shocks that move the exchange rate away from its medium-run multilaterally-consistent value.”

When central banks intervene to stabilise exchange rate while adjusting the interest rate to meet its inflation goal, it is called the two-target/two instrument regime. The paper indicates that such regime should not “give confusing signals to the public.”





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