inflation targeting, monetary policy and financial stability

Inflation Targeting, Monetary Policy

and Financial Stability

Mario Bergara

Second Workshop: “Rethinking inflation Targeting in Latin America”

IDB – Economía – Banco Central de Reserva de Perú

October, 2013

2

The Inflation Targeting perspective

Since 1989, when New Zealand introduced inflation targeting, many countries have joined this monetary policy framework According to initial empirical evidence, inflation targeting (IT) has been successful from several points of view:

IT countries were able to reduce average inflation and its volatility IT allowed to anchor inflation expectations IT contributed to improve the institutional framework of monetary policy, such as independence, accountability, transparency

Inflation Targeting, Monetary Policy and Financial Stability

Anemic growth/Recession

Advanced

economies

Differential situation in advanced and emerging economies

Emerging

economies

Monetary expansion

Quantatitive easings

Defensive strategies

Market intervention

Reserve accumulation

Reasonable growth

Fiscal problems Stronger fiscal positions

Debt issues Sustainable debt


Implications of volatile capital flows for

macroeconomic and financial stability

Growth

differentials

Volatile exchange rates in emerging markets

Uncertainty and volatility in the global environment

Interest rate

differentials

Differential

expectations on

exchange rates

Liquidity

conditions and

market

sentiment

Risks of asset price bubbles

and bank lending boom

Risks of capital flow

stop or reversal


5

Inflation Targeting in the current global context

Relevant differences in the situation of advanced and emerging economies pose diverse challenges to the IT perspective


6

Inflation Targeting in question

The crisis as well as policy responses open several questions about the IT framework, such as:

Price stability does not ensure financial stability; then, was the IT regime responsible for financial imbalances? The crisis should have been foreseen by the IT models? Was the target for inflation too low? What are the proper set of tools?

Alternatives in the current discussion: all with potential costs and benefits

Higher inflation target Price level targeting Nominal GDP targeting Financial stability included in the policy rule


7

Inflation Targeting from the emerging markets perspective

IT could help to isolate emerging economies from external shocks, such as those related to commodities prices

IT has been a useful tool to anchor expectations, a high relevant topic for emerging economies A flexible approach to IT can accommodate other interventions, as in the exchange rate market Inflation Targeting vs. Financial Stability: A Myopic Dilemma Complementarities between macroprudential policies (oriented to avoid financial imbalances) and a monetary policy based on IT can be explored They contribute to generate credibility and long term perspective, allowing a better decision-making on savings, credit and investments


Price stability: monetary policy Contributes to financial stability due to lower risk taking behavior by financial agents

Financial stability: micro-macro regulation and supervision of the financial system

Contributes to price stability and to enhance transmission channels of monetary policy

The financial crisis has shown that macroeconomic stability proved insufficient to preserve financial stability, which is crucial for the effectiveness of monetary policy

Central Bank concerns: price and financial stability


It has been necessary to put in place a set of macroprudential instruments to limit the exposure of the financial system to systemic risks They typically impose efficiency costs on financial intermediation, which nevertheless are lower than the benefits from preserving financial stability Central Banks in emerging economies have use reserve requirements and caps on foreign exchange positions in order to limit potential imbalances derived by surges in short-term capital inflows Lately, Central Banks have used instruments such as additional capital requirements, counter-cyclical provisioning, and additional liquidity requirements to reduce systemic risks and enhance financial resilience Nevertheless, the quantitative effect of macroprudential measures is difficult to establish and their effectiveness is challenged

Financial stability in the context of macroeconomic stability


The exchange rate flexibility acts as an automatic buffer to cushion against external shocks and contribute to provide an adequate incentive structure in the economy Foreign exchange market intervention is done in order to reduce excessive volatility and currency appreciation in the current (circumstantial) financial environment, but not against long term fundamentals Costly sterilized market intervention is done by balancing with other goals, such as low inflation and long term competitiveness The macroprudential perspective contributes with more instruments to deal with short term capital flows, without affecting macroeconomic and financial stability

The impact and effectiveness of policy options


A consistent set of policies must balance different objectives,

such as low inflation, competitiveness and financial stability


Monetary policy based on a trinity: Exchange rate flexibility Inflation target Monetary policy rule: contingency plan specifying the circumstances under which policy instruments are changed

“Taylor rule” are designed for economies with:

Fully developed long-term bond market Foreign exchange market with a high degree of capital mobility

Market conditions in emerging markets may require modifications of the typical policy rule recommended for economies with developed financial markets With uncertainty and difficulties in measuring the real interest rate, policy makers might want to give greater consideration to policy rules with monetary aggregates

The design and implementation of monetary policy: Taylor (2000)


Policy rule as a guideline for monetary policy decisions, but discretion is also needed Other objectives can be addressed as long as they are not inconsistent with the inflation target in the long run A flexible exchange rate policy does not mean that the exchange rate plays no important role in the policy rule and in the transmission mechanisms: country’s size, openness, capital mobility and FX market development matter In sum, monetary policy rules in emerging economies might require modified considerations on:

The choice of instrument (monetary aggregates) The variables in the rule (greater role for exchange rate) The size of response of the instrument to economic events (to deal with less developed financial markets)

The design and implementation of monetary policy: Taylor (2000)


Capital flows to emerging markets are strongly motivated by the seek of profitability and liquid assets: this motivation declines when returns of liquid assets in developed economies are expected to rise Capital flows intensifies with more volatility, because liquidity is endogenous: more used assets are more liquid An asset is liquid if the market considers it as liquid: thus, liquidity is not a fundamental and can disappear Dilemmas for Central Banks: in developed countries, they reduced interest rates to zero and then they opted for QE (monetary aggregates), purchasing assets of unknown quality Incentives for capital flows to emerging economies and trash bonds, inducing FX market interventions The interest rate might become ineffective as an instrument when is too high and threatens fiscal sustainability

The design and implementation of monetary policy: Calvo (2013)


Inflation Targeting, Monetary Policy

and Financial Stability

Mario Bergara

Second Workshop: “Rethinking inflation Targeting in Latin America”

IDB – Economía – Banco Central de Reserva de Perú

October, 2013

inflation targeting, monetary policy and financial stability

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