Transcript Making Inflation Targeting Appropriately Flexible Prof. Jeffrey Frankel, CID, Harvard University. South African Treasury, Pretoria, Jan.

Making Inflation Targeting
Appropriately Flexible
Prof. Jeffrey Frankel,
CID, Harvard University.
South African Treasury, Pretoria, Jan. 16 &
Stellenbosh University, Jan. 18, 2007
Inflation Targeting (IT)
1. What is IT?
2. Proposals to implement IT so as to make
greater allowance for the role of GDP.
3. Proposals to implement IT so as to make
greater allowance for the role of the
exchange rate.
• Background note: “On the Rand:
Determinants of the real exchange rate”
Inflation Targeting
• IT is the reigning champion among monetary
targeting regimes, for better or worse. So say:
– many academic economists,
– central bankers, and
– the IMF
• Why?
– The gold standard & monetarism had both become
discredited by the mid-1980s.
– Exchange rate targets played a useful role in stabilizations
of 1985-1994, but then outlived their usefulness for most
medium-sized countries <= currency crises of 1994-2002.
– For many, that leaves IT the only plausible candidate for
nominal anchor.
1. What is Inflation Targeting ?
• Broadest definition: CB declares explicit long-term
goal for inflation, e.g., FRB’s “comfort zone” of infl. < 2%
– For some, that, plus transparency, is IT.
– Can’t object, given absence of long-run tradeoff with GDP.
• Narrow definition: CB declares short-term goals for
CPI, and does its best to hit them, to the exclusion of
other considerations.
– For some, that, plus ex post deviations and
rationalizations in the event of supply shocks, is IT.
• There is a lot of room in between.
– We are inclined closer to the broad definition than narrow.
Bottom line of the CID team
• In the short run, monetary authorities should be
more flexible than strict IT would imply, so as to
reduce variation in some other variables:
– Real GDP
– Real exchange rate
• This may well be what the SARB – & other CBs -already do in practice. If so, we might urge a bit
more transparency in this policy.
– though transparency is often overemphasized by
academics. It can inhibit internal deliberation. The
FRB go too far, e.g., to "release the model."
2. Flexible IT:
greater allowance for GDP
• One can set an inflation goal for the LR, or 2-year
range, and yet set an intermediate target (other than
inflation) at the 1-year range.
• The argument in favor of intermediate targets is to
enhance transparency, accountability, and
monitorability, giving the public confidence that the
central bank is doing what it says it will do –
assuming the target is not habitually or massively
missed.
• The intermediate target number should be
consistent with a targeted inflation path that moves
in future years from whatever the recent inflation
rate has been, gradually toward the long-term goal.
The problem with the CPI as the
intermediate target (as is standard in IT)
• If CPI target is taken literally, it destabilizes
output unnecessarily.
– It can make monetary policy procyclical in the
event of supply shocks.
– Should want to take adverse supply shock partly
as temporarily higher CPI, not all as lost output
– E.g., when Poil$ ↑, IT => CB has to tighten money
so much, & appreciate the rand so much, that
Poilrand is unchanged.
– Currency should depreciate in response to adverse
shift in terms of trade, not appreciate.
The problem with the CPI as the
intermediate target (continued)
• In practice, CPI target is not taken literally.
– CB may explain ex post that it is temporarily deviating
from target due to supply shock.
– Or CB may say ex ante that its target is core CPI,
“excluding volatile food & energy.”
– But both approaches are less than transparent to
the person in the street, who is being told he
shouldn’t worry when the price of gasoline goes up.
– In addition, if the mineral price that goes up [or down]
on world markets is an exported commodity (gold,
platinum…), then there should be some appreciation
[or depreciation] of the rand, to accommodate the
change in the terms of trade. But core CPI excludes it.
I have proposed “Peg the Export Price.”
In South Africa’s case, inflation target would give
major weight to a basket of major mineral exports.
• The pitch: for countries with volatile terms of
trade, you want currency to appreciate when
Pexport goes up & vice versa , not Pimport.
• But I have sold PEP to nobody on my team, or in
S. Africa. 3 possible reasons:
– SA’s terms of trade are not that volatile, or
– The float has delivered plenty of appreciation when
mineral prices go up. (See rand equation in appendix.)
– Fear PEP would destabilize non-mineral export prices.
• So I am not pushing PEP here.
Instead, we propose consideration
that the intermediate yearly target
be nominal GDP (or nominal demand)
Satisfies 3 key requirements:
•
•
Easy and unambiguous to measure (exc. revisions)
Familiar to the public
–
•
unlike “core Personal Consumption Expenditure deflator”
and, especially, robust with respect to shocks
–
Adverse supply shocks automatically divided between real
output loss & inflation, as one would want
Closer to what CB controls (AD) than is inflation.
–
•
–
Nominal GDP ≡ velocity-adjusted M1
Robustness means CB doesn’t need to abandon target ex post
=> enhanced credibility.
Many prominent economists supported
nominal GDP targeting in the 1980s
after large velocity shocks discredited
money targets, including [1] :
– Charles Bean
– Martin Feldstein
– Bob Hall
– Greg Mankiw
– Ben McCallum
– & James Tobin.
[1] References in Frankel (1995).
Should small/medium developing
countries be suspicious of a proposal that
no large industrialized country has tried?
• Warwick McKibbin: nominal GDP targeting
proposal is more relevant for developing countries
than for industrial countries, [1] because
– they suffer greater supply shocks (e.g., weather events) &
terms of trade shocks (e.g., mineral commodity prices).
– Furthermore, their governments may have less credibility
historically than Federal Reserve, Bundesbank, or ECB,
so it is harder to explain away deviations from a CPI target.
• Perhaps applies less to S.Africa than some others.
[1] McKibbin and Singh (2003).
3. Flexible IT:
greater allowance for the exchange rate
• Of the many countries that officially float
(esp. ITers) , most in fact intervene to
dampen exchange rate fluctuations
– This is the famous Fear of Floating [1]
– South Africa may be typical in this regard
– If the SARB already pays attention to the
exchange rate, at a minimum transparency
would call for acknowledging this.
[1] Calvo & Reinhart
The importance of avoiding
real overvaluation of the rand
• A competitively-valued rand is key to
developing manufacturing & other non-resource
exports, which are in turn key to growth.
• Intervention can often dampen exchange rate
swings (an ASGI-SA goal), e.g., by pricking
speculative bubbles, without necessarily
diverting monetary policy from other objectives,
such as CPI or nominal GDP targets.
The entire CID team believes
• Preventing overvaluation & fears of overvaluation would
stimulate output of tradable, which is important.
• Speculative inflows (perhaps based on “carry trade”)
probably sent the rand too high in early 2006.
• The SARB could usefully
– say publicly that, were the rand to return to the value of early
2006, it would view this with concern, implying willingness to
intervene to cap the currency at, e.g., an exchange rate of 6.
• Stabilizing speculation might then keep the currency low even
without intervention
• Relative price signal would encourage movement into tradeables
– continue to add to reserves (unlike many Asian CBs now),
because it started the decade at such a low level.
References
• Bernanke, B., T.Laubach, F.Mishkin, & A.Posen, 1999, Inflation
Targeting: Lessons from the International Experience, Princeton Press.
• Calvo, Guillermo, and Carmen Reinhart, 2002, “Fear of Floating”
Quarterly Journal of Economics, 117, no. 2, May, 379-408.
• Fraga, Arminio, Ilan Goldfajn and Andre Minella, “Inflation Targeting in
Emerging Market Economies,” NBER Macro Annual 2003, K,Rogoff &
M. Gertler, eds. (MIT Press).
• Frankel, Jeffrey, 1995, "The Stabilizing Properties of a Nominal GNP
Rule," JMCB vol.27, 2, May 1995, 318-34.
• --“Experience of and Lessons from Exchange Rate Regimes in
Emerging Economies,” Monetary and Financial Integration in East
Asia: The Way Ahead, Asian Development Bank, (Palgrave Press)
2004, vol. 2, 91-138.
• -- “Should Gold-Exporters Peg Their Currencies to Gold?” Research
Study No. 29, World Gold Council, London, 2002.
• McKibbin, Warwick, & Kanhaiya Singh, “Issues in the Choice of a
Monetary Regime for India,” Brookings Disc. Papers in Int.Econ.
no.154, Sept. 2003.
On the Rand
revision of January 2007
Professor Jeffrey Frankel
Kennedy School of Government, Harvard University
Thanks are due the able research assistance of Melesse Tashu.
This work is part of the contribution of the Macroeconomics Group within
the Harvard University Center for International Development’s
Project on South Africa: Performance and Prospects
Two topics
• Econometric analysis of
determination of the rand exchange
rate
• Choosing a currency regime in the
face of volatility
What explains the large rand
movements in recent years?
• Is the rand a commodity currency, like Australian &
Canadian dollars? Does it appreciate when prices
of its mineral products are strong on world markets?
• Does the rand otherwise act like major currencies?
– in light of its developed financial markets?
– This does not necessarily mean fitting standard
theories closely, as those theories don’t work well in
practice for major industrialized currencies either.
– But such variables as GDP & inflation should show
up.
• Are expected returns important determinants?
• Has there been an element of momentum to some
recent movements?
Some other references on determination of rand exchange rate
• Aron, Janine, and Ibrahim Elbadawi, 1999, “Reflections on the
South African rand crisis of 1996 and policy consequences,”
Centre for the Study of African Economies Working Paper
Sereis No. 97, Sept. 20.
• Aron, Janine, Ibrahim Elbadawi, and Brian Kahn, 2000, “Real
and Monetary Determinants of the Real Exchange Rate in
South Africa,” in Development Issues in South Africa, eds.,
Ibrahim Elbadawi & Trudi Hartzenberg (MacMillan: London).
• Farrell, G.N., and K.R. Todani, “Capital Flows, Exchange
Control Regulations and Exchange Rate Poliyc: The South
African Experience,” OECD Seminar, Bond Exchange of
South Africa, March 2004.
• MacDonald, Ronald, and Luca Ricci, 2003, “Estimation of the
Equilibrium Real Exchange Rate for South Africa,” IMF
Working Paper /03/44.
We try various versions of the equation:
• with value of rand defined
– in nominal terms, or real;
– bilateral against $, or trade weighted.
Explanatory Variables:
• Real P Minerals
– computed as a weighted average of prices of specific
mineral products that South Africa produces &
exports.
– intended to capture terms of trade:
– deflated by US price level to express in real terms.
• (SA GDP per cap/foreign GDP per cap) is
intended to capture Balassa-Samuelson effect
(domestic relative to foreign).
• log rand value t-1 is entered experimentally
to capture momentum or dragging anchor.
• Rates of return …
2 variables capture rates of return.
• Real interest differential (nominal
interest rate on rand government bonds,
minus expected inflation, minus the same
for abroad) should have a positive effect.
• A country risk premium (South Africa’s
sovereign spread on $ debt) is included to
control for risk of default; it should have a
negative effect.
Impressive down-trend in perceived SA risk,
to well below 100 basis points in early 2006,
in tandem with upgrades by rating agencies
Spreads on South African Dollar Debt
Source: SA Treasury
700.00
S&P Upgrade (BB+ to BBB-)
S&P Upgrade (BBB- to BBB)
Moody's upgrade
(Baa3 to Baa2)
S&P Upgrade (BBB to BBB+)
600.00
Moody's upgrade
(Baa2 to Baa1)
500.00
400.00
300.00
200.00
100.00
Global 06
Global 09
Global 14
Global 17
Global 12
6/15/2006
2/15/2006
10/15/2005
6/15/2005
2/15/2005
10/15/2004
6/15/2004
2/15/2004
10/15/2003
6/15/2003
2/15/2003
10/15/2002
6/15/2002
2/15/2002
10/15/2001
6/15/2001
2/15/2001
10/15/2000
6/15/2000
2/15/2000
10/15/1999
6/15/1999
2/15/1999
10/15/1998
6/15/1998
2/15/1998
10/15/1997
6/15/1997
2/15/1997
10/15/1996
-
as among other emerging markets, but
more so
650
550
EMBI+
450
350
250
EMBI+
150
RSA EMBI+
50
2- 30- 26- 26- 28- 26- 25- 23- 21- 19- 20- 21- 18- 18- 14- 14- 13- 15- 12- 10Jun- Jul- Sep- Nov- Jan- Mar- May- Jul- Sep- Nov- Jan- Mar- May- Jul- Sep- Nov- Jan- Mar- May- Jul03 03 03 03 04 04 04 04 04 04 05 05 05 05 05 05 06 06 06 06
General equation is:
Log Real Rand value =
α + β 1 Log Real Mineral Price Index
+ β 2 Log (SA vs. foreign GDP/cap)
+ β 3 Lagged Log Real Rand value
+ β 4 Real Interest Differential
+ β 5 Country Risk Premium
+ β6 capital controls + u
1st look at data suggests role for GDP
Real exchange rate and relative real GDP of SA to USA
150.000
10.30
140.000
10.10
120.000
Real exchange rate index
9.90
110.000
100.000
9.70
90.000
9.50
80.000
70.000
9.30
60.000
50.000
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
96997997997997998998998998999999999999000000000000001001001001002002002002003003003003004004004004005005005005006006
9
1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
9.10
relative real GDP of SA to US (%)
130.000
RERI
RGDPRAT
19
9
19 6
9 Q
19 7 4
9 Q
19 7 1
9 Q
19 7 2
9 Q
19 7 3
9 Q
19 8 4
9 Q
19 8 1
9 Q
19 8 2
9 Q
19 8 3
9 Q
19 9 4
9 Q
19 9 1
9 Q
19 9 2
9 Q
20 9 3
0 Q
20 0 4
0 Q
20 0 1
0 Q
20 0 2
0 Q
20 0 3
0 Q
20 1 4
0 Q
20 1 1
0 Q
20 1 2
0 Q
20 1 3
0 Q
20 2 4
0 Q
20 2 1
0 Q
20 2 2
0 Q
20 2 3
0 Q
20 3 4
0 Q
20 3 1
0 Q
20 3 2
0 Q
20 3 3
0 Q
20 4 4
0 Q
20 4 1
0 Q
20 4 2
0 Q
20 4 3
0 Q
20 5 4
0 Q
20 5 1
0 Q
20 5 2
0 Q
20 5 3
0 Q
20 6 4
06 Q1
Q
2
Real exchnage rate index
150.000
120.000
110.000
1.400
100.000
90.000
1.200
80.000
50.000
1.000
70.000
60.000
0.800
0.600
Real mineral index
but also for Real Mineral Price index
Real Exchange rate index and real mineral price index
2.000
140.000
130.000
1.800
1.600
RERI
RWMPI
because mineral prices &
South African GDP are collinear.
Real mineral price index and relative GDP
Relative real GDP of SA to US (%)
2.000
10.20
10.10
1.800
10.00
Real mineral price index
9.90
1.600
9.80
1.400
9.70
9.60
1.200
9.50
9.40
1.000
9.30
0.800
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
96 997 997 997 997 998 998 998 998 999 999 999 999 000 000 000 000 001 001 001 001 002 002 002 002 003 003 003 003 004 004 004 004 005 005 005 005 006 006
9
1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
9.20
RWMPI
RGDPRAT
Regression estimates
• The real commodity price index is significant with the
hypothesized positive sign
• as does real GDP when included on its own; but
commodity prices knock it out.
• The lagged real exchange rate is highly significant,
suggesting a “dragging anchor” phenomenon.
• The real interest differential has the hypothesized effect,
enhancing the attractiveness of rand assets.
– Supports relevance of Mundell-Fleming analysis of
monetary/fiscal policy mix for South Africa.
• Sovereign spread or risk premium has a negative effect,
as one would expect.
Quarterly Results for Real Exchange
Rate: CPI-Based
• Dependent Variable: LOG(RERICPI)
• Sample: 1984:2 2006:2.
• No. of observations: 89 after adjustment for endpoints
Variable
LOG(RERICPI(-1))
LOG(RWMP)
GBRDIF
DUMMYRGBRDIF
DUMMYCAP
C
Coefficient
0.8171
0.2341
0.0215
-0.0113
-0.0367
0.8149
Std. Error
0.0433
0.0655
0.0055
0.0061
0.0235
0.2026
R2 = 0.91
t-Stat
18.89
3.57
3.94
-1.83
-1.56
4.02
2
Q
19
8
1 4
19
Q 85
4
19
Q 85
3
19
Q 86
2
19
Q 87
1
19
Q 88
4
19
Q 88
3
19
Q 89
2
19
Q 90
1
19
Q 91
4
19
Q 91
3
19
Q 92
2
19
Q 93
1
19
Q 94
4
19
Q 94
3
19
Q 95
2
19
Q 96
1
19
Q 97
4
19
Q 97
3
19
Q 98
2
19
Q 99
1
20
Q 00
4
20
Q 00
3
20
Q 01
2
20
Q 02
1
20
Q 03
4
20
Q 03
3
20
Q 04
2
20
Q 05
1
20
06
Q
The fit is surprisingly good
5.4
5.2
5
4.8
4.6
4.4
4.2
4
Choice of monetary regime
in a volatile world economy
• Emerging market countries have moved away
from pegged exchange rates towards floating.
• Some local conditions suit a country for
exchange rate flexibility
– Size, low openness, labor mobility, etc.
– Financial development
– High incidence of trade shocks
• But monetary policy still needs a nominal anchor
– Inflation-targeting is the new reigning favorite,
having replaced exchange rate targets
Aghion, Bacchetta, & Ranciere (2005, 2006)
interaction between choice of regime & development.
• Fixed rates are better for countries at low
levels of financial development:
because markets are thin => benefits of
accommodating real shocks are
outweighed by costs of financial shocks
• When financial markets develop,
exchange flexibility becomes more
attractive. RER volatility good for growth.
• Est. threshold: Private Credit/GDP > 40%.
Terms-of-trade variability has
returned
• Prices of oil, zinc, copper, platinum & other
minerals have hit record highs in 2006.
• = Favorable terms of trade shocks for some
– oil producers like Nigeria or Iraq;
– copper-producers like Zambia or Chile, etc.
• =Unfavorable terms of trade shock for others
– oil importers like Japan.
What currency regime suits a
country with volatile terms of trade?
• Textbook theory says a country where trade shocks
dominate should accommodate them by adjusting the
currency. I say it applies to S.Afr.
• What follows are my ideas alone (J.Frankel).
• My colleagues don’t necessarily agree:
– Hausmann, Panizza & Rigobon (2004): Why are RERs so
much more volatile for developing countries than for industrial
countries? Larger shocks explain only part.
– Federico Sturzenegger & Robert Lawrence: Recent
S.African export boom “small.” The recent rise in mineral
export prices has been roughly cancelled out by rise in oil
import prices.
– Ricardo Hausmann worries that a proposal to stabilize the
mineral sector may destabilize other tradeables.
New proposal: Peg the Export Price (PEP)
Combines the best of both worlds:
• The advantage of automatic
accommodation to terms of trade shocks,
• as floating rates promise (but fail to deliver in
the case of extraneous volatility),
• together with the advantages of a nominal
anchor and integration
• which exchange rate pegs promise (but fail to
deliver in the case of currency crashes).
6 proposed nominal targets and the Achilles heel of each:
Monetarist rule
Inflation targeting
Nominal income
targeting
Gold standard
Commodity
standard
Fixed
exchange rate
Targeted
variable
M1
CPI
Nominal GDP
Vulnerability
Velocity shocks
Import price
shocks
Measurement
problems
Vagaries of
world gold
market
Price of agr. &
Shocks in
mineral
imported
basket
commodity
$
Appreciation of $
(or euro)
(or other)
Price
of gold
Example
US 1982
Oil shocks of
1973, 1980, 2000
Less
developed
countries
1849 boom;
1873-96 bust
Oil shocks of
1973, 1980, 2000
1995-2001
How would it work operationally,
say, for mineral-exporter S.Africa?
Each day, after London gold or platinum
markets close, at spot price S($/oz.)t,
the Reserve Bank announces next day’s
exchange rate, according to formula:
E (rand/$)t =
fixed price P (rand/oz.) / S($/oz.)t .
How is PEP better than CPItargeting?
Better response to adverse terms of trade shocks:
• If the $ price of the export commodity (say gold
or platinum) goes down, PEP says to ease
monetary policy enough to depreciate currency.
Right.
• If the $ price of imported commodity (say, oil)
goes up, CPI target says to tighten monetary
policy enough to appreciate currency. Wrong.
More moderate versions of PEP
• Target a broader Export Price Index (PEPI).
• 1st step for any central bank dipping its toe in these waters:
compute monthly export price index.
• 2nd step: announce that it is monitoring the index.
• Target a basket of major currencies ($, €, ¥) and minerals.
• A still more moderate, still less exotic-sounding, version of
PEPI proposal: target a producer price index (PPI).
• Key point:
• Flaw of CPI target:
exclude import prices from the index,
& include export prices.
it does it the other way around.