Monetary sovereignty is incompatible with inflation targeting
When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates. As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold. Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy. What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy. Understanding exchange rate dynamic is mostly about understanding monetary policy rules But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not. A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation. Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency. On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged. Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules. Exchange rates are never truly floating under inflation targeting I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy. A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency. This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky). Monetary policy sovereignty and importing monetary policy shocks This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well. Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year. The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty. This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers. The global business cycle and monetary policy rules It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow. In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe. I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks. That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation. So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC - they need to stop targeting inflation and should instead target NGDP. PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe's recent blog post What is a "managed exchange rate"?