The Colombian central bank should have a look at the Export Price Norm
Yesterday I wrote a short blog post praising Colombian central bank governor Jose Dario Uribe for not fighting ten weakening of the Colombian peso. This post is a follow-up post. It is slightly less positive about the performance of the Colombian central bank, but I also give some policy advise (for free!) to Uribe and his colleagues. Colombia is a commodity exporter and hence I think it is useful to look at whether Colombia could benefit from moving closer to what I have called an Export Price Norm (EPN). The idea with the EPN is that a central bank can increase nominal stability by pegging the currency to the price of the country's main export good or to a basket of for example the dollar and the export price. Colombia exports a broad basket of commodities ranging from petroleum, coffee, coal, nickel, emeralds, apparel, bananas, and cut flowers! It might therefore make more sense to focus on a basket of commodities rather than on one commodity. One can easily construct such basket based on Colombia's actual export shares, but I here for illustrative purposes (because I don't have time for anything else) use the so-called CRB-index, which is a broad basket of commodities. The interesting thing is not the price of commodities in US dollars, but rather the price of commodities measured in local currency - the Colombian peso. Under a strict Export Price Norm a drop of 1% in the commodity index the central bank's peg would lead to an automatic 1% drop in the currency. Hence, under an EPN the export price in its own currency would be stable. The graph below illustrates the relationship between nominal GDP growth (our measure of nominal stability) the CRB-index measured in Colombian peso. The graph shows that there is a fairly high correlation between on the one hand Colombian NGDP growth and the CRB-index in local currency on the other hand. The correlation is certainly not perfect, but it should be remembered here that I used the CRB index rather than an actual basket of Colombian exports. Anyway, it is pretty clear that there over the past 15 years or so has been a fairly close relationship between the two - when commodity prices measured in peso increases NGDP growth will pick-up within 1-4 quarters. This in my view indicates quite clearly that the Colombian central bank could stabilize nominal GDP by at least "shadowing" commodity prices. Hence, if commodity prices drop the central bank could take action to push the peso weaker to make up for the drop in commodity prices (export prices). The graph, however, also shows that there is not a one-to-one relationship between export prices and NGDP growth. Hence, it would certainly not be wise just to peg the peso to for example the CRB index. However, it might make sense to use an index of export prices in peso as a policy instrument to target NGDP growth 12-18 months ahead. I am sure that the good economists at the Colombian central bank could fairly easy calculate what basket of for example the US dollar and export prices, which would best forecast NGDP growth 1-2 years ahead. Was 2011-12 a policy mistake? The graph above shows that the CRB index in peso increased sharply in 2010-11 and as a consequence nominal GDP growth pick-up strongly peaking above 15% y/y in late 2011. However, going into 2012 Colombian "export prices" (CRB index in peso) dropped sharply and within the year NGDP growth eased off sharply. This might obviously not be a policy mistake as NGDP clearly was growing too fast in 2010-2011, which warranted monetary tightening. However, the swings in NGDP have been quite large. Therefore, if the Colombian central bank had done more to moderate the swings in Colombian export prices the development in NGDP growth would have been much more stable. Monetary easing is warranted - but no drastic measures are needed During 2013 NGDP growth slowed to well-below the long-term "target" (or rather trend) of around 7-8% y/y. Monetary easing therefore has seemed warranted and as commodity prices seem to continue to trend downward as worries over China have grown it is right for central bank governor Uribe to welcome a weaker peso. This is exactly what the Export Price Norm would tell Uribe to do. That said, NGDP growth has been picking-up so Uribe should be careful not overdoing it on the easy side. Overall, I think it would make sense for the Colombian central bank to target NGDP growth (level targeting) of 7-8%. Given that trend RGDP growth is probably about 4-5% that would lead to around 3% inflation over the medium-term. Let the market do most of the work If governor Uribe announced today that he in the future would keep a very close eye on Colombian export prices measured in peso and that he would intervene in the currency market and/or change interest rates to ensure a development in export prices, which would ensure 7-8% NGDP over the coming 12-18 months then I think he would have a fairly easy job stabilizing NGDP growth AND also achieve his stated inflation target of 3% over the same time horizon. And more importantly - it would be the market, which would do most of the lifting given the expectation of intervention if export prices in peso moved to too much in any direction.