Chapter

VII Implications of Recent Global Shocks

Author(s):
Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
Published Date:
November 2009
Share
  • ShareShare
Show Summary Details

This section discusses the implications of the two recent global shocks for the role of the exchange rate in inflation-targeting emerging economies. The inflation episode of 2007–08 and the global financial and economic crisis that accelerated in late 2008 each serve in very different ways as severe stress tests of inflation-targeting frameworks. Broadly, these two episodes confirm the larger and more varied role played by exchange rate policy for inflation-targeting emerging economies than for inflation-targeting advanced economies. Furthermore, inflation targeting as a regime proved resilient to the inflation shocks of 2007–08. As of mid-2009, inflation-targeting economies had not made major adjustments to their regimes, although the global crisis was far from over.

Inflation Pressure and Capital Inflows46

Inflation in emerging economies was buoyed by inflationary global supply and demand shocks that crested in 2007. Capital inflows rose sharply, and rapid growth of private credit boosted demand and spurred above-trend aggregate growth. Labor markets tightened and wage pressures increased in some economies, reflecting growing supply constraints.

As a result, broad-based inflation rose and exchange rates appreciated. Inflation rose for 14 of the 16 emerging economies included in this study47 by a median of 3.4 percent, and inflation exceeded official targets for all but one of the inflation-targeting emerging economies, by significant margins in some cases. From December 2006 to August 2008, exchange rates appreciated for 14 of the 16 emerging economies, by a median of 7.6 percent (Table 7.1). Concern arose that the sharp rise in food and energy prices and increasing core inflation was leading to second-round effects. The surge in inflation and upward pressure on the exchange rate were seen to be the first significant test of inflation-targeting regimes in emerging economies.

Table 7.1.Inflation-Targeting Economies, Macroeconomic and Policy Developments, December 2006–August 2008
Headline

Inflation,

Aug. 29, 2008
Headline

Inflation

Compared to

Inflation Target1,

Aug. 29, 2008
Change in

Headline

Inflation,

Dec. 2006–

Aug. 2008
Exchange

Rate

Depreciation,

Dec. 29, 2006–

Aug. 29, 2008
Change

in Reserves

Dec. 2006–

Aug. 2008
Depreciation

+ Change in

Reserves
Policy rate,

Aug. 31, 2008
Real Rate

(Headline

Inflation),

Aug. 2008
Interest Rate

(PR): Change

Dec. 2006–

Aug. 2008
Emerging economies
Brazil6.23.023.7139.0162.613.06.8–0.3
Chile9.3+5.26.73.915.118.97.8–1.62.5
Colombia7.9+3.13.413.653.266.810.02.12.5
Czech Republic6.4+2.64.818.817.636.43.5–2.91.0
Hungary6.6+ 1.80.115.218.133.38.51.90.5
Indonesia1 1.8+6.75.2–1.737.035.39.0–2.8–0.8
Mexico5.6+ 1.51.54.927.232.18.32.71.3
Peru6.2+3.35.17.6104.7112.36.0–0.21.5
Philippines12.4+7.38.16.160.066.15.8–6.6–1.8
Poland5.0+ 1.03.621.868.390.16.01.02.0
Romania8.0+2.83.16.135.341.410.32.21.5
South Africa1 1.0+5.16.2–9.834.024.212.01.03.0
Thailand6.5+2.63.13.551.254.63.8–2.80.3
Turkey1 1.8+ 1.62.116.425.141.516.85.0–0.8
Median6.63.47.637.041.58.31.01.0
Advanced economies
Australia5.0+2.01.7–8.8–46.6–55.47.32.31.0
Canada3.5+0.41.88.821.530.23.0–0.5–1.3
Israel5.0+2.55.115.016.631.64.3–0.8–0.3
Korea5.6+ 1.63.5–17.11.8–15.35.3–0.40.8
New Zealand5.1+2.12.40.50.50.98.02.90.8
Norway4.5+2.82.313.1–16.3–3.26.82.31.3
Singapore6.4+ 1.25.67.724.832.61.3–5.2–2.2
Sweden4.3+ 1.42.75.813.719.54.50.21.5
Switzerland2.9+2.92.39.718.928.62.8–0.20.8
United Kingdom4.8+3.00.37.06.713.75.00.20.0
Median4.92.47.410.216.64.80.00.8
Source: IMF staff estimates.

√ denotes inflation is within the target band.

Source: IMF staff estimates.

√ denotes inflation is within the target band.

In response, most central banks tightened monetary policy by raising interest rates and buying foreign exchange, notwithstanding the conflicts raised by this policy mix. Policy interest rates were raised by 12 of the central banks.48 Further, all central banks bought large amounts of reserves, with percentage changes ranging from 16 percent to 139 percent from December 2006 to August 2008, indicating strong policy resistance to upward exchange rate pressure.49 A number of central banks were hesitant to raise interest rates more aggressively, owing to fears that such a move could lead to further exchange rate appreciation and capital inflows, fueling credit growth and higher inflation. Some tightened monetary policy using other tools.50

The inflation episode of 2007 to mid-2008 led to only limited changes in inflation-targeting regimes. No emerging (or advanced) economy dropped inflation targeting. Two (Guatemala and Turkey) raised their officially announced inflation targets. All other inflation-targeting economies maintained their original targets and associated parameters (target band width, targeted index, and target horizon), partly reflecting concerns about damaging credibility and possibly unmooring inflation expectations. Most inflation-targeting economies enhanced communication, explaining the nature of the supply shock and the central bank’s policy response.

Inflation-targeting advanced economies were less vulnerable to the commodity price shocks and undertook more limited policy responses. Inflation rose for all of them from December 2006 to August 2008, by a median of 2.4 percent (Table 7.1). Perhaps surprisingly, the median exchange rate appreciation was 7.4 percent—almost exactly the same as for the inflation-targeting emerging economies. In contrast, median reserve accumulation was about 10 percent, just over a quarter of the median for the emerging economies. The median interest rate increase was about the same for both advanced and emerging economies.

The Global Financial and Economic Crisis

Beginning in mid-September 2008, the main policy focus shifted abruptly from containing inflation to addressing the tightening of liquidity and the contraction in global growth (Table 7.2). Emerging economies were buffeted by an abrupt tightening of dollar liquidity, a sudden decline in global demand, and sharp falls in commodity prices. The unexpected closure of Lehman Brothers on September 12, 2008, quickly dried up funding markets for emerging market banks. The global economy rapidly contracted, and available measures of inflation expectations for the large emerging economies began to fall by mid-November.

Table 7.2.Inflation-Targeting Economies, Macroeconomic and Policy Developments, August 2008-March 20091
Headline

Inflation,

Latest
Headline

Inflation

Compared to

Inflation Target, Latest2
Change in

Headline

Inflation,

Jun. 30, 2008–

March 2009
Exchange

Rate

Depreciation,

Sept. 12, 2008–

March 2009
Change in

Reserves

Aug. 29, 2008–

March 2009
Depreciation +

Change in

Reserves
Policy rate,

Latest
Real Rate

(Headline

Inflation)
Interest

Rate: Change

Sept. 12, 2008–

March 2009
Emerging market economies
Brazil5.9–0.1–24.3–7.2–31.511.35.4–2.5
Chile5.0+ 1.0–4.4–10.22.4–7.81.8–3.3–6.5
Colombia6.5+2.0–0.7–12.9–0.7–13.77.00.5–3.0
Czech Republic2.3–4.4–21.9–0.3–22.31.7–0.5–1.8
Hungary2.9–3.8–37.0–11.0–48.09.56.61.0
Indonesia7.9+2.4–3.1–15.2–13.4–28.57.5–0.4–1.8
Mexico6.0+2.00.8–24.2–7.2–31.56.00.0–2.3
Peru4.8+ 1.8–0.9–3.5–11.5–15.06.01.2–0.3
Philippines6.4+ 1.9–5.0–4.45.91.64.8–1.6–1.3
Poland3.9+0.4–0.8–44.9–24.1–69.13.8–0.2–2.3
Romania6.7+2.2–1.9–28.8–12.4–41.110.03.3–0.3
South Africa9.2+3.2–1.2–11.4–1.6–13.09.50.3–2.5
Thailand–0.2–9.0–2.611.99.31.21.4–2.5
Turkey7.9–2.7–31.6–10.1–41.79.81.9–7.0
Median6.0–2.3–18.5–7.2–25.46.50.4–2.3
Advanced economies
Australia3.7+0.7–0.814.0–0.513.53.0–0.7–4.0
Canada1.2–1.9–16.61.4–15.20.3–1.0–2.8
Iceland15.1+ 15.12.4–46.6–15.9–62.515.50.40.0
Israel–1.5–6.3–17.530.012.50.52.0–3.8
Korea3.9+0.4–1.7–21.5–17.1–38.72.0–1.9–3.3
New Zealand3.4+0.4–0.616.6–11.15.53.0–0.4–4.5
Norway2.5–0.9–17.44.8–12.63.00.5–3.8
Singapore1.8–5.7–5.1–3.9–8.90.8–1.0–0.5
Sweden0.2–4.1–25.7–16.8–42.50.50.3–4.3
Switzerland–0.4–3.3–2.8–1.4–4.20.30.7–2.5
United Kingdom–0.4–5.019.1–10.19.00.50.9–4.5
Median1.8–1.9–16.6–3.9–8.90.80.3–3.8
Source: IMF staff estimates.

Developments through March 2009 or latest data.

√ denotes inflation is within the target band.

Source: IMF staff estimates.

Developments through March 2009 or latest data.

√ denotes inflation is within the target band.

The tightening of global liquidity quickly led to exchange rate depreciations, reserve sales, and other foreign exchange liquidity-alleviation measures. From September 12 to October 31, 2008, the exchange rates of all emerging economies depreciated, by a median of 13 percent. By October, all had sold official reserves to stem the depreciation, and reserve sales generally continued into early 2009. Many countries took systemic foreign exchange liquidity-easing measures in addition to intervening in foreign exchange markets. These measures—reinforced in some cases by foreign exchange liquidity provided by advanced economy central banks—showed some success in alleviating short-term liquidity pressures.51 Several of the large inflation-targeting emerging economies provided liquidity to specific markets and sectors, in addition to providing foreign exchange liquidity using standard foreign exchange market intervention. The willingness of inflation-targeting economies to use foreign exchange sales and other measures to soften downward pressure on the exchange rate, even in the context of their inflation-targeting regimes, reflects the magnitude of the external shock and possibly a view that it would be short-lived. Countries whose external vulnerability deteriorated the most sold more foreign exchange reserves (Figure 7.1).

Figure 7.1.Emerging Market Inflation-Targeting Economies, External Vulnerability and Foreign Exchange Intervention

Source: IMF staff estimates.

1 CDS = credit default swap.

By November 2008, the magnitude of the global contractionary pressure became clear, and the inflation-targeting emerging economies began to lower policy interest rates.52 From August 2008 to March 2009, inflation declined for most economies, by a median of 2.3 percent. Furthermore, industrial production began to fall in most economies and quite rapidly in several. Credit-default swap (CDS) spreads for many countries rose sharply. All but three inflation-targeting emerging economies lowered their policy interest rates after September. The sharp fall in interest rates in the United States, Japan, and United Kingdom (the Group of Three, or G3, economies) gave more scope to emerging economies for easing domestic monetary policy without undermining the stability of their currencies. As of April 2009, real interest rates were at a median of below zero.

The less externally vulnerable inflation-targeting emerging economies seem to have had more scope for easing interest rates. Those with smaller increases in their sovereign CDS spreads after September 12, 2008, had lower real policy interest rates (see Figure 7.1). This demonstrates the important differences within this group of economies.

Inflation-targeting advanced economies sharply loosened their domestic monetary policy stances using conventional and unconventional measures. Inflation fell even more quickly for the advanced economies than for the emerging economies. Exchange rate pressure was substantial, albeit about two-thirds the level for inflation-targeting emerging economies. Reserves were decumulated by a median 2.6 percent, about one-third the level for the inflation-targeting emerging economies. Policy interest rates dropped to historically low levels, well below those of the emerging economies, reflecting their relatively high degree of credibility and relative exchange rate stability. For several central banks, the advent of zero or near-zero policy interest rates has blocked the interest rate channel and led to use of “unconventional measures” to boost credit and economic activity, including cross-central-bank foreign exchange swaps. Switzerland is the advanced economy with probably the most active exchange rate policy.53

Like the emerging economies, the advanced economies have made only relatively limited adjustments to their inflation-targeting regimes. The only country that has abandoned inflation targeting is Iceland, which is by far the smallest inflation-targeting advanced economy in terms of population and the most financially open.54 In other advanced economies, no inflation targets have been adjusted, although the bursting of the global asset price bubble has reinvigorated the debate about the role of asset prices in inflation targeting and the length of the policy horizon.

Implications

The two recent global shocks have the following broad implications for the role of the exchange rate for inflation-targeting emerging economies:

  • Inflation-targeting emerging economies experience larger swings in capital flows and risk premiums than inflation-targeting advanced economies. This difference, which can be gauged by the simple sum of changes in exchange rates and foreign exchange reserves, is also an assumption of the model used in this paper.
  • Foreign exchange intervention plays a bigger role for the emerging economies as a result of more volatile capital flows. Interestingly, the exchange rate changes for each country group are broadly similar. However, the much larger changes in reserves mean that the emerging economies more actively resist exchange rate pressures, especially during periods of capital inflows. Relatedly, nonstandard exchange rate intervention plays a bigger role for the emerging economies. The more vulnerable economies have less scope to lower interest rates. These patterns are consistent with the results of the macroeconomic model.
  • Inflation-targeting regimes have been broadly resilient to the shocks. Only two countries have adjusted their inflation-target ranges, and only Iceland, the smallest inflation-targeting economy, suspended its regime. Of course, the crisis that accelerated in September 2008 is far from over, and further regime changes may well be in the offing.
46This subsection draws on Habermeier and others (2009).
47Guatemala is not included because data were not available; the Slovak Republic is not included because it joined the Euro area in January 2009.
48Some countries tightened monetary policy using other tools (in addition to or in place of higher interest rates), reflecting (to different degrees) capital inflows, weak monetary transmission, or costly sterilization.
49In some inflation-targeting economies, nominal appreciation of the domestic currency limited the pass-through of imported inflation pressures, whereas in others, depreciation of the currencies vis-à-vis the euro validated inflation.
50Colombia and Peru increased reserve requirements on deposits and raised reserve requirements on external liabilities to limit capital inflows. Colombia and Thailand introduced capital inflow controls in the form of unremunerated reserve requirements in 2006–08, to curb the appreciation of their currencies caused by strong portfolio inflows, but the effects were mixed and these measures were subsequently reversed. The use of tools in addition to or in place of higher interest rates and reserve sales reflected (to different degrees) capital inflows, weak monetary transmission, or costly sterilization.
51These measures are documented in Stone and others (2008). Brazil, Hungary, Mexico, and Poland agreed on foreign exchange swaps with advanced economy central banks.
52Sales of official foreign exchange reserves preceded declines of domestic interest rates for 12 of the emerging economies.
53Beginning in March 2009, the National Bank of Switzerland announced that it would undertake unsterilized sales of foreign exchange to prevent any further appreciation of the Swiss franc against the euro.
54The GDP of Iceland was $19 billion in 2008; the next smallest inflation targeter was the Slovak Republic (until adopting the euro in January 2009) with GDP of $100.6 billion.

    Other Resources Citing This Publication