Do Exchange Rates Affect Inflation? Evidence from Emerging Market Economies?

By Baki Demirel, Baris Alpaslan and Emre Guneser Bozdag

http://econpapers.repec.org/paper/kocwpaper/1318.htm

Policy Brief:

In this study, the findings show that inflation targeting policy plays a crucial role in managing expectations that may obstruct monetary policy in emerging market economies, thereby enhancing the central bank credibility and succeeding inflation-targeting.  The results of this research support the idea that the success of inflation targeting may help emerging market economies enhance de-dollarization and reduce pressure on general level of prices.[1]

The findings of this study are important for central bank independence implying the price stability-oriented monetary policy. However, due to the fact that some central banks in emerging market economies that have not successfully adopted a floating exchange rate regime, their independence has become questionable; it may be due to an increase in risk appetite.[2] During a “risk on” period currency appreciation and an increasing current account deficit due to credit expansion is a problem that emerging market economies may face whereas during a “risk-off” period there might be a sudden stop in investment activities in those economies, in response to global economic patterns.[3]

Another problem in emerging market economies adopting inflation targeting is that their credit markets are heavily dependent on banking globalization.[4] The interaction between banking globalization and the central bank is established through the activity in interest rates which might be another cause of a sudden stop in investment activities; implying that  under a floating exchange rate regime it would preclude independent monetary policy, deactivate the well-known “impossible trinity” or  the “Trilemma”, thereby leading to a fear of floating.

Emerging market economies should pay much attention to movements in exchange rates and exchange rate mobility, thus weakening the impact of the control that central banks have on interest rates, and that despite a floating exchange rate regime, exchange rates are thought of as a policy tool. In general, therefore, it seems that emerging market economies may move further away from their core mandate of price stability, in which case macroprudential regulations and even managing capital inflows might be a tool to use.[5] Consequently, central banks should tackle financial stability as well as price stability.

The financial crisis that erupted in 2007-2008 led to changes in managing monetary policies. Prior to the crisis, critics argued that central banks with price and output stability could ensure financial stability and interest rates could be a tool in accordance with this purpose. However, the crisis led to the fact that there is no dichotomy between monetary policy and financial stability. In other words, microprudential regulations that are designed for financial institutions cannot eliminate risks caused by disruptions in the general sense, which is the case for emerging market economies. In general, therefore, it seems that macroeconomic stability is sustained in line with price stability, output stability and together with financial stability.

Last but not least, it can thus be suggested that institutions should be founded for central banks to maintain price and exchange rate stability and to implement macroprudential policies. We believe that central banks should play an active role in macroprudential policies.[6]

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[1] Taylor, John B., “Low Inflation Pass-Through, and the Pricing Power of Firms”, European Economic Review, 44: 1389-1408, 2000.

[2] Calvo, Guillermo, Reinhart, Carmen M, “Fear of Floating”, NBER Working Paper, 793, 2000.

[3] IMF, “Global Financial Stability Report: Transition Challenges to Stability”, World Economic and Financial Surveys, International Monetary Fund, October 2013.

[4] Goldberg, Linda, “Banking Globalization, Transmission, and Monetary Policy Autonomy”, Federal Reserve Bank of New York, Staff Reports, No: 640, September 2013.

[5] Ostry,  Jonathan D., Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mahvash S. Qureshi, and Annamaria Kokenyne, “ Managing Capital Inflows:  What Tools to Use”, IMF Staff Discussion Note”, April 2011.

[6] Ostry, Jonathan D., Atish R. Ghosh, Marcos Chamon, “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies”, IMF Staff Position Note SPN/12/01 February 29, 2012.