making inflation targeting appropriately flexible

1. Making Inflation Targeting Appropriately Flexible Prof. Jeffrey Frankel, CID, Harvard University. South African Treasury, Pretoria, Jan. 16 & Stellenbosh University, Jan. 18, 2007

3. 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.

4. 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.

5. 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."

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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).

12. 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).

13. 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

14. The importance of avoidingreal 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.

15. 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.

16. 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.

17. On the Rand 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

18. Two topics Econometric analysis of determination of the rand exchange rate Choosing a currency regime in the face of volatility

19. 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?

20. Some other references on deter-mination 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.

21. We try various versions of the equation: with value of rand defined in nominal terms, or real; bilateral against $, or trade weighted.

22. 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 �

23. 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.

24. Impressive down-trend in perceived SA risk,to well below 100 basis points in early 2006, in tandem with upgrades by rating agencies

25. as among other emerging markets, but more so

26. General equation is: Log Real Rand value = a + � 1 Log Real Mineral Price Index + � 2 Log (SA vs. foreign GDP/cap) + � 3 Lagged Log Real Rand value + � 4 Real Interest Differential + � 5 Country Risk Premium + �6 capital controls + u

27. 1st look at data suggests role for GDPReal exchange rate and relative real GDP of SA to USA

28. but also for Real Mineral Price indexReal Exchange rate index and real mineral price index

29. because mineral prices &South African GDP are collinear.Real mineral price index and relative GDP

30. 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.

31. 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 Coefficient Std. Error t-Stat LOG(RERICPI(-1)) 0.8171 0.0433 18.89 LOG(RWMP) 0.2341 0.0655 3.57 GBRDIF 0.0215 0.0055 3.94 DUMMYRGBRDIF -0.0113 0.0061 -1.83 DUMMYCAP -0.0367 0.0235 -1.56 C 0.8149 0.2026 4.02 R2 = 0.91

32. The fit is surprisingly good

33. 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

34. Aghion, Bacchetta, & Ranciere (2005, 2006) 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%.

35. 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.

36. 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.

39. 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 .

40. How is PEP better than CPI-targeting? 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.

41. 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: exclude import prices from the index, & include export prices. Flaw of CPI target: it does it the other way around.