The Future Direction of Monetary Policy Making in Small Open Economies: The Case of Mauritius

1. The Future Direction of Monetary Policy Making in Small Open Economies:The Case of Mauritius Jeffrey Frankel Harpel Professor Harvard University

2. Fashions in international currency policy • 1980-82: Monetarism (target the money supply) • 1984-1997: Fixed exchange rates (incl. currency boards) • 1997-2001: The corners hypothesis • 2002-2007: Inflation targeting (& currency float) • became the new conventional wisdom • Among academic economists • At the IMF • Among central bankers

3. Problems with the conventional wisdom (floating) • Most who say they float don’t • “Fear of floating” (Calvo & Reinhart) • For example, the many central banks experiencing upward pressure on their currencies 2003-2008, • particularly Asians and commodity exporters, • intervened consistently in the same direction: adding to reserves, to dampen appreciation.

4. Problems with the conventional wisdom (Inflation Targeting) • Huge price shocks of 2008: worldwide spike in prices of oil & other mineral & farm products • The price index chosen in IT is always the CPI • For small countries that suffer from terms of trade shocks, it would be better to target the PPI • When the $ oil import price rises, CPI targeting says to contract M so much that % appreciation = % increase in $ oil price. • Only then will rupee price (and so CPI) be unchanged. • But proper response to adverse terms of hrade is depreciation. • When sugar export price falls, only PPI targeting (or Nominal Income Targeting, or Peg the Export Price) says to expand sufficiently that currency depreciates, which is needed.

5. Is Inflation Targeting Dead? IT evaluated in light of recent crisis • Inflation targeting explicitly missed the relevance of the run-up in asset prices • securities & housing • E.g. Borio, Goodhart… • Unexpectedly, the crisis has offered a bit of support for the ECB’s “two pillar strategy,” i.e., continuing to pay attention to monetary aggregates • As compared to interest rates, broad aggregates, expecially credit, seen to be • an indicator of coming troubles (“excessive credit creation) • Indicative of credit channel, which may be now more useful than I rates.

6. The Case of Mauritius: Some questions • Why has inflation remained persistently high? • Most other countries have brought theirs down. • Even many with economic performance inferior to Mauritius. • Is it the lack of a nominal anchor • whether exchange rate, inflation target or other? • or is it collective setting of wage policy (“corporatist model”)? • If so, will it soon be time to commit to enhanced price stability • As part of a package that includes an agreement with labor • to slow the rate of growth of nominal wages at the same time? • Or else to move to a more market-oriented wage-setting policies?

7. “On the Mauritius rupee” What is the exchange rate regime? Peg usually makes sense for a small open country. Probably a basket peg, in the case of Mauritius given trade patterns that are diversified across trading partners. Most basket pegs keep the weights secret, because they don’t in truth want to be bound by the equation. But if the managed float is to continue, the popular candidate for nominal anchor is inflation targeting. I recommend targeting the PPI or GDP deflator, rather than the standard CPI, or else nominal GDP, because these alternatives, though novel, are more robust with respect to terms of trade shocks & other supply shocks. 7