On Tropical Inflation Targeting

In his recent blog, Roberto Rigobon has directed attention to the role of fiscal policy in preventing real exchange rate appreciation in the inflation targeting (IT) regimes of Brazil, Colombia, and others. I would like to suggest a slightly broader focus, however, on the issue of what, if any, should be the role of exchange rate management in an inflation targeting regime. This is an aspect of inflation targeting regimes where the discrepancy between theory and practice has been most evident (at least to me), and where the extent of our ignorance may be quite damaging.


Inflation targeters in Latin America generally claim to have flexible exchange rates, as required by the conventional wisdom on IT. At the same time, however, IT central bankers openly admit that they reserve the right to depart from flexible rates under some circumstances. For example, Peru’s central bank “has the policy of moderating excessive exchange rate volatility in order to minimize the negative effects of large exchange rate movements in a financially dollarized economy” (Adrian Armas and Francisco Grippa, Targeting Inflation in a Dollarized Economy: The Peruvian Experience, April 2005, page 27).  As stated in the quote, central bankers in IT regimes often feel the need to prevent exchange rate movements that may not be warranted by fundamentals, and to fight large depreciations that may jeopardize financial and payments systems. As these concerns emerge relatively often, active exchange rate management has not been an occasional departure from the IT rulebook. Instead, it is an integral part of the rules.


What would conventional IT gurus say? In the well framework of Svensson (1998, 2000), for example, a central bank chooses its instrument path to minimize an expected loss function of inflation and the output gap. Svensson shows that the instrument should then be set as to minimize deviations of the inflation forecast from target. A corollary is that the instrument should respond to any variable that provides news useful to forecast future inflation. The exchange rate could be one such forecasting variable, and therefore the conventional IT wisdom may rationalize the need for policy to respond to exchange rate fluctuations.


But of course this argument, while theoretically tight, is clearly not the reason why Latin inflation targeters have engaged in active exchange rate management. The Svensson framework does not allow for either of the two concerns most frequently by our central bankers: that exchange rates may be driven by nonfundamental forces, and that large depreciations may destroy our financial systems. Two questions then emerge: What do we know about how these two concerns affect our views on how the economy works? And, what are the implications for exchange rate policy in an IT regime?


While we are very far from having a satisfactory theory, recent research has made considerable progress on the second concern. There is now a very active literature on liability dollarization, currency mismatches, and financial frictions, which emphasizes that a currency depreciation may indeed exert a contractionary effect on aggregate demand via net worth effects. This research has been rich on policy lessons. Unfortunately, it has not settled the question of how exactly the central bank should adjust its policy instrument in response to exchange rate news. Luis Cespedes, Andres Velasco, and I have developed models in which the contractionary effect of depreciations can be very strong, yet it is optimal for the exchange rate to float; this finding has been echoed by others (e.g. Devereux , Lane, and Xu 2004). But David Cook has presented models with opposite results. Therefore, while it is now widely accepted that balance sheet effects and dollarization means that exchange rate depreciation may be strongly contractionary, the theory has not yet provided a rationale for active exchange rate management.


The situation is much less satisfactory on the question of how nonfundamental exchange rate movements may affect the role of exchange rate management under inflation targeting. This reflects, of course, the lack of a satisfactory theory of “nonfundamental” phenomena. In addition, the few attempts I am aware of suggest that allowing for such phenomena has ambiguous implications for exchange rate policy. In particular, a few years ago Ben Bernanke and Mark Gertler asked whether allowing for asset price bubbles in financial accelerator models is likely to affect standard prescriptions for monetary policy. The answer, they found, is negative. Much more research seems to be needed on this front, however, as it is extremely hard to dispute the contention that exchange rate movements are (perhaps most of the time!) not justified by fundamentals.


My preliminary conclusion (and please correct me if you disagree!) is that, while IT central bankers may be right to be concerned about excessive and large exchange rate movements, I am unclear about whether their common reaction (to fight such movements) makes sense. And, by extension, I am unclear about how inflation targeting works in the tropics, if it does.

4 Responses to "On Tropical Inflation Targeting"

  1. Vitoria Saddi   May 31, 2007 at 3:14 pm

    On a Theory of nonfundamental phenomena?  Professor, I agree with you that the literature on IT has not made a clear distinction on the implementation of IT in advanced economies (like England) and the adoption of such regime in emerging economies (like Brazil).   Not sure if I agree of what you call “Theory of nonfundamental phenomena”. Calvo (2006; “Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort”)argues that emerging economies under IT face greater exchange rate volatility than the advanced economies under a similar regime. In his view, EM countries under inflation targeting regime should intervene in the exchange rate markets, especially in periods of volatility.   This is so because in times of high exchange rate volatility (like the episode of turmoil in the spring of 2006), the Central Bank should not follow a strict interest rate rule because such a rule would increase the outflow of capital. In his view, in those volatile periods policy makers should add to the strict IT regime a policy of sterilized intervention in the FX market as a way to curb FX volatility and prevent negative developments that might emerge in the absence of sterilized interventions.  Question: Are you unclear if IT works in the tropics or would you prefer to adopt something else?

  2. Roberto Chang   June 1, 2007 at 9:20 am

    Vitoria, thank you for the comment. As usual, I agree with Guillermo Calvo’s general views, but here I wonder about some of the details. In this case, it appears to me that IT central bankers do worry about exchange rate volatility that may be driven by animal spirits, herd behavior, or irrationality. These phenomena are not usually allowed for in our theories (with the exception of models of multiple equilibria), which typically assume rational expectations. One consequence is that we do not have an acceptable theory of how the exchange rate should be managed under those circumstances. (One possible reaction, of course, is that there is no reason to pay attention to the central bankers’ concerns with nonfundamental phenomena, but I would not push that line.)  As for my preferences about to maintain IT in the tropics, my first reaction is not to fix what seems not to be broken. “Something” has worked to reduce inflation in the tropics, and may be related to IT. But the evidence seems to be only mildly supportive of the view that IT has made a difference. In addition, tropical IT regimes have come in many flavors, some very different from others. So I think it is worth thinking about what about IT has been essential and what has been peripheral (and maybe counterproductive) before tropical macroeconomies become turbulent again.

  3. Anonymous   June 2, 2007 at 7:41 am

    Roberto, very interesting arguments. But note that the initial result of Bernanke and Gertler that the optimal Taylor rule should not be modified to respond to asset bubbles has now been refuted by a number of academic papers on the topic. The optimal policy rule, in the presence of both determinstic and stochastic bubbles and even in the presence of uncertainty about a bubble and about the effects of a bubble, is to respond to the bubble with monetary policy above and beyond what the optimal Taylor rule response of interest rates to growth and inflation is. See my paper “Why Central Banks Should Burst Bubbles” for a survey of this literature. The paper is at: http://www.rgemonitor.com/redir.php?sid=1&tgid=10000&cid=99228

  4. Anonymous   June 2, 2007 at 7:43 am

    If the exchange rate moves too much, the economy is very open and the pass-through of exchange rates to import prices is high (all typical conditions of emerging market economies) the inflation target of the monetary authorities may be at threat if the monetary authority does not smooth excessive movements of the exchange rate. That is an argument for including some smoothing of exchange rates in a IT framework.