The roller coaster that dollarized economies are riding

The combination of inflation and a financial crisis in the US has complicated the outlook for dollarized countries. We can see the roller coaster that dollarized countries in particular, but also those with fixed exchange rate regimes, are now riding by looking at Panama, a country for which we have better data than for most.

As in other emerging countries, Panama’s inflation increased strongly in the past twelve months (Panel A) primarily because of an increase in food inflation (Panel B, in the graph food inflation is for Panama city). There is no monetary policy in Panama: the interbank interest rate follows closely the policy rate of the US Federal Reserve (the federal funds rate, Panel C). The US policy rate has been set with respect to the US financial crisis and it is still uncertain whether at the end of this year, the policy rate will start to respond to the surge in inflation. There is no financial crisis in Panama and the surge in inflation in Panamá is much larger than that of the US. Nonetheless, as Panama does not have an autonomous monetary policy, it has to accept the policy rates that the US decides are best for the US.

Surging inflation and decreasing nominal interest rates have plunged Panama’s real interest rates to the depths (Panel D). The drop in real interest rates looks even more far-fetched as it is happening at a time when the cycle reaches its peak (Panel E).

In the simplest textbook, the adjustment mechanisms in a dollarized economy are twofold. First, a drop in interest rates in the US leads to a capital inflow in Panama in search for higher returns. This inflow raises the price of bonds and decreases its return. The adjustment persists until the return on bonds, adjusted for the country credit risk premium, is the same in both countries. Second, higher inflation in Panama leads to a trade deficit and the deficit implies a monetary contraction. The contraction makes prices fall. These mechanisms operate until prices are the same in the two countries. The consequence is that the real bilateral exchange rate remains constant.

With capital mobility, the first mechanism works well (Panel D). But the second mechanism operates imperfectly (Panel F shows that the bilateral real exchange rate is not constant). The price mechanism does not work well even between US states, so why should we expect it work with respect to Panama? In the absence of price convergence, other mechanisms will have to come into play. Within the US, the adjustment is through labor mobility and income diversification through state-diversified equity holdings. In the case of US and Panama the adjustment is carried out by larger output and income fluctuations and IMF bail outs.

The standard deviation of Panama’s cycle is more than three times that of the US. And while the correlation of the cycle between US states is in all cases positive and in average 0.55, the correlation of Panama’s and the US cycle is -0.27 (Panel E).

The cost of fixed exchange rates and dollarization is huge without adjustment mechanisms. And it also seems to be larger when the hegemony is so concerned with a financial crisis and is struggling to keep its inflation anchor.

Since dollarized countries do not have monetary policy and are only likely to take back that power if they hit a severe crisis, the moral of this story may be drawn mostly for those countries that do have monetary autonomy. As I showed in a July 29 article in this blog, inflation targeting central banks are allowing their real interest rates to decrease. Aren’t autonomous central banks also too concerned about the nominal exchange rate and too slow to raise real interest rates? Countries with monetary autonomy should exercise their sovereignty and fight inflation, in part to give their share of price stability to the international economy and help out those that can’t.