The Role of Exchange Rates in Inflation Targeting Regimes by Benjamin Hunt, Peter Isard, and Douglas Laxton Summary The paper considers two broad issues that arise for countries that adopt inflation targeting—the choice between different approaches for implementing inflation targeting, and the question of how monetary authorities should take account of and/or manage the exchange rate. On the first issue, it argues in favor of a strategy in which the authorities make use of all relevant information to form their best forecasts of inflation and rely on a simple inflation-forecast-based “rule” as a guideline for adjusting the policy interest rate. Because of lags in the response of the economy to interest rate adjustments, it is not feasible to keep inflation on target at all times, and efforts to eliminate deviations from the inflation target too quickly can have wrenching effects on economy activity. The task for policy, accordingly, is to ensure that the forecasted path of inflation converges to the inflation target within a reasonable time horizon. While emphasizing that policy analysis can benefit greatly from efforts to develop models of macroeconomic behavior, the authors stress that sophisticated macroeconomic models are not required to implement inflation targeting. Monetary policy in all countries relies heavily on the judgments of experts, and in the first instance such judgments can be guided by very simple models. Citing experience in the United Kingdom, the paper suggests that two keys to success are developing approaches that do not lead to persistent biases or persistently-large errors in the inflation forecast, and making it transparent to the public that the authorities are committed to achieving the inflation target (for example, through timely publication of the minutes of policy discussions). A more basic prerequisite—beyond the control of the monetary authorities themselves—is an environment in which fiscal imbalances are controlled and institutional and structural weaknesses are being seriously addressed. Leading advocates of inflation targeting for emerging market countries advise against benign neglect of the exchange rate but have not provided specific guidance on what this should mean. In addressing the issue, the paper starts with the obvious point that the authorities should try to enhance their forecasting and policy analysis by developing analytic frameworks that appropriately capture the role of the exchange rate in the transmission of monetary policy and various exogenous shocks. For emerging market countries, this requires models that capture not only pass-through effects on domestic prices and expenditure-switching effects on aggregate demand, but also “balance sheet effects” on risk premia (or country-specific interest-rate premia) and access to international capital markets. In this connection, the paper illustrates its arguments with simulations based on a linearized version of a model that includes such balance sheet effects. The paper notes that under an inflation-forecast-based rule, monetary policy reacts to the exchange rate indirectly through its direct response to the effects of the
2 exchange rate on the inflation forecast, which normally also takes account of the projected effects of the exchange rate on economic activity. In light of widespread “fearof-floating,” however, it is relevant to ask whether simple inflation-forecast-based rules can be improved by including a direct reaction to the exchange rate to further dampen currency fluctuations on a regular basis. It is important to analyze the issue in models that include persistent shocks to the risk premium—that is, in models consistent with widespread impressions that exchange rates in reality sometimes deviate persistently from levels consistent with macroeconomic fundamentals. The paper leaves this as an open question, pending further analysis. It notes, however, that the case for reacting directly to the exchange rate is likely to depend on how well the authorities can estimate its “equilibrium” or appropriate level. Reacting to the deviation of the exchange rate from an imprecise estimate of its appropriate level can inject noise into the forecasting and policy analysis process and may well be counterproductive.