IMF reversal on intervention in forex market – it seems fine now..

Another interesting twist from IMF econs. So far they strongly advised central banks to just look at inflation and interest rates. Now they seem to be ok with EME (emerging economies) central banks to also monitor exchange rate developments using exchange rate intervention as a tool:

EMEs are different from developed:

This note examines the case for using two policy instruments—the policy interest rate and sterilized foreign exchange market intervention—in emerging market countries aiming to maintain low inflation while avoiding currency movements that clearly represent substantial deviations of the exchange rate from its medium-run multilaterally-consistent value. It is often said that paying attention to the exchange rate can undermine the credibility of a commitment to low inflation. In fact, this argument has been used to suggest that countries unwilling to allow a free floating exchange rate should not adopt inflation targeting (IT) as part of their policy framework. And as others have noted, a number of early adopters of IT made an explicit commitment to allow the exchange rate to float more freely. 

But in countries with significant currency mismatches in domestic balance sheets, high passthrough of the exchange rate to inflation, and limited inter-sectoral factor mobility, ignoring exchange rate volatility can itself prove costly. And with emerging-market countries’ more limited integration with global financial markets and smaller stocks of outstanding localcurrency assets, scope for using sterilized intervention may be greater.

Hence instead of one policy and one tool, EME should have two policies and two tools:

The framework we use to explore these questions is unabashedly ad hoc. It makes two assumptions: that large deviations of the real exchange rate from its multilaterally-warranted value are costly (e.g., dynamic Dutch disease, balance sheet effects), implying that central banks should indeed care about the exchange rate in addition to inflation; and second, that there is imperfect capital mobility/asset substitutability, and so central banks can avail themselves of both policy interest rates and foreign exchange market intervention. How should a central bank use these two policy instruments to achieve its two targets?

Fully discretionary monetary and exchange rate policies obviously allow maximum flexibility in responding to unexpected shocks. Yet full discretion is not costless: it may result in conflicting signals about the central bank’s objectives, thus undermining credibility. For this reason, our analysis highlights the benefits for the monetary authority of signaling that the policy interest rate will be used to safeguard the primacy of the inflation target. But if, for example, a sudden surge in capital inflows leads to a large, temporary appreciation of the currency above its medium-term value, and that results in economic dislocation, then some intervention in the foreign exchange (FX) market is likely to be optimal even under an IT regime.

Though communications will be crucial as it will lead to confusion:

The analysis underscores that such intervention should only be undertaken against shocks that move the exchange rate away from its medium-run multilaterally-consistent value, and that it should be two-way, involving both purchases and sales of FX reserves. Because the central bank would be deploying its second instrument to influence the exchange rate, while adjusting the policy interest rate to meet its inflation goal, the two-target/two instrument regime should not give confusing signals to the public.

So after the turn around on capital controls, here is some turn around on exchange rate management as well. The lessons from the crisis continue to roll on. What is even more interesting to note is that all these turn arounds are happening after a crisis in developed economies. In previous developing econ crisis, no one really listened..


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