RBI’s once used multiple indicator approach is becoming preferred approach for EME monetary policy…

BIS chief Agustin Carstens in this speech reviews monetary policy framework in emerging markets.

He says it was thought that have an inflation target and allow the currency to float and find its own level.  However, this approach is not what emerging markets have strictly followed:

The vast majority of EME central banks today operate under an explicit inflation targeting regime with flexible exchange rates, while only a few use an explicit exchange rate anchor. This framework has taken deep root and has served central banks well. Last summer, EMEs suffered from financial turbulence. By and large, however, most EMEs came out of this turbulence unscathed. I believe their resilience owes much to the flexibility built into their monetary policy frameworks, together with stronger fundamentals, including more prudent fiscal policies and enhanced financial regulation and supervision.

But reality reflects the importance of the exchange rate. Irrespective of the official labelling, EME central banks have, in practice, attached a significant weight to the exchange rate in the conduct of their monetary policy, as reflected for instance in the evolution of FX reserves in EMEs over the past two decades. “Benign neglect of the exchange rate” has been a dictum honoured more in its breach than in its observance as a guide for monetary policy. As a consequence, many EMEs have a quasi-managed floating exchange rate regime where central banks lean against swings in the exchange rate, both on the way up and on the way down.

I shall argue that this approach is one where the practice outruns the theory, and it is arguably the theory that needs to catch up. That said, the enduring challenge for EME central banks is to design their monetary policy frameworks in a way that incorporates in a rigorous way the precise role of the exchange rate for their domestic economic outcomes. The BIS is expending a great deal of analytical effort in this direction, and I would like to share a few of the key findings today.

He then reviews how exchange rate creates its own pressures for financial stability:

In EMEs, the exchange rate also affects domestic economic activity through financial conditions, further complicating the central bank’s task. EMEs’ exposure to financial channels of the exchange rate arises from two key features of their financial structure: (i) EME borrowers, especially corporates, rely heavily on foreign currency borrowing; and (ii) foreign investors’ large holdings of EME local currency sovereign debt. Through both channels, exchange rate appreciation tends to loosen domestic financial conditions, exerting an expansionary effect on domestic economic activity.

Since monetary policy works through financial markets, central banks understandably care about exchange rates in the context of their domestic demand conditions. More broadly, looser financial conditions lead to the build-up of financial vulnerabilities that may pose risks to price stability over longer horizons.

He suggests a multiple indicator approach to look at several things impacting macro conditions:

EME central banks have risen to this challenge through their innovative use of additional policy instruments. They have turned to FX intervention to deal directly with the financial channel or insure against undesired exchange rate swings, and to other non-orthodox balance sheet policies as well as macroprudential tools to deal with specific imbalances or vulnerabilities in a targeted way.

EME central banks’ policy reaction function in the pursuit of price stability can therefore be described as a multi-instrument reaction function responding to multiple-indicator variables, including the exchange rate. Interest rates, FX intervention and targeted measures can be seen as forming the corners of a policy triangle, which authorities rely on in the pursuit of price stability. The calibration of the multi-dimensional instrument strategy will depend on country-specific characteristics and the underlying factors driving exchange rate and macro-financial dynamics.

Going forward, EME central banks will need to further develop their toolbox for dealing with the challenges of exchange rate and capital flow gyrations. In particular, in a time of large and internationally mobile stocks of financial capital and low interest rates, search for yield and risk-taking acquire greater prominence in global capital flows and can expose EMEs to disruptive stock adjustments by global investors. In order to deal with this challenge, EME central banks may need to consider whether to further develop non-orthodox balance sheet policies to deal with stock adjustments, such as asset purchases or asset swaps similar in nature to the measures launched by major AE central banks to bring down long-term interest rates once short rates hit the lower bound.

Carstens says the EME central banks are doing this but most would say we are just targeting inflation.

Infact, all this reads like much RBI’s multiple indicator framework used to do a while ago which was heavily criticised for looking at too many indicators. This led to RBI also adopting inflation targeting in 2015.

This article by Andres Velasco reviews Cartsens’s speech and says clean floating is out and dirty floating is in. He says BIS is giving up its orthodoxy and making its theory closer to reality.

Well, well, well. RBI perhaps gave up reality and went to inflation targeting orthodoxy! Though, RBI continues to intervene in forex markets and pile up reserves but has done away with sterilisation etc instruments which are being suggested by Carstens.

How ideas keep coming back! More so the discredited ideas. BIS should acknowledge RBI as one of the pioneers of the approach..

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