The style of swimming: how to reduce inflation and not to forget the exchange rate

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What are the consequences of the crisis of 2015, Russian banks: the five main risks 23 Mar 2015, 16:53

The experience of Central banks in developing countries shows that the Bank of Russia could smooth out fluctuations in the exchange rate while maintaining inflation targeting regime

Flexible exchange rate regimes began to be actively used in developing countries only in the 1990-ies, following the liberalization of trade and financial relations. The expansion of transnational capital flows has put the Central banks to choose between an independent monetary policy and the maintenance of a fixed exchange rate was the prerequisite of increasing the flexibility of exchange rate. The maintenance of fixed exchange rates Central banks was complicated by the deteriorating terms of trade for most developing countries in 1980-1990-ies.

A return to intervention

The final stage of increasing exchange rate flexibility has been the introduction in most developed and developing countries with floating exchange rate regimes. Currently only three developing countries, the Central banks adhere to a freely floating exchange rate, without involvement of monetary authorities in the process of exchange rate. It is the Central banks of Chile, Mexico and Poland. In most cases, Central banks in developing countries follow floating exchange rate, but maintain its presence on the domestic foreign exchange market, not with the aim of maintaining exchange rate at a certain level.

In the periods of crises and high volatility in the exchange rate of the decision on the resumption of intervention has repeatedly taken even in countries adhering to free-floating exchange rates. This is true not only for the currency crises of the 1990-ies, but also the global crisis of 2008-2009 and post-crisis period 2010-2016 years. In the latter case, the purpose of foreign exchange intervention consisted in limiting excessive volatility and/or risks to maintain monetary and financial stability, and the need to replenish foreign exchange reserves.

The renewal of the Central banks of the single intervention is not contrary to the principles of free-floating exchange rate in determining the IMF. The methodology of the Fund admits not more than three cases of intervention, the duration of each of which does not exceed three days. While FX interventions should not generate risks to achieving target inflation benchmark. However, after more than two decades of application of floating exchange rates in developing countries have changed significantly the conditions and objectives of Central banks resume currency interventions. In the late 1990-ies it was about the so-called fear of swimming, and in 2000-ies while increasing commodity prices and increasing foreign capital inflows — about “fear”. If in the first case we are talking about the risks associated with increased exchange rate volatility and debt load denominated in foreign currency liabilities, and the second is the maintenance of competitiveness of made production in the conditions of massive inflow of foreign currency in the pre-crisis period and the replenishment of foreign exchange reserves in the post-crisis period.

Combining the objectives

For inflation-targeting Central banks it is important that even with interventions the primary objective of monetary policy remained the maintenance of price stability, while the volume of foreign exchange interventions would have a minimal impact on the level and dynamics of the exchange rate. However, only for Central banks, sticking to a freely floating exchange rate, a resumption of currency intervention is seen as extraordinary measures taken if there is a risk of significant deviations of actual inflation from the target trend. As international experience shows, for switched to floating exchange rates in developing countries are characterized not only higher compared to fixing the exchange rate countries exchange rate volatility, but the volatility of interest rates.

In most cases, the failure of monetary authorities from participation in the process of the exchange rate was accompanied by a surge in exchange rate volatility, and the most significant it was in the countries that adopted the decision to opt out of targeting the exchange rate in the crisis period. It is significant that in the process of adaptation of the economy to a floating rate regime exchange rate volatility in all the developing countries are gradually diminishing, although it remains higher than in developed countries.

Thus, international experience shows that the Bank of Russia in the framework of inflation targeting may affect the functioning of the foreign exchange market to smooth out exchange rate volatility without significant impact on the level of the exchange rate caused by economic fundamentals.

The authors ‘ point of view, articles which are published in the section “Opinions” may not coincide with ideas of editorial.

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