Chapter

Chapter 6 Intervention under Inflation Targeting

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
January 2019
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Author(s)
Marcos Chamon, David Hofman, Nicolas E. Magud, Umang Rawat and Alejandro Werner 

This chapter takes a close look at the experience with intervention under inflation- targeting frameworks in Latin America. In particular, it discusses the challenges of combining foreign exchange intervention with the commitment to inflation targets, and how central banks in the region have dealt with that challenge. Further, the chapter compares the transparency and predictability in foreign exchange intervention with that of the standard monetary policy instrument (for example, the policy rate) for inflation targeting. Finally, the chapter investigates the extent to which buy and sell interventions have been symmetric, the costs of intervention, and its pros and cons in the presence of high financial dollarization. A key takeaway is that clear communication and transparency policies may have been instrumental in conveying the subordination of the intervention policy to the inflation objective, thus keeping inflation expectations anchored and building the credibility of central banks.

Introduction

The analysis in the book thus far has mostly skirted the relationship of foreign exchange interventions with the broader monetary policy framework, the topic of this chapter. The experience of several Latin American countries with decidedly hybrid policy frameworks—in which inflation targeting and (sometimes very frequent) foreign exchange interventions have now coexisted for a considerable period—is of broader interest and provides a rich source for study.

The chapter highlights specific tensions and trade-offs that inflation-targeting central banks face when they intervene, and it discusses how Latin American central banks have dealt with them. It concludes that monetary authorities appear to have successfully handled these tensions, helped by communication policies that managed public inflation expectations.

Challenges of Combining Intervention with Monetary Policy

An inflation-targeting central bank should, by construction, focus monetary policy on its inflation target and allow the exchange rate to float freely. In theory, its response to exchange rate movements should not go beyond the pass-through to inflation and inflation expectations (that is, second-round effects). But as documented in other chapters, Latin American inflation-targeting central banks have continued to care about, and indeed sought to influence, in some cases, developments in the exchange rate for reasons beyond its impact on inflation.

Figure 6.1 shows that the volumes of intervention have not been trivial in the region. As discussed in Chapter 2, the motivations for this are manifold. In particular, currency mismatches on borrowers’ balance sheets—a key issue in several countries in the region—can lead to financial stability concerns, which are often within the central bank’s mandate. Sharp movements in the exchange rate may also have nonlinear effects on inflation expectations, particularly if there are credibility concerns. That is, even if the pass-through is perceived to be relatively small, sharp movements may have confidence effects and lead to more agents changing their prices based on the exchange rate.

Figure 6.1.Intervention Volumes in Selected Latin American Countries, by Instrument, 2006–16

(Percent of annual GDP)

Sources: Central banks data; and IMF staff calculations.

In practice, Latin American central banks have used foreign exchange intervention as the main instrument to achieve exchange rate objectives and address such concerns. Having this additional tool has given these central banks more options, and it may have improved overall policy outcomes. In particular, foreign exchange intervention has arguably helped mitigate the impact of shocks to the exchange rate, while allowing central banks to maintain the primacy of their inflation objective (along the lines argued in Ostry, Ghosh, and Chamon 2012). As such, the use of foreign exchange intervention may have created the space for central banks to focus interest rate policy squarely on inflation.

The use of foreign exchange intervention, however, involves considerable trade-offs. For one, its use could send mixed signals to the general public about the central bank’s objectives and thereby undermine the credibility of its commitment to the inflation target. Generally, it appears that Latin American central banks have managed this potentially important tension well. Inflation expectations have mostly remained anchored at the target in Latin American countries, including for frequent interveners (such as Peru) or for those that experienced a temporary increase in size and frequency of intervention (such as Mexico in recent years) (Figure 6.2).1,2

Figure 6.2.Annual Deviation of Inflation Expectations from Target, 2010–17

(Percentage points)

Sources: Central banks data; and IMF staff calculations.

This has been, in part, supported by clear foreign exchange intervention communication strategies. Central banks in the region have published official communiques whenever they have put in place programs for purchasing international reserves or when they adjusted intervention rules. This information was readily available to the public, including on central bank web sites. At the same time, when intervention was implemented, central bank authorities would spread the message by educating markets and the public as needed. In addition, even if intervention was discretionary, information and data disclosure policies have been very transparent (see Chapter 3). These communication efforts also contributed to an understanding that even when intervention was deemed necessary, central banks did not deviate from their commitment to price stability. This may have helped maintain the credibility of the central banks’ inflation targets.

A possible trade-off also pertains to the interaction between exchange rate and inflation developments. A simple assignment of tools (policy rate for inflation; foreign exchange intervention for smoothing excess exchange rate volatility) may provide a framework to communicate policy and to analyze the trade-offs involved. But foreign exchange interventions will still have spillovers to monetary policy. Even if intervention is fully sterilized, any effects on the exchange rate will have implications for prices and domestic demand. When a central bank decides to intervene, the extent of the intervention and its traction therefore matters for the fine-tuning of monetary policy. For example, if foreign exchange sales significantly slow the pace of depreciation, they may shorten the monetary policy tightening cycle required to reduce inflationary pressures, and vice versa. And given the uncertainties about the effectiveness of intervention, fine tuning this policy mix can be a considerable challenge. In principle, the impact of intervention on the exchange rate should be front-loaded (in the sense that intervention should affect the exchange rate on impact, and if anything, the effect will only become weaker over time). This attenuates the coordination problem, as the exchange rate would have adjusted by the time the policy rate needs to be fine-tuned again. In other words, intervention likely has a short transmission lag, which would facilitate coordination with other policies.3 Conversely, however, the effect of intervention may be temporary (as some of the evidence presented in Chapter 4 suggests). Uncertainty over its persistence can complicate the decision of how to take foreign exchange interventions into account when setting the policy rate. Matters become even more complicated if the exchange rate response incorporates the market’s expectation of future interventions by the central bank, as temporary effects fade.

Given the close interaction between exchange rate and inflation, some central banks elsewhere in the world have used exchange rates, at least partially, as an operating target to help achieve the inflation objective.4 For instance, the Monetary Authority of Singapore uses the nominal exchange rate as the instrument of monetary policy. The exchange rate is sometimes also used as a temporary instrument when other transmission channels are impaired. For example, in 2013, the Czech National Bank used the exchange rate as an additional monetary policy instrument to fight deflationary pressures while at the zero lower bound. This latter case illustrates the use of the exchange rate as an instrument of monetary policy even in an inflation-targeting context. The Latin American central banks in this book, however, generally rely on the policy rate as their policy instrument and have not declared the exchange rate a formal operating target under their inflation-targeting strategies.

The literature and country experience provide limited guidance for deciding how to best integrate foreign exchange intervention into monetary policy decisions. But central banks arguably already face similar challenges in the absence of intervention. For example, whenever there is a shock to the exchange rate, central banks must choose whether they view it as persistent or transitory when deciding whether to adjust policy. While mistakes can be made on that assessment, opportunities often exist to adjust mid-course (for example, lengthening or shortening a monetary policy cycle as the shock proves more or less persistent). Central banks do not publish any hard numbers on the perceived effectiveness and persistence of their foreign exchange intervention. While they may have internal models to inform decisions, if the academic literature is any indication, that guidance is likely incomplete. This suggests there is a good amount of trial and error when implementing intervention policy.

Has the Response to Appreciation and Depreciation Pressures Been Symmetric?

Central banks facing excessive appreciation have typically responded by increasing international reserves accumulation—often trying to mitigate the negative impact of stronger currencies on competitiveness, owing to Dutch disease. A simple (perhaps simplistic) view is that the intervention response to appreciation and depreciation pressures should be symmetric, particularly for small shocks. But matters become more complicated in the face of large shocks. Countries can run out of reserves when they respond to depreciation pressures, while there is no upper bound on their reserve accumulation when responding to appreciation pressures. The cost of policy errors may also be asymmetric as overaccumulation of reserves may be easier to correct or accommodate than overdeployment. For example, if a central bank feels it has accumulated too many reserves, it can simply stop accumulating reserves until the stock of reserves comes in line with its precautionary needs, or it can gradually unwind some of these reserves (see Chapter 11 on Mexico). But an excessive loss of reserves can prove costlier, especially if the central bank is perceived ex post as having tried to maintain an unsustainable level of the exchange rate. These issues are particularly pertinent if the stock of reserves is relatively low, leaving the economy more vulnerable to external shocks.

In line with this intuition, countries have proved far more willing to accumulate reserves than to deploy them. Some examples include Brazil and Mexico. Brazil did engage in a large-scale intervention program through swaps. At the peak of that program, the stock of swaps (which settled in local currency) corresponded to about one-third of the stock of reserves. Mexico deployed about 10 percent of its reserves in 2015–16. The relative extent of foreign exchange sales was much smaller in other countries in the region. The observed asymmetry of interventions suggests that, in practice, intervention policies affect not only short-term volatility but can also affect the longer-term trend of exchange rates. This, in turn, has implications for monetary policy.

Costs of Intervention

The discussion so far abstracts from the pecuniary cost of intervention. As mentioned in Chapter 2, there is no consensus in the profession as to the exact nature of these costs. But several observers have focused on the differential between domestic and foreign interest rates as the cost of intervention. That metric has some drawbacks, however. For instance, it does not take into account the extent to which reserves reduce risk premia. Nonetheless, the interest differential can provide a useful first approximation of the cost. Normally the cost of holding reserves should not deter central banks from accumulating reserves until precautionary needs are met. Past that point, however, significant costs would warrant a close look at the marginal benefits of any further accumulation. Each percentage point of interest differential implies that the carry cost of 10 percent of GDP worth of reserves is 0.1 percent of GDP. That is no small figure. And in practice, countries have much higher stocks of reserves and face much wider interest rate differentials. Costs can be amplified if reserve accumulation is a one-way street (that is, countries accumulate permanent reserves even in response to transitory shocks).

Transparency and Communication

The predictability of inflation-targeting central banks, when it comes to monetary policy, contrasts with the predictability of foreign exchange intervention. Inflation targeting implies having clear, transparent rules for the implementation of a central bank’s monetary policy to anchor inflation expectations at the target. When it comes to foreign exchange intervention, we observed in other chapters that the region has an inclination for rules over discretion. Yet, we also document that rules are often updated, and that central banks switch from rules to discretion over time, and vice versa.

It is conceptually useful to compare the transparency embedded in anchoring inflation expectations under inflation targeting to that of foreign exchange intervention. One of the virtues of inflation-forecast targeting is that, based on the most recent and broad-based data available, interest rates are set to achieve the inflation forecast on the central bank’s policy horizon. If no further shocks were to occur, the interest rate path would ensure that inflation would match the current inflation forecast. That is how anchoring of inflation expectations is achieved. Of course, unexpected shocks do happen. And central banks need to reflect these shocks in their future policy decisions to keep inflation expectations anchored in the inflation forecast at any future point in time. Transparency and effective communication are key in this process, including conveying to the market the relevant data used by the central bank to compute its inflation forecast. Latin American central banks provide this information, for the most part. This communication and transparency includes, among other things, monetary policy reports, data available on central banks’ web sites, expectation surveys, board member speeches, and so on. Monetary policy rates are adjusted in a fairly gradual manner. And markets have developed a sense of under which circumstances (and by how much) monetary policy could be adjusted following different shocks.

There is nothing remotely close to that framework when it comes to the communication of intervention policy. Even when intervention is rules-based, there tends to be frequent changes to the rules in response to exchange rate market developments. For example, Mexico increased the volume or lowered the trigger for its intervention rules in 2015, as depreciation pressures proved more persistent than originally anticipated. This contrasts with having an overarching contingent rule or framework in place that could accommodate a wide range of shocks and both appreciation and depreciation pressures as they materialize.

There are important differences between the inflationary process and the exchange rate. One major difference is that stabilizing inflation is the objective of monetary policy. As a result, we should not expect intervention, even when rules are clearly spelled out, to necessarily have the same stabilizing effect on the exchange rate as, say, a Taylor rule would have on inflation. Indeed, foreign exchange intervention, whether based on rules or discretion, appears not to anchor expectations for exchange rate volatility in the way that inflation expectations are anchored with inflation forecasts. In fact, it is not uncommon to observe spikes of market volatility or disorderly conditions even when there are rules dictating when and how much the central bank would intervene. It is worth stressing that this discussion does not factor in the operational secrecy discussed in Chapter 3—as opposed to the transparent operational mechanisms of monetary policy implementation.

Intervention by Latin American central banks is already among the most transparent. Further improvements in communication could help financial markets better internalize the reaction function of the central bank to sharp and unstable movements in exchange rates. The more this internalization occurs, the less likely that actual intervention will be necessary. This then matters in mitigating excessive intervention—closing a virtuous cycle of anchoring exchange rate volatility expectations. That is, disorderly market conditions may be prevented by the expectation of intervention through clearly communicated rules should those conditions arise, thereby reducing the need for actual intervention. If so, and to the extent that such anchoring does not prevent needed adjustments in the level of the exchange rate, in response to structural shocks, this could also help keep inflation stable. Thus, it contributes to achieving central banks’ inflation targets.

Interventions and Currency Mismatches

As discussed in Chapter 2, the presence of significant currency mismatches or dollarization can raise financial stability risks associated with exchange rate volatility. They are therefore often cited as a motivating factor for foreign exchange interventions. Banks in highly dollarized countries often lend in foreign currency to borrowers with little or no foreign exchange earnings. This does not eliminate the currency risk, which is just transferred to the borrower. In fact, it transforms it into a higher credit risk, since the borrower would struggle to repay in the event of a significant exchange rate depreciation. In such circumstances, depreciation can increase the amount of nonperforming loans and potentially induce a financial crisis. In addition, banks’ dependence on foreign currency liabilities (as core funding decreases) can put pressure on international reserves when central bank liquidity support is needed. If currency mismatches are widespread, therefore, interventions to smooth exchange rate adjustments can help ease the pressures related to short-term fluctuations by providing borrowers with a window on which to hedge their balance sheet risks and reduce currency mis-matches. Arguably, by reducing sharp, short-term movements in the exchange rate, interventions may also help prevent panics and self-fulfilling runs on foreign currency.

At the same time, however, intervention can provide adverse incentives for economic agents and facilitate, or even encourage, currency mismatches. As mentioned in Chapter 2, large foreign exchange reserves may encourage risky liability structures; for example, as borrowers taking on short-term external debt count on the central bank to provide foreign exchange liquidity if they were to face tighter global financial conditions (Kim 2008). The volatility of inflation relative to that of change in the real exchange rate is an important determining factor for the degree of financial dollarization. Residents hold a larger share of their portfolio in foreign currency assets as inflation becomes relatively more volatile and as the real exchange rate becomes more stable (Ize and Levy-Yeyati 2003). Thus an exchange rate that can move freely in both directions makes foreign exchange risk more apparent and introduces a disincentive to financial dollarization. According to Rennhack and Nozaki (2006), allowing greater exchange rate flexibility and refraining from seeking an undervalued currency discourages financial dollarization. Similarly, Hardy and Pazarbasioglu (2006) show that greater two-way exchange rate flexibility may deter foreign currency deposits, as they increase the risk of holding foreign currency assets.

Among the countries examined in this book, dollarization continues to be an issue mainly for Costa Rica, Peru, and Uruguay (Box 6.1). In part because of this structural vulnerability, Peru intervenes more frequently than many of its peers. While these interventions have helped smooth exchange rate volatility in Peru, by limiting upside exchange rate risks, and may thus have helped stave off financial stability risks, it is also possible that they have incentivized continued dollarization or contributed to a slower de-dollarization.

Conclusion

The experience of Latin American central banks with foreign exchange intervention under inflation-targeting frameworks has been instructive. While there can be inherent tensions between the effective pursuit of exchange rate objectives alongside an inflation target, Latin American central banks, on balance, appear to have managed these tensions with considerable success. Clear communication policies appear to have played a key role. Indeed, these may have been instrumental in maintaining the primacy of the inflation objective and facilitating a relatively firm anchoring of inflation expectations as the inflation-targeting frameworks gained credibility. Moreover, a transparent and well-communicated foreign exchange policy appears to have helped the market internalize the central bank’s reaction function. It also contributed to understanding that these interventions were subordinated to the interest rate policy aimed at anchoring inflation expectations. The Latin American experience thus suggests that this internalization can enhance the effectiveness of intervention and inflation stabilization more generally, while helping improve the credibility and effectiveness of the central bank.

Box 6.1.Dollarization in Latin America

Latin America has countries with persistently high dollarization as well as countries that have avoided financial dollarization altogether.

During 1990–01, dollarization rose markedly in several countries, including Bolivia, Costa Rica, the Dominican Republic, Honduras, Nicaragua, Paraguay, Peru, and Uruguay (Rennhack and Nozaki 2006). Thereafter, some of these countries—in particular, Bolivia, Paraguay, and Peru more recently—have managed to achieve a significant reduction in dollarization.

Most of the countries that are part of our study in this book, such as Brazil, Chile, Colombia, and Mexico, have avoided significant dollarization (Figures 6.1.1 and 6.1.2), despite experiencing severe macroeconomic problems in the 1980s. The availability of indexed financial instruments helped prevent dollarization in the case of Brazil and Chile (despite the former experiencing a hyperinflation). In other countries, however, such as Peru, the public responded by switching away from the domestic currency toward dollars. Today, dollarization remains high in Peru despite more than two decades of prudent macroeconomic management, albeit with a declining trend.

Figure 6.1.1.Deposit Dollarization, 2001–17

(Ratio of foreign currency deposits to total bank deposits, percent)

Source: IMF staff calculations.

Note: Data are from December of each year.

Figure 6.1.2.Loan Dollarization, 2001–17

(Ratio of foreign currency deposits to total loans, percent)

Source: IMF staff calculations.

Note: Data are from December of each year.

While dollarization continues to be an issue in selected economies only, even countries that never experienced domestic dollarization still experienced significant currency mismatches on the liability side as governments, banks, and firms accessed international financial markets in the 1990s, thus accumulating foreign debt. These mismatches contributed to currency crises in Mexico in 1995 and in Brazil in 1999.

References

    HardyDanielC. andCeylaPazarbasioglu. 2006. “De-Dollarizing the Hard Way.” In Financial Dollarization—The Policy Agenda edited by AdrianArmasAlainIze andEduardoLevy-Yeyati. London: Palgrave Macmillan.

    IzeAlain andEduardoLevy-Yeyati. 2003. “Financial Dollarization.” Journal of International Economics59 (2): 32347.

    KimJunI. 2008. “Sudden Stops and Optimal Self-Insurance.” IMF Working Paper 08/144International Monetary FundWashington, DC.

    OstryJonathanD.Atish R.Ghosh andMarcosChamon. 2012. “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies.” IMF Staff Discussion Note 12/01International Monetary FundWashington, DC.

    RennhackRobert andMasahiroNozaki. 2006. “Financial Dollarization in Latin America.” IMF Working Paper 06/07International Monetary FundWashington, DC.

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The views expressed in this chapter are those of the authors and should not be attributed to the IMF.

Inflation expectations became unanchored in Brazil but for reasons that were unrelated to foreign exchange intervention.

In Uruguay, however, inflation is more volatile and not as strongly anchored as in other countries. In part, this could be because Uruguay is the only country that stopped using inflation targeting when it moved back to monetary aggregate management in July 2013.

What makes monetary policy challenging is the long transmission lag for the policy rate to affect domestic demand and prices. If intervention had a similarly long transmission lag, combining the two policies would be even more challenging.

Disinflation in several Latin American countries was carried out through “crawling peg” schemes. Once inflation stabilized at acceptable levels and inflation expectations were anchored, these countries moved to flexible exchange rates and eventually to a full-fedged inflation target, using the interest rate as the policy instrument.

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