Intervention Under Inflation Targeting--When Could It Make Sense?

Abstract

We investigate the motives inflation-targeting central banks in emerging markets may have for intervening in foreign exchange markets and evaluate the case for such interventions based on the existing literature. Our findings suggest that the rationale for interventions depends on initial conditions and country-specific circumstances. The case is strongest in the presence of large currency mismatches or underdeveloped markets. While interventions can have benefits in the short-term, sustained over time they could entrench unfavorable initial conditions, though more work is needed to establish this empirically. A first effort to measure the cost of interventions to the credibility of policy frameworks suggests that the negative impact may be smaller than often assumed—at least for the set of more sophisticated inflation-targeting emerging-market central banks considered here.

Toward an Integrated Policy Framework

“…For instance, Adler et al (forthcoming) report that more prevalent use of FXI increases the propensity to overshoot inflation targets, thus suggesting weakened credibility. Hofman et al (2020), however, find no such evidence.…”

“…FXI is also used widely, including among inflation-targeting central banks in EMDEs with flexible exchange rates. Country authorities report that they use (sterilized) FXI for a multitude of objectives including (i) inflation control; (ii) building reserves; (iii) muting volatility in shallow FX markets; (iv) preserving financial stability in the presence of balance sheet mismatches; and (v) preventing overvaluation of the currency that may hurt competitiveness (Hofman et al, 2020;Poirson et al, forthcoming). Data suggests that interventions in EMDEs tend to be asymmetric, leaning more often against currency appreciation during inflow periods than against depreciation during outflows (Adler, Chang et al, 2020;Adler et al, forthcoming;Chamon et al, 2019;, possibly motivated by the objective to build reserves.…”

“…Several studies suggest that sustained FXI may encourage corporate leverage and foreign currency borrowing. Indirect cross-country evidence from studies that look at the relationship between exchange rate regimes and financial vulnerabilities have long suggested that exchange rate rigidity may contribute to dollarization and the buildup of FX mismatches (Hofman et al, 2020;Ghosh et al, 2015;Ye et al, 2014). Csonto and Gudmundsson (2020) confirm that countries that exhibit greater exchange rate flexibility experience lower vulnerability in the form of declining foreign currency debt.…”

The Illusions of Inflation Targeting, With an Application to Ukraine

“…Although foreign exchange interventions might amplify inflation volatility, the more credible a central bank is, the narrower the tradeoff between reduced output and increased inflation volatility (Adler, Lama, and Medina 2019, 1). Finally, research from the IMF concludes that there might be plenty of good reasons for an IT central bank to intervene on the forex market: manage risks from currency mismatches, contain an exchange rate shock, support a weak interest rate transmission channel, build up official reserves, and buffer foreign capital flows to contain the credit cycle (Hofman et al 2020). In spite of two potential costs, namely moral hazard due to the implicit public guarantee on private risky behavior and possibly confusing and deanchoring inflation expectations, the compatibility of IT with any exchange rate regime has been established de facto (ibid., 18).…”

Impacto de la intervención cambiaria y su duración

“…2 Véase, Mishkin y Savastano (2001), Calvo y Reinhart (2002), Kamil (2008), Vargas et al (2013), Pincheira (2013), Fuentes et al (2014) y Hofman (2020). Por ejemplo, los bancos centrales pueden comprometer sus metas de inflación cuando el "miedo a la flotación" los conduce a buscar el alcance de un nivel determinado de sus monedas (Calvo y Reinhart, 2002).…”