Mon | Dec 18, 2017

Briefing | Inflation vs exchange rate targeting

Published:Wednesday | November 1, 2017 | 12:00 AMDr Andre Haughton
The Bank of Jamaica building at Nethersole Place, downtown Kingston and location of the local office of the International Monetary Fund.
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What is inflation targeting?

 

Inflation targeting is the process through which a central bank establishes a targeted rate of inflation for a particular period of time and employs its monetary policy instruments to achieve this target through expectations. For example, the Bank of Jamaica (BOJ) has a targeted inflation rate between four per cent and six per cent for Jamaica, and uses interest rate mechanism, moral suasion along with other mechanisms and software to achieve these objectives in the real economy. For example, the BOJ's move from a 30-day interest rate to an overnight interest rate as the policy tool is designed to contribute to achieving this inflation target.

 

What is exchange rate targeting?

 

Exchange rate targeting is the process through which a central bank intervenes in the market mechanism to maintain the exchange rate at a particular level that they deem as desirable. For example, some countries have fixed exchange rate regimes where the central bank use their net international reserves to alter the supply of currency to keep it fixed or maintain it at a particular rate with another currency. For example, Barbados currency is fixed $2 to $1 with the US while Trinidad and Tobago manages their floating exchange rate at an average of $6.50 to $1 with the US. Maintaining a fixed exchange rate mechanism can be very costly in reserves and requires excessive monetary controls. Jamaica mainly practises a floating exchange rate regime with minor interventions.

 

What is the relevant discussion?

 

I recently invited the International Monetary Fund (IMF) representative to Jamaica to discuss inflation versus exchange rate targeting with my macroeconomics class at the University of West Indies, Mona. To initiate the conversation, students were asked two questions:

n What is the JMD to USD nominal exchange rate? Which most of the students readily knew and answered a resounding $128 to $1.

n What was last month's inflation rate? Many hesitated, one person answered after doing a quick Google search to answer 0.7 per cent.

This icebreaker gave us an idea of which of the two was more important to the students. If the BOJ is to attempt to achieve its targeted inflation rate based on expectations, the general public, including university students, must be aware of what to expect.

 

Which is more important?

 

To explore the discussion a bit further, students were explicitly asked, which is more important to them, the inflation rate or the exchange rate? Some students highlighted that the exchange rate was more important because they shop online and purchase mainly foreign goods, while others emphasised that the inflation rate was more important because average wages in Jamaica are fixed, especially in the short run, as a result, a higher inflation rate depletes a person's real wage and reduces their consumption and therefore their standard of living. These two contrasting yet similar answers allowed us to set the pace for a very fruitful discussion. There were no wrong or right answers, just questions to feed the discussion. The IMF representatives replied that the inflation rate was also more important to them, to the rest of the world, to the Bank of Jamaica, and should be so for the rest of the country. But it appears that due to fundamental differences in Jamaican citizens' perception, there appears to be a fixation with the nominal exchange rate.

 

Why does the IMF prefer inflation targeting?

 

The IMF believes that as long as the inflation rate for a given period is targeted, then the value of the nominal exchange should not matter, because the exchange rate is just one price, i.e., the price of one currency in terms of another, while the inflation rate is the charge price of many goods that the citizens consume grouped together in a basket. Over the last three years, the Jamaica dollar has depreciated more than 25 per cent, but they believe this nominal depreciation should not matter if the country achieves the targeted inflation rate.

 

What are the expectations in reality?

 

The discussion has been on-going and many are just getting the concept of this inflation targeting, especially because the BOJ must achieve its objectives through the monetary transmission mechanism where policy rate passes through to general public via the commercial bank's retail rates to consumers. This process in Jamaica has been very weak and slow. In Jamaica, output volatility, especially in the agricultural sector, high cost of imported inputs, low total factor productivity and other fundamental handicaps might have also had an impact on the inflation rate.