The old orthodoxy of inflation targeting with flexible exchange rates is coming under increasing challenge. Many emerging and developing economies have long exhibited a ‘fear of floating’ (Calvo and Reinhart 2002), but recently, major policy institutions have also tempered their traditional recommendations against such regimes. The BIS and the IMF have both suggested that more active exchange-rate management may be necessary in some emerging markets subject to volatile financial flows (Carstens 2019, IMF 2019). While nuanced policy advice is welcome, we think that the debate currently neglects a key feature of these financial cycles: many emerging and developing economies are commodity exporters, where cycles are driven by booms and busts in global commodity markets.
Commodity prices and financial cycles
To illustrate why the monetary policy response to commodity price movements has become the key question for many emerging markets, we make three observations. First, the contribution of commodity price shocks to macroeconomic volatility has been growing in many countries, as shown in Figure 1 for the example of Argentina. Second, there is a strong relation between the commodity-price cycle and borrowing conditions in commodity-exporting economies: when commodity prices increase, borrowing terms in commodity exporting economies improve (e.g. Bastourre et al. 2012, Shousha 2016, Fernandez, Gonzalez and Rodriguez 2018). Third, there has been an increase in the correlation across prices of different commodities and between commodity prices and other asset prices over the past two decades. This has coincided with a sharp increase in the number of positions in financial contracts in which commodities feature as the underlying asset, and has triggered a debate around the financialisation of commodity markets.
Figure 1 Contribution of commodity price shocks to macroeconomic fluctuations in Argentina (%)
Note: Forecast error variance contribution of commodity price shocks in a structural model estimated with Bayesian methods using annual data from Argentina. The model is a two-sector small open economy. The light blue bars show the results for the full sample 1900-2015. The dark blue bars are based on re-estimating the model on post-1950 data. For details on the methodology, see Drechsel and Tenreyro (2018).
A model with commodity exports and a financial channel
In a recent paper (Drechsel et al. 2019), we ask how monetary policy should respond to commodity price fluctuations in a small open economy where financial conditions also play an important role. We model a net exporter of commodities that takes prices on world markets as given and uses domestic goods as an intermediate input, building on the framework of Ferrero and Seneca (2019). Gyrations in global commodity markets therefore affect resource allocation between sectors in our economy. We link domestic financial conditions to the commodity cycle by introducing a borrowing constraint for commodity producers that loosens when commodity prices rise. This financial channel amplifies the reallocation induced by commodity price movements and increases their importance for monetary policy.
Monetary and exchange rate policy
In our model, the best policy in response to an increase in commodity prices is to raise interest rates and let the exchange rate appreciate, with the magnitudes increasing in the strength of the financial channel. This is shown in Figure 2, with the welfare-maximising optimal responses in the black lines. A rise in commodity prices causes the commodity sector to expand, increasing its demand for domestic resources as inputs in production. This leads to an increase in the demand for domestically produced inputs relative to foreign goods, putting upward pressure on domestic inflation. The expansion is amplified by the relaxation of borrowing terms owing to higher commodity prices. It leads to an inefficiently large increase in commodity production, as households do not benefit from an equivalent increase in consumption. The process bears some similarities to classic ‘Dutch disease’-type reallocations (Corden and Neary 1982).
In response, higher interest rates and a stronger exchange rate reduce household demand for domestic consumption, limiting undesirable increases in domestic output and inflation. The exchange rate appreciation brings additional benefits because it mitigates the inefficient reallocation towards the commodity sector. Domestic firms do not internalise this latter effect of the appreciation, so do not increase their prices in line with social benefits of doing so, instead increasing production by too much. Sticky prices exacerbate this effect. Importantly, there is no divine coincidence. Output rises above the efficient level, creating a stabilisation trade off: returning inflation to target is not enough to close the output gap.
Figure 2 Impulse response functions to commodity price shock under different policy rules
Note: Responses to a 10% positive commodity price shock under alternative policy rules in the model assuming perfect international risk sharing in Drechsel et al. (2019). The results are generated under the calibration shown in Table 1 of the paper. The black lines show the responses when policy is set optimally under commitment to minimise welfare losses and the other lines show the responses under alternative policy rules: a CPI inflation targeting rule, a domestic inflation targeting rule, and a nominal exchange rate peg. Inflation and interest rates are shown in annualised percent. The nominal and real exchange rates are plotted so that an increase corresponds to an appreciation.
The results suggest that policies that attempt to limit exchange-rate volatility via a peg are likely to perform poorly, especially in the presence of a large financial channel. In contrast, targeting either consumer price inflation or domestic inflation leads to outcomes more similar to the optimal policy. When commodity prices increase, the resulting increase in demand for domestically produced inputs creates pressure for the exchange rate to appreciate. If monetary policy resists this by committing to an exchange-rate peg, then input prices cannot adjust, leading to a larger inefficient boom in commodity production. This excessive volatility in commodity production is amplified by the effect of commodity prices on borrowing conditions, making a fixed exchange rate even more costly. Arguments made in favour of less-flexible exchange rates tend to focus on a different type of financial friction, arising from currency mismatches on corporate and bank balance sheets. We abstract from such mismatches in our model, but our results highlight that any balance sheet considerations must be weighed against the significant output and inflation volatility that can arise from smoothing exchange rates in the face of commodity price shocks.
Given our current theoretical understanding, fixed exchange rate regimes remain remarkably prevalent in emerging and developing commodity-exporting economies. That is partly because our models are silent on some of the key practical issues facing monetary policymakers in emerging and developing economy commodity exporters. We typically examine the appropriate policy response to commodity price shocks starting from benign conditions of low inflation, passive fiscal policy and no in-built inflation inertia. But for emerging and developing economies with a history of high inflation, those favourable conditions are less likely to hold. The practical experience of such economies may require a more nuanced approach. In our paper, we provide examples of disinflation programmes for a selection of Latin American commodity exporters in the 1980s and 1990s, which suggest that sustainable fiscal policies are a necessary condition for success, but not sufficient. To attain credibility and reduce inertial inflation, authorities need to implement a coherent and consistent set of policies, but also to build consensus via a clear communication process that persuades people of the benefits of working together to achieve low inflation. We think research still has more to discover to inform the advice we offer policymakers in these circumstances.
Bastourre, D, J Carrera, J Ibarlucia and M Sardi (2012), “Common drivers in emerging market spreads and commodity prices”, Central Bank of Argentina Working Paper.
Calvo, G A and C M Reinhart (2002), “Fear of floating”, The Quarterly Journal of Economics 117(2): 379–408.
Carstens, A (2019), “Exchange rates and monetary policy frameworks in emerging market economies”, speech at the London School of Economics, 2 May.
Corden, W M and J P Neary (1982), “Booming sector and de-industrialisation in a small open economy”, The Economic Journal 92(368): 825–848
Drechsel, T, M McLeay and S Tenreyro (2019), “Monetary policy for commodity booms and busts”, paper prepared for the 2019 Jackson Hole Economic Policy Symposium, organised by the Federal Reserve Bank of Kansas City.
Drechsel, T and S Tenreyro (2018), “Commodity booms and busts in emerging economies”, Journal of International Economics 112: 200–218.
Fernandez, A, A Gonzalez, and D Rodriguez (2018), “Sharing a ride on the commodities roller coaster: Common factors in business cycles of emerging economies”, Journal of International Economics 111: 99 – 121.
Ferrero, A and M Seneca (2019), “Notes on the underground: Monetary policy in resource-rich economies”, Journal of Money, Credit and Banking 51: 953-976.
IMF (2019), External Sector Report, July.
Shousha, S (2016), “Macroeconomic effects of commodity booms and busts: The role of financial frictions”, unpublished manuscript.