The global crisis has brought many issues into question, including the choice of a nation’s nominal anchor. In a simple Walrasian world, this choice is a triviality – any nominal variable is as good as any other. But as Ken Rogoff showed twenty-five years ago, in a world of shocks and less-than-perfect price adjustments, the question over whether a central bank should publicly commit in advance to target the money supply, the exchange rate, domestic inflation, or some other index becomes hugely important (Rogoff 1985).
Latin America and the Caribbean provide an ideal focus to explore this topic. In perhaps no other region have attitudes to nominal anchors for monetary policy changed so much. Inflation soared in the early 1980s, to hyperinflation in cases such as Argentina, Bolivia, Brazil, and Nicaragua. As a result, the need for a nominal anchor was plain to see. When stabilisation was finally achieved in the 1980s and early 1990s, the successful stabilisation programmes were virtually always built around the exchange rate as the nominal anchor, whether it was Chile’s tablita, Bolivia’s exchange-rate target, Argentina’s convertibility plan, or Brazil’s real plan. Yet still matters continued to evolve.
With exchange-rate targets somewhat out of favour by the end of the 1990s, there was a clear vacancy for the position of preferred nominal anchor. Inflation targeting was a fresh young face adopted by Brazil, Chile, Colombia, and Mexico. In many ways, inflation targeting has functioned well. One could argue, however, that events of the past few years, particularly the global crisis, have put strains on inflation targeting much as the events of 1994-2001 earlier put strains on the regime of exchange-rate targeting.
Beyond the CPI, three other kinds of nominal variables have subsequently forced their way into the attentions of central bankers. One nominal variable, the exchange rate, never really left – certainly not for the smaller countries. A second category of nominal variable, asset prices, has been the most relevant in the last few years in industrialised countries. The international financial upheaval that began in mid-2007 with the US subprime mortgage crisis has forced central bankers to re-think their intent focus on inflation and consider the inclusion of equity and real estate prices. But a third category, prices of agricultural and mineral products, is particularly relevant for countries in Latin America. The greatly heightened volatility of commodity prices in the past decade, culminating in the price spike of 2008, has resurrected arguments about the desirability of a currency regime that accommodates terms-of-trade shocks.
What is different about Latin America?
Developing countries tend to have less developed institutions and lower central bank credibility than industrialised countries. This makes central bank independence and a transparent and monitorable nominal target particularly important. Another distinct feature is that supply shocks tend to be large. One reason is the larger role of farming, fishing, and forestry in the economy. Droughts, floods, hurricanes, and other weather events – good as well as bad – tend to have a much larger effect on GDP. When a hurricane hits a Caribbean island, it can virtually wipe out the year’s banana crop and tourist season. A second reason for larger supply shocks is terms-of-trade volatility, which is particularly severe for commodity exporters. Some countries have a large share of their exports concentrated in a product – such as coffee, copper, or oil – that is so volatile that it periodically experiences swings in world market conditions that double or halve their prices.
The regimes currently followed by the Latin American and Caribbean countries are generally distributed across three categories: monetary targets, exchange-rate targets, and inflation targets. But what is desirable as a nominal target is a variable that is simpler for the public to understand ex ante than core CPI, and yet that is robust with respect to supply shocks. If the supply shocks are terms-of-trade shocks, then the CPI choice is particularly inappropriate. The alternative is an output-based price index.
Export price targeting
In a 2008 paper, I propose pegging the export price explicitly for those developing countries that happen to be heavily specialised in the production of oil or some other particular mineral or agricultural export commodity (Frankel 2008). The proposal is to fix the price of that commodity in terms of domestic currency. For example, Chile would peg its currency to copper – in effect adopting a metallic standard. Ecuador, Trinidad, and Venezuela meanwhile, would peg to oil. Jamaica would peg to bauxite. The Dominican Republic would peg to sugar. Central American coffee producers would peg to coffee. Argentina would peg to soybeans. And so forth.
How would this work operationally? Conceptually, one can imagine the government holding reserves of gold or copper or oil, and buying and selling the commodity whenever necessary to keep the price fixed in terms of local currency. Operationally, a more practical method would be for the central bank each day to announce an exchange rate vis-à-vis the dollar, following the rule that the day’s exchange-rate target (dollars per local currency unit) moves precisely in proportion to the day’s price of gold or copper or oil on the New York market (dollars per commodity). Then the central bank could intervene via the foreign exchange market to achieve the day’s target. Either way, the effect would be to stabilise the price of the commodity in terms of local currency.
Some have responded to this proposal by pointing out, correctly, that the side effect of stabilising the local-currency price of the export commodity in question is that it would destabilise the local-currency price of other export goods. If agricultural or mineral commodities constitute virtually all of exports, then this may not be an issue. But for a heavy majority of these countries, no single commodity constitutes more than half of exports. Moreover, even those that are heavily specialised in a single mineral or agricultural product may wish to encourage diversification further into new products in the future, so as to be less dependent on that single commodity.
One way to moderate the proposal is to interpret it as targeting a broad index of all export prices, rather than the price of only one export commodity, which I call the Peg the Export Price Index. A way to moderate the proposal still further is “product price targeting” that targets a broad index of all domestically produced goods whether they are exportable or not. The GDP deflator is one possible output-based price index, but has the disadvantage of only being available quarterly, and being subject to lags in collection, measurement errors, and subsequent revisions. Even in a small poor country with limited capacity to gather statistics, government workers can survey a sample of firms every month to construct a product price index.
Why target an output-based price index?
The argument for targeting any of the output-based price indexes relative to an exchange-rate target can be stated succinctly. It delivers one of the main advantages that a simple exchange-rate peg promises, namely a nominal anchor, while simultaneously delivering one of the main advantages that a floating regime promises, namely automatic adjustment in the face of fluctuations in world prices of the countries’ exports.
What about relative to the CPI target? The argument in favour of an output-based price index can also be outlined simply. It is more robust with respect to terms-of-trade shocks. If the terms-of-trade shock is a fall in the export price, these output-based indices allow the currency to depreciate, a desirable property unavailable with CPI-targeting. If, on the other hand, the terms-of-trade shock is a rise in the price of imported oil for example, CPI-targeting says to tighten monetary policy enough to raise the currency, an undesirable property that is not held by output-based targeting.
How good are the competing monetary targets in stabilising relative prices?
In a recent paper (Frankel 2010), I examine a set of countries in Latin America and the Caribbean and compare the paths of prices under the historical monetary regime with what would have happened under eight other possible regimes, i.e. dollar target, euro target, SDR target, CPI target, and my output-based price targets.
- First, the simulations suggest that the currency anchors offer far more price stability than the historical reality. This is because our counterfactual was that the countries had the benefits of the anchor from before the beginning of the sample.
- Second, export-price pegging perfectly stabilises the domestic price of export commodities, by construction.
Yet, the more striking findings are when comparing the CPI target with a product price target as alternative interpretations of inflation targeting.
- The results show that producer-price targeting generally delivers more stability in the prices of traded goods, especially the export commodity.
This is a natural consequence of the larger weight on commodity exports. Perhaps surprisingly, both the CPI target and the Product Price Index target deliver more relative price variability than any of the three exchange-rate targets (dollar, euro, and SDR). More research is clearly needed to see if the estimation of the sectoral weights and the price series can be improved and to make the comparison more realistic by allowing the CPI and product price index to fall within a target range rather than requiring the central bank to hit a target precisely.
Frankel, Jeffrey (2008), “Peg the export price”, CEPR Policy Insight No. 25.
Frankel, Jeffrey (2010), “A comparison of monetary anchor options, including product price targeting, for commodity-exporters in Latin America”, NBER Working Paper 16362.
Rogoff, Kenneth (1985), “The Optimal Degree of Commitment to an Intermediate Monetary Target”, Quarterly Journal of Economics ,100, November: 1169-89.