Mr. Blanchard, chief economist and director of the IMF’s research department, has used his position to force the global policy makers to rethink economic orthodoxy.
He jettisoned the IMF’s doctrinaire notion that emerging markets should simply accept excessive capital inflows, leading to a shift in the IMF’s policy on capital controls, and he controversially suggested that central banks should consider accepting higher inflation to generate economic momentum coming out of the financial crisis.
On Wednesday, Mr. Blanchard’s policy revolutionaries struck again. Canadian Jonathan Ostry, the deputy director of the IMF’s research department, led a study that concludes central banks in emerging market economies (EMEs) should expand their inflation-targeting regimes to include a formal commitment to counter exaggerated changes in exchange rates with sterilized currency intervention.
“The crisis has taught us that policy makers need to deliver more than stable consumer prices if they are to achieve sustained and stable growth, and that the instruments at their disposal include more than just the policy interest rate,” Mr. Ostry writes with his co-authors, Atish Ghosh and Marcos Chamon. “There are potentially two policy targets: inflation and the exchange rate.”
It has long been assumed that central bankers can’t chew gum and walk at the same time. As central banks adopted inflation targets, the theory was that focusing on anything other than the inflation goal only would confuse things. As a result, the advice was to pair inflation targets with flexible exchange rates.
Mr. Ostry’s paper is simply a discussion note, so his conclusions don’t (yet) reflect official IMF policy. Still, it shows the financial crisis and the growing role of emerging markets is forcing a rethinking of the way the global economy works. Mr. Ostry’s report will have repercussions for Group of 20 negotiations, where established powers such as the United States and Canada tend to insist emerging markets stick with flexible exchange rates.
Many emerging-market central banks are following Mr. Ostry’s advice in practice. Central banks in Brazil, Colombia and Thailand are among those that have either intervened to weaken their currencies, or say they are prepared to do so if exchange rates diverge from what they consider acceptable levels.
The received wisdom among economists was that central banks would lose the public’s trust if they sought to control the exchange rate. Mr. Ostry argues that doing so actually increases confidence in policy makers. The reason is that consumers and businesses are keenly aware of the effects that changes in exchange rates have on their lives. A central bank that ignores this will quickly lose credibility.
Mr. Ostry’s advice is for emerging markets, not developed ones, and he makes clear that a liberal currency intervention program would hurt a central bank’s credibility as much as completely ignoring exchange rates. And he stresses that central banks should only seek to address what clearly are temporary changes in exchange rates. A permanent shift in values brought about by a change in fundamentals should be left alone.
However, the main message is clear: there’s much more to managing an economy than controlling inflation.
“The idea of using more tools to address economic problems is one that has been gaining traction in the wake of the financial crisis, which has brought home that a narrow view in which all will be well as long as central banks deliver stable consumer prices simply doesn’t hold water,” Mr. Ostry writes in a post on the IMF’s blog.
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