Real Market Economics by Philip Rush

Author:Philip Rush
Language: eng
Format: epub
Publisher: Palgrave Macmillan UK, London

Trade and financial linkages between countries create spillovers between them that lend cohesion to the global economic cycle. Individual central banks focusing on their domestic situation will often be seeing signals that warrant similar actions to each other. Sometimes, central banks might even coordinate their response in the interests of sending a stronger global message. Under such circumstances, the exchange rate channel is curtailed. Domestic yields don’t become more attractive if foreign yields have increased by a similar amount. Because any given national rate is less restrictive than it otherwise would have been, this is a bit like saying that the neutral rate rises during a global tightening cycle. That is in stark contrast to when the hiking cycle is unilateral and the exchange rate response can be potentially so severe as to lower the domestic neutral interest rate.

Foreign exchange rates moves can be highly politically sensitive as they strike at countries’ international competitiveness. There can be a temptation to control them, either by explicitly fixing the exchange or by controlling capital flows. By fixing the rate, monetary policy will need to be targeting that instead of things like inflation directly, so any shocks to the economy can’t be smoothed out. This limitation can be problematic when exchange rate pressure is coming from developments in the other country. Potentially painful real adjustments still need to be made domestically. But by fixing the exchange rate, the credibility of the other central bank is imported, which can be more beneficial for some countries, especially if foreign trade is mostly denominated in the other country’s currency. Fixed exchange rates are a legitimate option for developing countries. What isn’t an option is fixing the exchange rate, having free movement of capital and an independent monetary policy. That is the so-called impossible trinity.

For an inflation targeter, monetary policy is independent, and the dynamism of a flexible exchange rate and capital controls tend to be desirable enough for both to be allowed. They must do this subject to the 3-dimensional trade-off discussed in the previous section (i.e., inflation , the output gap and intolerance of error). The interactions of the domestic policy setting with global peers also need to be considered, not least because it can create a state-dependent feedback on to the neutral interest rate. With spreads to quoted rates also potentially dependent on the policy rate setting and uncertainty in each of the three constituent gaps in the Taylor rule, judgement is inevitably needed. Forecasting the central bank reaction function can require some artistic flair, but there is also the aforementioned science beneath it that can be applied in anticipation of potential policy changes and the market movements that will flow from it.

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