Monetary Policy in Central Europe

Miroslav Beblavý

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781134138982
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

In this book Miroslav Beblav who has been involved in policy-making at the highest level in his country, offers a detailed study of monetary policy and monetary institutions in the Czech Republic, Hungary, Poland and Slovakia during the 1990s and the early 2000s and a more general look at monetary policy in less developed, but highly open and fin

1 Monetary policy objectives, frameworks and institutions

The first chapter reviews existing literature dealing with monetary policy in order to set the stage for the rest of the book. It focuses on those areas of monetary policy research that are most relevant for the findings presented here – objectives, frameworks and institutions of monetary policy – with emphasis on empirical research on small open economies, especially the ones in transition.

It is clear from the literature on monetary policy targets and central bank autonomy that the foreign exchange rate regime, money targeting and inflation targeting are widely perceived as alternative instruments policy-makers can use as intermediate targets/nominal anchors to achieve the final target of non-inflationary economic growth and are frequently analysed with a view to their mutual interaction and/or substitution in these roles.

On the other hand, the interaction between these instruments and central bank independence was largely ignored until recently and central bank independence tends to be analysed separately as an institutional device that can (or cannot, according to some) bring about low inflation regardless of the monetary policy framework. A possible exception to this rule concerns the relationship between an exchange rate regime and central bank autonomy, which has been analysed quite extensively since the early 1990s.

Fischer pointed out that monetary and exchange rate policies cannot be independent, especially under a fixed exchange rate, where the independent ability of the central bank ‘to determine the rate of inflation and interest rates is sharply curtailed’ (Fischer 1994: 304). Empirical research confirmed this a priori assumption, with Anyadike-Danes (1995) showing that for countries with fixed exchange rates, the connection between central bank independence and the inflation performance was much weaker than in countries where no such rule was in place. Wyatt (1999) also found that while central bank independence was significant for inflation performance even in countries with a fixed exchange rate, it was much less so than in countries with flexible frameworks.

Alogoskoufis et al. (1992) and Hadri et al. (1998) claim, based on empirical studies, that while a pegged exchange rate cannot substitute for an independent central bank when it comes to stopping governments from instituting a short-run election boom, it is a partial substitute for central bank independence (CBI) in stopping governments from indulging their preferences in the long run.

A more recent literature betrays an increasing awareness that central bank independence, the foreign exchange rate regime and so-called domestic targets (money/inflation targets), particularly in a small open economy, all interact together in constraining the discretion of policy-makers and assuring their continuing commitment to low inflation. Despite approaching the issue from different perspectives, Cukierman (1994), Freytag (2001), Hayo and Hefeker (2001), Kuttner and Posen (2001) as well as Mishkin and Savastano (2001) all agree that in order to analyse the choices made by policy-makers with regard to monetary policy, an integrated analysis of central bank independence and traditional intermediate targets is necessary.

Hayo and Hefeker argue that

societies have to make two decisions about monetary policy. First, they decide on the importance being attached to fighting inflation as an important objective. Then the second decision has to be made on what is the best institutional arrangement to achieve the objective of price stability, given the existing political, legal and economic framework.

(Hayo and Hefeker 2001: 22)

Cukierman (1994), Freytag (2001) and Hayo and Hefeker (2001), based on research focusing on central bank autonomy, conclude that while delegation of authority to an independent central bank, together with an unequivocal mandate to focus on price stability, is an important institutional device for committing monetary policy, alternatives, such as inflation targets, fixed exchange rates and inflation contracts, exist. In other words, an independent central bank is neither a necessary, nor a sufficient instrument for low inflation (Hayo and Hefeker 2001).

Mishkin and Savastano (2001) start from an analysis of exchange rate regimes in emerging market economies, but come to a similar conclusion that the debate over monetary policy regimes in emerging market countries should not be about flexibility of the exchange rate, but about what is the best way to constrain discretion over monetary policy. Even though an increasing though small number of monetary economists pose this question, few have attempted to answer it explicitly and empirically.

Kuttner and Posen, based on their empirical study, state that domestically based monetary constraints like inflation targeting or central bank independence confer nearly the same benefits as an intermediate exchange rate regime, but without large discrete depreciations. They conclude that a ‘combination of inflation targeting plus exchange rate float (and central bank autonomy) would appear to be a full substitute for a hard exchange rate commitment in terms of inflation level and exchange rate depreciation with an improvement in both exchange rate volatility and inflation persistence’ (Kuttner and Posen 2001: 3–4).

Based on a review of the situation in Latin American countries, Mishkin and Savastano conclude that

there are some emerging market countries which may not have the political and other institutions to constrain monetary policy if it is allowed some discretion. In these countries there is a strong argument for hard pegs, including full dollarisation, which allow little or no discretion to the monetary authorities. On the other hand, there are many emerging market countries that seem to have the ability to constrain discretion, with Chile being the clearest example, and for these cases we believe that inflation targeting is likely to produce a monetary policy which keeps inflation low and yet appropriately copes with domestic and foreign shocks.

(Mishkin and Savastano 2001: 45–7)

On the other hand, Eichengreen and Hausmann (1999) are skeptical about the ability of developing countries to develop institutions which would promote good monetary policy and prefer a currency board or full dollarisation.

Monetary policy objectives and frameworks

This section will briefly review the literature, defining key terms used in discussion of the topic such as final targets of monetary policy, intermediate and operational targets and nominal anchor. The section is predicated on the emerging consensus in macroeconomic policy identified by Allsopp and Vines, which points to two normative lynchpins of monetary policy – clear and unequivocal commitment to the medium-term control of inflation and a view that the commitment should be honoured at minimum cost in terms of fluctuations in output and inflation (Allsopp and Vines 2000: 27–8). Similarly, Ball (1997) defines an efficient rule for monetary policy as one that minimises an appropriately weighted sum of output variance and inflation variance, with the weights decided by the political process.

The tentative consensus is based on two assumptions. The first, which has become nearly universally shared during the last 25 years, is that while expansionary monetary policy cannot expand output in the long run, it is very likely to decrease it. A relaxed and expansionary monetary policy does not induce longterm growth (Friedman 1968). On the contrary, there is a solid body of evidence that high inflation caused by a relaxed monetary policy damages economic growth. Barro (1995) and Ghosh and Phillips (1998) come to a conclusion that the negative relationship between inflation and growth is statistically significant at all but the lowest levels. Sinclair (2000) and Briault (1995) find that the result is not as clear-cut, but conclude that even though faster inflation can both increase and decrease the rate of growth, the balance of arguments points strongly to a negative effect (Sinclair 2000); well-run economies tend to exhibit both low inflation and high growth (Briault 1995).

King (2002) summarises principal costs of both anticipated and unanticipated inflation. Even an anticipated increase in prices causes front-end loading of debt burdens and distortions to cash balances, decreases savings due to incomplete indexation of the tax system and involves costs of changing price lists. Unanticipated inflation, in addition to all these problems, increases aversion to long-term contracts, induces devotion of excessive resources to hedging inflation risks and is accompanied by distortions to production and investment resulting from mistakes in distinguishing between relative and absolute price changes, as well as by redistribution of wealth between debtors and creditors.

The economic case is supported by political-economic arguments and selfreinforcing expectations. Because of an increasing belief that a stable currency, i.e. a currency with low inflation, is the best contribution that a central banker can make to long-term prosperity, central banks have been gradually abandoning targets other than monetary ones and this has been reflected in their statutes – particularly in the run-up to the creation of European Monetary Union (EMU) in Europe. Also, as Scheve (2001) documents, public opinion is highly concerned with inflation even in low-inflation countries and the concern increases sharply as actual inflation grows. O’Flaherty (1990) argues that if someone is hired to mend the plumbing and instead bakes a cake, she would not be hired again regardless of whether the employer wished, after hiring the plumber, that he had acquired the services of a cook. Therefore, price stability as the principal goal of central banks reinforces the anti-inflationary role of central banks even in situations when the electorate might ex post have different short-run inflation-output preferences than before.

A price stability target does not represent an effort to achieve zero measured inflation. In developed economies, price stability is typically understood to mean price increases at about 1–2 per cent per year (Begg et al. 1999). The measured and published inflation rate usually overestimates actual price growth. Although there are no relevant studies available in the transition economies, research shows that in certain cases the actual rate of inflation overestimates reality by as much as 5 per cent (Skreb 1998). Price stability can be interpreted in various ways; nevertheless, all these interpretations are concerned not only with consumer prices, but also with the prices of industrial producers and asset prices. The exchange rate (which expresses the price of one type of asset – foreign exchange) is thereby connected, too. In practice, price stability is usually seen as the stability of consumer prices. It is an index that reflects the type of inflation which is strongly felt by consumers/citizens/the electorate. Producer prices and the exchange rate are ultimately reflected in consumer prices.

This normative view of price stability as the final target of monetary policy can, in practice, be replaced by any positive inflation target set by policymakers, while still resting on the assumption that influencing the price level is the only thing a central bank can and should do in the medium to long run.

The second assumption underpinning the emerging consensus identified by Allsopp and Vines (2000) is that monetary policy can and should have a shortrun stabilisation role. Medium-term commitment to price stability certainly does not exclude a short-run objective of minimising the variance of output.

In order to successfully achieve the ultimate target of price stability or a given inflation target, all policy-makers face several challenges related to controllability and credibility. The relationship between instruments of monetary policy (usually a short-term interest rate) and inflation outcomes is tenuous and fraught with lags and uncertainties. At the same time, inflation ...