Tag: inflation

Monetary Policy in Belarus Since Mid-2020: From Rules to Discretion

Posted on February 12, 2024 | Policy Brief

20240211 Monetary Policy in Belarus Image 00

The most important “safeguard” against negative consequences from government’s economic policy mistakes is an independent monetary policy aimed at maintaining inflation near a pre-announced target and smoothing out short-term fluctuations. In Belarus, various monetary policy regimes have been employed and, for most of history, the ability of the National Bank of Belarus to set goals and deploy monetary policy instruments without government intervention has been limited. As a result, monetary policy in Belarus tend to exacerbate negative shocks to the Belarusian economy rather than play a stabilizing role. Since mid-2020, the National Bank has de facto lost operational and institutional independence, and monetary policy has become discretionary – focused on stimulating economic activity. As of 2024 this discretionary and expansionary monetary policy has increasingly come into conflict with the need to ensure macroeconomic stability.

Monetary Policy Design in Belarus: Developments in the Last Decade

Since 2015, the National Bank of Belarus (henceforth the National Bank) has declared its monetary policy regime to be monetary targeting. The primary goal of such policy is price stability, while the intermediate target is broad money supply growth. However, research results show that monetary targeting was employed only until mid-2016. From mid-2016 to mid-2020, the National Bank implicitly employed flexible inflation targeting (Kharitonchik, 2023b).

In mid-2020 the National Bank de facto lost its operational independence as the bank was no longer in control of the rules concerning monetary policy (Kharitonchik, 2023a). In 2022-2024, among other things, targets were set for inflation, the growth of the ruble monetary base, broad money supply, the banks’ claims on the economy, and the refinancing rate level. Thus, the National Bank seeks to simultaneously control both the volume of money in the economy and the prices. This is, in practice, expressed in the implementation of discretionary and situational monetary policy.

Under pressure from the government, the National Bank’s monetary policy has since mid-2020 focused on stimulating economic activity, with a high degree of tolerance to inflationary risks. After the US, EU, UK, and several other countries imposed strict sanctions on Belarus in the beginning of 2022, the government’s pressure on the National bank to support economic activity increased even further.

Since October 2022, the only inflation regulator has been strict price controls, exercised by the government in the form of a system of price regulations for approximately 85 percent of the items in the consumer basket. According to the system, manufacturers are obliged to coordinate wholesale prices with government authorities and retailers were in Q4 2022 forced to adjust prices. The system has been modified several times, but as of 2024, it continues to operate in an extremely rigorous version.

Besides the erosion of operational independence, the recent years have been characterized by a marked decline in the institutional framework for executing monetary policy. Aspirations to enhance transparency and accountability of the National Bank to the public seem to be history, at least for the time being. The frequency of the bank’s communication has decreased significantly and its content, as well as the bank’s published data and analytical materials have deteriorated. There are no longer any National Bank briefings on the outcomes of its board meetings, nor are there clear explanations of the decisions made or meetings with the expert community.

The National Bank also introduces uncertainty and undermines confidence in its policies with its strange approach to setting and announcing inflation targets. The increased inflation target, from the previous 5, to 7-8 percent for 2023 is unexplained, the explicit inflation target for 2024 was not presented until the end of August 2023, and the medium-term inflation target is nonexistent. Under such conditions, investment planning and forecasting becomes challenging, necessitating substantial efforts to rebuild trust in monetary authorities for the future.

Figure 1. Inflation and inflation targets in Belarus, 2015–2023.

Source: Author’s estimates based on data from Belstat and the National Bank of Belarus.

Between 2020 and 2023, the National Bank was unable to effectively implement monetary policy in a coordinated manner, falling short in achieving de jure primary and intermediate targets. Thus, inflation in 2020–2022 was significantly higher than targeted levels, while the money supply growth was close to the lower bound of its target range (see Figure 1 and 2).

Figure 2. Broad money growth and its target in Belarus, 2015–2023.

Source: Author’s estimates based on data from the National Bank of Belarus.

In 2023, the inflation was below its target due to total price controls, while money supply growth was twice its target (see Figure 2). Such targeted monetary policy dynamics indicate the instability of the economy’s demand for money and the money multiplier, the instability and poor predictability of money velocity in the face of shocks to the Belarusian economy, as well as the lack (or inability) of a strict commitment by the National Bank to achieve the primary goal of monetary policy.

Monetary Conditions Between 2020 and 2023

Monetary conditions are calculated as a weighted combination of deviations of real interest rates on assets in Belarusian rubles and the real effective exchange rate of the Belarusian ruble from their equilibrium levels. As detailed in Figure 3, the monetary conditions for 2020–2023 are considered stimulative for economic activity and pro-inflationary.

Figure 3. Monetary conditions in Belarus,2015–2023.

Source: Author’s estimates based on QPM BEROC (Kharitonchik, 2023b).
Note: Monetary conditions are estimated as a combination of deviations of real interest rates on the Belarusian ruble assets and of the real effective Belarusian ruble exchange rate from their equilibrium (or inflation-neutral) levels (assessed within the model). Positive monetary condition values indicate their restraining-economic-activity and disinflationary stance, and negative monetary condition values indicate their stimulating and pro-inflationary stance.

In 2020, the soft monetary conditions (the combined effect of interest rates and the exchange rate on the economy) were determined by the behavior of the exchange rate. The Belarusian ruble weakened significantly and became undervalued in 2020 due to a sharp increase in demand for foreign currency at the onset of the Covid-19 pandemic in Belarus and following the presidential elections in August 2020.

As a result of the National Bank’s discretionary monetary policy, interest rates’ volatility significantly increased. A deterioration of the liquidity situation in the banking system and increased risks to the economy during the acute phase of the socio-political crisis in 2020 resulted in interest rates restraining economic activity in September-December 2020.

In 2021, there was a notable improvement in the economic situation in Belarus compared to the crisis experienced in 2020. External demand for Belarusian goods and services rose, and export prices increased significantly which contributed to an increase in foreign currency earnings. As a result, the undervaluation of the Belarusian ruble neutralized during 2021, the banking system moved to a liquidity surplus, and interest rates decreased noticeably, creating soft monetary conditions (see Figure 3).

In 2022–2023, monetary conditions became even softer against the backdrop of increasing priority for the National Bank to support economic activity over inflation containment. The Belarusian ruble again became undervalued which increased foreign trade and allowed for the banking system’s liquidity surplus to expand significantly (see Figure 4).

The realization of a substantial liquidity surplus in 2022 resulted from the National Bank’s active emission policy, likely associated with considerable government pressure. The National Bank injected at least 1.7 billion Belarusian rubles (0.9 percent of GDP) into the financial system through lending to non-deposit financial organizations in 2022, and more than 1.9 billion Belarusian rubles (1 percent of GDP) in 2022 and 1.1 billion Belarusian rubles (0.5 percent of GDP) in 2023, through the purchase of government bonds on the secondary market.

Figure 4. Banking system liquidity in Belarus, 2017–2023.

Source: Author’s estimates based on data from Belstat and the National Bank of Belarus.

Under a colossal and stable liquidity surplus – not withdrawn by the National Bank – interest rates in the money and credit-deposit markets, in 2022-2023, repeatedly reached historically low levels in nominal terms, and in real terms remained  significantly below their equilibrium levels (see Figure 3).

The Monetary Conditions’ Impact on Economic Activity and Inflation in Belarus, 2022–2024

Under loose monetary conditions there was a significant strengthening of the credit impulse (share of new loans in GDP) from Q3 2022 and onwards (BEROC, 2023). In this environment of increased credit activity, the money supply grew at a rapid pace in the second half of 2022–2023 (see Figure 2). The money supply growth significantly exceeded an inflation-neutral pace and by the end of 2023, the volume of real money supply exceeded the inflation-neutral level by almost 10 percent.

Expansionary monetary policy was one of the drivers of the rapid economic recovery in the second half of 2022–2023. The negative output gap, which widened in Q2 2022, following increased sanctions against Belarus, was offset in Q1 2023. Moreover, in Q2–Q4 2023, GDP surpassed its equilibrium level (see Figure 5).

Figure 5. Output gap decomposition in Belarus, 2015–2023.

Source: Author’s estimates based on QPM BEROC (Kharitonchik, 2023b).
Note: The output gap is the deviation of real GDP from its potential (or equilibrium) level, where potential is understood as such a volume of GDP that does not exert any additional pro-inflationary or disinflationary pressure.

By 2024, the Belarusian economy reached a state of moderate overheating (see Figure 5). Currently, loose monetary policy fuels demand but the ability to adjust supply to increased demand levels is limited under sanctions and labor shortages. This mismatch between supply and demand would normally lead to a significant acceleration of inflation. However, due to the strict price controls, this is yet to realize. In fact, inflation reached a historically low value of 2.0 percent Year over Year (YoY), in September 2023. Nonetheless, inflation in Belarus began to accelerate in Q4 in 2023 and amounted to 5.8 percent YoY at the end of the year. In an environment of excess demand and a shortage of workers, firms’ costs rise and translate into higher selling prices, albeit on a limited scale and with a time lag due to the price controls (see Figure 6).

Figure 6. CPI inflation in Belarus, 2015–2023.

Source: Author’s estimates based on data from Belstat. Calculations based on QPM BEROC (Kharitonchik, 2023b).

A prolonged combination of total price controls and loose monetary policy leads to an inflationary overhang – the potential for delayed accelerated price growth. Inflation overhang is a highly undesirable phenomenon since it increases the risk of a price surge in the future and the need for a sharp and aggressive tightening of monetary policy. The inflationary overhang in Belarus is estimated at 5–9 percent (for the end of 2023).  This means that there is a risk of a sharp increase in prices by 5-9 percent if price controls are removed or significantly relaxed.

Conclusion

Since mid-2020, the National Bank has de facto lost its operational independence, and monetary policy has become discretionary, focused on stimulating economic activity. By the beginning of 2024, this discretionary and overly loose monetary policy has increasing come into conflict with the task of ensuring macroeconomic stability.

The Belarusian economy enters 2024 in a state of low economic growth potential (about 1 percent per year) and an imbalance of supply and demand, which creates threats of intensified inflation and a decline in foreign trade.

Attempts by the authorities to artificially maintain high rates of GDP growth and low inflation through excessively stimulating economic policies and archaic price controls may lead to an economic overheating by the end of 2024 similar to the situations leading up to the currency crises in 2009, 2011 and 2015. Under such developments, the fragility of the economy and the likelihood of an economic crisis in Belarus will increase.

To prevent such negative development, it is critical to gradually normalize the monetary policy design in coordination with fiscal policy. Key recommendations from experts for a strengthening of the stabilizing role of monetary policy include ensuring the National Bank’s independence, eliminating discretionary and subjective policymaking, and outlining a clear hierarchy of monetary policy goals (Kruk, 2023).

Simulation results indicate that the use of flexible inflation targeting is the most preferable monetary policy strategy for Belarus under existing sanctions and internal and external capital control measures (as discussed in Kharitonchik, 2023a).

Lastly, as monetary policy is about managing expectations for which trust (i.e. credibility) plays a key role, restoring the public’s trust in the National Bank is essential. To achieve this, the National Bank needs to reestablish communication with the public and resume the publication of analytical and statistical reports, at a minimum matching the extent seen in early 2021.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Polish Parliamentary Elections 2023: Social Transfers and the Voters the Government is Counting On

Posted on October 9, 2023 | Policy Brief

20231009 Polish Parliamentary Elections Image 02

The heated election campaign preceding the October 15th election in Poland has focused on fundamental issues related to the rule of law, migration, media freedom, women’s and minority rights, climate policy as well as Poland’s role on the international arena. The election outcome will determine Poland’s role in the EU and as well as the country’s future relations with Ukraine. It will also be decisive for the direction of Polish politics and the foundations of socio-economic development for many years to come. Despite these issues, the primary worries for a substantial portion of Polish households concern the domestic challenges of increasing prices and material uncertainty. With this in mind, this Policy Brief summarizes the results of CenEA’s recent analysis, which demonstrates a clear pattern in the United Right government’s policy, that in the last four years has strongly favored older groups of the Polish population. In the 2019 elections financial support directed to families with children was a key factor in securing a second term in office for the governing coalition. It remains to be seen if the focus on older voters pays off in the same way on October 15th.

Introduction

The upcoming parliamentary elections on October 15th will close a very special term of the Polish Parliament, marked by the Covid-19 pandemic, a surge in prices of goods and services, as well as the full-scale, ongoing Russian invasion of Ukraine and the tragic consequences associated with it. An evaluation of the second term of the United Right’s (Zjednoczona Prawica) government should, on the one hand, cover the most important decisions made in response to these crises. On the other hand, the last four years have also been a time of significant decisions with important medium- and long-term consequences, both directly for Polish households’ financial situation and more broadly for the economy at large and the country’s socio-economic development.

The heated election campaign has focused on the fundamental issues related to the rule of law, migration, media freedom, women’s and minority rights, climate policy as well as Poland’s role on the international arena. The upcoming vote is likely to be decisive in regard to Poland’s relations with partners in the EU, the role it will play in the EU and – as recent government declarations have demonstrated – the development of future relations with Ukraine. The result of the October elections will be pivotal also for the direction of Polish politics and the foundations of socio-economic development for many years to come. At the same time however, recent surveys have shown that the main concern for a significant part of the Polish society lies closer to home, driven by the challenges of rising prices of goods and services and related material uncertainty.

In light of this, this policy brief summarizes the tax and benefit policies directly affecting household finances, which were implemented in the first and second term of the United Right’s rule (i.e., 2015-2019 and 2019-2023). The brief draws upon a detailed analysis published recently in the CenEA Preelection Commentaries (Myck et al. 2023 a,b,c). The results show a notable shift in the government’s focus – while families with children were the main beneficiaries of the reforms implemented in the first term, the policies over the last four years have concentrated transfers and tax advantages to older generations. As we approach election day, it seems likely that the government will further try to mobilize support from this group of voters

The United Right’s Second Term: Tax and Benefit Reforms During High Inflation

In recent years, Polish households has, apart from two major crises (the Covid-19 pandemic and the complex consequences from the Russian invasion of Ukraine), faced one of the greatest price increases in the EU. During the closing term of Parliament, from January 2020 to July 2023, prices increased by 35.6 percent and have continued to grow at a rate significantly exceeding the inflation target set by the National Bank of Poland (2.5 percent +/- 1 percentage point per year). By the end of 2023 the combined inflation rate will reach 38.7 percent. Although average wages have also been rising (nominally by 41.7 percent from January 2023 to July 2023), wage growth has not kept up with the inflation for many workers. One needs to also bear in mind that a significant proportion of Polish households rely on income from transfers and state support. At the same time households’ material conditions have deteriorated as a result of a significant reduction in the real value of their savings.

In 2022 and 2023 the government introduced a number of temporary policies designed specifically to assist households facing higher energy and food prices. Throughout the final term in office, it also adopted several reforms which – as we show below – affected some groups more than others, reflecting a clear policy preference:

a) in January 2020 and May 2022 respectively, the government legislated an additional level of support addressed to retirees and disability pensioners. These so-called 13th and 14th pensions have raised the minimum level of pension benefits.

b) in January 2022 the government implemented a major overhaul of the income tax system (the so-called Polish Deal) which significantly influenced the tax burden on most taxpayers, strongly benefitting pension recipients.

c) throughout the term of Parliament, the government has kept the values of most social benefits frozen at their nominal level. This includes its flagship program – the universal 500+ parental benefit (500 PLN, roughly 110 EUR per child per month), introduced in 2016 – as well as means tested family benefits directed to poorer families with children. As a result, both the values as well as eligibility thresholds has fallen by nearly 40 percent.

The implications of these three policy areas are reported in Table 1 for the 2019-2023 term of Parliament and contrasted with benefits and costs from government policies implemented in the first term of Parliament (2015-2019). The results have been calculated using the SIMPL microsimulation model and are based on a representative sample of over 30 000 Polish households from the 2021 Household Budget Survey (for methodological details see Myck et al., 2015; 2023c). The applied method allows for singling out policy effects from other factors affecting household incomes.

Table 1 shows a clear difference in focus; from substantial benefits directed at families with children in 2015-2019 to policies targeted at pensioners, partly at the cost of families with children, in the second term. It is also worth noting that while government policy continued to increase household incomes, the resulting gains in disposable incomes in the second term have been much more modest.

Table 1. The impact of modelled policies in the tax and benefit system on household income in the two terms of the United Right’s government.

Source: CenEA – own calculations using the SIMPL model based on 2021 Household Budget Survey data (reweighted for simulation purposes and indexed to July 2023).
Notes: Simulations with respect to the system and price level from July 2023. Changes are presented in relation to the indexed system from 2015 for the first term of office of the United Right government and the indexed system from 2019 for the second term of office. *Including family allowance with supplements, care benefits, parental leave benefit, and one-off allowance for the birth of a child. The applied exchange rate is 4.6PLN=1EUR.

The contrast is also visible when the totals from Table 1 are divided and allocated to specific family types, as presented in Figure 1. On average lone parent families gained about 800 PLN (170 EUR) per month as a result of policies implemented in the 2015-2019 term, while they lost 160 PLN (35 EUR) in the second term. Married couples with children gained 950 PLN (205 EUR) and lost 259 PLN (55 EUR) in each term, respectively. In contrast to this, gains of pensioner families were modest during the first term, while the policies implemented in the second term imply gains of about 310 PLN (70 EUR) per month for single pensioners and 630 PLN (140 EUR) per month to pensioner couples. Gains and losses by family type resulting from policies implemented between 2019-2023 are shown in more detail in Figure 2. Over 85 percent of single pensioners have seen gains of more than 200 PLN (45 EUR) per month, and a similar proportion of pensioner couples gained over 400 PLN (90 EUR) per month. At the same time the majority of families with children, both among lone parent families and married couples, principally as a result of benefit freezes, saw their incomes fall in real terms. The values of the universal 500+ parental benefit will be indexed in January 2024, and the government has made this indexation an important element of the campaign. However, the indexation will not compensate the losses that families experienced in the last four years, a period with high inflation. It remains to be seen if a promise of higher transfers in the future will translate into political support, as seen in the 2019 elections (Gromadzki et al. 2022).

Figure 1. The impact of modelled policies in the tax and benefit system on household income in the two terms of the United Right’s government, by family types.

Source: CenEA – own calculations using the SIMPL microsimulation model based on 2021 Household Budget Survey data (reweighted for simulation purposes and indexed to July 2023).

Figure 2. Ranges of monthly benefits and losses resulting from the modelled policies introduced in the United Right government’s second term of office (2019-2023), by family type.

Source: CenEA – own calculations using the SIMPL microsimulation model based on 2021 Household Budget Survey data (reweighted for simulation purposes and indexed to July 2023).

Timing and Other Tricks: Securing the Votes of Older Generations

The so-called 13th and 14th pensions are paid once per year, in May and September respectively, to recipients of public pensions, at a value equivalent to a monthly minimum pension (approximately 360 EUR). While the first is a universal benefit, the latter has a withdrawal threshold and is thus targeted at lower income pensioners. In 2023 the government decided to increase the value of the 14th pension to about 580 EUR, with the benefits paid out to pensioners in September, the month before the election. This additional bonus came at the cost of about 7 billion PLN (1.6 billion EUR) – a budget which could have paid for two years of indexation of benefits targeted at low-income families with children or financed the payment of the indexed value of the universal 500+ parental benefit for nearly four months. The decision completes the picture of a clear preference for the older generation in regard to social policy in recent years and suggests a clear focus on this group of voters prior to the upcoming election.

The government has also taken a number of steps to facilitate electoral participation among voters in smaller communities by increasing the number of polling stations and making it obligatory for local administrations to finance transportation for older individuals with mobility limitations. The government is also mobilizing voters in smaller communities with turn-out competition initiatives. Additionally, some commentators have pointed out that the choice of election day – one day ahead of the so-called ‘Papal day’, devoted to the memory of John Paul II – is also non-accidental.

Conclusion

The analysis presented in the recent CenEA Preelection Commentaries and summarized in this brief indicates that in the area of reforms directly affecting household incomes, pensioners are the social group that benefited most from the United Right’s government policies in the 2019-2023 term of office. This is evident both from policies that have become a permanent feature of the Polish tax and benefit system, as well as from various one-off decisions. Taking into account other policies surrounding the approaching parliamentary election, it seems clear that the government is strongly counting on the support of older generations of voters on October 15th. As election day is approaching it becomes more and more evident though, that securing their vote may not suffice to win a third term in office. Numerous policy and corruption scandals, a significant departure from judicial independence and an extreme degree of governing party dominance in public media have come to the fore of public debate ahead of the vote. According to recent polls the final outcome is still uncertain and even small shifts in support might swing the future parliamentary majority. According to Gromadzki et al. (2022), financial support directed to families with children was a key factor for securing a second term in office for the United Right coalition four years ago. It remains to be seen if the policy focus on older voters pays off in the same way on October 15th.

Acknowledgement

The authors wish to acknowledge the support of the Swedish International Development Cooperation Agency (Sida) under the FROGEE and FROMDEE projects. FREE Policy Briefs contribute to the discussion on socio-economic development in the Central and Eastern Europe. For more information, please visit www.freepolicybriefs.com.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Dollar and the Global Monetary Cycle

Posted on November 11, 2019 | Policy Brief

A bunch of dollar bills covering table that represents capital flows in Russia

The dominance of the dollar in international markets is at the heart of recent policy and academic debates at almost all conferences on international economics. Most recently, Bank of England Governor Mark Carney has suggested a new global electronic currency to reduce the dominance of the dollar (Carney 2019). What are the negative effects of the dollar’s dominance, and how can countries protect against its influence? We answer this and other related questions in our recent paper (Egorov and Mukhin 2019), which we summarize in this policy brief.

Stable prices

What are the sources of the dollar’s global powers? Ultimately, the dollar matters as long as it is used by private agents in their transactions. Recently, a lot of attention has been devoted to the role of the dollar in global financial markets, which gives rise to the so-called “global financial cycle” (Rey 2013). However, a growing literature (e.g., Gopinath et al. 2019) shows that the dollar also plays a central role in international goods markets with many exporters setting their prices in the U.S. currency. According to recent estimates, the share of goods with dollar prices is about 4-5 times larger than the share of the US in global trade (Gopinath 2016). That means many firms set prices in dollars even when they trade not with the US, but with other countries.

Even though this global invoicing role of the dollar may not seem important, many studies show that prices remain stable, or sticky, in the currency in which they are set. This means that in many countries, the prices of imported goods are almost fixed in dollars. Then movements in the dollar exchange rate immediately result in changes in the prices of these goods in the local currency. Of course, even dollar prices adjust occasionally, but recent empirical studies show that the dollar prices of imported goods remain pretty stable even two years after a change in the exchange rate (Gopinath et al. 2019).

Such stability of global prices in dollars has three important implications. First, the dollar exchange rate affects the volume of global trade. In any given country, appreciation of the dollar raises the local-currency prices of imported goods. Because of that, consumers switch from more expensive imported goods to cheaper domestic goods. The same happens in other countries, and thus all consumers buy fewer foreign goods, and the volume of global trade decreases.

Second, the dollar exchange rate affects world inflation and output. A rise in import prices after appreciation of the dollar increases inflation both directly and indirectly, through an increase in the costs to all domestic firms that use imported goods as inputs. The higher the costs, the more firms raise their prices, and the higher the inflation. Indeed, a recent empirical study shows that the dollar exchange rate is a good predictor of world inflation and the volume of global trade (Gopinath et al. 2019). Moreover, an increase in global inflation reduces consumers’ real income, and this leads to lower aggregate demand and thus to a reduction in world output. Therefore, dollar appreciation could trigger a world recession.

Third, we show that all countries find it optimal to partially peg their exchange rates to the dollar. Since changes in the dollar exchange rate could negatively affect output and inflation, all countries try to protect themselves from these external shocks. If it is not possible for a government to convince its private agents to stop using the dollar in their transactions, then the government could reduce the changes in the dollar exchange rate by pegging its currency to the dollar. Of course, this policy cannot address all issues, but at least the prices of imported goods can become more stable in the local currency.

Rigged system

What does this global use of the dollar imply for the US? First of all, it enables the US’s so-called “privileged insularity”. Since the prices of both local and imported goods in the US are stable in dollars, changes in exchange rates do not lead to inflation or expenditure switching between home and foreign goods. This gives rise to a significant asymmetry across countries: the dollar exchange rate has a substantial effect on other countries, but all other exchange rates have only a negligible effect on the US.

We show that the asymmetry in countries’ exposure to exchange rate shocks leads to an asymmetry in their monetary policy. All countries find themselves responding to US policy by partially pegging their exchange rates to the dollar. In contrast, due to its “privileged insularity”, the US can focus on its domestic targets, respond primarily to domestic shocks, and potentially achieve higher welfare than other countries, which are more exposed to foreign shocks.

So, when a local recession hits the US, the Fed stimulates the US economy regardless of the conditions of the world economy. Then all other countries stimulate their economies as well in order to keep their exchange rates more stable relative to the dollar. This creates what we call a “global monetary cycle”, where the whole world becomes more synchronized even when there are no global shocks common to all countries. The more prominent the role of the dollar is in the international goods market, the stronger this “global monetary cycle”. In fact, a recent empirical study confirms this prediction and shows that the higher the share of the dollar in the country’s import basket is, the stronger its peg to the dollar, and the more nominal interest rates follow the US interest rates (Zhang 2018).

Leveling the playing field

What can other countries do to diminish negative consequences from the “global monetary cycle”? One possible way to discourage firms from using the dollar could be the creation or expansion of a monetary union such as the Euro area. The larger the Eurozone is, the more countries within this area use the euro and not the dollar to trade with each other. Moreover, the Eurozone’s trading partners are more likely to use the currency of a larger monetary union (Mukhin 2018). If enough firms switch from the dollar to the euro, then we find that the Eurozone may gain the same advantage of “privileged insularity” as the US.

Another frequently mentioned policy to protect from the undesirable exchange rate effects is the use of capital controls, which are found to be effective in softening the “global financial cycle”. For example, a tax on borrowing in foreign currency can reduce the size of the foreign-denominated debt, so that depreciation does not lead to an increase in the nominal debt burden and start a recession. However, we find that under the “global monetary cycle” these measures turn out to be much less effective. Basically, capital controls primarily affect decisions in financial markets. But it’s the decisions of global exporters, that is decisions in international goods markets, that give rise to the “global monetary cycle”. And the effect of capital controls on exporters is much more subtle if present at all.

Conclusion

To sum up, we argue that as long as many firms continue to set prices in dollars, it is optimal for central banks to smooth movements in exchange rates in order to diminish the effects of the dollar on their economies. This partial peg to the dollar leads to the “global monetary cycle”. As a result, the US is free to implement a mostly independent monetary policy, while the rest of the world has to follow their lead.

References

  • Carney, M.,  2019. “The Growing Challenges for Monetary Policy in the Current International Monetary and Financial System”, Speech given at the Jackson Hole Symposium.
  • Egorov, K., and D. Mukhin,  2019. “Optimal Monetary Policy under Dollar Pricing”, Working paper.
  • Gopinath, G., 2016. “The International Price System”, Jackson Hole Symposium Proceedings.
  • Gopinath, G., E. Boz, C. Casas, F. Diez, P.-O. Gourinchas, and M. Plagborg-Moller, 2019. “Dominant Currency Paradigm”, Working paper.
  • Mukhin, D., 2018. “An Equilibrium Model of the International Price System”, Working paper.
  • Rey, H., 2013. “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, Federal Reserve Bank of Kansas City Econoic Policy Symposium.
  • Zhang, T., 2018. “Monetary Policy Spillovers through Invoicing Currencies”, Working paper