There are two important challenges I would like to address: the current global environment for emerging markets (Ems), and the recent difficulties of central banks around the world to reach their targets in the short term.
The global economy is in a transition to a new ‘steady state’. Currently, the combination of abundant liquidity and slow recovery in growth among major economies constitutes, from the perspective of EMs, a truly ‘benign interregnum’. It is benign because abundant global liquidity in a scenario of zero interest rates has enabled cheaper funding for EMs.
However, it is unlikely this environment will last for long. Eventually, advanced economies (AEs) will recover more fully and liquidity will dry up. The normalisation of monetary conditions in advanced economies should end the ‘fight from zero interest rates’ period.
Determination necessary
EMs should take advantage of this window of opportunity to reform and adjust their economies but they need to face their problems with determination. The normalisation of global monetary conditions should not be interpreted as bad news; after all, the world is recovering. Nonetheless, one should not ignore the possibility of volatility surges ahead.
In this interregnum, some measures are imperative, such as addressing the public sector balance sheet and opening the fiscal space via the rationalisation of expenditures, to restore order to debt dynamics. I also believe there is a need to advance the broad agenda of structural reforms aimed at fostering productivity in emerging economies and boosting long-term economic growth.
In the meantime, there is another challenge for central banks (and not only those from emerging markets): the recent failure to achieve inflation targets. Even though this phenomenon may be new to AEs, the situation is familiar for policy-makers in EMs. The difference is the relative position of inflation and the target: while some important EMs are struggling to bring inflation down to the specified target, major AEs strive to raise inflation towards the target.
Therefore it seems that, without even noticing, AE central banks have entered the world of EM policy-makers – a world occasionally characterised by larger-than-expected shocks. These shocks are not theoretical conjectures, but common to EMs that face large foreign exchange depreciations, which pressure inflation, even when the pass-through coefficient is relatively low.
A question of credibility
These situations put the credibility of central banks’ actions under scrutiny. So what should be done? EMs have pondered several options in the past. First, there are always those who suggest that if targets seem hard to achieve, you should be even bolder and set more challenging targets. There is always a good basis to support these suggestions, mostly related to ‘steady state’ arguments.
Let me mention two such arguments. The first prescribes higher inflation targets for AEs. It states that inflation targets should be higher in order to keep policy rates far from the zero lower bound rate (ZLB). Given the currently perceived lower natural interest rate, negative demand shocks should drive the policy rate near the ZLB if inflation targets are set too low.
The second argument prescribes a reduction in inflation targets for countries with inflation targets in the higher ranges. It affirms, correctly, that large inflation rates induce inertia and indexation in price setting.
Time of the essence
I acknowledge the importance of these types of arguments, but timing is of the essence. Maybe this is not the moment to debate steady state considerations – after all, economies that are distant from their targets are also far from the steady state. At this moment, these suggestions will appear far-fetched to the public. Thus, let me address policy strategies to deal with inflation when the economies are outside the steady state.
Bolder targets are not efficient if the public does not believe that central banks can meet them. Imagine a target that is not achievable in the short term or, in other words, is too costly to return rapidly to its specified value. Setting a challenging target that is viewed as unachievable will erode the remaining credibility the central bank still possesses and, consequently, raise the cost of disinflation even further.
The idea that bolder targets will help the convergence of inflation tends to work only if such targets are realistic. But, remember, in this case, inflation would be further from the target. This situation reminds me of an old Chinese proverb, which I will paraphrase: it is often better to take small steps in the right direction than to risk a great leap forward only to stumble backward.
As anyone who has gone on a diet knows, the answer to a very difficult starting point is not to set overly ambitious goals (in this case, weight loss) but the opposite: to set realistic goals and be able to achieve them.
Tempering ambition
This brings me to a second issue. When is it worthwhile to set a less ambitious target? I can picture a case for intermediate goals, communicated by central banks in a transparent manner, on the way to the original target. If achieving the initial target – say 2% – is not fully credible over the next 12 months but it is credible under a longer horizon, why not announce that the path to 2% passes through 1% at some earlier date?
Achieving intermediate goals can help maintain credibility despite missed targets. It is far more important for credibility’s sake to be able to achieve the established goals than to adjust targets up or down. Inflation-targeting regimes embed enough flexibility to define appropriate horizons in which inflation converges with targets credibly. Furthermore, intermediate goals may help to restore efficient guidance to economic agents.
Of course, steady state and transition arguments interact if one believes that current targets are inadequate, and therefore very hard to achieve even at longer horizons. But I think it is too soon to jump to this conclusion based on current dynamics. Not long ago, it was argued that AEs had reached a ‘great moderation’ phase after a few good years. Let’s not leap to the opposite conclusion after just a few challenging years.
But intermediate goals are not always appropriate. In Brazil, our assessment is that achieving the target next year is challenging but realistic. It has been a long road since inflation began to decline. Inflation fell from almost 11% at the end of 2015 and is now expected to end 2016 at 7.3%. Expectations are now finally anchored at the target of 4.5% for 2018, 2019 and 2020, and higher for 2017, at 5.1%.
We are confident that inflation in Brazil will converge with the target in all relevant horizons, including in 2017.
Ilan Goldfajn is Brazil's central bank governor.
