Economic Research Forum (ERF)

Inflation targeting versus nominal exchange rate targeting in MENA

Targeting inflation – a monetary policy strategy that has been successfully used in several developed countries – has become an increasingly attractive alternative to nominal exchange rate targeting in emerging economies. This column compares recent experiences with the two policy regimes in Egypt, Jordan, Lebanon, Morocco, Tunisia and Turkey – and outlines the key requirements for the effective adoption of inflation targeting.

In a nutshell

The first requirement for MENA countries wanting to adopt inflation targeting is to render their central banks more independent from political interference, and to draw a clear wedge between fiscal and monetary policy.

A country that chooses a fixed exchange rate system subordinates its monetary policy to the exchange rate objective, and is not able to target inflation directly.

High external debt should not deter countries from adopting more flexible exchange rate regimes, though this should be preceded by fiscal adjustment and reserve accumulation to soften the impact on the exchange rate adjustment.

It is now well established in economic research that targeting inflation is likely to improve the effectiveness of monetary policy. In contrast, discretionary monetary policies tend to increase uncertainty and may be ineffective on the real side of the economy due to the existence of time lags and other macroeconomic uncertainties.

Since the early 1990s, some developed economies – including Australia, Canada and Germany – have adopted the monetary policy regime of inflation targeting. This shift was justified by the difficulties of targeting the nominal exchange rate or, in some instances, the money supply due to nominal uncertainties and limited foreign exchange reserves. The shift paved the way for an enhancement of these countries’ records of controlling inflation, and made their monetary policies more independent, transparent and effective.

Policies to control inflation

Given the very encouraging experience of some developed economies, a number of countries in the Middle East and North Africa (MENA) have recently decided to adopt price stability and inflation targeting, either as an explicit or implicit monetary policy objective. Two that have explicitly adopted inflation targeting as their main monetary policy goal are Egypt and Turkey.

Other MENA economies, such as Jordan and Lebanon, have been able to contain the inflationary pressures of the last two decades by targeting the nominal exchange rate. By pegging their currencies to a relatively low inflation currency, such as the US dollar, and relying on high interest rate policies to defend their exchange rates, they have succeeded in containing inflation (see Neaime 2000; Mansoorian and Neaime, 2003; Michelis and Neaime, 2004).

Even though this policy has helped them to reduce inflation substantially, it has also generated persistent real exchange rate appreciations, depletion of foreign exchange reserves, losses in international competitiveness, large trade and budget deficits, the accumulation of sizeable debts and, in some instances, serious currency crises. Some recent examples are Egypt, Jordan, Lebanon and Turkey (see Neaime, 2012, 2015a, 2015b, 2016; Mora et al, 2013).

Moreover, the unhappy experience of MENA and other developing countries in Latin America and East Asia with pegged exchange rate regimes has led policy-makers in emerging economies to search for alternative nominal anchors.

Targeting inflation, a monetary policy strategy that has been successfully used by a number of developed countries, has thus become an increasingly attractive alternative. It has been adopted in a growing number of emerging economies, including Brazil, Chile, the Czech Republic, Poland and, more recently, Turkey (see Neaime, 2004, 2008, 2010; Neaime and Gaysset, 2017, 2018; Neaime et al, 2018; and Guyot et al, 2014).

After a series of currency crises and despite renewed recent pressure on the Turkish lira, which has recently depreciated by about 40%, coupled with high interest and inflation rates, the country’s central bank has been working for the past few years on an inflation targeting regime. Since the mid-2000s, the central bank became to some extent independent from the government, with an explicit price stability objective and a floating exchange rate.

While interest and exchange rates continue to be heavily influenced by fiscal policies due to large public sector borrowing requirements, the central bank has been successful in building credibility over time. It is increasingly shaping interest rate expectations, despite recent political interference aiming to reduce them.

Lebanon

Lebanon’s experience is very similar to Turkey’s. This is a highly indebted and dollarised economy, characterised by a history of high inflation.

Since 1993, the monetary authority aimed, on the one hand, to achieve currency stability and, on the other hand, to help the government finance its deficit without resorting to seigniorage revenues. The monetary authority has succeeded to some extent in building credibility over time, and it has been successful in stabilising the local currency after the exchange rate crisis of 1990.

To date, Lebanon’s central bank has succeeded in managing a heavy public debt burden and recurrent budget and current account deficits while maintaining nominal exchange rate stability. Through the use of the Treasury bill rate and the management of foreign exchange reserves, the central bank has been able to achieve nominal exchange rate stability.

Moreover, the recent accumulation of a sizeable stock of external public debt and the high degree of dollarisation of Lebanon’s economy have both transformed the exchange rate into a nominal anchor for monetary policy that takes precedence over the inflation target.

Therefore, if the monetary authority wants to shift to targeting inflation, it will have to adopt a transparent policy of smoothing short-run exchange rate fluctuations, while making it clear to the public that it will allow the exchange rate to reach its equilibrium level in the long run.

Moreover, to be able to shift costlessly to a monetary policy that targets the inflation rate, the central bank will first have to stop targeting the nominal exchange rate by allowing it to float, and then introducing more independence of the monetary authority. This can only be achieved after the fiscal stance is put back on a sustainable path.

In addition, with the accumulation of a sizeable internal and external public debt, and in order to keep debt service under control, targeting the nominal exchange rate may prove to be optimal, at least in the short run, to avert an imminent currency and debt crisis. Similarly, and in the case of Jordan, monetary policy is officially geared towards maintaining a fixed exchange rate peg to the US dollar, and Jordan’s central bank does not yet enjoy the status of an independent and autonomous entity.

Egypt and Turkey

In 2002, Egypt allowed more flexibility of its exchange rate. Subsequently, the Egyptian pound depreciated by 33%, reaching 6.15 pounds per US dollar.

One of the most important challenges facing Egypt today is to sustain a monetary policy framework that focuses on price stability with a flexible exchange rate regime. By recently allowing more flexibility of its exchange rate, Egypt has been able to stimulate exports and, subsequently, the growth rate of real GDP.

Egypt’s central bank has successfully managed the nominal exchange rate to achieve a certain level of the real exchange rate, and has subsequently maintained external competitiveness. At the same time, with the help of the International Monetary Fund, the central bank has recently benefited from increased monetary policy independence.

Similar dynamics are observed in Turkey. Flexible exchange rates paved the way for the central bank to shift smoothly to targeting inflation. While the future success of the inflation targeting policy regime shift in Egypt will depend on the ability of the central bank to isolate the real side of the economy from nominal domestic and foreign shocks, its success in Turkey will depend on the ability to isolate the monetary side of the economy from weaknesses emanating from a weak public sector and from further political interference in the conduct of monetary policy.

Turkey should enhance the independence of its central bank and continue with its efforts to reduce the debt burden and its related service costs if it is to avoid further increases in interest rates and preserve the inflation target.

Morocco and Tunisia

With further trade and economic integration with the European Union, other MENA countries, such as Morocco and Tunisia, are slowly moving towards an inflation targeting regime. They are already targeting the real exchange rate rather than the nominal rate in order to maintain competitiveness and avoid currency overvaluation, while opening up their capital markets to international capital flows.

With further capital account liberalisation in Morocco, the monetary authority may be compelled to introduce further flexibility of the exchange rate. Fully flexible exchange rates may render the independence of monetary policy more effective, as interest rates will no longer have to shadow the interest rate of the anchor currency to which the dinar is pegged, but may be used towards addressing domestic macroeconomic imbalances. Only then can Morocco shift to targeting inflation.

Similarly, in Tunisia, greater flexibility in the exchange rate should be allowed first to stimulate exports and ease pressure on interest rates. Once this is achieved, Tunisia will be able to shift to an inflation targeting mechanism with minimal costs in terms of GDP and employment. The transition from targeting output to prices needs to be accompanied with structural adjustment measures on the fiscal side.

How to adopt inflation targeting

The first requirement for MENA countries considering the adoption of inflation targeting is to render their respective central banks more independent from political interference, and draw a clear wedge between fiscal and monetary policy. Even though full independence is not required, the monetary authorities must have the freedom to gear the instruments of monetary policy toward the inflation target without political pressure.

While recent efforts in Egypt and to a lesser extent in Turkey have rendered their respective central banks relatively more independent, the MENA governments of Jordan, Lebanon, Morocco and Tunisia will have to devote additional efforts towards enhanced fiscal sustainability and central bank independence, if they wish to shift their monetary policy successfully to targeting inflation.

The second pre-requisite for adopting inflation targeting is for MENA central banks to refrain from targeting the level or path of any other nominal variable, such as the nominal exchange rate. A case in point is Jordan and, more recently, Lebanon. A country that chooses a fixed exchange rate system subordinates its monetary policy to the exchange rate objective, and is not effectively able to target directly any other nominal variable, such as the inflation rate.

But a crawling peg or exchange rate target zone may co-exist with an inflation target in the short run, so long as it is clear, and central bank actions show, that the inflation target has priority if a conflict arises.

Further reading

Guyot, Alexis, Thomas Lagoarde-Segot and Simon Neaime (2014) ‘Foreign Shocks and International Cost of Equity Destabilization: Evidence from the MENA region’, Emerging Markets Review 18: 101-22.

Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.

Michelis, Leo, and Simon Neaime (2004) ‘Income Convergence in the Asia-Pacific Region’, Journal of Economic Integration 19(3): 470-98.

Mora, Nada, Simon Neaime and Sebouh Aintablian (2013) ‘Foreign Currency Borrowing by Small Firms in Emerging Markets: When Domestic Banks Intermediate Dollars’, Journal of Banking and Finance 37(3): 1093-1107.

Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, AFP Press.

Neaime, Simon (2004) ‘Sustainability of Budget Deficits and Public Debt in Lebanon: A Stationarity and Cointegration Analysis’, Review of Middle East Economics and Finance 2(1): 43-61.

Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.

Neaime, Simon (2010) ‘Sustainability of MENA Public Debt and the Macroeconomic Implications of the US Financial Crisis’, Middle East Development Journal 2: 177-201.

Neaime, Simon (2012) ‘The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets’, Emerging Markets Review 13(2): 268-82.

Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.

Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.

Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.

Neaime, Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.

Neaime Simon, and Isabelle Gaysset (2018) ‘Financial Inclusion and Stability in MENA: Evidence from Poverty and Inequality’, Finance Research Letters 24: 230-37.

Neaime, Simon, Isabelle Gaysset and Nasser Badra (2018) ‘The Eurozone Debt Crisis: A Structural VAR Approach’, Research in International Business and Finance 43: 22-33.

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