For four decades economists have been finding that the forward discount is a very biased forecast of future changes in the exchange rate. The carry trade makes money, on average. For just as long, they have been debating the appropriate interpretation of the bias. Is it evidence of an exchange risk premium? Under that interpretation, a currency that sells at a forward discount does so not because it is expected to depreciate in the future but because it is perceived as risky. Using data on survey-based expectations over 32 years across 17 currencies, we reject that interpretation of the forward bias. We find that when investors sell a currency at a forward discount, it is indeed because they expect it to depreciate. But we also find concrete evidence of a risk premium, in that expected return differentials are correlated with the VIX measure of risk -- even though the risk premium can’t explain forward bias.
When the US Bureau of Labor Statistics releases new numbers, in theory it should make no difference whether the press release emphasizes the most recent 1-month number, which is what it does, or the 12-month number, as many other countries’ statistical agencies do. This paper offers the hypothesis that it does matter: Markets react to CPI inflation news via whichever framing the agency chooses.
Government forecasts of GDP growth and budget balances are generally more over-optimistic than private sector forecasts. When official forecasts are especially optimistic relative to private forecasts ex ante, they are more likely also to be over-optimistic relative to realizations ex post. For example, euro area governments during the period 1999-2007 assiduously and inaccurately avoided forecasting deficit levels that would exceed the 3% Stability and Growth Pact threshold; meanwhile private sector forecasters were not subject to this crude bias. As a result, the budget-making process could probably be improved by using private-sector forecasts.
Two distinct questions concern the desirability of constraints on the monetary authorities. (1) To what extent should the central bank be constrained, versus being allowed full discretion? (2) To whatever extent it is to be constrained, should it be by a rule and if so what rule? With respect to the second question, a good argument for Nominal GDP targeting is that it is robust with respect to supply shocks, whereas CPI targets, for example, are vulnerable to them. But with respect to the first question, I am increasingly convinced that the constraint – whether a NGDP target or something else – must be very loose. Even the most sincere of central bankers will often fail to hit their targets, due to unforeseen shocks. I therefore propose only a mild innovation: the FOMC could include nominal GDP in its Summary of Economic Projections. A final thought concerns a different kind of constraint: if Fed independence from political influence is compromised, monetary policy will likely become more pro-cyclical.
A majority of countries neither freely float their currencies nor firmly peg. But most of the remainder in practice also don’t obey such well-defined intermediate exchange rate regimes as target zones. This paper proposes to define an intermediate regime, to be called “systematic managed floating,” as an arrangement where the central bank regularly responds to changes in total exchange market pressure by allowing some fraction to be reflected as a change in the exchange rate and the remaining fraction to be absorbed as a change in foreign exchange reserves. An operational criterion for judging systematic managed floaters is a high correlation between exchange rate changes and reserve changes. The paper rejects the view that exchange rate regimes make no difference. In regressions to test effects on real exchange rates, we find that positive external shocks tend to cause real appreciation for most systematic managed-floaters; more strongly so for pure floaters; and not at all for most firm peggers. Two measures of exogenous external shocks are used: (i) for commodity-exporters, a country-specific index of global prices of the export commodities and (ii) for other Asian emerging market economies, the VIX.
The paper proposes an exchange rate regime for oil-exporting countries. The goal is to achieve the best of both flexible and fixed exchange rates. The arrangement is designed to deliver monetary policy that counteracts rather than exacerbates the effects of swings in the oil market, while yet offering the day-to-day transparency and predictability of a currency peg. The proposal is to peg the national currency to a basket, but a basket that includes not only the currencies of major trading partners (in particular, the dollar and the euro), but also the export commodity (oil). The plan is called Currency-plus-Commodity Basket (CCB). The paper begins by fleshing out the need for an innovative arrangement that allows accommodation to trade shocks. The analysis provides evidence from six Gulf countries that periods when their currencies were “undervalued”, in the sense that the actual foreign exchange value lay below what it would have been under the CCB proposal, were periods of overheating as reflected in high inflation and of external imbalance as reflected in high balance of payments surpluses. Conversely, periods when the currencies were “overvalued,” in the sense that their foreign exchange value lay above what it would have been under CCB, featured unusually low inflation and low balance of payments. The implication is that the economy would have been more stable under CCB. The last section of the paper offers a practical blueprint for detailed implementation of the proposal.
What monetary regime should commodity-exporting developing countries adopt? On the one hand, it is desirable to let the currency appreciate (depreciate) in response to positive (negative) terms of trade shocks. Such accommodation is precluded if the exchange rate is fixed or if the CPI is targeted literally. On the other hand, countries need some sort of nominal anchor. Monetary policy can be made automatically more counter-cyclical, judged by the criterion of currency appreciation in reaction to positive terms-of-trade shocks, under either of two regimes. Peggers can add the export commodity to a currency basket (CCB, for “Currency-plus-Commodity Basket”). Others can target Nominal Income instead of the CPI.
Countries that specialize in commodities have in recent years been hit by high volatility in world prices for their exports. This paper suggests three ways that commodity-exporters can make themselves less vulnerable. (1) They can use option contracts to hedge against short-term declines in the commodity price without giving up the upside, as Mexico has shown. (2) Commodity-linked bonds can hedge longer-term risk, and often have a natural ultimate counter-party in multinational corporations that depend on the commodity as an input. (3) The well-documented pro-cyclicality of fiscal policy among commodity exporters can be reduced by insulating official forecasters against optimism bias, as Chile has shown.
Keynote address, Bank of Algeria, Algiers, May 28-29, 2016.
The editors of this volume explore the philosophical conflict between German Ordoliberalism and Anglo-Saxon or American pragmatism. This chapter asks which of these two approaches got which questions right with respect to the euro. In advance, the ordos correctly identified the problem of moral hazard in national fiscal policy, while the pragmatists correctly identified the problem that asymmetric shocks would create when national monetary policy was no longer available to respond to them. When the euro crisis hit in 2010, the ordos pointed out the importance of structural conditionality while the pragmatists were right to emphasize that fiscal austerity was highly contractionary and even worsened debt/GDP ratios.
The revival of interest in nominal GDP (NGDP) targeting has come in the context of large advanced economies. We consider the case for NGDP targeting for mid-sized developing countries, in light of their susceptibility to supply shocks and terms of trade shocks. For India, in particular, one major exogenous supply shock is the monsoon rains. NGDP targeting splits the impact of supply shocks automatically between inflation and real GDP growth. In the case of annual inflation targeting (IT), by contrast, the full impact of an adverse supply shock or terms of trade shock is felt as a loss in real GDP alone. NGDP targeting automatically accommodates supply shocks as most central banks with discretion would do anyway, while retaining the advantage of anchoring expectations as rules are designed to do. We outline a simple theoretical model and derive the condition under which an NGDP targeting regime would dominate other regimes such as annual IT for achieving objectives of output and price stability. We go on to estimate for the case of India the parameters needed to ascertain whether the condition holds, particularly the slope of the aggregate supply curve. Estimates suggest that the condition may indeed hold.
Two big questions look somewhat different than they did 10 or 20 years ago. First: would the long-term trend of globalization continue? Contrary to all predictions, trade growth has slowed markedly since the Global Financial Crisis of 2008-09. But the feared increase in protectionism did not materialize, so one must look elsewhere for explanations. Two likely factors behind the slowdown in trade are a maturing of global supply chains and a slowdown in trade-intensive physical investment.
Second, would the rapid growth of emerging market economies (EMEs) continue, and which ones? Most EMEs recovered strongly in 2010-11, but now seem to be slowing down in a more long-lasting way.
For both these issues the role of China is crucial, since it now carries so much weight in the global economy. Breathless reports in 2014 that the Chinese economy had overtaken the US economy as the world’s largest (measured by Purchasing Power Parity) were followed rapidly in 2015 by breathless reports that its economy was failing. That China has slowed down from past growth rates of 10% to a more moderate rate of 7% or lower should not have come as a surprise. It is part of a natural process of long-term convergence and involves a “rebalancing” of the economy from manufacturing into services that is desirable, even if it means a loss of export markets for some others. The open question is whether the Chinese transition to a more moderate and sustainable growth path will take the form of a hard landing or a soft landing.
After a 30-year absence, calls for international coordination of macroeconomic policy are back. This time the issues go by names like currency wars, taper tantrums, and fiscal compacts. In traditional game theory terms, the existence of spillovers may imply that countries are better off if they coordinate policies than under the Nash non-cooperative equilibrium. But what is the nature of the spillover and the coordination? The paper interprets recent macroeconomic history in terms of four possible frameworks for proposals to coordinate fiscal policy or monetary policy: the locomotive game, the discipline game, the competitive depreciation game (currency wars) and the competitive appreciation game. [The paper also considers claims that monetary coordination has been made necessary by the zero lower bound among advanced countries or financial imperfections among emerging markets.] Perceptions of the sign of spillovers and proposals for the direction of coordination vary widely. The existence of different models and different domestic interests may be as important as the difference between cooperative and non-cooperative equilibria. In some cases complaints about foreigners’ actions and calls for cooperation may obscure the need to settle disagreements domestically.
The paper reviews an event of 30 years ago from the perspective of today: a successful G-5 initiative to reverse what had been a dangerously overvalued dollar. The “Plaza Accord” is best viewed not as the precise product of the meeting on September 22, 1985, but as shorthand for a historic change in US policy that began when James Baker became Treasury Secretary in January of that year. The change had the desired effect, bringing down the dollar and reducing the trade deficit. In recent years concerted foreign exchange intervention, of the sort undertaken by the G-7 in 1985 and periodically over the subsequent decade, has died out. Indeed the G-7 in 2013, fearing “currency manipulation,” specifically agreed to refrain from intervention in a sort of “anti-Plaza accord.” But the day will come when coordinated foreign exchange intervention is again appropriate.
Mauritius is a top performer among African countries. It developed a manufacturing sector soon after independence and has managed to respond well to new external shocks. What explains this success? This paper draws on the history of the island, the writings of foreign economists, the ideas of locals, and the results of econometric tests. Mauritius has mostly followed good policies. They include: creating a well-managed Export Processing Zone, conducting diplomacy regarding trade preferences, spending on education, avoiding currency overvaluation, and facilitating business. The good policies can in turn be traced back to good institutions. They include: forswearing an army, protecting property rights (particularly non-expropriation of sugar plantations), and creating a parliamentary structure with comprehensive participation (in the form of representation for rural districts and ethnic minorities, the “best loser system,” ever-changing coalition governments, and cabinet power-sharing). But from where did the good institutions come? They were chosen around the time of independence in 1968. Why in Mauritius and not elsewhere? Luck?
Some fundamental geographic and historical determinants of trade and rule of law help explain why average income is lower in Africa than elsewhere, and trade and rule of law help explain performance within Africa just as they do worldwide. Despite these two econometric findings, the more fundamental determinants are not much help in explaining relative performance within Africa. Fundamental determinants that work worldwide but not within Africa are remoteness, tropics, size and fragmentation. (Access to the sea is the one fundamental geographic determinant of trade and income that is always important.) A case in point is the high level of ethnic diversity in Mauritius, which in many places would make for dysfunctional politics. Here, however, it brings cosmopolitan benefits. The institutions manage to balance the ethnic groups; none is excluded from the system. It is intriguing that the three African countries with the highest governance rankings (Mauritius, Seychelles and Cape Verde) are all islands that had no indigenous population. It helps that everyone came from somewhere else.