Two central banks surprised the world last week with unexpected hikes in interest rates in the face of panicky financial markets. Raising rates a startling 150 basis points, the Central Bank of Russia was reacting sharply to yet another week of runs on the rouble. (It fell further this week nonetheless.)
The other, the Central Bank of Brazil, increased the cost of borrowing by a more modest 25 basis points. It seemed to be attempting to re-establish its independence credentials after the previous weekend’s presidential elections and subsequent worries that economic policy would tend towards the populist and the inflationary.
Yet just as with the advanced economies’ central banks – the Bank of Japan ramping up quantitative easing just as the Fed withdraws – monetary policy has diverged rather than unified in the big emerging economies.
Taking a selection – India, Brazil, South Africa and Turkey from the “fragile five” and Russia for variety – it is clear that the performance of central banks has varied considerably. Not only have interest rates been moved differently, but the very frameworks of monetary policy are evolving in contrasting ways, some improving and some regressing.
All those economies have faced stagflation over the past year and all except Russia a current account deficit (Russia has a surplus, but a shrinking one). This is a tricky bind for central bankers. If economic expansion is slowing but inflation high, it takes a courageous and independent policymaker, eyes fixed on a longer time horizon than that of politicians, to raise rates in the cause of price stability at the risk of worsening growth.
That, though, is exactly what the Reserve Bank of India did under its new governor, Raghuram Rajan. Rajan took over in September last year and soon afterwards surprised investors by tightening, raising the main policy rate in three stages by 75 basis points and focusing on reducing inflation as the RBI’s primary goal. India has been rewarded with consumer price inflation almost halving to 6.5 per cent by this September (admittedly helped by lower food prices) and a relatively stable currency. It has also earned credibility that reduces the need for tightening in the future, particularly since it has resisted some grumbling from politicians about the level of interest rates.
At the other end of the spectrum, in keeping with a national deterioration in economic and political governance, is Turkey. The Central Bank of the Republic of Turkey held benchmark interest rates at the historically low level of 4.5 per cent for the second half of 2013 despite rising inflationary pressure. The bank was then forced to hike rates dramatically to 10 per cent when the Turkish lira collapsed during the second bout of “taper tantrum” this January. Since then it has loosened again, its independence clearly compromised by continual pressure from the government. Recep Tayyip Erdogan, until recently prime minister and now president, has made repeated public demands for looser monetary policy. Perversely, this is likely to lead to higher rates in the long run, as the central bank’s inflation-fighting credibility is eroded.
South Africa and Brazil are middling cases. The Brazilian central bank’s action last week, though unexpected, fitted into its desire to show its political independence. Like the RBI it had already raised rates in the second half of 2013. Yet the fact that this autumn it waited until after the election to tighten policy suggested that its independence is tempered with an unhealthy dose of political calculation.
One of Brazil’s problems is that monetary policy is being asked to do too much. With political constituencies that need placating with public spending, Dilma Rousseff’s administration has not delivered enough fiscal tightening to stabilise Brazil’s public debt ratios and is unlikely to do so. The central bank is having to do what the government will not.
South Africa is in a similar situation to Brazil. Although the SARB has an orthodox inflation goal, it is not an easy target to hit in a small open economy that is frequently buffeted by commodity prices and the exchange rate. Its task would also be greatly eased by fiscal and regulatory policy from the government to increase investment and reduce the current account deficit.
The Russian central bank, meanwhile, has asserted its independence both by hiking rates sharply and by continuing to move towards a free-floating rouble, defying those who thought that Moscow might impose capital controls. The central bank has in effect set itself the honourable but difficult task of coping with capital flight and a falling currency with domestic monetary policy only.
Indeed, the frameworks for central banking in the emerging markets are diverging as much as their recent monetary policy stances. Until the financial crisis, the standard model in central banking was to use one instrument – short-term interest rates – to hit one target – inflation. That framework took something of a battering in the advanced economies after it transpired that low and stable inflation was perfectly compatible with the massive financial and housing bubbles that caused the global crisis. Still, a monetary framework centred on inflation and with measurable and transparent goals is still the anchor for the actions of most central banks, including, in the main, those of Brazil and South Africa.
By this measure, not only is India conducting much better monetary policy than Turkey but its rules are moving in a more positive way. The Reserve Bank of India has traditionally had a confusing plethora of targets and tools, though for historically understandable reasons. In an economy where food prices are bounced around by the monsoon’s effect on agriculture and other unpredictables, a single inflation target based on consumer prices was generally considered inappropriate.
Nonetheless, India has been moving closer towards simplicity and transparency. A commission headed by the RBI’s deputy governor earlier this year recommended the RBI adopt a clear consumer price inflation target of 4 per cent. The government has declared itself in favour if it can specify the target itself and if a monetary policy committee rather than Rajan on his own can decide on interest rates.
In Turkey, by contrast, the central bank’s task has only been compounded by a set of instruments and a confusion of targets which, with historical aptness, might be termed Byzantine. Turkey has a corridor for policy interest rates around four percentage points wide and manages liquidity by shifting operations back and forth from a one-week repo rate to its overnight rate. Meanwhile, the central bank has multiple objectives over and above its inflation target, including economic growth and financial stability.
Targeting several outcomes unsurprisingly means Turkey has missed them all. Inflation has been above the 5 per cent target for the past three years and the economy has slowed sharply. Nor have the central bank’s interventions necessarily delivered financial stability: there has been a rapid increase in private sector leverage and short-term capital inflows during the last five years. The confusing system has also weakened the credibility and hence the impact of monetary policy. The IMF has noted that hikes in short-term rates in Turkey have relatively little effect further down the yield curve, where borrowing costs for companies are generally set.
The central banks of many emerging markets have been faced with similar problems over the past couple of years. But their reactions have taken them in markedly different directions. If the economic slowdown persists, and particularly if capital inflows dry up because of a tightening of global credit, those differences will only become more evident.