Convergence Criteria – How Tight a Constraint under Inflation Targeting?

1. Convergence Criteria – How Tight a Constraint under Inflation Targeting? Jan Frait Dubrovnik, June 2004

2. Presentation Outline • Introduction • Exchange rate constraints • Monetary policy constraints • Financial market constraints • Strategies for ERM2 • What kind of IT in ERM2?

3. Introduction • How tight a constraint is the exchange rate criterion for the conduct of inflation targeting (IT)? • How to use IT as an independent anti-cyclical monetary policy to some extent even after joining ERM2? • Claims against the countries wishing to adopt the euro in the future are skewed in a way that "punishes" the countries pursuing IT under floating exchange rate • They are pressured to switch to exchange rate targeting and pass through the double shift in monetary policy

4. Exchange Rate Criterion and ERM2 • Exchange rate criterion should basically be understood as 2.25 % on the weaker side and 15 % on the stronger side. • Going above the 2.25 % limit on the weaker side does not automatically mean the violation of the criterion. • There is a scope for manoeuvre, the uncertainty remains as to the size of it and how the underlying tensions will be assessed and how the fundamental breaches will be told from the non-fundamental ones.

5. Exchange Rate Criterion and ERM2 The Eurosystem position: „… ERM2 offers a meaningful framework for combining nominal and real convergence and should be seen as a useful regime on its own right …“ "That's the most important piece of evidence we've heard yet." said the King … "I don't believe there's an atom of meaning in it." said Alice … "If there's no meaning in it, that saves a world of trouble, as we needn't try to find any." said the King Lewis Carroll, Alice's Adventures in Wonderland, Chapter XII, Alice's Evidence

6. Exchange Rate Criterion and ERM2 „ … an asymmetric band with an ostensible guarantee against significant depreciation seems to be the most dangerous policy…“ Leslie Lipschitz (2004) „… ERM2 is a pointless and potentially dangerous arrangement … an enforced period in ERM purgatory represents a potentially costly investment without any return …“ Willem Buiter (2004)

7. Exchange Rate Criterion and ERM2 • There is no value added in ERM2 for the Czech Republic. • ERM2 cannot be superior to IT, one can even hardly think of ERM2 as a reasonable substitute of IT. • The band of + 15 % does not have any stabilisation potential. • Intra-marginal intervention of the ECB unlikely, marginal intervention of the ECB not guaranteed. • The Czech Republic does not need ERM2 to stabilize nominal exchange rate.

8. Exchange Rate Criterion and ERM2 - nominal exchange rate roughly stable for 14 years

9. Exchange Rate Constraints Trend for equilibrium real appreciation often cited as a major constraint, as a source of potential conflict between the inflation and the exchange rate convergence criteria. The estimates of Balassa-Samuelson effect (BSE) in more recent studies reveal relatively small effect. BSE may be very a poor description of the current state of affairs due to its assumptions as well as mechanism. The additional factor calling the strength of BSE into question is the the economy-wide restructuring.

10. Loss and Reaction Function of Central Bank There is an apparent the lack of anti-cyclical policy measures compatible with the process towards the euro, squeezing crucial macroeconomic variables to a very narrow range in a particular point in time required. Asymmetric reaction function in line with asymmetric convergence criteria looks as a natural solution for the IT regime in ERM2. The corollary to this is the risk of excessive exchange rate appreciation. The loss and reaction functions of the central bank in the pre-euro phase are thus forced to be modified in a way that it abstracts from the need to minimize certain combination of the output gap and inflation volatility.

11. VLADIMIR: Nothing you can do about it. ESTRAGON: No use struggling. VLADIMIR: One is what one is. ESTRAGON: No use wriggling. VLADIMIR: The essential doesn't change. ESTRAGON: Nothing to be done. Samuel Beckett - Waiting for Godot

12. Interest Rate Constraints Medium- and long-term interest rates will be more and more determined in the euro area as the country approaches the assumed date of entry. The reason is the logic of the term structure and uncovered interest rate parity (UIP). Unless there is a major uncertainty as to the two key features of ERM2, the interest rate component of monetary policy conditions may be set to a large extent by the euro area conditions even two years before adopting the euro. The data on current euro area members experience during ERM2 indicate relatively large differential for some countries that persisted even half a year ago before the final conversion. The scope for NMS may be much lower.

13. Interest Rate Constraints How large is the scope for interest rate differential?

14. Interest Rate Convergence and UIP The use of UIP is justified by the situation of the new entrants - once in ERM2, their risk premium is approaching zero, exchange rate expectations are influenced by the explicit central parity and interest rates are converging to the euro area levels. The basic macroeconomic convergence in the Czech Republic has been fully achieved. The only problem, though really serious, is the state of public finances. The long-term as well as short-term interest rates already stay on the levels of the euro area, in some present euro area countries such a convergence was achieved just before adopting the euro.

15. Interest Rate Convergence and UIP CZK - interest rate differential close to zero levels

16. Interest Rate Convergence and UIP CZK/EUR - expected and true changes

17. Interest Rate Convergence and UIP ex post premium

18. Interest Rate Convergence and UIP ex ante premium

19. Interest Rate Convergence and UIP Ireland - the case of negative ex post premium

20. Interest Rate Convergence and UIP Greece - the case of positive ex post premium

21. Exchange Rate Strategies for ERM2 UIP framework is useful for describing the alternative strategies regarding the initial setting of the central parity. Strategy I - Central parity weaker than the actual exchange rate - seems to be rather attractive. Nevertheless, it is thus suitable only for the initial situation characteristic of the excessively low inflation. Otherwise the country will face the risk of overshooting the inflation criterion.

22. Exchange Rate Strategies for ERM2 I. central parity weaker than the actual spot rate - credible case

23. Exchange Rate Strategies for ERM2 I. central parity weaker than the actual spot rate - „Greek-like“ case

24. Exchange Rate Strategies for ERM2 Strategy II. - Central parity equal the actual spot rate - high relevance since it does not expose the policy makers to the risk of excessive inflation induced by depreciation. Strategy III. - Central parity stronger than the actual spot rate - suitable for the initial situation characteristic of relatively high inflationary expectations Both strategies have a potential to create initial appreciation expectations and may lead to appreciation, though not necessarily. Risk of loosing competitiveness owing to the excessive appreciation or due to the pressures to devalue and breach the exchange rate criterion if the parity chosen was too strong.

25. What Kind of IT in ERM2? The Czech Republic decided to keep the koruna outside ERM2 after joining the EU, the CNB prefers to continue with IT in the period before joining the euro area. Combination of a nominal exchange rate target zone with a 'fixed but adjustable' central parity and an inflation target is a risky monetary policy regime. Buiter (2004): date and a rate for the irrevocable conversion should be announced, otherwise a currency board, or free float combined with IT can only be pursued. Free float is not compatible with ERM2, but some features may be compatible, and at the same time even available.

26. What Kind of IT in ERM2? • The option is to continue with IT utilising limited scope for interest policy and accompany this with careful and flexible application of ERM2 features: • entering ERM2 only for the shortest possible period, • low inflation and subdued inflation pressures, • clearly sustainable external balance, • sound fiscal policy and a credible program for long-term fiscal consolidation, • central parity perceived close to the equilibrium level, • flexible interpretation of exchange rate criterion, and with a clear strategy for interventions backed by high level of exchange reserves.

27. What Kind of IT in ERM2? The interpretation of the exchange rate criterion is the crucial aspect of the strategy. “Severe tensions" conditions will be assessed by taking into account indicators like side, timing, size and duration of the deviations, size of the interventions or interest rate hikes. All necessary steps that would prevent from the depreciation pressures of fundamental nature have to be taken. If the authorities find the flexible interpretation of the exchange rate criteria too risky, the exchange rate targeting polar regime is the solution.

28. People are crazy and times are strange I'm locked in tight, I'm out of range I used to care, but things have changed Bob Dylan - Things Have Changed

29. Thank you for the attention jan.frait@cnb.cz www.cnb.cz