Theory of economics

Exchange rate targeting mode

The exchange rate targeting regime involves linking the national exchange rate to the currencies of developed countries with low and stable inflation.
There are also types of exchange rate targeting, such as the establishment of horizontal and conditional corridors where the national exchange rate can fluctuate, and the targeting of the real exchange rate against the basket of currencies of major trading partners.
The exchange rate targeting regime is actively used in countries where the economy depends on exports, especially the export of raw materials, as well as in countries with a high share of imported goods in the consumer basket.
This regime will allow to quickly and effectively reduce inflation during periods of economic crisis. In this case, monetary policy is aimed only at ensuring the target level of the exchange rate. In particular, a tight monetary policy is pursued when the exchange rate depreciates, and a soft monetary policy is pursued when the value of the currency exceeds the target level.¹⁵
Due to the accuracy and simplicity of the exchange rate targeting regime, it is easily understood by the population, businesses and other market participants.
Another advantage of this regime is that it remains effective even when financial institutions are not well developed. In this case, the exchange rate is affected by monetary policy measures and foreign exchange interventions.
At the same time, the ability to effectively implement this regime in times of strong capital inflows will be limited, making it difficult for the central bank to stabilize the exchange rate during times of economic crisis.
The application of the exchange rate targeting regime is closely related to the following conditions:
- the ability of central banks to ensure that the exchange rate is within the target range depends on the size of gold and foreign exchange reserves. Insufficient reserves lead to a devaluation of the exchange rate, which in the future will increase devaluation and inflation expectations. This, in turn, leads to an increase in import prices and the emergence of a shadow currency market and various exchange rates in the economy as a result of restrictions in the domestic foreign exchange market;
- in case of repeated scheduled devaluation of the national currency exchange rate, there is a risk of rising inflation due to increased devaluation and inflation expectations;
- an increase in the real exchange rate under conditions where the nominal exchange rate is fixed leads to a deterioration of the balance of payments and an increase in devaluation risks in the economy;
- rising price levels and pressure on the exchange rate create uncertainty about the ability of central banks to ensure financial stability. In this case, stability is achieved by raising interest rates. This, in turn, has a negative impact on the development of the real sector of the economy.
Experience of foreign countries, including the Commonwealth of Independent States Target exchange rate Significant decrease in gold and foreign exchange reserves, decrease in the competitiveness of domestic producers due to artificial exchange rate slowdown, slowdown in the export sector and increase the sensitivity of the economy to external factors such as a number of adverse effects.
Under the nominal non-target monetary policy regime, central banks are not obliged to achieve specific target nominal indicators. The long-term goals are economic growth, high employment and low inflation, but the medium-term goals are not disclosed to the general public.
Various monetary policy targets are used by central banks to achieve macroeconomic targets.
In countries with low and low volatility and long-term monetary policy measures, it is advisable to use this regime.
Inflation targeting mode
In the inflation targeting mode of monetary policy, the central bank announces a medium-term inflation target, and monetary instruments are aimed at achieving this inflation target.
This method of monetary policy is widely used in many developed and developing countries. The inflation targeting regime is an effective way to reduce the volatility of the inflation rate and the duration of inertia, creating favorable conditions for achieving sustainable and balanced economic growth in the medium term.
The inflation targeting regime was first introduced in 1989 in New Zealand. Today, more than 30 countries around the world, including Australia, Argentina, Brazil, Great Britain, Georgia, Israel, India, Canada, Poland, Turkey, Sweden, Japan, and the Czech Republic, use this monetary policy regime.
Among the CIS countries, Armenia and Russia have inflation targeting regimes. The central banks of Kazakhstan and Belarus have announced plans and programs for the transition to inflation targeting in the medium term.¹⁶
The choice of the inflation targeting regime in the conduct of monetary policy is explained by the advantages of this regime, as well as a number of problems observed in the exchange rate or aggregate targeting regimes.
A clear definition of the central bank's monetary policy goals and priorities, as well as its commitment to achieve inflation targets, will contribute to the formation of positive economic expectations in society.
Achieving inflation targets in an inflation targeting regime requires a high degree of central bank independence. At the same time, the ability to adapt quickly to changes in macroeconomic conditions allows the central bank to focus on internal problems in the economy.
Increasing the transparency of the central bank in this regime will reduce inflation expectations of the population and strengthen confidence in the central bank.
At the same time, the transition to this regime and its effective implementation requires a set of important organizational, legal and macroeconomic conditions in the country.
In particular, the task of achieving low and stable inflation should be the main goal of the central bank's monetary policy, not only formally but also in practice.
This requires the central bank to have a reliable analytical and forecasting base for assessing the current inflation rate and expected price dynamics. The quality of the analysis, in many respects, requires the availability of reliable and detailed statistics that reflect the real dynamics of prices in the domestic market.
The effectiveness of the inflation targeting regime depends in large part on the degree to which the central bank is independent in setting quantitative targets for inflation and in choosing monetary instruments.
The regime also requires that fiscal policy not take precedence over monetary policy, that is, that monetary policy should not be focused on fiscal goals.¹⁷
One of the urgent tasks is to strengthen public confidence in monetary policy, as inflation expectations of the population and businesses play an important role in achieving inflation targets in the inflation targeting regime.
At the same time, the transparency of the central bank and the strengthening of the system of communication with the population will help to ensure the implementation of the above tasks. In particular, the central bank regularly publishes statistics and informs the participants of the real sector of society and the economy about the measures taken to achieve the targets.¹⁸
Since the central bank's interest rate is the main instrument of monetary policy in the inflation targeting regime, the effectiveness of this regime depends on the level of development of financial institutions and markets in the country.
At the same time, the central bank influences the level and dynamics of interest rates in the money market through the provision of liquidity or liquidation operations.
In this case, it is important that the central bank sets the inflation interval. The central bank will focus on ensuring that targets are within this range.
In case of non-fulfillment of these parameters, the central bank should explain the reasons for the discrepancies and formulate a clear position on the measures to be taken in the next period.
However, the analysis of the application of inflation targeting in the experience of foreign countries shows that there are a number of problems in the implementation of this regime.
In particular, the fact that the main factors influencing inflation in developing and CIS countries are non-monetary and are outside the control of the central bank significantly limits the effectiveness of monetary policy instruments.
Another important requirement for applying the inflation targeting regime is the selection of a price index that reflects the real situation as a target.
In some countries, the Consumer Price Index (IBI) is replaced by indices that exclude a number of factors, such as changes in world markets, administrative prices, and seasonality. The use of modified indicators increases the risk of differences with the official IBI or GDP deflator.¹⁹
Although the implementation characteristics of the inflation targeting regime differ from country to country, in general, the results show that this method is effective in developed countries, as well as in countries with economies in transition.
The introduction of an inflation targeting regime requires a wide-ranging improvement in economic policy.
In Latin America, for example, the use of inflation targeting has necessitated a review of fiscal policy.
In addition, the quality of macroeconomic indicators will improve in the countries that have implemented the inflation targeting regime, and the technical and analytical and forecasting capabilities of the central bank will increase.
Given that the effectiveness of inflation targeting largely depends on the efficiency of the monetary policy interest rate channel, the main focus in foreign countries is on the development and stability of the financial system.
Measures to further liberalize the domestic foreign exchange market and improve exchange rate policy
The transition to inflation targeting requires a free-floating exchange rate based on market mechanisms.
At the same time, it is important to clearly define the monetary policy and intervention strategy of the Central Bank, to ensure transparency and to fully understand the decisions made by foreign exchange market participants.
In this regard, the Central Bank will continue to prioritize measures to ensure market conditions in the formation of the national currency exchange rate in the liberalization of the domestic foreign exchange market.
To this end, it is planned to reduce the Central Bank's interference in the formation of exchange rates, improve the strategy of foreign exchange intervention based on free floating exchange rate principles and prepare economic entities and foreign exchange market participants to work in new conditions.
In the medium term, subsequent interventions will be neutral in order to prevent the Central Bank's interventions from having a significant impact on exchange rate formation.
In international practice, the free setting of the exchange rate in the foreign exchange market requires minimal involvement of the central bank. At the same time, the Central Bank intervenes only in crisis situations in order to prevent sharp exchange rate fluctuations and stabilize the foreign exchange market.
However, in the context of Uzbekistan, the need for the Central Bank to participate regularly in the foreign exchange market is explained by the fact that the Central Bank buys monetary gold and other precious metals directly from local producers.
The purchase of precious metals directly by the Central Bank will lead to a direct inflow of funds in the national currency into the economy and increase inflationary risks. At the same time, foreign exchange earnings from the sale of precious metals do not enter the domestic foreign exchange market.
In order to prevent the negative impact of direct purchases of precious metals by the Central Bank and to ensure the balance of the foreign exchange market, the Central Bank regularly sells appropriate amounts of foreign currency in the foreign exchange market.
In international practice, the Central Bank's full and effective mediation of the purchase of precious metals from producers and the sale of foreign exchange earnings in the domestic foreign exchange market is not considered a direct intervention.
In this case, the sale of foreign currency by the Central Bank is only an intermediary, and the active participation of the Central Bank in the foreign exchange market is not aimed at managing the exchange rate and is not considered an intervention in the classical sense.
Given that today the population's inflation expectations are largely related to the dynamics of the exchange rate in the foreign exchange market, ensuring the stability of the national currency in the short term is one of the important tasks of monetary policy.
In the use of interest rate instruments of monetary policy in the inflation targeting regime, the main focus is on the objectives of liquidity management of commercial banks. This will increase the efficiency of the Central Bank's interest rate instruments, based on the task of intensifying the use of market instruments.²⁰
In particular, in order to increase their impact, it is planned to expand the types and scope of operations to provide liquidity and attract funds of commercial banks to the deposits of the Central Bank.
The introduction of the basic rate and interest rate corridor on monetary operations as the main goal of monetary policy will increase the efficiency of the Central Bank's interest rate instruments.
In addition, the operational parameters of monetary policy will be reconsidered, taking into account international experience.
In the future, the terms of the Central Bank's lending operations will be reconsidered, their types will be optimized and generalized. At the same time, deposit schemes will be introduced that will allow commercial banks to place excess reserves in the national currency, which will ensure that the lower limit of the interest rate corridor is maintained.
At the same time, in order to support the liquidity of commercial banks, it is planned to improve the liquidity mechanism by expanding the types and procedures of collateral.
The issue of quality forecasting of short-term liquidity in the banking system is of great importance in the effective use of interest rate instruments of monetary policy. In this regard, the forecasting and analytical capabilities of the Central Bank will be strengthened, and cooperation and exchange of information with the Ministry of Finance and other relevant organizations will be further strengthened.
The transition to inflation targeting in the medium term will require the strengthening and gradual improvement of the Central Bank's analytical and forecasting capacity.
The task of developing a clear strategy for the implementation of monetary policy and the effective use of its instruments largely depends on the quality of analysis and forecasts carried out by the Central Bank.²¹
Monetary policy based on well-developed macroeconomic forecasts reduces uncertainty in the domestic financial markets, facilitates the interpretation of the nature of decisions and allows to determine its direction in advance.
Today, the Central Bank is in the early stages of organizing forecasting based on international practices. At the same time, the first steps have been taken to develop the first models of inflation forecasting.
In particular, the ARIMA (Autoregression - Integrated Model of Floating Average) model has been used and tested with a grouped consumer price index.
However, OLS (smallest squares method) and VAR (vector autoregression) models are also used.
Because the application of these models is based on past data, the quality of statistics from previous years is critical to the development of reliable forecasts. Therefore, along with the formation of a modern system of forecasting, work is underway to create a reliable database of statistics.
In 2018-2021, the work on factor analysis of inflation and liquidity in the banking system, compilation of balance of payments statistics on the basis of modern methods, improvement of tools for forecasting and modeling key macroeconomic and monetary indicators will be intensified.²²
In addition to creating the necessary database, it is planned to expand the list of models used on the basis of semi-structural and structural models.
At the same time, surveys and observations conducted by the Central Bank to determine inflation expectations in the economy from 2018 will help in-depth study of inflation risks, development and effective implementation of monetary policy.
Cooperation with the Government and relevant ministries will be improved in order to comprehensively study the process of price formation, as well as to identify inflationary risks that may arise under the influence of non-monetary factors and reduce their impact on domestic price stability.
The Central Bank will continue to cooperate with international financial institutions and foreign central banks at a qualitatively new level.
In order to improve the role of monetary policy and its instruments, analyze and forecast the liquidity of the banking system and increase the efficiency of operations in the money market in 2018-2021, attract special technical missions of the International Monetary Fund, learn from the best practices of foreign central banks. It is planned to expand the practice of learning and mutual exchange of experience.²³
Existing problems, risks and limitations of the introduction of inflation targeting
Despite the creation of a legal framework for the transition to inflation targeting and the beginning of the process of practical revision of the principles and mechanisms of monetary policy, the full transition to this regime will be difficult due to a number of risks and restrictions.
In particular, the persistent high level of inflation expectations of the population and businesses is one of the main limitations in the successful transition to inflation targeting. At the same time, the increase in inflationary pressures during the liberalization of all sectors of the economy allows inflationary risks to remain.
Given that inflation expectations are formed on the basis of price dynamics in previous years, reducing and stabilizing inflation expectations in the economy is one of the main tasks in the transition period.
These tasks are more difficult to accomplish due to the high impact of non-monetary factors on inflation and create a number of obstacles to the successful transition to inflation targeting.
These factors include the maintenance of administratively regulated prices for some goods, the monopolization of local markets, high commodity prices, imports of inflation due to the recovery of the world economy, low production efficiency and high energy consumption, underdeveloped infrastructure and others.
In these circumstances, the effectiveness of the inflation targeting regime will depend on the effectiveness of the Central Bank's communication policy and public confidence in the monetary policy. It is important to explain to the population the reasons for the rise in prices and the measures taken to ensure price stability.
There are also risks associated with the continuation of foreign exchange policy and the process of liberalization of foreign economic activity in the context of the formation of the foreign exchange market.
At the same time, it is important to reduce the negative effects of the transition to a free-floating exchange rate by mitigating short-term sharp fluctuations in the exchange rate and developing currency hedging instruments.
Achieving these goals is inextricably linked to addressing the factors that reduce the effectiveness and efficiency of monetary policy instruments.
Institutionally underdeveloped financial sector and large cash flows in the shadow economy are among the factors reducing the effectiveness of the Central Bank's monetary policy.
The non-existence of government debt limits the ability of the central bank to conduct open market operations and to attract short-term liquidity by using these debt instruments as collateral.
Although there are no objective reasons for the issuance of public debt in the context of balanced execution of the state budget in recent years, the advantage of debt securities in the diversification and optimization of sources of financing for investment, including regional and sectoral development programs can be the basis.
External economic risks are largely related to the structure of exports and the dynamics of foreign exchange inflows into the economy. In such cases, it is necessary to minimize the risks posed by changes in prices in the precious metals market and as a result of economic problems in neighboring countries and major trading partners.