The effectiveness of emerging markets monetary policy in controlling the inflation surge post-pandemic has been one of the policy surprises of the last few years . In many respects, emerging markets have outperformed industrial countries, responding more rapidly and more forcefully to inflation shocks1. This experience shows that monetary policy in emerging markets is worth studying and understanding fully, for the benefit of monetary policy making everywhere.
In our recent ERSA Working Paper we give a comprehensive evaluation of South African monetary policy in the Inflation Targeting period, using high frequency identification techniques2 and narrative analysis. Our results show four different dimensions of monetary policy.
- Conventional monetary policy shocks affect the economy with conventional contractionary effects, in line with results from advanced economies, and with no evidence of ‘perverse transmission’. Monetary policy works.
- Policy communication delivers significant macroeconomic effects. Any central banks, formally or informally, gives information about the expected future path of policy and this information is important in the private agents decision making. Communication matters.
- Country risk is as important as the policy rate in determining the effect of policy. An increase in country risk has a large contractionary effect on the South African economy and “risk management” is core in monetary policy making. Long term policy stability and institutional credibility are the foundation of macroeconomic stabilization.
- Central banking in emerging markets performs a complex balancing act in controlling inflation while protecting macroeconomic stability, in a vulnerable environment. For this reason, policy decisions are often not fully anticipated by the markets, especially given the dominance of supply and global shocks. Markets look to the Central Bank for guidance.
The analysis shows the importance of maintaining the credibility of monetary policy making. Monetary policy always operates on the edge between the flexibility necessary to support the economy and the commitment to long term stability essential for the efficacy of the policy. In Emerging markets the commitment to long term stability needs to be reaffirmed frequently. When uncertainty increases, either because the external shocks or because of internal policy conflicts, the Central Bank has to reinforce the policy with a commitment to do “whatever it takes” to maintain long term stability.
Why, then, did emerging market central banks respond forcefully to the post-pandemic inflation shocks and never entertain the idea of a transitory inflation shock? Our analysis suggest that this was the correct action in a situation where the real cost of long term inflation risks is as big as and more persistent than the macroeconomic stabilization cost. Without actions, the effect of the shock on exchange rates, long term interest rates and country risk premium would have depressed the economy and it would have later required a much stronger policy action. The cost of a mistake was all in one direction: inaction was not an option.
In a world with increasing global uncertainty, emerging market monetary policy provides a lesson of robust policy, where risk management is a fundamental part of policy making, possible only in a credible and predictable policy environment.
1Evdokimova, T, P Nagy Mohacsi, O Ponomarenko and E Ribakova (2023) “Central Banks and Policy Communication: How Emerging Markets have Outperformed the Fed and ECB”, Peterson Institute for International Economics Working Paper No. 23-10.
2Gürkaynak, R. S., Sack, B. and Swanson, E. T. (2005). Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements. International Journal of Central Banking, 1 (1)
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