The Bank of Jamaica has been targeting higher growth and not the exchange rate


Friday, August 24, 2018

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On Wednesday, Minister of Finance Dr Nigel Clarke released his correspondence with Bank of Jamaica Governor Brian Wynter over undershooting the inflation target to the press.

Both he and the governor then participated in a subsequent press briefing covered in an excellent article by Balford Henry entitled “BOJ denies manipulating the exchange rate” in yesterday's Jamaica Observer, the gist of which has also been covered in other media. However, despite this briefing, it still appears necessary to resolve the confusion in the public's mind over what undershooting the inflation target actually means, as well as the Bank of Jamaica and International Monetary Fund's (IMF) policy on the exchange rate.

The principal point of confusion is the use of similar “technical” language for both “undershooting” and “overshooting” the inflation target. Jamaicans are not used to the idea, unlike advanced countries over the past decade, of inflation being below, as opposed to above target.

Inflation in Jamaica has almost always been above target, often well above, which is clearly a bad thing in almost all respects. The use of the word “breach” compounds the problem, as the imagery is of breaking a wall or perhaps an opening in the hull of a boat.

Nevertheless, the undershooting of the inflation target, which from the letters appears to be reviewed on a rolling year-on-year basis, should not be viewed in the same manner as an overshooting of the inflation rate. Over the past decade inflation rates in the developed countries have repeatedly undershot the typical target of two per cent. The main reason this was a concern for them (low inflation is after all a good thing as the governor also noted at the press conference) has been because it typically meant that the economy is, weaker than expected, and that potential growth and employment is therefore, below what it could be. The same appears to be true in Jamaica.

Both the Bank of Jamaica and the IMF have repeatedly made the point that they do not want a higher rate of devaluation to increase inflation to meet the inflation target. Jamaicans should believe them.

In the case of the Bank of Jamaica, the governor explicitly denied that they are trying to get inflation higher by manipulating the exchange rate. As he quite rightly noted, central banks like stable and predictable prices, or as he put it more graphically “we don't want more inflation – believe me”.

He noted, however, that the central bank has been cutting interest rates because they believe that the interest rates facing small businesses “are still too high”, although he confirmed that their current forecast was that inflation would meet their five per cent target (the mid point of their four to six per cent range) without further cuts in interest rates.

Minister of Finance Dr Nigel Clarke, in his own presentation, provided the context to the discussion. “Why are we concerned about inflation dipping below target?” he asked rhetorically. He noted that they are not concerned that inflation is low, but if it limits the space of the central bank to respond to, say, a weak economy. Their current number one priority of macroeconomic stability and debt reduction necessitates a tight fiscal policy, which means that they want monetary policy to be as accommodative as possible to encourage private sector credit expansion to create favourable conditions for growth and job creation.

Clarke described this as an advantage of having our own monetary policy, in that we could have both a tight fiscal and loose monetary policy. He had therefore encouraged the governor in his response letter to “carefully balance the risk of overshooting the inflation target” against “the risk of continuing to miss the inflation target on the downside by failing to fully exploit the space for accommodative monetary policy action in the face of continued sluggishness in demand”.

The minister also usefully addressed the other “gross misunderstanding” in the way the Bank of Jamaica now interacts with the foreign exchange market, namely the new auction system.

The fact that when using the auction system someone got filled at $138 (meaning the Bank of Jamaica technically bought US dollars from them at $138), does not mean that the Bank of Jamaica wanted the rate to go to $138 to US$1. This is simply the result of the rules of the auction, and would be at the top of a much lower range.

Furthermore, a look at the IMF's last article 4 review, which, although released in April, would have been prepared in March when the exchange rate was just under $126 to US$1, reveals that using their preferred measure — the real effective exchange rate — the IMF thought that “the external position is broadly in line with medium–term fundamentals and desirable policy settings”.

On the basis of their then projection of the current account deficit of roughly three per cent of gross domestic product for the fiscal year, their second preferred measure — “current account sustainability” — actually had the real exchange rate undervalued relative to their expected norm for Jamaica's current account deficit.

Finally, their third measure — the very long-term “external sustainability” approach, which looks at the net overall net international investment position — explained that the external position was in line with medium-term fundamentals and desirable policies.

In short, the missing of the inflation target simply meant growth in Jamaica was below what it should and could be.

Our central bank cut interest rates to spur faster credit creation to achieve faster growth and, therefore, job creation. The current low pass through from the fall in the exchange rate to prices is just confirmation of a depressed economy.

The IMF, which only does its exchange rate assessments once a year, did not think the exchange rate overvalued in March, and therefore would not have called for further devaluation in June, particularly as net international reserves, at US$3.1 billion, are well above the required target at this point in the programme.

The key issues then become what a “disorderly” market correction in a thin foreign exchange market means for the IMF and Bank of Jamaica (and the associated issue of dealing with excess Jamaican dollar liquidity), and how to achieve an albeit difficult transition to the single target of inflation, with a level of communication and transparency that can meet the needs of the everyday man.

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