Four graphs EM central bankers should study – lessons from two Reserve Banks (1997-98)

This week has brought more turmoil in the global Emerging Markets and this has caused a number of EM central banks to move to hike interest rates to “defend” their currencies (despite most Emerging Markets today officially have floating exchange rate regimes). Most notable the the Turkish central bank on Tuesday in a desperate move hiked its key policy aggressively. So far the aggressive actions from EM central banks around the world have done little to calm nerves in the global markets.

I have in a number of posts warned that this fear-of-floating can have a rather catastrophic macroeconomic and financial impact and that central bankers in Emerging Markets need to remain committed to the floating exchange rate regimes. Indeed I think central bankers need to learn a lesson from history.

In that regard I think it is illustrative to look at the experience of two countries, which had floating exchange rates and inflation targeting regime during the Asian and Russian crisis in 1997-98. I will here look at the conduct of monetary policy by the Reserve Banks of New Zealand and Australia in this period.

While the two Reserve Banks had very similar policy frameworks they reacted very differently to the external shocks in 1997-98. I will illustrate this with four graphs. Four graphs that today’s central bankers in Emerging Markets should study very closely to avoid repeating past mistakes.

The twin currency collapse

In a very similar fashion to today’s sell-off in Emerging Markets currencies in a number of countries came under serious depreciation pressures in 1997-98 as the both the Asian and the Russian crisis played out. That was also the case for the Australian dollar – the Aussie – and the New Zealand dollar – the Kiwi. Hence, during 1997-8 both the Aussie and the Kiwi weakened by 25-30%.

Aussie Kiwi

To hike or not to hike?

The sharp depreciation of the Kiwi and the Aussie caused inflation fears to increase. The Reserve Bank of New Zealand feared that a weaker currency would push up inflation as a result of higher import prices. On the other hand the Reserve Bank of Australia was more concerned with the negative impact of the negative shock to demand coming from a collapse in external demand.

This different perceptions of the risks led to different policy responses. Hence, the RBNZ reacted by pushing up interest rates during 1997 (only later to reverse its policy stance sharply in 1998), while the RBA kept its key policy rate on hold all through 1997-98. It is also notable  that these very clear differences in interest rate developments did little to change the performance of the Kiwi compared to the Aussie. This indicates that aggressive rate hikes will not help much if you want to prop up your currency in such environment.

rates NZ AU

Little difference in inflation performance

Hence, during 1997 there was a marked difference in the development in monetary conditions in the two countries. However, it is notable that there was very little difference in the inflation performance of the two countries.

Despite the sharp sell-off in both the Kiwi and the Aussie inflation remained low and below 2% in 1997-98 in both countries and it is very clear that the “import price effect” was nearly irrelevant compared to the negative demand effect.


New Zealand’s unnecessary recession

While there was very little difference between the inflationary developments in the two countries in 1997-98 the story was very different when it comes to real GDP growth.

Hence, the graph below very clearly illustrates that the RBNZ’s interest rate hikes caused the New Zealand economy to go into recession. Obviously the RBNZ claimed that it was the result of the negative external shock. However, looking the what happened in Australia it is very clear that the recession in New Zealand was a result of monetary policy failure. In fact the RBA by not panicking and keeping its key policy rate unchanged ensured that recession was avoided in Australia despite being as negatively hit by an external demand shock as New Zealand.

This very clearly demonstrates that the central bank has the final word when it comes to nominal spending/aggregate demand in the economy. Any negative demand shock – whether a shock to exports or fiscal tightening – can be offset by monetary policy. The RBA seems to have understood this, while the RBNZ failed to understand it – which rather negative consequences.


The TCMB just repeated the 1997-mistakes of the RBNZ 

The conclusion from the experience in 1997-98 in Australia and New Zealand seems clear – there is very little to gain from fighting a currency weakening caused by a major negative shock and monetary tightening in respond to such a shock is very likely to be recessionary.

This week’s monetary tightening in Turkey is much bigger than what we saw in New Zealand in 1997 and it is therefore only natural to think that the impact on Turkish real GDP could be at least as negative as was the case in New Zealand in 1997-98. Therefore, the Turkish central bank (TCMB) should of course reverse cause as fast as possible. Yes, inflation is likely to increase as a result of a weaker lira, but the monetary policy response could also send the Turkish economy into recession.

Central bankers in Emerging Markets should stop fighting the depreciation of their currency and instead focus on their medium-term nominal policy objectives. Stop-go policies as presently being implemented in Turkey are likely to end in tears.

Instead EM central bankers should stay calm and let markets determine exchanges like the Reserve Bank of Australia did in 1997-98 and then it is likely that they will avoid importing recessions and financial distress and at the same time  any major risks to their nominal policy objectives in the medium-term.

HT David Laidler