Wolfgang Münchau has a good up-ed on the risk of deflation in the euro zone, while I do not agree with everything Wolfgang says I think he is 100% right about the significant risk of deflation in the euro zone and that bold policy action is urgently needed to curb deflationary pressures in the euro zone.

I particularly find this paragraph interesting:

Remember what happened in Japan? Once its economy settled to a new steady state with negative inflation and zero growth rates during the 1990s, it got stuck in a hole. There is still a dispute over whether fiscal or monetary policy is the more suitable instrument in such a situation. But there is no dispute that a policy mixture that consists of fiscal rigour, excessive monetary tightness and a refusal to deal with the zombie banks is not going to work. The ECB always says Europe is not Japan. Indeed, it is not. Europe’s position is potentially worse.

I am in Stockholm today, but it is not the Swedish economy which is on my mind – rather it is Kazakhstan. On Tuesday the Kazakhstani central bank devalued the Kazakh tenge by 19%. This is what I have said about the issue another place:

 The latest ‘news flash’ in the still-ongoing emerging market turmoil was the decision of the National Bank of Kazakhstan (NBK) to devalue the Kazakhstani tenge by around 19% on Tuesday. In line with other emerging market currencies, the tenge has been under pressure for some time. The central bank has been intervening and the foreign currency reserve has been in steady decline for some time. However, the pressure on the tenge has been fairly ‘light’ and therefore Tuesday’s large devaluation was a surprise. We believe the devaluation was a pre-emptive move rather than the NBK caving into pressures.

It should also be noted that since the NBK has been intervening to keep the tenge stable, it has only weakened moderately against the US dollar. Most other emerging markets’ more freely floating currencies have been weakening significantly over the past year.

If we compare the development in the tenge with the Russian rouble since early 2013, we see that the devaluation has just brought the tenge more or less in line with the sell-off in the rouble over the past year. Hence, over this period, the rouble has weakened by around 15% against the US dollar, while the tenge had only weakened a couple of percentage points prior to Tuesday’s devaluation. Therefore, the 19% devaluation could be said to have more or less aligned the tenge with its ‘peers’.

The decision to devalue the tenge does not come without some cost. First, it is likely to push inflation up – at least in the short term. Even though we do not expect a major spike in inflation, it is unlikely to make the decision to devalue more popular among Kazakhstanis. Second, the drop in the value of the tenge also means that we will see an increase in foreign-denominated debt – something which will be not welcomed by the Kazakhstani banking sector, which continues to struggle with large debt problems.

However, overall we believe that the NBK made the right decision. With risk remaining on the downside in oil and gas prices – Kazakhstan’s main exports – and emerging market outflows continuing, it is likely that the tenge could come under more pressure in the future, particularly taking into account that the currency had become significantly overvalued versus peers such as the rouble. Therefore, the NBK would have been forced to continue its policy of FX intervention to prop up the tenge. This does not come for free.

Hence, FX intervention is effectively monetary tightening. When the NBK sells foreign currency to prop up the tenge, it is effectively reducing the money base. The cost of this is a potentially sharp reduction in economic activity and a pronounced risk of financial sector distress, which could spark another banking crisis. Hence, the cost of having tried to maintain an artificially strong tenge would be significantly bigger than the short-term cost of the devaluation. In this light, we think the devaluation was a wise move. Furthermore, a devaluation seems preferable to the kind of draconian capital controls seen in Ghana and Ukraine (two other commodity exporters) recently, or the steep interest rate hike introduced in Turkey.

Going forward, we think it is fairly clear that Kazakhstani growth is likely to soften on the back on the capital outflows seen over the past year. However, the decision to pre-emptively and aggressively weaken the tenge is likely to soften that blow, which should help support growth towards the end of the year.

However, now the big question is what the NBK will do going forward. We believe that the right thing to do would be to move closer to a more freely floating tenge or at least a currency regime that is more flexible than has been the case in Kazakhstan. On the other hand, we are not sure that Kazakh policy makers are ready to take that step yet. A lot is dependent on overall EM sentiment and the development in commodity prices going forward. Events could force the NBK towards a truly freely floating tenge, but if capital outflows die down, we believe the NBK will try to keep the tenge fairly fixed around current levels against the dollar.

Yesterday I wrote a short blog post praising Colombian central bank governor Jose Dario Uribe for not fighting ten weakening of the Colombian peso. This post is a follow-up post. It is slightly less positive about the performance of the Colombian central bank, but I also give some policy advise (for free!) to Uribe and his colleagues.

Colombia is a commodity exporter and hence I think it is useful to look at whether Colombia could benefit from moving closer to what I have called an Export Price Norm (EPN). The idea with the EPN is that a central bank can increase nominal stability by pegging the currency to the price of the country’s main export good or to a basket of for example the dollar and the export price.

Colombia exports a broad basket of commodities ranging from petroleum, coffee, coal, nickel, emeralds, apparel, bananas, and cut flowers! It might therefore make more sense to focus on a basket of commodities rather than on one commodity. One can easily construct such basket based on Colombia’s actual export shares, but I here for illustrative purposes (because I don’t have time for anything else) use the so-called CRB-index, which is a broad basket of commodities.

The interesting thing is not the price of commodities in US dollars, but rather the price of commodities measured in local currency – the Colombian peso. Under a strict Export Price Norm a drop of 1% in the commodity index the central bank’s peg would lead to an automatic 1% drop in the currency. Hence, under an EPN the export price in its own currency would be stable.

The graph below illustrates the relationship between nominal GDP growth (our measure of nominal stability) the CRB-index measured in Colombian peso.

The graph shows that there is a fairly high correlation between on the one hand Colombian NGDP growth and the CRB-index in local currency on the other hand. The correlation is certainly not perfect, but it should be remembered here that I used the CRB index rather than an actual basket of Colombian exports. Anyway, it is pretty clear that there over the past 15 years or so has been a fairly close relationship between the two – when commodity prices measured in peso increases NGDP growth will pick-up within 1-4 quarters.

This in my view indicates quite clearly that the Colombian central bank could stabilize nominal GDP by at least “shadowing” commodity prices. Hence, if commodity prices drop the central bank could take action to push the peso weaker to make up for the drop in  commodity prices (export prices).

The graph, however, also shows that there is not a one-to-one relationship between export prices and NGDP growth. Hence, it would certainly not be wise just to peg the peso to for example the CRB index. However, it might make sense to use an index of export prices in peso as a policy instrument to target NGDP growth 12-18 months ahead. I am sure that the good economists at the Colombian central bank could fairly easy calculate what basket of for example the US dollar and export prices, which would best forecast NGDP growth 1-2 years ahead.

Was 2011-12 a policy mistake? 

The graph above shows that the CRB index in peso increased sharply in 2010-11 and as a consequence nominal GDP growth pick-up strongly peaking above 15% y/y in late 2011. However, going into 2012 Colombian “export prices” (CRB index in peso) dropped sharply and within the year NGDP growth eased off sharply.

This might obviously not be a policy mistake as NGDP clearly was growing too fast in 2010-2011, which warranted monetary tightening. However, the swings in NGDP have been quite large. Therefore, if the Colombian central bank had done more to moderate the swings in Colombian export prices the development in NGDP growth would have been much more stable.

Monetary easing is warranted – but no drastic measures are needed

During 2013 NGDP growth slowed to well-below the long-term “target” (or rather trend) of around 7-8% y/y. Monetary easing therefore has seemed warranted and as commodity prices seem to continue to trend downward as worries over China have grown it is right for central bank governor Uribe to welcome a weaker peso. This is exactly what the Export Price Norm would tell Uribe to do. That said, NGDP growth has been picking-up so Uribe should be careful not overdoing it on the easy side.

Overall, I think it would make sense for the Colombian central bank to target NGDP growth (level targeting) of 7-8%. Given that trend RGDP growth is probably about 4-5% that would lead to around 3% inflation over the medium-term.

Let the market do most of the work

If governor Uribe announced today that he in the future would keep a very close eye on Colombian export prices measured in peso and that he would intervene in the currency market and/or change interest rates to ensure a development in export prices, which would ensure 7-8% NGDP over the coming 12-18 months then I think he would have a fairly easy job stabilizing NGDP growth AND also achieve his stated inflation target of 3% over the same time horizon. And more importantly – it would be the market, which would do most of the lifting given the expectation of intervention if export prices in peso moved to too much in any direction.