Egypt floats the pound – now it is time to implement a rule-based monetary policy framework

This morning we got some very good news out of Egypt as this statement was released by the Egyptian central bank:

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I have to say I agree with everything in the statement and I think it is the only right thing to do.

The pound almost immediately dropped 48% against the US dollar on the news.  There is no doubt that this in many ways will be unpopular in Egypt and we are likely to see a rather sharp initial spike in Egyptian inflation, which certainly will have short-term negative impact on the purchasing power of many Egyptians.

This is certainly regrettable, but we have to remember what the alternative was. The alternative was to continue the present policy of trying to ‘peg’ the Egyptian pound at a far too strong level and by doing so continuing to tighten monetary conditions.

The result of artificially trying to keep the pound (too) strong has been that we have seen a continued rather sharp slowdown in aggregate demand in the Egyptian economy at a time where we also have seen a rather significant negative supply shock from the continued very high level of political uncertainty and the lack of substantial economic reforms.

Therefore we have effectively entered a situation of stagflation in recent years – where a negative supply shock has pushed up inflation and continuous monetary tightening is causing growth to slow.

By floating the pound at least the downward pressure on aggregate demand growth will disappear.

Weak political structures and a weak economy necessitate a weak currency

There is no doubt that the fact that the pound today was halved in values in a matter of minutes will be a major shock to many (most) Egyptians. However, it is important to remember that if a country has weak political institutions and a weak economy then a weak currency is also a necessity.

Hence, the drop in the pound today really is not a result of the fact that the Egyptian central bank has floated the pound. This was not a devaluation – this was the market determining what the fundamental value of the pound should be given the state of the Egyptian economy and quality (or rather lack of quality) of Egyptian institutions.

Therefore, Egyptian policy makers should certainly not try to prop up the pound by returning to FX interventions. Rather Egyptian policy makers should ensure currency stability though economic and political reforms.

Egypt has a massive economic potential with the largest population in Northern Africa and a strongly growing labour force the country should easily be able to grow by at least 6-8% if not faster. The Egyptian government therefore should do everything to unleash this potential by implementing bold economic reforms.

I would particularly focus on eliminating all tariffs on trade and dramatically opening up the Egyptian economy for trade and investments. Furthermore, government-owned companies should be fully privatized as soon as possible and finally the legal framework has to be significantly strengthened so the rule of law applies and the projection of private property is strengthened significantly.

Such reforms would give a marked boost to the supply side of the economy and lift potential growth significantly, which in turn would help boost the currency without having to tighten monetary conditions. Said in another way if you want a stronger currency implement massive structural reforms rather than tightening monetary conditions.

Time to implement a rule-based monetary policy framework

Freeing up capital movements and allowing the pound to float freely is the first step in a necessary monetary reform. However, it should not be the final step. Rather the Egyptian central bank now should focus on formulating a clear rule-based monetary policy framework that will ensure nominal stability in Egypt.

I would certainly recommend a framework where the Egyptian central bank targets nominal GDP growth rather than inflation.

The main reason I prefer a nominal GDP target to an inflation target is that in a low-income country – particularly in one which hopefully undergoing structural reforms – a lot of the short-term movements in inflation is driven by supply side factors (for example changes in food prices and variation in political uncertainty). The central bank should not react to such shock and the best way to avoid that is targeting NGDP rather than inflation.

However, that does not mean that we cannot think of a long-term “inflation target”. Rather it might make sense to set NGDP growth targets for example every five years based on a expectation about trend real GDP growth in the economy and what long-term inflation you might have.

Hence, presently the IMF expect long-term real GDP growth of 5-6% (in 2020-2021). Given the extremely high growth rate in the labour force this is not particularly optimistic. An assumption of 5% real GDP growth therefore does not seem completely unrealistic over the medium-term given the present structures in the economy (but with less political uncertainty).

If we then say that we would like to see inflation of 5% (half of what we have seen in the recent years) then that would mean that the Egyptian central bank should target around 10% nominal GDP growth. 

This is in fact more or less the present growth rate of nominal GDP, which would make it a natural starting point for a new target for the central bank.

There are of course some very serious challenges with targeting nominal GDP in a country like Egypt, but I would not overestimate these challenges and the fact is that targeting inflation in a country with a lot of supply side driven variation in particularly consumer prices is no less of a statistical challenge.

Now lets hope that Egyptian policy makers are open for taking the next steps – massive structural reforms and the implementation of a new monetary policy framework. The sooner the better.


Update:

I have noticed that a number of news stories today have said that the Egyptian central bank “devalued” the pound. This is not correct. A devaluation of the currency is an active (typically discretionary) act of the central bank to weaken the currency.

This is not what the Egyptian central bank did today. Rather the the central bank gave up targeting the exchange rate and instead allowed the currency to float freely. The result was a depreciation (not a devaluation) of the currency.

 

Swedish monetary conditions are becoming too easy

Believe it or not – there is a country in the world where I now believe that monetary policy is becoming (moderately) too easy. Yes, that is correct – I will not always say that monetary policy is too tight. The country I talk about is Sweden. More on that below.

Assessing monetary conditions

I strongly believe that the assessment of the monetary stance of a country should not be based on for example looking at the level of nominal interest rates, but rather on whether or not the country is on track to hitting the central bank’s nominal target in lets say 12-18 months.

A way of assessing that is of course to look at market inflation expectations (if the central bank targets inflation as in the case of Sweden’s Riksbank). If inflation expectations are below (above) the target (for example 2%) then monetary conditions are too tight (easy).

An alternative to this approach is to look at other monetary indicators – for example money supply growth, nominal GDP growth, interest rates and the exchange rate. And this is exactly what we are doing in our (Markets & Money Advisory’s) upcoming publication on Global Monetary Conditions.

Policy consistency  

Hence for all of the nearly 30 country we analyse in the publication we look at the four monetary indicators mentioned above and compare the development in these indicators with what we believe would be consistent with the given central bank’s inflation target.

This means for example in the case of money supply growth we determine what money supply growth rate is consistent with the Riksbank’s inflation target of 2% given the trend in real GDP growth and and then trend in money-velocity. If the actual money supply growth rate is faster than our “policy consistent” growth rate then monetary conditions are too easy.

We have then calibrated the four indicators individually so a “zero” score is the policy consistent monetary stance and we think of the range between -0.5 and +0.5 as a “neutral stance”.

Four Swedish indicators

Below you see the development in the four monetary indicators for Sweden:

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What we are seeing is that both money supply growth and nominal GDP growth have been faster than the policy consistent growth rate since 2014-15 and the key policy rate has been below the  policy consistent level since mid-2014.

In terms of the exchange rate it has been the last of the four indicators to turn in a more “accommodative” direction, but recently the exchange rate development has also helped ease monetary conditions in Sweden.

Based on these four indicators we create a composite indicator for Swedish Monetary Conditions.

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As mentioned above the indicator is calibrated so that zero is monetary conditions, which is consistent with the Riksbank’s 2% inflation target. If the indicator is above (below) then the Riksbank is more likely to overshoot its inflation target in the medium-term.

We see that Swedish monetary conditions essentially have been too tight since mid-2009, but we also see that since late-2013 monetary conditions have become less tight and in the past two years or so we have been in the “neutral” range (above -0.5) and we are now approaching +0.5 meaning we are moving out of the “neutral” range and into the “too easy”-range.

Riksbanken needs to tighten monetary conditions

Riksbanken without a doubt has been one of the best performing central banks in the world in the post-2009 period and particularly the performance over the last couple of years has been very positive in the sense that inflation expectations seem to have become somewhat unanchored in recent years in the US and the euro zone, while the Riksbank has been able to ensure nominal stability and ensure that inflation expectations have been close to 2%.

However, we now – based on our monetary indicator analysis of Sweden – believe that the Riksbank is beginning to overdo it on the “easy side”. It is certainly not dramatic and there are absolutely no reason for the Riksbank to slam the brakes on and if the Riksbank is credible it is likely that the markets will do most of the job tightening Swedish monetary conditions – most likely through a stronger Swedish krona, but if that does not happen the Riksbank likely will have to more forcefully start to express concerns that monetary conditions are becoming too accommodative.

Finally, compared to this analysis the Riksbank’s monetary policy announcement last week seems to have been overly dovish. That said given the track-record of the Riskbank I don’t believe that it is about to make a major policy mistake, but I would certainly expect it to scale back on the dovish signal going forward.

Want to know more?

If you want to more on our Global Monetary Conditions publication (we still need a sexy title) and discussion the indicators or have suggestions please contact me (LC@mamoadvisory.com) or my colleague Laurids Rising (LR@mamoadvisory.com).

The publication will be a monthly and will likely be priced around EUR 2000 for 12 months.

Read more on the publication here and here.

 

 

 

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