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April 5, 2005
JS-2358 Monetary Policy in Emerging Market Countries with Implications for Egypt
Remarks at the Egyptian Center for Economic Studies
John B. Taylor
Under Secretary for International Affairs
United States Treasury
Cairo
April 5, 2005 Thank you for inviting me to speak today about monetary policy in emerging market countries and the implications for Egypt. One of the most rewarding parts of my job as U.S. Treasury Under Secretary has been working with officials in emerging market countries on the formulation and implementation of monetary policy. I particularly welcome the opportunity to speak here in Egypt today, because Egypt is not only making noteworthy changes on economic reforms in reducing tariffs and taxes, but also on monetary policy operations.
In recent years, a number of other countries have adopted monetary policies similar to those which Egypt is heading toward, and their experience is very encouraging.
First, inflation has come down significantly in countries that have followed these policies. Instead of spiraling upwards, nearly out of control, prices have become much more stable. We can call this the new era of price stability.
Second, recessions have become less frequent and milder and economic expansions have gotten longer. In other words, the new era of price stability has been accompanied by a new era of overall economic growth and stability.
I began studying this connection between price stability and economic stability back when I was a professor in the mid 1990s and I concluded that this connection is causal, not accidental. Why? Simply put, the improvement in price stability has virtually flattened the boom-bust cycles in which inflationary booms inevitably were followed by recessionary busts. In any case, by studying the experiences in other countries, I believe one can find important implications for Egypt.
Improvements in Price Stability
Figure 1 shows this reduction in inflation, or, in other words, the increase in price stability. Starting about 20 years ago, and then gaining momentum, the rate of inflation has fallen in every region of the world. This contrasts with the much higher inflation around the world from the late 1960s through the 1970s. The reduction in inflation in the United States in the late 1970s and early 1980s was one of the first successful attempts to move toward price stability and it ushered in a period of price stability that has been the subject of an enormous amount of research.
But while the movement toward price stability may have begun in the United States, the movement is clearly not confined to the United States, as Figure 1 shows. Inflation has declined for every region. Moreover, if you look at data for individual countries within the regions, you see the same phenomena. For example, looking at the data for countries in the Middle East, we see trends toward price stability in many countries in recent years. In 1990, six of the 12 countries in the Middle East, for which data are available, had inflation rates in double digits; and now, according to the most recent data, only three of 16 countries had inflation in double digits.
What brought about this reduction in inflation? I believe it can be traced to two factors. First, central banks began to focus more seriously on the goal of price stability, or low inflation. Second, and equally important, they developed more effective and systematic procedures for changing the instruments of monetary policy to bring about the price stability goal. Consider each of these factors in more detail.
Price Stability Goals
The increased emphasis on price stability first began in the late 1970s and early 1980s and now commands worldwide respect. This emphasis followed from the growing consensus that no long-run trade-off exists between inflation and unemployment or economic growth. In the 1960s and 1970s, economists thought a trade-off existed. The more recent view is that inflation is harmful to economic growth. It creates volatility, raises real interest rates, and reduces private investment. Inflation also hurts the poor, who are least able to hedge.
I recall best the change in focus in the United States. The intellectual forces included Milton Friedman's work on the inflation-unemployment trade off and the new rational expectations school of monetary policy, which lowered the estimated costs of reducing inflation. The practical implementation was, of course, the job of the Federal Reserve, and under Paul Volker's leadership polices were put in place to bring inflation down by radically changing how the instruments of policy responded to inflation. Since then, under Alan Greenspan's leadership, price stability has remained the goal. While not setting a specific numerical definition of price stability, Chairman Greenspan's statements that price stability occurs at a level of inflation at which inflation does not distort decisions suggest an inflation level of around two percent. Indeed, two percent was the target inflation rate I suggested as a benchmark in designing the Taylor rule.
As the importance of the goal of price stability spread around the world, a number of countries found setting a numerical target, or target ranges, to be useful. For example in the early 1990s Chile and New Zealand adopted specific numerical targets for inflation. In New Zealand, they even used the target as part of an official performance agreement between the governor of the central bank and the minister of finance. The Bank of England adopted numerical inflation targets in the mid-1990s. Since then, a number of other central banks--Canada, Brazil, Turkey, for example--have found setting numerical targets for inflation to be useful. Except for transition periods, the target for inflation is in all cases very low, and not too far from the two percent benchmark.
There has been some debate about whether setting a formal numerical target for inflation is useful. Clearly it is possible to achieve the goal of low inflation without setting a numerical target, as the Federal Reserve has shown, so the answer depends on circumstances in each country. Whether a numerical target is used or not, it is essential that the central bank takes the goal seriously and that it is understood to be a very low rate of inflation. It is easy to say that the goal is price stability, or to post such a goal on a central bank web page, but it is much different to actually make the decisions that will bring it about.
Systematic, Transparent Procedures for Setting Policy Instruments
A second important change in monetary policy is in the way central banks set their instruments of policy as they endeavor to achieve the goal of price stability. There are two main choices for the instrument of monetary policy: the interest rate, or a monetary aggregate such as the monetary base. Either type of instrument can be used to achieve an inflation target, but in recent years there has been an increased focus on the interest rate.
Increased focus on the interest rate has encouraged policy makers and economists to think more systematically and transparently about central bank decisions. They need to consider whether the change in the interest rate instrument is large enough, or too large. For example, they need to decide how much to raise interest rates when inflation picks up, and they need to know whether lowering interest rates when there is a recession is consistent with the goal of price stability. Furthermore, each adjustment decision and the policy instrument should not be viewed as an isolated one-time adjustment, but rather as part of a multi-period strategy taking expectations and their long-term effects into account. This is where the use of policy rules can be helpful.
The Taylor rule, for example, sets out certain principles that help policy makers determine whether the instruments are changed in a way that will achieve price stability. For example, it calls for increasing the interest rate instrument by more than an increase in inflation. This principle, which is imbedded in the Taylor rule, aims at increasing the real interest rate in the face of an increase in inflation. The Taylor rule also calls for lowering interest rates when there is a recession. And the use of such a policy rule emphasizes the importance of transparency and clear communications because it implies that these same principles will be applied in future decisions.
Experience has shown that central banks that have been successful in lowering inflation have followed these principles, and central banks that have not been successful in achieving price stability have not followed these principles. For example, during the late 1960s and 1970s when the Fed was not successful in achieving price stability, interest rates did not rise by more than increases in the rate of inflation.
As part of the effort to be more systematic and transparent, central banks now reveal much more information about how they arrive at their policies and what effects those policies have. They now release information about monetary policy meetings more quickly, and communicate to the public through speeches and press releases more than ever before. Effective central banks use these channels of information to inform the public of their strategy for monetary policy. It is especially useful for the public to know that the central bank remains committed to a long-term strategy for achieving price stability in the face of temporary ups and downs in inflation.
An important aspect of a transparent monetary policy is a unified exchange rate. A unified rate sends the clearest market signal and is far likelier than dual or multiple rates to be free of corruption and other distorting influences. In 2001, Egypt established a unified official rate. More recently, it eliminated differences between the official rate and the unofficial parallel rate. These are praiseworthy steps.
The Exchange Rate Question
When capital markets are open internationally the interest rate decisions described above have obvious implications for the exchange rate and exchange rate policy. There are two viable approaches to exchange rate policy. One is to adopt a flexible exchange rate so that the central bank is free to make the interest rate decisions according to the policy principles discussed above that are needed for price stability. The other choice, more relevant to small countries, is to join a currency union or adopt the currency of another central bank that follows good policy principles. An intermediate case is to adopt a pegged exchange rate, which does not create a permanent tie to another currency. But the lack of permanence has led to credibility problems and the frequent collapse of such pegs. The Bretton Woods system was based on such pegs and it indeed collapsed.
More recently there has been movement away from such intermediate exchange rate arrangements so that now many countries have flexible exchange rates. Among them are the United States, the United Kingdom, the euro area as a whole, as well as large emerging market economies such as Brazil and South Africa. The movement away from intermediate exchange rate arrangements is also visible to some extent in the Middle East. Egypt, Yemen, and Turkey have flexible exchange rates. Alternatively, some other countries have dollarized, adopting a foreign currency as their official national currency. By the IMF's count, 46 countries had flexible exchange rates at the end of 2003. There are also 50 countries and 30 or more territories that have monetary unions, dollarization, currency boards, or currency board-like systems.
Some Implications for Monetary Policy in Egypt
Having considered the principles of price stability and exchange rate regimes, how could these lessons be applied to Egypt? In 2004, inflation in consumer prices was 11.3 percent in Egypt. The rise in inflation from the low single digits that prevailed for several years previously is related to two factors. One factor is the gradual passing through of higher prices resulting from the depreciation of the Egyptian pound in 2003. The other factor is the revision of the consumer price index in 2004 to reflect prices more accurately. Appropriate monetary policy--emphasizing the principles that have worked in other countries--can ensure that these factors remain one-time occurrences. But, as our review of the experiences of other countries has shown, this requires (1) a strong commitment to price stability and (2) a policy for the instruments to achieve price stability.
Egypt is following a flexible exchange rate route, so it should be able to adjust interest rates by the right amount to achieve price stability. In this regard the change the Egyptian government undertook in the second half of 2004 to make Egypt's foreign exchange market more efficient are most welcome. The decisions to rescind the foreign exchange surrender requirement and to launch an interbank foreign exchange market have boosted foreign currency liquidity. Delays in obtaining foreign exchange for imports or profit remittances were a staple of the Egyptian business environment in recent years. They have disappeared, as has the parallel market for foreign currency. Removing these distortions will do much to promote sustained growth. The Egyptian pound has appreciated by seven percent against the dollar and by 12 percent against the euro since late December. It is the first appreciation since the pound broke its ten-year peg to the dollar in 2000. Confidence in the Egyptian pound reflects increased confidence in Egypt's economic policymaking.
The Central Bank of Egypt, under the leadership of Governor el-Okdah, has introduced more coherence into monetary management. Interest rates on Treasury bills and other savings instruments have been raised in an effort to counter inflation. And later this month, for the first time, the Monetary Policy Committee will meet to discuss a monetary policy framework, including goals and strategies to achieve those goals. Here it is important to state publicly a clear goal for price stability or low inflation whether stipulated as a formal numerical target of not. Here also is the time to be specific that the policy instruments--whether an interest rate or a monetary aggregate--be set in a way that will achieve this goal. There is no reason to postpone such actions while preparations to get better measures of inflation or better ways to forecast are underway. It may be sufficient for now to state what the instrument of policy will be and if it is the interest rate that it should change by enough to avoid reducing real interest rates when inflation rises.
To be sure, implementing a coherent monetary policy framework is particularly challenging in an emerging market country like Egypt. I reviewed some of these challenges in a paper I presented at a conference at the Bank of Mexico several years ago. It is often difficult to estimate the potential growth rate, the output gap, or the equilibrium interest rate. These challenges are greater where the informal sector is large and statistical coverage is limited. But none of the obstacles need be fatal to implementing a monetary policy framework oriented toward price stability, as I have discussed here.
Measures of inflation such as the consumer price index are never perfect. They are measures of where inflation has been rather than where it is going, and therefore need to be supplemented with forecasts of futures data. Judiciously used, these indicators offer information about the direction prices more generally are likely to take. Another way of dealing with lack of a reliable measure of inflation is to widen the target range for inflation, if an explicit numerical target for the rate of inflation is being used.
Fiscal dominance can also be a problem if the central bank is reluctant to raise interest rates when necessary because the government relies heavily on debt finance. There are two main ways to address the problem. One is to reduce government debt. Egypt's debt to GDP ratio is high. Restraint on spending combined with faster growth would reduce the ratio to a more comfortable level. The other way to address the problem is to make the central bank more independent. Changes to the banking law in Egypt in 2003 moved in that direction, but a more independent central bank would have a greater ability to make interest rate changes when appropriate.
To reduce government debt, and enhance economic growth, Egypt must focus on reforming its banking system. Like many other countries, Egypt nationalized its banking system, and it has paid a heavy price. Directed lending channeled funds to state-owned enterprises, depriving viable private sector firms of credit. Almost everywhere, government-dominated banking systems have been a hindrance rather than a help to economic growth. The government recently adopted a plan to reform the financial sector. Plans to reduce nonperforming loans at the state banks, the commitment to privatize the Bank of Alexandria by the end of this year, and the sale of state shares in some joint venture banks are tangible signs of the government's belief that the state's role in the financial sector must be reduced. Privatizing other state banks would also be beneficial. By providing greater efficiency in providing credit, a liberalized financial system will spur growth. It will also help monetary policy by providing market-based information that is critical for helping the central bank to make good decisions.
Other Recent Economic Reforms in Egypt
Moreover, the changes in monetary policy that I have focused on here serve as part of a broader set of reforms now being undertaken in Egypt. The United States supports President Mubarak and Prime Minister Nazif's joint vision of a more competitive, dynamic economy that meets the growing employment needs of the Egyptian population. The Prime Minister and his cabinet have already established their reform credentials by enacting a number of significant measures, including trade and tariff reform; foreign exchange market reform; and adjustments in administered prices. These market-oriented reforms have already paid dividends by boosting investor confidence in Egypt. Foreign direct investment in Egypt and portfolio inflows are on the rise. The Egyptian stock market has outperformed almost every other equity market in the world, rising more than 100 percent in the last nine months.
The reforms enacted to date are just the first stage of those necessary to bring about the growth Egypt needs. Nor will reform be quick and painless. Fulfilling Prime Minister Nazif's vision will require sustained strong, and at times difficult, actions by the cabinet and the People's Assembly. Plans to reduce personal and corporate income tax rates, reform the financial sector, and privatize many state-owned firms are welcome. The subsidies distort the economy and place a heavy burden on government finances, which also need sustained reform. Carrying out reforms will further improve investor confidence in Egypt and improve the nation's ability to compete in the global economy.
Conclusion
Other countries have faced challenges similar to Egypt's and have addressed them. As I mentioned, price stability is being achieved in many countries around he world. Price stability has proved to be a robust framework capable of operating in a variety of environments. So, even though Egypt faces a variety of challenges in implementing monetary policy, it can employ solutions successfully applied elsewhere. And, success in monetary policy will contribute enormously to Egypt's fundamental economic challenges of economic growth, job creation and raising living standards.
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