In December, the National Bank of Ukraine hosted its traditional workshop Monetary Policy in Emerging Markets: Crafting Integrated Solutions. Leading economists and experts from the International Monetary Fund, the European Central Bank, the central banks of Ukraine, Poland, Georgia, Chile, and the Dominican Republic, as well as analysts from Germany, Austria, and the Czech Republic and representatives of the academic community, attended the event.
This year’s workshop focused on crafting an integrated policy framework that contributes to achieving macroeconomic and financial stability in the face of global challenges. The event’s program included both cutting-edge fundamental research in specific areas and presentations of empirical models that central banks can use to expand their policy toolkits.
"Not just Ukraine, but all countries are facing the challenges and consequences of uncertainty – Emerging Markets are no exception. Striking a balance between short-term emergency measures and strategic goals is a task that faces us all. I believe that integrated approaches, the exchange of experience, and international cooperation are key elements for success in this endeavor," said NBU Governor Andriy Pyshnyy as he opened the workshop.
In today’s environment of large economic shocks and uncertainty, central banks in Emerging Markets should pursue flexible policies. However, it is important to maintain a clear focus on a coherent strategic goal. Finding an optimal balance between flexibility and consistency is key to achieving macrofinancial stability. As Governor Pyshnyy said, "russia’s war against Ukraine, the unstable geopolitical situation, and global economic shocks... require effective and strategic responses from central banks."
Below are the key takeaways from what the speakers at the NBU’s workshop talked about.
Expanding the toolkit of central banks is necessary for optimal monetary policy response to short-term shocks
For small open economies that are deeply integrated into the world economy, conventional interest rate instruments may not be sufficient amid large global shocks. This is especially true for Emerging Markets, which are extremely sensitive to adverse global events that pose considerable risks of sudden stops to foreign investment inflows and of sharp capital outflows.
To achieve macrofinancial stability, central banks in Emerging Markets are therefore increasingly using an unconventional mix of policy tools that apart from interest rate policy also includes foreign-exchange interventions (FXIs) and capital flow measures (CFMs). A balanced policy mix allows central banks to meet their goals and control inflation expectations.
The IMF’s Marcin Kolasa, a key speaker at the workshop, presented a theoretical model that makes a strong case for using FXIs and CFMs as useful complements to conventional instruments. The findings suggest that such an augmented toolbox can significantly enhance the effectiveness of monetary policy, especially for countries more vulnerable to external shocks, including due to less-anchored inflation expectations and significant FX mismatches.
Capital flow management and international reserves accumulation reduce the risks of economic destabilization going forward
Not only can a number of unconventional central bank policy instruments be an effective anti-crisis measure, they also may be used to maintain macrofinancial stability in the long run. In one instance, the buildup of foreign reserves can create a safety buffer to tide the economy over potential emergencies in the future by mitigating uncertainty for financial markets now.
Luis Felipe Céspedes of the Central Bank of Chile showcased a study on optimal foreign reserves. Based on a structural model and empirical evidence, he highlighted a number of factors that affect the optimal level and speed of international reserves accumulation. Those include the risk premium, the depth of financial markets, the level of uncertainty, and the degree of financial stress.
Capital flow management could also be another tool to use for maintaining stability in the long term. Alejandro Van der Ghote of the European Central Bank substantiated the application of capital controls amid significant inflows of international investment into Emerging Markets. Investment inflows that are accompanied by an increase in a country’s share of foreign-owned domestic equities restrain the impact of conventional central bank tools due to frictions in economic relationships. Capital controls can be used to reduce mismatches and prevent potential adverse effects.
Ensuring macrofinancial stability requires effective fiscal-monetary interaction
Global experience and countless studies show that fiscal and monetary policies can both hinder each other and work in synergy to produce positive effects in achieving the legally defined goals of each institution. Max Breitenlechner from the University of Innsbruck presented the results of an analysis of the fiscal channel of monetary policy. His work shows that in a stagflationary environment, tax cuts are the optimal fiscal response that can reinforce the impact of monetary policy. By contrast, supporting consumption through direct social transfers under such conditions may pose greater inflationary risks, impede the effectiveness of monetary policy, and ultimately lead to greater losses for the country’s economy.
The roles of monetary and fiscal policies in achieving macrofinancial stability need to be clearly distinguished. Gernot Müller from the University of Tübingen outlined the results of estimating the optimal interaction between monetary policy and fiscal policy based on a complex multi-sectoral structural model. While monetary policy is the main stabilizer of the aggregate economy, the effective fiscal policy involves stabilizing specific sectors that have suffered the most. Such a combination allows for effective interaction and restrains trade-offs that may arise when adverse multifaceted shocks occur simultaneously.
Effective use of combined policy instruments requires a consolidated and integrated analytical approach
The central bank may use various challenge-specific tools. However, all elements in its toolkit must be coordinated with each other and applied in an integrated manner. This requires an analytical approach to modeling and forecasting that integrates a mix of instruments and accounts for their interrelationships.
Jesper Lindé of the IMF, a key speakers at the workshop, presented an Integrated Policy Framework (IPF) model that is estimated for a number of small open economies. Such a model makes it possible both to simulate the features of applying policy tools in specific countries within a historical horizon and to identify their optimal combination going forward. The results of the model’s estimation based on data from advanced economies and emerging markets provide compelling evidence that the use of FXIs and CFMs, together with interest rate policy, increases the effectiveness of central banks’ monetary policy in developing economies.
The IMF’s Adam Remo spoke about another analytical method that incorporates a set of policy instruments. He described the Forecasting Model of Internal and External Balance (FINEX), which builds on a simpler and more conventional Quarterly Projection Model that is widely used by central banks around the globe, including the NBU. Although FINEX draws on the insights from the IPF model, FINEX is simpler to maintain and apply for macroeconomic forecasting and policy analysis purposes.
It is important to keep a balance between the complexity of models and their comprehensibility to the public
Volodymyr Lepushynskyi, Director of the NBU’s Monetary Policy and Economic Analysis Department, said that given the specific features of flexible inflation targeting, the need to improve the analytical toolkit is particularly relevant for Ukraine. Using FINEX, we can take into account an economy’s current conditions and expand the options for analyzing a set of policy instruments.
Shalva Mkhatrishvili of the National Bank of Georgia and Nabil López of the Central Bank of the Dominican Republic also shared their experience applying advanced models. They agreed that in the current environment of global shocks and high uncertainty, crafting and applying appropriate analytical methods is a difficult but urgent task.
Despite substantial scientific and practical achievements, there is a need to consider the usual trade-off between complex models that cover numerous aspects of the economy and simpler models that are easier to interpret and that avoid yielding a distorted understanding of economic relationships, emphasized Jaromir Benes of OGResearch. Central banks should have different models in their arsenal that can be applied under specific conditions, he said. However, it is not only the analytical capabilities of central banks to maintain their modeling toolkits that are important, but also the correct communication of modeling results both within the institution and out to the public.
"The insights we got from the speakers today have significantly enriched our understanding of the complications of the real world and our ability and attempts to model it… We anticipate that the knowledge and connections gained today will... strengthen our collective efforts toward achieving macroeconomic stability and steady growth," said NBU Deputy Governor Sergiy Nikolaychuk as he recapped the event.
A video of the workshop is available here, and the speakers’ presentations and program can be found on the event’s special landing page.