Currency stability is now the pre-eminent monetary policy objective in nearly all jurisdictions. While there are many ways of achieving it, the consensus is that this objective should not be blurred or side-tracked by other policy objectives, however desirable they might be in the short term.
Following the Asian financial crisis of 1997 and 1998, there has been extensive discussion in international financial forums about the pros and cons of different exchange rate regimes. This was, as it should be, often conducted in the context of the wider subject of which monetary policy objective is the appropriate one and how it should be achieved. Indeed, the exchange rate is merely one of the instruments, though often the crucial one, for achieving a monetary policy objective, whatever it happens to be.
Obviously, in such a discussion, it is difficult to generalise, for it is essential to take into account the circumstances of individual economies, including the economic structure and, most important, the preference of the people. But current practice seems to indicate a consensus that the objective of monetary policy that should be accorded overriding importance is currency stability. There seems also to be a consensus among financial experts and policy makers throughout the world that this objective should be a very focused one, in that it should not be blurred by the presence of other objectives, however desirable they may be, if the policy is to command credibility. The general view is that a stable currency, in the long run, facilitates the achievement of such other desirable objectives as high economic growth and low unemployment. Furthermore, given the limited monetary policy tools available - in effect, a single tool in the form of either the interest rate or the exchange rate - it would be impracticable to set multiple objectives for monetary policy.
Again, the consensus is that it is essential, to ensure the credibility of monetary policy, that there should be an unambiguous definition of currency stability. Here, in terms of current practice, a low inflation rate is the more common definition. But for externally oriented economies, where domestic prices are strongly influenced by the prices of their trading partners, a stable external value for the currency, i.e. a fixed exchange rate, is often more suitable. As markets become increasingly global, this requirement for clarity intensifies, and this is particularly so for the small and open economies, whose markets are often dwarfed by voluminous and volatile international capital. This has further encouraged explicit inflation targeting in the conduct of monetary policy or the use of rule-based exchange rate systems of the currency board type.
It is, of course, up to individual economies to weigh the costs and benefits, and to choose which of these realistic and focused monetary policy objectives to pursue in the light of their own circumstances. They also need to decide which monetary mechanisms to adopt in achieving the chosen objective. It is commonly recognised that in trying to maintain a low inflation rate, whether or not there is an explicit target, the interest rate is the only monetary policy tool and the exchange rate will basically have to be allowed to float freely. But, depending on the degree of external orientation of an economy, the exchange rate does impact upon domestic prices, and therefore will have to be taken into account in the discretionary determination of interest rates. And the exchange rate, which in most cases is expressed against the US dollar, is dependent, among other things, on the interest rate differential between the domestic currency and the US dollar, particularly when the currency is freely traded in global markets. This often constrains the discretion in the determination of domestic interest rates. The higher the degree of external orientation of an economy, the greater is this constraint. In effect, a small and truly open economy that is also highly externally oriented does not really have an interest rate policy that is meaningfully independent of world - in particular US - interest rates.
It is also generally recognised that, under the alternative objective of maintaining a fixed exchange rate, whether or not through currency board arrangements, there is no scope for the manipulation of interest rates, which will have to follow those of the anchor, foreign currency. The level of interest rate of another currency, obviously, is not always "appropriate" when one considers objectives other than a stable exchange rate. And these other objectives may be highly desirable, particularly in the short term: for example, boosting economic growth, creating employment opportunities or stabilising property prices. But it has to be accepted that these are primarily not "appropriate" monetary policy objectives. However, the temptation, and the political pressure, to use interest rates to achieve these desirable objectives can at times be great. They are nevertheless to be firmly resisted. International practice clearly suggests that monetary policy should be very focused and consistent in its objective if it is to have long-term credibility in a global market environment.
Joseph Yam
29 June 2000
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